Over the past several years, a number of transactions in the credit default swap (CDS) market have been scrutinized by the public, market participants and regulators. These transactions — which we have labeled as “opportunistic CDS strategies” in previous publications — have generally involved a lender providing some financing to another company in a manner that also benefits the value of the lender’s CDS positions. These transactions have been viewed in various lights, from creative and lucrative to sharp and unfair, and to some as potentially illegal market manipulation under applicable securities and commodities regulations.

Market participants and regulators have spent the past year and a half attempting to address these opportunistic strategies, a process resulting most recently in changes to the language utilized in market standard contracts as well as the potential for aggressive regulatory investigations and enforcement actions for market manipulation.[1] Regulators have gone so far as to suggest that they will pursue investigations regardless of whether courts would ultimately agree with their view of what is or is not market manipulation. Regulators well know that such investigations are expensive and risky propositions for market participants, and that the threat of an investigation alone may have a chilling effect on future opportunistic strategies. But there is a risk of defeat in litigation and the setting of unhelpful precedent for the regulators as well, particularly given the high bar for establishing market manipulation under the securities and commodities laws. Indeed, the stakes are now high in the changing landscape of the CDS market.

A Brief History of the Recent Opportunistic Strategies

Opportunistic strategies have existed in the CDS market for much of the life of the product. Those strategies have taken many forms and have evolved over time as market participants gained a better understanding of the CDS contract and the various changes made to the product over time. Over the past few years, however, opportunistic strategies have flourished, or at least the amount of media attention devoted to them has, and include Hovnanian (2018), McClatchy (2018), Sears (2018), Supervalu (2019) and Neiman Marcus (2019), to name just a few.

The relatively negative press coverage, coupled with a sense of impropriety in these strategies, has brought regulatory scrutiny to the CDS market. The voluntary defaults of both Codere and iHeart received, at least publicly, little regulatory scrutiny. These strategies did, however, involve voluntary defaults on debt controlled by CDS market participants (Codere) or the borrower (iHeart). Hovnanian, on the other hand, did not fly under the radar. The elaborate structuring of a debt exchange designed to trigger the CDS contract and involving the creation of cheap debt to maximize return on a potential CDS settlement as well as the widely publicized litigation that ensued caught the attention of regulators. This is not to mention that a number of market participants standing to lose from the strategy lobbied regulators to intervene.

However, voluntary default strategies are not the only ones that have attracted public scrutiny. Strategies reducing or, conversely, increasing the amount of qualifying debt for purposes of settling the CDS contract have also been prevalent. Cases such as McClatchy, Sears, Supervalu and Neiman Marcus this past year alone come to mind in this respect and have had their share of impact on trading or settlement prices..[2]

Regulators and market associations have reacted to these opportunistic strategies with gradually increasing alarm. Initially, on April 11, 2018, the International Swaps and Derivatives Association’s (ISDA) board of directors warned that manufactured credit events “could negatively impact the efficiency, reliability, and fairness of the overall CDS market,” and ISDA would consider material changes to its documentation to address manufactured events.

A week after ISDA’s cautionary note, the Commodity Futures Trading Commission (CFTC) warned CDS market participants that “manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities.” The CFTC further admonished that “[m]arket participants and their advisors are advised that in instances of manufactured credit events, the [CFTC] will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS.”

When market participants nevertheless continued to engage in opportunistic strategies, regulators upped the ante. On June 24, 2019, Securities and Exchange Commission (SEC) Chairman Clayton, then-CFTC Chairman Giancarlo, and UK FCA Chief Executive Bailey issued a joint statement announcing a collaborative, cross-border effort among their agencies to end the practice of opportunistic defaults in the CDS market. The regulators warned that “the continued pursuit of various opportunistic strategies in the credit derivatives markets, including but not limited to those that have been referred to as ‘manufactured credit events,’ may adversely affect the integrity, confidence and reputation of the credit derivatives markets, as well as markets more generally. These opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws, as well as public policy concerns.”[3]

Shortly thereafter, on July 10, 2019, CFTC staff published a podcast providing greater insight into its views on “opportunistic strategies in the credit derivative markets.”[4] For instance, the regulators noted that “what may seem like a strategy to keep a company alive may be viewed by the CFTC staff as a problematic, opportunistic CDS strategy.” The CFTC warned that market participants who engage in those strategies “should be prepared for document requests and other outreach by regulatory authorities and take steps to ensure that their trading strategies have not and do not run afoul of the law on market manipulation.” Strikingly, the CFTC went further, stating that “while courts may ultimately disagree with these views, derivative market participants will be well served to understand the staff’s view, as enforcement investigations and proceedings are exceedingly costly and time-consuming.” Clearly, the CFTC is prepared to aggressively pursue market manipulation investigations and understands the practical cost to market participants, even if market participants were to prevail on the merits.

At the same time, the CFTC also implicitly acknowledged that it is difficult to establish market manipulation under the commodities laws, and that courts may reject the CFTC’s interpretation of opportunistic strategies.

There is sound reason for concern that the CFTC’s view of market manipulation may be rejected by courts. Market manipulation is a term of art under applicable securities and commodities laws and is difficult to prove. Unfair, self-interested or even manipulative conduct generally is not enough to show market manipulation.

Under commodities laws, the touchstone of market manipulation is a showing of intentional fraud (i.e., deceptive or manipulative conduct) with respect to the value of a commodity in connection with the purchase or sale of that commodity. Specifically, regulators must demonstrate that (1) a defendant possessed an ability to influence market prices of a commodity; (2) an artificial price existed; (3) the defendant caused the artificial price of that commodity; and (4) the defendant specifically intended to cause the artificial price of the commodity in connection with the purchase or sale of a commodity in interstate commerce.[5] Alternatively, regulators may demonstrate attempted market manipulation where (1) a defendant specifically intended to cause an artificial price of a commodity and (2) some overt act in furtherance of that intent.[6] Under either test, price artificiality is required and occurs when the price does not reflect true, legitimate economic forces.[7]

CDS market participants need to be cautions when engaging in opportunistic strategies, because every transaction signals that the buyer and seller have legitimate economic motives for that transaction. If either party lacks that legitimate economic motivation, the resulting signal could be deemed inaccurate or even impermissibly manipulative. In other words, an otherwise legitimate transaction entered into with an improper motive can be market manipulation.[8] However, market participants are permitted to trade, even with an intent to effect the price of a security, as long as there are legitimate reasons for the trade. Two recent cases highlight this tension between legitimate and illegitimate motivations.

The decision in CFTC v. Kraft Foods Group, Inc.[9] is an example of how an otherwise legitimate transaction can become manipulative under applicable commodities laws when the signaled motivation for the transaction is false. Kraft addressed CFTC market manipulation claims in connection with the procurement of wheat. The CFTC alleged that Kraft traditionally purchased wheat through the cash market as opposed to the futures market, but altered its trading practices and purchased a significant long position in the futures market. Kraft’s large trade signaled to the market that it was changing its sourcing methods from the cash market to the futures market, which caused a significant decline in the price of wheat in the cash market. However, once the price in the cash market declined — which the CFTC alleged was Kraft’s true motivation for the futures market purchase — Kraft sold its substantial long position and purchased wheat in the depressed cash market.[10] In denying Kraft’s motion to dismiss the market manipulation claims, the court held that the CFTC had adequately pleaded that Kraft had “concocted and implemented a scheme to manipulate the price of . . . wheat futures and cash wheat by purchasing a huge position in . . . wheat futures . . . .”[11] Critically, the court held that the CFTC adequately alleged that Kraft did not have a bona fide commercial need for its wheat futures position.[12]

In contrast, where a market participant can show that it had a legitimate business reason for entering into a transaction, regulators will be hard pressed to show market manipulation. For example, last November, in CFTC v. Wilson,[13] following a bench trial, then-District Judge Richard Sullivan (now on the Second Circuit Court of Appeals) found that the CFTC failed to prove that the defendant, DRW, engaged in market manipulation in connection with interest rate swaps because there was insufficient proof of price artificiality. DRW had been submitting a large number of IDEX bids during the 15-minute window before the close, which had the effect of driving up the settlement price of the IDEX securities and had the collateral benefit of increasing the value of DRW’s other positions in swap contracts.[14]

The CFTC alleged that DRW’s unconsummated IDEX bids were market manipulation. The court disagreed, finding that the CFTC’s case “founders on its abject failure to produce evidence — or even a coherent theory — supporting the existence of an artificial price.” In this regard, the court held that a price is “artificial when it has been set by some mechanism which has the effect of ‘distorting those prices’ and ‘preventing the determination of those prices by free competition alone.’” In other words, an artificial price is one that does not reflect the basic forces of supply and demand.[15] Judge Sullivan observed that “[p]roving the existence of an artificial price is difficult — and with good reason,” as market participants are allowed to engage in legitimate trades even though those trades might impact prices and even benefit the trader’s market position elsewhere.[16] The CFTC had no evidence that DRW pursued its IDEX bids for illegitimate purposes. To the contrary, DRW had detailed, contemporaneous documentation supporting its bona fide commercial rationale for its IDEX bids.[17] In addition, there was evidence that DRW was prepared to have its bids accepted and that there were, in fact, market participants that “would surely have accepted Defendants’ open bids if they thought they were above market value.”[18] Undeterred, the CFTC effectively argued that “any price influenced by Defendants’ bids was ‘illegitimate,’ and by definition ‘artificial,’ because Defendants understood and intended that the bids would have an effect on the settlement prices.”[19] The court rejected this argument because it conflated “artificial prices with the mere intent to affect prices.”[20] The fact that DRW’s legitimate IDEX bids also happened to impact IDEX settlement prices or even benefited the price of DRW’s other securities positions was of no moment.

So, what does this all mean? As an initial matter, participants in the CDS market must be aware that opportunistic strategies are under the microscope and will almost certainly result in a regulatory inquiry by one or more agencies.[21] Regulators have wide latitude to investigate and pursue enforcement proceedings. The CFTC’s recent statements in connection with opportunistic strategies in the CDS markets show that it is prepared to do so even in the face of the risk that courts will reject its theory of market manipulation (as happened in the Wilson case). Such investigations usually include burdensome subpoenas for emails, instant messages and phone recordings and also often require testimony from current and former employees. And the CFTC appears ready to use this burden to foreclose or stem future opportunistic strategies. Prudence and the lessons from the Wilson decision suggest that market participants carefully vet putative transactions, including getting the input of counsel, and have documented and sound business reasons for the transaction.