On July 27, 2022, a unanimous panel of the United States Court of Appeals for the Seventh Circuit affirmed a decision of the United States District Court for the Northern District of Illinois dismissing a putative securities fraud class action asserting a claim under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder, as well as claims under the Commodities Exchange Act, against an options and futures exchange company (the “Company”). Brian Barry, et al. v. CBOE Global Markets, Inc., et al., No. 20-1843 (7th Cir. July 27, 2022). Plaintiffs alleged that the Company violated the Exchange Act by trading options and futures based on an index it created (“VIX”) that was designed to estimate the near-term volatility in the S&P 500 Index, but allegedly was subject to market manipulation by unknown traders (the “Doe Defendants”) soon after its creation. The Seventh Circuit affirmed the dismissal of the claims, holding that plaintiffs failed to plead scienter.

According to the amended complaint, when the Company created VIX, the calculation was based on options prices for four stocks. Plaintiffs alleged that the index would rise when the S&P 500 Index was expected to become more volatile in the coming 30 days, and it would decrease when the S&P 500 Index was expected to become less volatile. In 2003, the Company purportedly increased the number of options in the formula from 4 to 130, allegedly in an attempt to make VIX “more reliable and replicable.” Plaintiffs alleged that this increase allowed bad-faith-traders to buy or sell out strategically in order to manipulate the VIX. Additionally, in 2004 and 2006, the Company allegedly created futures and options contracts, respectively. Plaintiffs further alleged that these derivatives drove even more manipulation of the index, which plaintiffs alleged the Company should have known would occur.

According to the Seventh Circuit, plaintiffs’ claim under the Exchange Act was that the Company “knew that scoundrels could take advantage of the formula for determining VIX on settlement dates,” and plaintiffs’ claim under the Commodity Exchange Act was that the Company “failed to enforce rules forbidding manipulation.” The district court dismissed plaintiffs’ amended complaint with prejudice and plaintiffs appealed.

In considering the Exchange Act claim, the Seventh Circuit held that, at most, plaintiffs had accused the Company of negligence, which is insufficient for pleading an intent to deceive (i.e., scienter) under the Exchange Act. In so holding, the Court rejected plaintiffs’ argument that “scienter may be inferred from the fact that [the Company] made money on the trades that the Doe Defendants may have used to manipulate inputs into calculation of the VIX,” finding instead that plaintiffs failed to quantify how much the Company stood to lose in trading the VIX options and futures contracts themselves, and that plaintiffs’ “observation that [the Company] could gain from the options traded in an effort to affect VIX does not help their position without a comparison against what [the Company] stood to lose.” Further, according to the Court, the Company’s “potential losses outweighed potential gains, making it implausible to attribute wrongful intent to the Company. The Court emphasized the Company’s engagement “in some anti-manipulation enforcement action”, made the imputation of fraudulent intent “even harder,” and accordingly affirmed the dismissal of plaintiffs’ Exchange Act claim.

The Seventh Circuit also affirmed dismissal of the Commodities Exchange Act claim, holding first that plaintiffs had not alleged specific transactions from which they sustained losses due to the alleged manipulation, and second that plaintiffs had failed to plead that defendants acted in bad faith in failing to take action, for the same reason that the amended complaint does not show scienter for the purpose of securities-law liability.” The Court further emphasized that plaintiffs’ “allegations do not imply bad faith under the ordinary meaning of that phrase, and they do not satisfy the Second Circuit’s [self-interest or ulterior motive] elaboration,” which is to say that plaintiffs “do not allege that [the Company] acted with knowledge of manipulation” and do not contend that the Company was “in cahoots with the Doe Defendants (an ‘ulterior motive’).” The Court concluded by stating “[r]emedies, if any are appropriate, lie with the SEC, the CFTC, and the National Futures Association (which could expel or discipline its members) rather than the judiciary at the behest of private litigants.”