The CFTC and SEC have each proposed new rules to implement anti-manipulation and anti-fraud provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 753 of the Dodd-Frank Act greatly expands the CFTC's authority to pursue those who engage in fraud and manipulative conduct in connection with over-the-counter and exchange-traded swaps and commodity and futures contracts, while Section 763(g) makes clear that the SEC has authority to pursue fraud, deception, and manipulative conduct in connection with security-based swaps. These provisions take effect on either July 11, 2011 or 60 days after the CFTC or SEC, as applicable, adopts the implementing rules — whichever is later. On October 26, 2010, the CFTC unveiled its proposed rules to implement Section 753 of the Dodd-Frank Act. On November 3, 2010, the SEC issued a proposed rule to implement Section 763(g).
The SEC's Proposed Rule to Prevent Fraud, Manipulation, and Deception in Connection With Security-Based Swaps
Section 763(g) of the Dodd-Frank Act added a new subparagraph (j) to Section 9 of the Securities Exchange Act of 1934, making it unlawful for “any person… to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security-based swap, in connection with which such person engages in any fraudulent, deceptive, or manipulative act or practice, makes any fictitious quotation, or engages in any transaction, practice, or course of business which operates as a fraud or deceit upon any person.”
The SEC seems to have determined that existing SEC rules and regulations are insufficient to enforce Section 9(j). Specifically, the SEC appears concerned that potential wrongdoers could avoid liability under Rule 10b-5 because that rule only prohibits conduct “in connection with the offer, purchase or sale… .” The SEC noted that most security-based swaps are characterized by ongoing payments or deliveries throughout the life of the swap and “[b]ecause such payments or deliveries occur after the purchase of a security-based swap but before the sale or termination of the security-based swap, we believe a rule making explicit the liability of persons that engage in misconduct to trigger, avoid, or affect the value of such ongoing payments or deliveries is a measured and reasonable means to prevent fraud, manipulation, and deception in connection with security-based swaps.”
Proposed Rule 9j-1 reads as follows:
§ 240.9j-1. Prohibition against fraud, manipulation, and deception in connection with security-based swaps.
It shall be unlawful for any person, directly or indirectly, in connection with the offer, purchase or sale of any security-based swap, the exercise of any right or performance of any obligation under a security-based swap, or the avoidance of such exercise or performance,
(a) To employ any device, scheme, or artifice to defraud or manipulate;
(b) To knowingly or recklessly make any untrue statement of a material fact, or to knowingly or recklessly omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading;
(c) To obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(d) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
Subsections (a) and (b) are modeled after Rule 10b-5. The SEC, however, has proposed certain changes to the language to expressly include elements that have been incorporated into Rule 10b-5 through judicial interpretation. Subsection (a), for example, expressly prohibits any “device, scheme or artifice to defraud or manipulate.” The SEC stresses that, while the term “manipulate” does not appear in the text of Rule 10b-5, it has been interpreted to reach manipulative activities and expressly including it in the proposed rule is merely a “clarification.” The CFTC's proposed Rule 180.1, discussed below, similarly prohibits the use of “any manipulative device, scheme, or artifice to defraud.”
Subsection (b) of proposed Rule 9j-1, unlike Rule 10b-5, expressly includes the terms “knowingly or recklessly.” The SEC states that this addition is intended simply to make clear that, as with Rule 10b-5(b), this subsection requires scienter. Notably, the CFTC, in its proposed anti-manipulation rule, used the terms “intentionally or recklessly,” rather than “knowingly or recklessly.”
Unlike proposed subsections (a) and (b), proposed subsections (c) and (d) do not require scienter. According to the SEC, subsection (c) would extend to negligent conduct including, for example, “when a party to a security-based swap knows or reasonably should know that a statement was false or misleading and directly or indirectly obtains money or property from such statement.”
The SEC is accepting comments on the proposed rule for a period of 45 days following its publication in the Federal Register.
The CFTC's Proposed Rules to Prevent Price- and Fraud-Based Manipulation
The SEC issued its proposed rule just days after the CFTC issues two new proposed rules in light of its expanded authority under the Dodd-Frank Act.
Prior to Dodd-Frank, to prove market manipulation, the CFTC had to establish that: (1) the accused had the ability to influence market price; (2) the accused specifically intended to do so; (3) an artificial price existed; and (4) the accused caused the artificial price. Under this four-part test, the CFTC's ability to pursue non price-based manipulation has been limited and its track record on manipulation cases has been extremely poor.
Dodd-Frank, however, significantly expanded the authority of the CFTC to prohibit fraudulent and manipulative behavior and lowered the standard for proving manipulation. Dodd-Frank adds a new Section 6(c)(1) of the Commodity Exchange Act (CEA), which provides that:
It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate by not later than 1 year after the date of enactment of the Dodd-Frank Act.
Subsection 6(c)(1)(A) defines “unlawful manipulation” to include dissemination of a “false or misleading report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing, or acting in reckless disregard of the fact that such report is false, misleading or inaccurate.”
Pursuant to the mandate in Dodd-Frank, the CFTC proposed a new Rule 180.1, modeled, in part, on SEC Rule 10b-5. Rule 180.1 provides that:
(a) It shall be unlawful for any person, directly or indirectly, in connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity, to intentionally or recklessly:
(1) use or employ, or attempt to use or employ, any manipulative device, scheme, or artifice to defraud;
(2) make, or attempt to make, any untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statements made not untrue or misleading;
(3) engage, or attempt to engage, in any act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person; or,
(4) deliver or cause to be delivered, or attempt to deliver or cause to be delivered, for transmission through the mails or interstate commerce, by any means of communication whatsoever, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing, or acting in reckless disregard of the fact that such report is false, misleading or inaccurate. Notwithstanding the foregoing, no violation of this subsection shall exist where the person mistakenly transmit, in good faith, false or misleading information to a price reporting service.
(b) Nothing in this section shall be construed to require any person to disclose to another person nonpublic information that may be material to the market price, rate, or level of the commodity transaction, except as necessary to make any statement made to the other person in or in connection with the transaction not misleading in any material respect.
(c) Nothing in this section shall affect, or be construed to affect, the applicability of Commodity Exchange Act section 9(a)(2).
The CFTC proposes that the same requirements of scienter and materiality applied in Rule 10b-5 cases also apply to CFTC cases. In addition, the CFTC proposed that the “in connection with” requirement be interpreted consistent with Supreme Court precedent in interpreting the same language in Rule 10b-5.
In other words, to prove manipulative conduct, the CFTC is no longer limited to price manipulation and no longer has to prove the four factors that have long stymied the CFTC, including specific intent. Rather, it will only have to prove recklessness.
While Section 6(c)(1) and proposed Rule 180.1 focus on fraud-based manipulation, the CFTC continues to have authority to pursue price-based manipulation under existing Section 9(a) of the CEA as well as a new Section 6(c)(3), also created by Dodd-Frank. Section 6(c)(3) provides that “it shall be unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity.”
The CFTC proposes a new Rule 180.2 that simply repeats the language of Section 6(c)(3). Unlike Rule 180.1, in proposing Rule 180.2, the CFTC expressly reaffirms the four-part test for proving price manipulation. The CFTC “emphasizes,” however, that “the conduct giving rise to a manipulation charge need not itself be fraudulent or otherwise illegal.” While the CFTC states that its position is consistent with “the weight of existing precedent,” some courts have refused to find manipulation where there was an intent to affect price but the underlying conduct itself was not fraudulent See, e.g., CFTC v. Delay, 2006 WL 3359079, *3 (D. Neb. Nov. 17, 2006).
The CFTC is accepting comments on Proposed Rules 180.1 and 180.2 until January 3, 2011.