The U.S. Commodity Futures Trading Commission recently settled its first-ever insider-trading case, relying on new powers granted to it under the Dodd-Frank Act and embodied in CFTC Regulation § 180.1 (“Rule 180.1”).
This development should be examined closely by all private fund managers that trade or engage in transactions that include “commodity interests” (i.e., futures, options on futures and related swaps), irrespective of whether they are registered with the CFTC and irrespective of whether they are trading for their own account or for clients. Among other things, managers should consider extending the scope of their current insider-trading protection efforts to commodities trading and broadening their personal trading disclosure requirements and review practices to cover commodity interest trading.
The CFTC brought this action against Arya Motazedi, a proprietary gasoline and energy trader at an unnamed public company in Chicago. According to the CFTC, Motazedi had access to confidential, proprietary information concerning his employer’s proprietary trading in energy commodities (e.g., timing, amounts and prices) and he used that knowledge:
- To enter “opposite side” orders that matched with his employer’s orders at least 34 times (causing the employer’s account to buy energy futures at higher prices and sell at lower prices, profiting Motazedi and harming his employer), at least some of which were designed as “round trip” transactions (where both sides bought and sold with the other and neither party experienced a net change in its positions); and
- To “front run,” on at least 12 occasions, his employer’s orders (allowing Motazedi to benefit from any subsequent price movement caused by the subsequent execution of the employer’s oil and gas futures orders).
The CFTC noted that, of the two accounts that Motazedi controlled and utilized in these activities, he only owned one of them.
The Motazedi matter was resolved in a settlement order (the “Order”) in which the CFTC:
- Issued a “cease and desist” order against Motazedi relating to the statutory provisions and CFTC regulations implicated in the Order;
- Required Motazedi to pay $216,955.80 in restitution;
- Required Motazedi to pay a civil monetary penalty of $100,000;
- Permanently banned Motazedi from trading commodity interests; and
- Permanently banned Motazedi from registering with the CFTC as a futures professional in any capacity.
Rule 180.1 Liability
Motazedi is noteworthy because it is a “plant the flag” case for the use of Rule 180.1 as a source of liability in general and for insider trading in particular. In the Order, the CFTC reiterated its intent to interpret CEA Section 6(c)(1), which permits the CFTC to prosecute fraud in connection with any contract of sale of any commodity for future delivery, as a “broad, catch-all provision reaching fraud in all its forms — that is, intentional or reckless conduct that deceives or defrauds market participants.” Rule 180.1, which is the means for carrying out this interpretation, was promulgated under Section 6(c)(1) and demonstrates the extent of the CFTC’s efforts to extend its antifraud powers. Prior to the promulgation of Rule 180.1, CFTC enforcement efforts generally were subject to a requirement that the CFTC show actual price manipulation, which historically has been difficult to prove; the use of Rule 180.1 in the Motazedi case may make it possible for the CFTC to bring, and win, more cases.
Taken together, Section 6(c)(1) and Rule 180.1 establish a CFTC prohibition on deceptive or manipulative conduct that is expressly modelled on the SEC’s use of Securities Exchange Act Rule 10b-5. Both regimes are utilized to sanction insider-trading activity under a “misappropriation theory,” that is, “trading on the basis of material nonpublic information in breach of a pre-existing duty (established by another law or rule, or agreement, understanding or some other source), or by trading on the basis of material nonpublic information that was obtained through fraud or deception.”
The Motazedi case also confirms that the CFTC and the SEC insider-trading regimes share a mental state requirement: While Section 6(c)(1) is silent with respect to scienter, Rule 180.1 allows the CFTC to pursue traders who act “recklessly,” defined as an act or omission that “departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he was doing.” Applying Rule 180.1 to Motazedi’s alleged conduct, the Order highlights several facts that demonstrate Motazedi’s recklessness:
- He was privy to material, nonpublic information regarding his employer’s intended trading, including the timing, contracts, prices and volume of its orders.
- Motazedi owed a duty (to his employer) based on an understanding: He held a relationship of trust and confidence with his employer and owed a duty not to misuse proprietary or confidential information.
- Motazedi also owed a duty (to his employer) based on an agreement: Under the company’s personal trading and conflict of interest policies, he was prohibited from trading energy commodities in his personal accounts and engaging in personal transactions that created an actual or potential conflict of interest.
- Despite this policy, he used his employer’s trading information to trade for his own benefit and failed to disclose those plans to his employer.
Thus, the CFTC found that Motazedi’s misappropriation and misuse of his employer’s material nonpublic trading information was “knowing or reckless” and that he breached his duty to his employer, violating both Section 6(c)(1) and Rule 180.1. However, it appears from the Order that the CFTC would have found a violation of Rule 180.1 even without a company policy prohibiting personal trading, based on the duties inherent in the employment relationship.
Implications of Motazedi for Managers
Motazedi has several clear and direct implications for private fund managers:
- A precedent has been set on CFTC insider-trading enforcement actions. The CFTC has demonstrated a willingness to pursue these cases and can be expected to vigorously pursue additional actions in the future.
- The CFTC has aligned its theory and standards of liability in a manner consistent with its sister regulators (i.e., the SEC and the Department of Justice). There is now a consistent fraud and misappropriation theory that underpins insider-trading actions in all three regulatory regimes.
- The penalties for insider trading in the futures markets will be stiff. In addition to financial penalties, Motazedi has a lifetime industry bar and a lifetime bar on trading for his personal account in the futures markets. This sanction is clearly intended to send a message.
Motazedi shows that the franchise risk posed by an insider-trading allegation is not limited to managers that are registered with the CFTC and the National Futures Association (as, e.g., commodity pool operators or commodity trading advisors); any individual or entity can be sued under Section 6(c)(1) and Rule 180.1.
Therefore, all private fund managers that trade commodity interests (in any quantity) should consider taking steps to expand the insider-trading protections on the securities side of their businesses to trading in futures commodity options and swaps markets. These measures should include specific policies, targeted training and surveillance. Managers that do not request records of personal trading (including records of accounts that are controlled, but not owned, by firm personnel) in futures and options and that do not surveil those trading records to the same degree as equity trading should begin doing so.