CFTC Issues Proposed Rules under the Dodd-Frank Act on the Prohibition of Market Manipulation and an Advance Notice of Proposed Rulemaking on the Prohibition of Disruptive Trading Practices SUMMARY On November 3, 2010, the Commodity Futures Trading Commission (the CFTC ) issued two proposed rules relating to its expanded anti-manipulation authority to prohibit fraudulent and manipulative behavior in connection with its implementation of Title VII of the Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ). In addition, on November 2, 2010, the CFTC published an advance notice of proposed rulemaking, pursuant to its authority to prohibit certain trading practices deemed disruptive of fair and equitable trading. The two proposed rules relate to the CFTC s expanded anti-manipulation authority under Section 753 of the Dodd-Frank Act to prohibit fraudulent and manipulative behavior. The first proposed rule is essentially an anti-fraud rule that appears to be intended to clarify the CFTC s general anti-fraud authority as well as its ability to bring enforcement actions against fraud-based market manipulation. The second proposed rule, promulgated pursuant to the CFTC s general rulemaking authority under Section 8(a)(5) of the Commodity Exchange Act (the CEA ), is consistent with recent judicial precedent from the Court of Appeals for the Second Circuit holding that a market power manipulation charge can be sustained based solely on trading practices that exploit illiquidity in the markets, even in the absence of fraud or cornering. An advance notice of proposed rulemaking and request for comments was also issued in connection with the CFTC s promulgation of rules to prohibit trading practices that are disruptive of fair and equitable trading, pursuant to Section 747 of the Dodd-Frank Act. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
PROPOSED RULE ON THE PROHIBITION OF FRAUDULENT AND MANIPULATIVE CONDUCT Section 753 of the Dodd-Frank Act amends Section 6(c) of the CEA to expand the authority of the CFTC to prohibit fraudulent and manipulative behavior. In particular, Section 6(c)(1) of the CEA, as amended by the Dodd-Frank Act, prohibits the use or employment of any manipulative or deceptive device or contrivance in contravention of the rules and regulations that the CFTC promulgates no later than one year following the enactment of the Dodd-Frank Act. Pursuant to its authority under Section 6(c)(1), the CFTC issued proposed regulations that would make it 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 1 to intentionally or recklessly do, or attempt to do, any of the following activities: use or employ, or attempt to use or employ, any manipulative device, scheme or artifice to defraud; 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 statement made not untrue or misleading; 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 deliver or cause to be delivered, or attempt to deliver or cause to be delivered, for transmission through... 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. The proposed rule is fundamentally an anti-fraud rule and one that the CFTC has referred to as a broad, catch-all provision reaching fraud in all its forms that is, intentional or reckless conduct that deceives or defrauds market participants. The CFTC has historically relied upon other provisions of the CEA, including Section 9(a)(2) and the prior Section 6(c) in its administrative and civil enforcement actions against fraud-based manipulation and attempted manipulation, requiring some form of deception such as reporting of false prices or the making of false statements. It is unclear how the proposed rule under Section 6(c)(1) of the CEA will grant to the CFTC any new anti-fraud authority with respect to manipulations which it did not already have under either Section 9(a)(2) or the broader antifraud provision Section 4(b). 1 A contract for future delivery is the statutory term for an exchange-traded futures contract. -2-
The proposed rule models the language of the anti-manipulation rules promulgated by the Federal Energy Regulatory Commission ( FERC ) in 2006 2 and the Federal Trade Commission ( FTC ) in 2009, 3 which are in turn based on the Securities Exchange Commission s (the SEC ) Rule 10b-5, which was enacted pursuant to Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act ). The CFTC highlighted the similarity of the language in Section 753 of the Dodd-Frank Act ( any manipulative or deceptive device or contrivance ) to the language of the anti-manipulation authority granted to FERC in the Energy Policy Act of 2005 and the language of the anti-manipulation authority granted to FTC under the Energy Independence and Security Act of 2007. The CFTC declared that judicial precedent in securities laws would guide, but not control the Commission and that the Commission intends to take into account the purposes of the CEA and the functioning of the markets regulated by the CFTC. 4 Intentional or reckless conduct that deceives or defrauds market participants would be prohibited by the proposed rule. Consistent with the Supreme Court s interpretation of Section 10(b) of the Exchange Act, it would be necessary to show that a person acted with scienter to prove a violation of the CFTC s proposed rule. Similar to the anti-manipulation rules of FERC, scienter in the context of the CFTC s proposed rule is defined to include recklessness. By contrast, under the FTC s anti-manipulation rules, the requisite scienter is the higher standard of extreme recklessness. In addition, Section 747 of the Dodd-Frank Act further adds a new Section 4(c)(7) of the CEA, making it: unlawful for any person to enter into a swap knowing, or acting in reckless disregard of the fact, that its counterparty will use the swap as part of a device, scheme, or artifice to defraud any third party (emphasis added). 2 3 4 FERC, Prohibition of Energy Market Manipulation, 71 Fed. Reg. 4244 (January 19, 2006). FTC, Prohibitions on Market Manipulation, 16 C.F.R. pt. 317 (August 12, 2009). On November 3, 2010, the SEC proposed Rule 9j-1 under the Exchange Act that would prohibit fraud, manipulation and deception in connection with security-based swaps. The proposed rule was issued pursuant to Section 763(g) of the Dodd-Frank Act, which directs the SEC to issue rules reasonably designed to prevent fraudulent, deceptive or manipulative transactions, acts, practices and courses of business in connection with the purchase and sale of, or a transaction in, a securitybased swap. The proposed rule would prohibit, with respect to security-based swaps, misconduct prohibited by Rule 10b-5 under the Exchange Act and Section 17(a) of the Securities Act of 1933 (the Securities Act ), which prohibit fraud, deception and material misstatements and omissions in connection with the purchase or sale of a security. The proposed rule would extend these prohibitions to the exercise of any right or performance of any obligation under a security-based swap, or the avoidance of such exercise or performance. This broader language is intended to prohibit fraudulent or deceptive acts occurring during the term of a security-based swap, such as misconduct intended to avoid or affect the value of ongoing payments or collateral requirements under a security-based swap. See Prohibition Against Fraud, Manipulation and Deception in Connection with Security-Based Swaps, 75 Fed. Reg. 215 (Nov. 8, 2010) (to be codified 17 C.F.R. pt. 240). -3-
To the extent the CFTC utilizes the recklessness standard in both its proposed rule and pursuant to Section 4(c)(7) of the CEA, the new rules collectively have the potential to create enhanced duties of inquiry and diligence on the part of all swap market participants, in order to prevent exposure to enforcement actions if that participant s actions are determined to have been fraudulent or deceptive. Implementing a recklessness standard in the context of actions that could result in substantial civil penalties, however, could cause traders to limit their trading activities for fear of competitive trading strategies being misconstrued with the benefit of hindsight. In addition, potential entrants into the markets may decide that the regulatory risks outweigh the potential benefits and not enter the market, adversely affecting the liquidity and depth of markets. Finally, the CFTC s proposed rule clarifies that nothing therein should be construed as requiring any person to disclose non-public information that may be material to the market price, rate, or level of a transaction, except as necessary to make any statement made to another person in connection with the transaction not materially misleading. PROPOSED RULE ON MANIPULATION OR ATTEMPTS TO MANIPULATE Pursuant to its general rulemaking authority under Section 8(a)(5) of the CEA, the CFTC has proposed a rule under the new Section 6(c)(3) of the CEA. The proposed rule mirrors the language of Section 753 of the Dodd-Frank Act, making it: unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity. The CFTC reaffirmed the traditional four-part test, developed from manipulation cases involving corners and squeezes, needed to impose liability under this section, which requires the CFTC to establish: (1) that the accused had the ability to influence market prices; (2) that the accused specifically intended to do so; (3) that artificial prices existed; and (4) that the accused caused the artificial prices. The proposed rule under Section 6(c)(3) is consistent with the recent judicial precedent established in the Second Circuit that conduct giving rise to a manipulation charge need not be intrinsically fraudulent or otherwise illegal, a theory of liability that was upheld in the case of DiPlacido. 5 DiPlacido was the first case in which a court of appeals has held that a manipulation charge could rest solely on trading practices, such as banging the close, even in the absence of any showing of fraud or monopolization of the deliverable supply, recognizing that prices can be manipulated by exploiting the liquidity of markets without any fraud or cornering. 5 In re DiPlacido, 2008 WL 4831204 (CFTC 2008), aff d in pertinent part, DiPlacido v. Commodity Futures Trading Comm n, 364 Fed. Appx. 657, 2009 WL 3326624 (2d Cir. 2009), Comm. Fut. L. Rep. (CCH) 20,271 at 21,477. -4-
The CFTC stated that the conclusion that an artificial price (defined as a price that is not the product of legitimate forces of supply and demand) existed, will often follow inescapably from proof of the actions of the alleged manipulator. The CFTC referred to the making of uneconomic trades, such as placing disproportionately large orders while ignoring more favorable bids and offers in an illiquid market, as actions from which distorted prices would foreseeably follow in asserting that an illegal effect on price can often be conclusively presumed from the nature of the conduct in question. However, the CFTC recognized that the Dodd-Frank Act did not amend or otherwise affect the traditional market power manipulative strategies that exploit market power (i.e., a corner or a squeeze ), an area of market power manipulation which the CFTC has had notoriously little success in litigating. The CFTC has requested comments on all aspects of the two proposed rules for a period of 60 days. Comments are due no later than January 3, 2011. ADVANCE NOTICE OF PROPOSED RULEMAKING ON THE PROHIBITION OF TRADING PRACTICES DISRUPTIVE OF FAIR AND EQUITABLE TRADING Section 747 of the Dodd-Frank Act makes it unlawful for a person to engage in any: trading, practice, or conduct on or subject to the rules of a registered entity that: (A) violates bids or offers; (B) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (C) is, is of the character of, or is commonly known to the trade as spoofing (bidding or offering with the intent to cancel the bid or offer before execution). The CFTC has the authority to promulgate rules that in its judgment are reasonably necessary to prohibit the trading practices enumerated above and any other trading practice that is disruptive of fair and equitable trading. Section 747 is extremely vague and the application of these concepts to electronic trading markets is unclear. Pursuant to its statutory authority to promulgate rules under this section, the CFTC seeks comment on all aspects of Section 747. The advance notice of proposed rulemaking poses nineteen numbered questions, including: Should the CFTC provide additional guidance as to the nature of the conduct that is prohibited by the specifically enumerated practices in paragraphs (A-C)? With respect to the practice enumerated in paragraph (A) violating bids and offers how should the provision be applied in the context of electronic trading platforms with predetermined order-matching algorithms that preclude a trader from executing an order against a quote other than the best one available? In particular, should the provision apply to buying the board of an illiquid market? -5-
How should the CFTC distinguish between orderly and disorderly trading during the closing period as articulated in paragraph (B)? What factors should a factfinder consider in this inquiry? How should orderly execution be defined? How should the closing period be defined? Should the definition of closing period include: Daily settlement period? Some period prior to contract expiration? Trading periods used to establish indices or pricing references? How should the CFTC distinguish spoofing, as articulated in paragraph (C), from legitimate trading activity where an individual enters an order larger than necessary with the intention to cancel part of the order to ensure that his or her order is filled? Should executing brokers have an obligation to ensure that customer trades do not constitute disruptive trade practices? If so, in what circumstances? What pre-trade risk checks should executing brokers have in place to ensure customers using their automated trading systems, execution systems or access to their trading platforms do not engage in disruptive trading practices? Should the Commission articulate specific duties of supervision relating to the prohibited trading practices articulated in paragraphs (A C) (as well as any other trading practice that the Commission determines to be disruptive of fair and equitable trading) to supplement the general duty to supervise contained in Commission Regulation 166.3? To which entities should these duties of supervision apply? Should the Commission consider promulgating rules to regulate the supervision and monitoring of algorithmic or automated trading systems to prevent disruptive trading practices? If so, what kinds of rules should the Commission consider? Should algorithmic traders be held accountable if they disrupt fair and equitable trading? If so, how? The CFTC has requested comments on all aspects of Section 747 of the Dodd-Frank Act for a period of 60 days. Comments are due no later than January 3, 2011. * * * Copyright Sullivan & Cromwell LLP 2010-6-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish (+1-212-558-3715; rishj@sullcrom.com) or Alison Alifano (+1-212- 558-4896; alifanoa@sullcrom.com) in our New York office. CONTACTS New York David J. Gilberg +1-212-558-4680 gilbergd@sullcrom.com Steven R. Peikin +1-212-558-7228 peikins@sullcrom.com Kenneth M. Raisler +1-212-558-4675 raislerk@sullcrom.com NY12528:505853.3-7-