Two court cases currently slogging their way through the US judicial system could help define the enforcement powers of the Commodity Futures Trading Commission (CFTC) for decades to come.
The CFTC's foes in the two legal battles are a pair of very different companies. One is Kraft, the Illinois-based food giant whose brands have included household names such as Chips Ahoy! cookies, Ritz Crackers and Kool-Aid. The other is DRW Holdings, the Chicago-based proprietary trading firm that engages in liquidity provision, as well as high-speed and algorithmic trading strategies, on exchanges around the world.
Both are fighting the CFTC's charges of market manipulation. Kraft and its sister company, Mondelez, which was spun out of Kraft in 2012, stand accused of manipulating wheat futures listed on the Chicago Board of Trade (CBOT), an exchange owned by Chicago-based CME Group. Meanwhile, DRW is alleged to have manipulated an obscure, thinly traded market for interest rate swap futures.
In both cases, the CFTC is pushing the envelope when it comes to the definition of unlawful market manipulation, lawyers say. The results could have big implications for market participants – particularly firms that are large players relative to the markets in which they trade, which the commission appears to be singling out for tighter scrutiny.
"The common theme in these two cases is that both Kraft and DRW were very large players in the market," says Dan Berkovitz, a Washington, DC-based partner at law firm WilmerHale and a former general counsel at the CFTC.
"The CFTC has alleged in each of those cases that both those market participants believed that their actions would have an influence on price and that they intended to have an influence on price," he explains. "So I think it's clear that, if you have a very large market position and you believe that how you trade will affect the price, you need to be really careful."
Kraft and its ‘scheme'
The trades that got Kraft and Mondelez in hot water took place during the closing months of 2011.
According to the CFTC, Kraft put on a $90 million long position in CBOT wheat futures for delivery in December of that year, at one point controlling 87% of open interest in the contract. But instead of taking physical delivery of those wheat futures, Kraft entered into offsetting short positions to zero out most of its position and only settled a small portion physically, the CFTC alleged in its lawsuit against Kraft and Mondelez, which was filed on April 1, 2015.
If you have a very large market position and you believe that how you trade will affect the price, you need to be really careful
Dan Berkovitz, WilmerHale
Kraft's real objective, the CFTC claimed, was to deceive other market participants into thinking it would take delivery of the wheat futures at locations along the Mississippi River, in order to depress the cash price of wheat in Toledo, Ohio, where Kraft's mill was located. The "manipulative and deceptive scheme" yielded $5.4 million in profits for the food giant, by lowering Kraft's procurement costs and benefiting a separate spread position put on by Kraft's traders, which made money as the spread between December 2011 and March 2012 wheat futures narrowed, the CFTC said in its lawsuit.
Kraft and Mondelez have denied the accusations and are fighting them in court. Legal observers say the case is unlikely to go to trial before 2017.
In its lawsuit, the CFTC cited a new anti-manipulation authority that it gained with the US Dodd-Frank Act of 2010, along with a commission rule that went into effect just months before Kraft carried out its alleged scheme. Dodd-Frank amended section 6(c) of the Commodity Exchange Act (CEA) to give the CFTC what lawyers call a ‘fraud-based' anti-manipulation authority. Under the provision, traders who carry out a "manipulative or deceptive device or contrivance" in the futures or derivatives markets can be punished for manipulation. In July 2011, the CFTC finalised a regulation – Rule 180.1 – that barred manipulation in line with CEA section 6(c).
The bottom line of all that law-making and rule-writing, according to legal experts, was to lower the bar that the CFTC must clear in order to win a manipulation case in court.
Before Dodd-Frank, the CFTC had an older anti-manipulation authority, enshrined in section 9(a)(2) of the CEA, but the commission's track record of enforcing it was spotty. In fact, in all the decades that the old authority was on the books, the CFTC won just one contested manipulation case in court. Most of the time, according to lawyers and former CFTC officials, commission lawyers would settle out of court or drop cases altogether rather than attempt to go to trial against a determined opponent.
That is because section 9(a)(2) imposed a relatively high burden of proof on the commission. To prove market manipulation under the old authority, traditionally the CFTC needed to prove each element of a four-part test. The elements are: first, that the accused had the ability to influence market prices; second, that the accused specifically intended to create a price or price trend that did not reflect legitimate forces of supply and demand; third, that artificial prices existed; and fourth, that the accused caused the artificial prices.
"The old anti-manipulation authority was always kind of an albatross around the agency's neck," says Daniel Nathan, a Washington, DC-based partner at law firm Morvillo and a former deputy director of enforcement at the CFTC.
"In particular, it was very difficult to prove artificial price," Nathan explains. "The two sides would bring in competing economists and experts, and it was always easiest for a finder of fact to say, ‘no, we can't conclude that there is any artificiality here'. With the new rule, all that has been taken off the table."
Although CEA section 6(c) has been invoked in several CFTC enforcement actions in recent years, the Kraft case is perhaps the most prominent case that has relied on the new Dodd-Frank authority and its corresponding regulation, Rule 180.1. Notably, the commission has accused Kraft of violating both section 6(c) and 9(a)(2) of the CEA, meaning the regulator could potentially fail to prove manipulation under the old, pre-Dodd-Frank authority but succeed using the new, fraud-based authority.
Lawyers for Kraft and Mondelez have rejected the notion that the wheat trades in question amounted to fraud, characterising them as a legitimate strategy for procuring the cheapest wheat. The CFTC's lawsuit "does not allege conduct by which Kraft purportedly misled, deceived or tricked the market", the companies wrote in a June 2015 motion to dismiss the suit.
The companies also warned of broader industry implications stemming from the CFTC's stance. Under the commission's interpretation, "a whole swath of perfectly legitimate and legal conduct in the commodities markets would come under cloud based on nothing but price fluctuations and a trader's pursuit of its legitimate business interest", they wrote.
So far, Kraft and Mondelez's arguments have not enjoyed much success in court. In December 2015, a federal judge in Illinois denied the companies' motion to dismiss, ruling the CFTC had enough evidence to proceed with its suit. In July, the companies' interlocutory appeal – a rare legal manoeuvre in which defendants appeal to a higher court before completion of a trial – was also shot down.
The CFTC denies that its fraud-based authority is overly broad. CFTC officials note that Rule 180.1 was modelled closely on US Securities and Exchange Commission Rule 10b-5, a longstanding regulation that has been used to combat stock-market fraud since the 1940s, weathering many court battles over the years.
"It's a fact of life that Rule 180.1 is broad, but it is not susceptible to a void for vagueness challenge," Aitan Goelman, director of the CFTC's division of enforcement, tells Risk.net. "It is lifted verbatim from language that has been operative on the securities side for decades, and it does require – as the Kraft court held – some sort of misleading, deceptive or fraudulent intent."
It's a fact of life that Rule 180.1 is broad, but it is not susceptible to a void for vagueness challenge
Aitan Goelman, CFTC
The Kraft case has raised particular concern among large market participants, including some energy firms, which fear that the commission has effectively criminalised big trades with the potential to move the market. But Goelman pushes back against that interpretation.
"There is nothing wrong with being a big player and taking big positions," the CFTC enforcement chief says. "What Kraft did is it tried to move a position it did not like. It thought the price of wheat was too high, and it went into the futures market as part of a scheme to move wheat to a price it liked better. If you are trying to adjust a price to a place that is more favourable to you, and you use methods such as banging the close, or some other more creative or novel method, you can't just move the price because you've discovered a way to do so. Having market power is not in and of itself a violation."
A lawyer for Kraft and Mondelez declined to comment. Contacted by Risk.net, a spokesman for the Kraft Heinz Company – the firm that resulted from Kraft's merger last year with Pennsylvania-based ketchup-maker Heinz – said the company had no liability associated with the CFTC case. A spokesperson for Mondelez declined to comment on the case, but noted that the litigation would not have a material impact on the firm's financial results.
DRW and ‘artificial price'
DRW's battle with the CFTC revolves around a series of bid orders that the firm placed on the Nasdaq OMX Futures Exchange over an eight-month period in 2011.
According to the CFTC, DRW's bids were aimed at boosting the value of a long position that the firm had accumulated the previous year in Idex Three-Month Interest Rate Swap Futures. By September 30, 2010, the position had a notional value of $350 million, and for much of the period under scrutiny, DRW held close to 90% of open interest in the contract, the CFTC says.
The commission alleges that DRW placed bids during a 15-minute settlement window, from 1:45pm to 2:00pm Chicago time, that Nasdaq used to determine the daily settlement price of the interest rate futures, which were thinly traded. Of more than 2,400 bids that DRW placed in the contract from January to August 2011, nearly 60% were in the settlement window, the CFTC said in a lawsuit filed against the trading firm in November 2013.
The CFTC compared that bidding strategy to ‘banging the close', a form of market manipulation in which a trader either buys or sells aggressively in the closing minutes of the settlement process for a futures contract in order to push the closing price up or down, respectively, with the aim of benefiting a related position held by the trader. DRW earned at least $20 million in profits from the "illegal scheme", the commission says. The CFTC's lawsuit accused the firm and its chief executive, Don Wilson, of manipulation and attempted manipulation.
DRW's response has been defiant. In a highly unconventional move, it even filed its own, pre-emptive lawsuit against the CFTC in September 2013, accusing the commission of "exercising its regulatory authority arbitrarily and unreasonably" and seeking to prevent the CFTC from launching an enforcement action against the firm. The manoeuvre failed to prevent the regulator from suing DRW soon afterwards, but it did have the effect of winning media attention and presenting DRW's version of events before the commission could.
From DRW's perspective, the bids placed in the settlement window were part of a legitimate trading strategy aimed at fixing a mispricing in Nasdaq's interest rate futures. In other words, rather than creating an artificial price, DRW contends that its trading did the opposite, by taking an artificial price and making it less artificial.
The argument hinges on a phenomenon in exchange-traded interest rate futures known as ‘convexity bias'. The phenomenon, which academics first identified more than 20 years ago, arises because of the variation margin exchanged between longs and shorts when interest rates fluctuate. When rates rise, longs collect variation margin, which they can reinvest at the higher rate; by the same token, shorts collect variation margin when rates fall, but the cash they receive is effectively less valuable because rates have just fallen. This leads to a divergence between listed interest rate futures contracts and unmargined, over-the-counter swaps for the same rates and maturities.
Exchanges that list interest rate futures can correct for convexity bias, but 2010–11, the time when DRW carried out its trading strategy, the International Derivatives Clearing House (IDCH) – which calculated daily settlement prices for the contract in question – did not perform such a price adjustment. That led DRW to believe that Nasdaq's contract was mispriced.
According to the CFTC's lawsuit, Wilson and his staff concluded in November 2010 that the contract should have been trading 240 basis points higher than the corresponding OTC swap. That theoretical difference did not materialise in reality, though, because "there was very little, if any, trading of the contract", the CFTC says. Instead, in the absence of real trading activity, IDCH simply relied on OTC prices to compute its daily settlements.
The launch of DRW's bidding strategy in January 2011 brought prices for Nasdaq's contract more in line with what the firm's models indicated was the right price. By February 2012, DRW's bids effectively began to set the price of the contract, according to the CFTC.
DRW says its conduct was not manipulative because it did not result in an artificial price. "Courts have held that the existence of an artificial price is essential for a manipulation claim," the firm said in a January 2014 court filing. "Yet the complaint alleges the opposite: that defendants' actions moved market prices toward, rather than away from, their intrinsic values."
They will say things in fairly aggressive and vigorous tones, and it will sound to a third party like someone has the intention to engage in mischief, when in fact they're just speaking the way traders speak
Daniel Nathan, Morvillo
Craig Pirrong, a professor at the Bauer College of Business at the University of Houston, sides with DRW. "The crucial question is whether they were causing the price to be artificial in some way," Pirrong says. "That, to me, should be the touchstone of a manipulation case – that you're distorting prices, that you're causing prices to move away from what they would be in a well-functioning, competitive market."
Unlike in the Kraft case, the CFTC's prosecution of DRW does not depend on the commission's post-Dodd-Frank anti-manipulation authority. While its lawsuit against DRW invokes both section 6(c) and 9(a)(2), the vast majority of the trades in question took place before the commission's Rule 180.1 went into effect. Hence, most of the legal wrangling in the DRW case has focused on competing interpretations of the CFTC's old anti-manipulation authority under section 9(a)(2).
Industry groups have voiced alarm over the CFTC's stance in the DRW case. In June, the judge presiding over the case accepted a so-called amicus curiae brief, or ‘friend of the court' brief, from a group of industry heavyweights: CME Group, the Washington, DC-based Commodity Markets Council and Futures Industry Association, Atlanta-based Ice and the New York-based Managed Funds Association.
The brief accused the commission of attempting "to recast three decades of law, asserting that proof of intent to create an ‘artificial price' is not required to prove attempted manipulation". According to the brief, the CFTC's case against DRW ignores a key precedent established in a 1982 case known as Indiana Farm Bureau – the case that established the traditional four-part test for market manipulation. Instead, the industry heavyweights said the CFTC was relying on an alternative legal formula for attempted manipulation under section 9(a)(2), which contains just two elements: "an intent to affect the market price of the commodity"; and "some overt act in furtherance of that intent".
CME, Ice and the trade groups argued in their brief that "an intent to affect the market price" was a much weaker standard than the old version, which required specific intent to create an artificial price. Under the new, weaker standard, a rancher who bought cattles futures expecting their price to rise, and knowing that her trade would help move the market in that direction, might be guilty of attempted manipulation, the industry brief suggested. The CFTC has dismissed the arguments in the brief as "without merit".
For some market participants, the commission's stance in the DRW case is troubling. "Any time that you trade, you move the price," says an industry source familiar with the case. "Any time that you enter an order, you know you're going to move the price. Isn't that what price discovery is all about? Especially if you're in an illiquid market, and you are looking to accumulate a large position, of course you're going to move the price. And maybe you already have a large position. How can you have price discovery in markets if the notion is that any time you affect the price you're manipulating the market?"
DRW and the CFTC are currently waiting for a key ruling in the case, which is being fought in federal court in New York. In November 2015, both sides filed motions for summary judgement – meaning that they asked the court to rule on the legal merits of their arguments, without necessarily going to trial. It is unclear when the judge will issue her ruling.
DRW declined to comment.
Big guys beware
With the CFTC pushing an expansive view of its anti-manipulation authority, companies need to be on guard to ensure they don't end up on its radar, lawyers say.
"There isn't a whole lot of guidance on what you can do versus what you can't do," says Berkovitz at WilmerHale. "But in situations where there is a reasonable belief that companies' trading strategies will move price, I think it's important to ensure that those strategies haven't been designed with the intent to move price.
Companies should ensure that their trading strategies are justified by legitimate business reasons, and that those reasons are documented, rather than for some other reasons."
Nathan at Morvillo advises firms to conduct training and monitor trader communications to ensure that nothing said via emails or instant messages could land the firm in trouble down the road. "Watch anything you put in writing," he says.
"Because traders speak in a certain way and, in my experience, the way their emails and statements read isn't necessarily consistent with what they meant. They will say things in fairly aggressive and vigorous tones, and it will sound to a third party like someone has the intention to engage in mischief, when in fact they're just speaking the way traders speak."
It may take years for the Kraft and DRW cases to play out in court. In the meantime, the CFTC is likely to remain emboldened in its approach to market manipulation. Larger participants, which have the ability to swing markets around with their trading, are likely to face the toughest scrutiny from the regulator, legal experts warn.
"The CFTC is going to be very vigilant in situations where entities have market power and trade in a way where that market power potentially has an impact on price," Berkovitz says.
The week on Risk.net, September 8-14, 2018Receive this by email