On July 7, 2011, the Commodity Futures Trading Commission ("CFTC") approved five rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act" or "Dodd-Frank"). In adopting the first major rules under Dodd-Frank, the Commission launched an intense rulemaking period in which approximately 50 final rules are expected to be finalized during regular Commission meetings held over the coming months.
Most significantly, during the July 7th CFTC meeting, the Commission unanimously approved new anti-fraud and anti-manipulation rules implementing key provisions of Dodd-Frank. The rules, which will be effective 30 days after publication in the Federal Register, grant the Commission significant new authority to pursue fraud and manipulation in the futures, swaps and commodities markets. As of the preparation of this briefing, the final rules have not yet been published in the Federal Register.
In addition to the anti-manipulation rules, the CFTC finalized four Dodd-Frank rules addressing: (i) the definition of agricultural commodity; (ii) business affiliate marketing and disposal of consumer information; (iii) privacy of consumer financial information; and (iv) large trader reporting for physical commodity swaps.
Rules Prohibiting Fraud and Fraud-Based Market Manipulation
The final anti-fraud and anti-manipulation rules implement key provisions of Dodd-Frank Section 753, which provides the Commission with significant new enforcement tools to pursue fraud and manipulation in futures, swaps and physical commodities.1 Although the final rules adopt regulations that are virtually identical to those proposed by the Commission in its proposed rules,2 the preamble to the rules illustrates the breadth and significance of the Commission's new authority. Despite the lack of specificity as to prohibited conduct, the views expressed during the Commission's meeting, coupled with the flexible standard adopted, illustrate the significance of the Commission's new enforcement powers.
Final Rule Under CEA Section 6(c)(1)
Dodd-Frank Section 753 amended subsection 6(c)(1) of the Commodity Exchange Act ("CEA") by adding a fraud-based manipulation provision modeled on section 10(b) of the Securities Exchange Act of 1934. In implementing Section 753, the CFTC adopted a new final regulation, to be promulgated at 17 CFR § 180.1, which is based on SEC Rule 10b-5.
Specifically, new Rule 180.1 makes it unlawful to:
- 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;"
- engage in any "act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person;" or
- deliver a "false or misleading or inaccurate report concerning crop or market information."
In modeling the final rule on SEC Rule 10b-5, the Commission stated that it "will be guided, but not controlled, by the judicial precedent applying comparable language in Rule 10b-5." In doing so, the Commission provided that it intends to interpret the rule "not technically and restrictively, but flexibly to effectuate its remedial purposes" and notes that proof of a market or price affect is not required.
Lower Scienter Threshold
Although the CFTC has historically been vested with broad powers to prosecute market manipulation, specific intent to manipulate the market was required. In the past, the CFTC has struggled to prove intent in manipulation or even attempted manipulation cases. While Dodd-Frank does not specifically establish a recklessness standard, final Rule 180.1 adopts a recklessness scienter standard consistent with precedent interpreting SEC Rule 10b-5. The new rule thus creates a lower scienter threshold and prohibits fraud and fraud-based manipulative devices employed intentionally or recklessly, regardless of whether the suspect conduct was intended to create an artificial price. Specifically, the Commission clarified that "a showing of recklessness is, at a minimum, necessary to prove the scienter element of final Rule 180.1." In doing so, the rule closes a perceived regulatory gap in the Commission's anti-manipulation enforcement activities and brings the CFTC's authority in line with the enforcement powers of the FERC, the FTC and the SEC.
The Commission defines recklessness 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 or she was doing." While the Commission has not provided any specific examples of the type of trading behavior that would be captured by the "reckless" scienter element, it has equated the new scienter standard to the corresponding requirement under securities laws, and further declared that it will apply a "facts and circumstances" test to each case it brings under the new enforcement provision. The Commission affirmed, however, that the "reckless" standard of final Rule 180.1 will not capture "inadvertent mistakes" or "negligence." Nonetheless, by shifting from the "affirmative intent" requirement of the past, the CFTC is moving to an enforcement environment where inadequate controls, lax supervision, or flawed compliance programs could be sufficient to establish "recklessness" under the new anti-fraud rule.
Disclosure and Trading Based on Material Nonpublic Information
New CEA Section 6(c)(1) provides that "no rule or regulation promulgated by the Commission shall require any person to disclose" certain nonpublic information, including information that may be material to the price of a commodity transaction. Consistent with this statutory requirement, the final rules do not impose affirmative new duties on market participants (such as disclosure, diligence or inquiry requirements). The Commission acknowledged that it is not a violation of final Rule 180.1 to withhold information that a market participant lawfully possesses about market conditions and that, absent a pre-existing duty to disclose, silence is not deceptive under the new rule. Disclosure of certain nonpublic information is required, however, where such disclosure is necessary to make any statements made not misleading. The Commission specifically emphasized that fraud by "partial-omission" or "half-truths" could violate final Rule 180.1, if warranted under the facts and circumstances.
In addition, the Commission emphasized that it interprets new Section 6(c)(1) and final Rule 180.1 to prohibit trading on the basis of material nonpublic information to the extent such information was obtained in breach of a "pre-existing" duty. The duty breached may originate from "another law or rule, agreement, understanding, or some other source." According to the Commission, the new rule also prohibits any trading on the basis of material nonpublic information obtained fraudulently or through deceptive practices.
"In Connection With" Requirement
New CEA Section 6(c)(1) and final Rule 180.1 provide that the fraud or manipulation must be "in connection with" a swap, commodity or future. In addressing the "in connection with" requirement, the Commission stated that, while the scope is not limitless, it will look to securities law precedent and interpret the term "broadly, not technically or restrictively." Accordingly, the prohibitions of Section 6(c)(1) and final Rule 180.1 will reach "all manipulative or deceptive conduct in connection with the purchase, sale, solicitation, execution, pendency, or termination" of any swap, commodity, or future. This reach includes all of the payment and other obligations arising under a swap.
The Commission has focused much of its enforcement efforts in recent years on cross-market manipulations, that is, when alleged manipulative activity in one market is used to benefit positions held in another market. Significantly, in adopting the final rule, the Commission also emphasized that it will apply final Rule 180.1 "to the fullest extent allowed by law" when determining whether conduct in one market meets the "in connection with" requirement and is sufficiently related to activity subject to the Commission's jurisdiction.
Relationship to Existing Anti-Manipulation Authority
The Commission affirmed that its existing market manipulation and false reporting authority under CEA Section 9(a)(2) is not impacted by the final rules and will continue to serve as an additional device to combat market manipulation. Final Rule 180.1(c) specifically provides that "[n]othing in this section shall affect, or be construed to affect, the applicability of Commodity Exchange Act section 9(a)(2)." The Commission's historic anti-manipulation authority under CEA Section 9(a)(2) differs from the new authority under CEA Section 6(c)(1) in that it not only requires a higher scienter standard, but also requires price manipulation or an effect on prices to be proven, while revised CEA Section 6(c)(1) and Rule 180.1 only require an "intentional or reckless" mental state and do not require proof of price or market impact.
Manipulation by False Reporting & Good-Faith Mistakes
New CEA Section 6(c)(1)(A) includes within the Commission's anti-manipulation authority a prohibition of manipulation by false reporting, which prohibits, among other things, knowingly or recklessly delivering a "false or misleading or inaccurate report concerning crop or market information." New CEA Section 6(c)(1)(C), however, provides an exception to this prohibition for good faith mistakes in transmitting false or misleading or inaccurate information to a price reporting service. The Commission included a good faith exception in final Rule 180.1 but declined to expand the exception beyond the statutory language relating to the mistaken reporting of information to a price reporting service.
Final Rule Under CEA Section 6(c)(3) – Other Manipulation
Dodd-Frank Section 753 also amends CEA Section 6(c) by adding new subsection (c)(3), which prohibits manipulation and attempted manipulation of the price for swaps, commodities, and futures contracts. The final rule implementing this price manipulation provision, Rule 180.2, mirrors the Dodd-Frank statutory language and makes it "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 Commission affirmed that in applying Rule 180.2 it would follow the Commission's traditional four-part test for manipulation that has developed through case law under CEA Section 9(a)(2), which requires that the Commission establish that: (i) the accused had the ability to influence market prices; (ii) the accused specifically intended to create artificial market prices; (iii) an artificial price existed; and (iv) the accused caused the artificial prices.
The Commission confirmed that "recklessness" will not be sufficient to meet the scienter requirement under new CEA Section 6(c)(3) and final Rule 180.2. The Commission also emphasized that it will interpret the term "indirectly" in Rule 180.2 to include circumstances where a person uses a third party to engage in conduct designed to manipulate. As an example, the Commission indicated that it will not be a defense to a manipulation charge under CEA Section 6(c)(3) that a trader utilizes an executing broker to execute suspect trades and does not execute the trades himself.
During the Commission's meeting, Commissioner O'Malia expressed concern that the proposed final manipulation rules did not provide market participants with sufficient clear and straight-forward guidance to enable them to correctly identify their legal obligations and what constitutes prohibited conduct. Commissioner Sommers also noted that neither the CEA amendments to Section 6(c) nor the final rules provided any indication under what circumstances the Commission would prosecute: (i) false reporting under Section 9(a)(2) as opposed to the new false reporting prohibition under new Section 6(c)(1)(A) and Regulation 180.1(a)(4); or (ii) manipulation under Section 9(a)(2) as opposed to the new manipulation prohibition under new Section 6(c)(3) and Regulation 180.2. Notwithstanding these expressed concerns, the final rules were adopted unanimously.
Enforcement Director David Meister emphasized during the Commission's open meeting that the new anti-fraud and anti-manipulation provisions, and the final rules thereunder, will be a "priority" for the Commission's Enforcement Division in conducting investigations. Chairman Gensler added that the new rules will "broaden the types of cases" the CFTC can pursue and will improve its chances of successful prosecution. With a lower, "recklessness" scienter standard and application to all manners of fraudulent and deceptive conduct, these new authorities, once effective, will provide the Commission with substantial tools to aggressively investigate and prosecute fraud-based market misconduct. Accordingly, market participants should immediately consider taking steps to educate traders and other relevant personnel on prohibited trading practices and the CFTC's new enforcement powers.
The above is based on the discussion during the CFTC's public meeting and related materials published by the CFTC, available here.
This article was prepared by Peggy A. Heeg (email@example.com or 713 651 8443), Michael Loesch (firstname.lastname@example.org or 202 662 4552) and Lui Chambers from Fulbright's Energy Practice and Fulbright's Corporate Governance Practice.
1 Among other things, Section 753 of Dodd-Frank amends Section 6(c) and Section 22(a) of the CEA, which in turn are codified at 7 U.S.C. 9, 15 and 7 U.S.C. 25, respectively.