“It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented the product.”1 So wrote Judge Sullivan nearly two years after the bench trial in CFTC v. DRW, in entering judgment in favor of the Defendants on all of the CFTC’s market manipulation claims. The long-anticipated decision is a significant setback for the CFTC’s anti-manipulation campaign.
The CFTC’s complaint alleged that, during a seven-month period in 2011, Defendants attempted to manipulate, and did manipulate, the settlement price of the IDEX USD Three-Month Interest Rate Swap Futures Contract (“Three-Month Contract”) by making a large number of bids on the electronic NASDAQ OMX Futures Exchange with the intent to move prices of those contracts in their favor and to increase the value of the futures contracts positions that they held in their portfolio. Defendants contended that they recognized that the fair value of the Three-Month Contract was significantly higher to the comparable OTC interest rate swap rate, which had created an opportunity for arbitrage.
While acknowledging that there was no question that Defendants had the ability to influence the settlement of the Three-Month Contract by making bids on the electronic exchange, the Court ultimately found that the CFTC’s case “founders on its abject failure to produce evidence – or even a coherent theory – supporting the existence of an artificial price.”2 The Court found that the opinions of the CFTC’s expert on this issue to be “conclusory and circular,” and “not premised on evidence or settled economic principles.”3 The Court also had noted several evidentiary deficiencies in the CFTC’s case, namely that there was no evidence that Defendants ever made a bid that it thought might be unprofitable or could not be accepted by a counterparty, what the fair value of the contract actually was at the time Defendants made its bid, that Defendants’ bidding practices ever scared off would-be market participants, or that Defendants ever made a bid that violated any exchange rule. Defendants were found to have demonstrated that the value of the Three-Month Contract was consistently higher than Defendants’ bids and the corresponding rates, and that Defendants’ bidding practices contributed to price discovery rather than price manipulation. Fatal to the CFTC’s market manipulation claim was the CFTC’s failure to articulate any theory as to why the market was inefficient, or why would-be counterparties were prevented from enforcing market discipline by hitting Defendants’ allegedly inflated bids.
The CFTC’s “fallback argument that endeavors to conflate artificial prices with the mere intent to affect prices” was dismissed as “tautological.”4 The CFTC argued that the bids were inherently manipulative, regardless of whether those bids were reflective of fair market value or whether they were designed to attract counterparties, because Defendants understood and intended that their bids would affect the settlement price. The Court characterized this argument as an attempt to “read out” the artificial price element of the four-part test for establishing manipulation.5 The Court declined to collapse the artificial price element into the subjective intent requirement, which would lower the bar for proving the bar for proving market manipulation.6 Because Defendants articulated and demonstrated a rationale and a formula supporting its pricing strategy, the Court found that the Defendants’ trading pattern could not be a basis for liability under the Commodity Exchange Act.
The CFTC’s attempted manipulation claims were likewise rejected because the CFTC failed to prove that Defendants intended to cause artificial prices. Moreover, Defendants proved that they sincerely believed the fair market value of the Three-Month Contract was higher than the bids they submitted during the relevant period. The Court found that the mere intent to affect prices was not enough to prove attempted manipulation; rather the CFTC must show that Defendants intended to cause artificial prices that do not reflect the forces of supply and demand. Noting that “a slogan is a poor substitute for evidence, particularly when the slogan doesn’t fit the facts of the case,” the Court found that, even though Defendants made numerous trades during the settlement period with an understanding that those bids would affect the settlement price, the CFTC failed to prove that Defendants intended to bang the close in this case as those numerous bids “says nothing about whether they understood those bids to be artificially high.”7 Nor was the Court persuaded by the lack of consummated trades in the Three-Month Contract to demonstrate an intent to manipulate the market.
In finding that the CFTC failed to meet its burden on any of its causes of action, the Court found that the cry of market manipulation “based on little more than an ‘earth is flat’-style conviction that such manipulation must have happened because the market remained illiquid” was insufficient to establish market manipulation or attempted manipulation.8 The scathing decision will likely impact the Division’s approach in pending and future manipulation matters, especially as the focus now shifts to Mondelēz for further clarity on the Division’s posture in these types of cases. Mondelēz is a lawsuit commenced by the CFTC alleging manipulation and attempted manipulation of the prices of cash wheat and wheat futures in the Northern District of Illinois currently at the summary judgment stage.9 It remains to be seen whether the CFTC will appeal the decision, especially since this case involved pre-Dodd-Frank conduct. Should the CFTC choose to appeal, however, the CFTC undoubtedly will face an uphill battle.
UPDATE: On February 27, 2019, the Commission announced that Chairman Giancarlo decided that the agency will not appeal the district court’s decision. A Commission spokesperson stated that “[w]hile the agency will not move forward with this case, it will continue to vigorously enforce the Commission’s anti-manipulation provisions and prosecute cases through trial where necessary.” Given that the trading activity occurred before Dodd Frank, the Commission will undoubtedly seek to limit the application of the district court’s decision of DRW by distinguishing it from future manipulation cases brought by the agency.
1 CFTC v. Donald R. Wilson and DRW Investments, LLC, Case No. 1:13-cv-07884-RJS-KNF (S.D.N.Y. Nov. 30, 2018), p. 26.
2 Id., at p. 16.
4 Id., at pp. 16-17.
5 In order to establish manipulation, it must be shown that: (1) Defendants possessed an ability to influence market prices; (2) an artificial price existed; (3) Defendants caused the artificial prices; and (4) Defendants specifically intended to cause the artificial price. See In re Amaranth, 730 F.3d 170, 183 (2d Cir. 2013).
6 Id., at p. 18.
7 Id., at p. 21.
8 Id., at p. 26.
9 CFTC v. Kraft Food Grp., Inc., et al., Case No. 1:15-cv-02881 (N.D. Ill.).
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