The Changing Landscape of the CFTC’s Enforcement Actions

Posted by Kobi Kastiel, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Saturday May 4, 2013 at 10:39 am
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Editor’s Note: The following post comes to us from John H. Sturc, partner and co-chair of the Securities Enforcement Practice Group at Gibson, Dunn & Crutcher LLP, and is based on a Gibson Dunn alert by Mr. Sturc and Jeffrey L. Steiner; the full text, including footnotes, is available here.

During the past four years, the Commodity Futures Trading Commission (“CFTC” or the “Commission”) has substantially expanded its regulatory reach and flexed stronger enforcement muscles. Since 2010, the CFTC has dramatically increased its annual enforcement action totals, and has imposed record high financial penalties on significant market participants. In 2011 and 2012, the CFTC filed at least 201 enforcement actions, almost as many as the past five years combined, and has already recovered approximately $1.8 billion in total sanctions. As CFTC Chairman Gary Gensler has stated, “Dodd-Frank expands the CFTC’s arsenal of enforcement tools. We will use these tools to be a more effective cop on the beat, to promote market integrity, and to protect market participants.” Notwithstanding budgetary constraints, the next four years are likely to show continued emphasis on expanded enforcement efforts as the agency implements its new rules. This post focuses on the CFTC’s new rulemakings and how Title VII has increased the CFTC’s power to create and police the derivatives markets.

I. Expanding the CFTC’s Enforcement Actions

Over the past two years, the agency has hit record levels of enforcement actions and civil penalties imposed. Figure 1 below details the types of enforcement actions that the CFTC has brought from 2006 through 2012, as well as the total amounts of monetary penalties it recovered during each fiscal year.

Fiscal Year 2006 2007 2008 2009 2010 2011 2012
Total number of enforcement actions filed 33 37 39 50 57 99 102
Total monetary penalties recovered and sanctions imposed (millions) $446 $542 $636 $280 $200 $450 $935
Manipulation, attempted manipulation, false reporting 2 3 3 2 6
Commodity pools, hedge funds 11 8 13 15 12
CTAs, managed accounts, and trading systems 6 3 1 3 3
Fraud 2 1 1 1
Forex fraud 6 6 1 16 14
Statutory disqualification 5 4 5 2 2
Other illegal off exchange 1 1 1
Supervision and compliance 8 9 8 7
Trade practice 4 5 3 12

In contrast to earlier years, in 2011 and 2012, the CFTC brought actions involving major market participants which captured significant attention in the media and have led to some of the largest monetary fines ever levied by the CFTC. Several have arisen out of the multi-agency and multi-national investigations of the LIBOR market, investigations in which the CFTC has had a central role. For example, in 2012, the CFTC filed charges against Barclays PLC and two affiliates for alleged attempted manipulation and false reporting of benchmark interest rates. The charges were simultaneously settled pursuant to an order requiring Barclays to pay $200 million, the largest fine ever imposed by the CFTC to that date, and requiring Barclays to implement a number of remedial measures to ensure the integrity of the bank’s benchmark submissions. Also in 2012, the CFTC filed charges against JPMorgan Chase Bank for its allegedly unlawful handling of Lehman Brothers, Inc.’s customer segregated funds before and after Lehman filed for bankruptcy in the midst of the financial crisis of 2008. This action too was settled pursuant to an Order requiring JPMorgan to pay $20 million, the largest CFTC sanction for a segregated fund violation to date. In 2013, the CFTC imposed its largest penalty to date when it ordered the Royal Bank of Scotland plc and RBS Securities Japan to pay a $325 million penalty to resolve charges of manipulation, attempted manipulation, and false reporting of LIBOR. The CFTC has also imposed large fines on individuals and their companies for allegedly fraudulent conduct. For example, on April 3, 2013, a federal court ordered defendants and their company to pay a total penalty of over $4.8 million, in an action that the CFTC brought for misappropriation and issuing false statements in a fraudulent commodities scheme.

The CFTC continues to bring forex and commodity futures enforcement actions alleging violations as to retail customers, and has done so on a larger scale than in the past. For example, in 2012, the CFTC filed charges against a Texas corporation and its principals, alleging they conducted a global off-exchange forex scheme accepting at least $53 million from at least 960 clients. In March 2013, the CFTC obtained a federal court judgment against two Mexican companies and their forex divisions, requiring them to pay more than $57 million in sanctions for defrauding their U.S. forex customers. One critical factor in the CFTC’s recent enforcement expansion is the increased authority that Congress granted to the CFTC in the Dodd-Frank Act. The following section describes some of the most important ways in which the Dodd-Frank Act has expanded the CFTC’s authority, and how it has enabled the CFTC to cast a wider net over previously unregulated behavior.

II. The Dodd-Frank Act’s Expansion of the CFTC’s Enforcement Authority

A. New Regulation of the Swaps Market

Title VII extended the CFTC’s jurisdiction from conventional derivatives (futures and options) to include the vast majority of the swaps market. The term “swap” is broadly defined in Commodity Exchange Act (“CEA”) Section 1a(47) and further defined in CFTC Regulation 1.3(xxx). Pursuant to the legislation, the CFTC has issued rules regulating (i) new swap “registrants” (e.g., swap dealers (“SDs”) and major swap participants (“MSPs”)), each of whom must now register, meet capital and margin requirements, maintain records and meet reporting requirements; and (ii) new “registered entities” (e.g., swap execution facilities (“SEFs”) and swap data repositories (“SDRs”)), each of whom must now register and comply with core principles and other requirements. CFTC registrants and registered entities that historically had been regulated only with respect to futures-related activities (e.g., commodity pool operators (“CPOs “), commodity trading advisors (“CTA”), futures commission merchants, introducing brokers, designated contract markets, and derivatives clearing organizations) are now being regulated with respect to their swaps activities. Title VII and the CFTC’s regulations extend requirements (e.g., reporting, clearing, trade execution) to all swap market participants, including non-registered commercial end-users.

Most of the Dodd-Frank rules are in place and the CFTC is expected to promulgate the remaining rules this year. For example, the CFTC has already finalized rules for clearing, reporting, real-time public reporting, and business conduct standards for SDs and MSPs. The agency is expected to finalize rules relating to trading, capital and margin requirements later this year.

B. Expanded Authority to Prosecute Cases Alleging Manipulation and Fraud

Section 753 of the Dodd-Frank Act significantly enhanced the CFTC’s “anti-manipulation authority” by amending CEA Section 6(c). In particular, amended CEA Section 6(c)(1) is virtually identical to the language in Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”). Congress modeled the amended CEA Section 6(c)(1) after Exchange Act Section 10(b) to harmonize the definition of manipulation, expand the CFTC’s authority, and strengthen the CFTC’s enforcement powers to the level of the SEC. Accordingly, the Commission adopted CFTC Regulation 180.1 as the functional equivalent of SEC Rule 10b-5. The CFTC has noted that by modeling CFTC Regulation 180.1 after Rule 10b-5, its goal was to “take an important step toward harmonization of regulation of the commodities, commodities futures, swaps and securities markets.” The CFTC has also stated that, given the similarities between CEA Section 6(c)(1) and Exchange Act Section 10(b), the CFTC “will be guided, but not controlled, by the substantial body of judicial precedent applying the comparable language of SEC Rule 10b-5.”

1. The CFTC may rely on evidence of “reckless” misconduct rather than “specific intent” to prove manipulation.

CFTC Regulation 180.1 lessens the CFTC’s burden of proving manipulative or fraudulent conduct. Heretofore, the CFTC was required to prove a defendant’s specific intent to create an artificial market price. While the CFTC had settled numerous manipulation and attempted manipulation cases, CFTC Commissioner Bart Chilton stated in 2009, “in the CFTC’s 35-year history we have only successfully prosecuted and won a single case of manipulation in the futures markets . . . [p]roving manipulation under current law is so onerous as to be almost impossible.”

The Dodd-Frank Act changed the intent requirement to prohibit “the reckless use of fraud-based manipulative schemes.” Because proof of reckless conduct does not rely exclusively on the defendant’s state of mind, this change closes a significant gap in CFTC authority. Secondly, Dodd-Frank allows the agency to bring anti-manipulation or fraud actions under CFTC Regulation 180.1 without having to always prove concrete changes on market price. The CFTC has stated that while a market or price effect “may well be indicia” of manipulation, “a violation of final Rule 180.1 may exist in the absence of any market or price effect.” Due to these decreased evidentiary requirements, the CFTC is now able to bring anti-fraud and manipulation actions more readily, increasing the chances that market participants could face high monetary penalties for previously unregulated conduct.

Finally, the Dodd-Frank Act also establishes limits on insider trading in futures and swaps based on material nonpublic information. The CFTC has recognized that unlike securities markets, derivatives markets have long operated in a way that permits market participants to trade on the basis of lawfully obtained, material nonpublic information, and therefore has limited the scope of CFTC Regulation 180.1. Accordingly, CFTC Regulation 180.1 only prohibits trading on the basis of material nonpublic information as provided in the Commission Determination or as otherwise prohibited by law. Thus, CFTC Regulation 180.1 prohibits trading based on misappropriated information obtained or used in breach of a duty of confidence owed to the source of the data. Furthermore, the Commission has noted that CFTC Regulation 180.1 does not create an affirmative duty of disclosure (except, as provided by Section 6(c)(1), such disclosure may be required “as necessary to make any statement made to the other person in or in connection with the transaction not misleading in any material respect”).

2. Dodd Frank expands the CFTC’s authority to sanction false reporting.

The Dodd-Frank Act also expanded the CFTC’s authority to bring new types of enforcement actions alleging false statements to the CFTC. CEA Section 6(c) previously prohibited the dissemination of false information to the Commission in registration applications or reports filed with the Commission. However, the Dodd-Frank Act expanded this prohibition to also forbid the dissemination of false information through false statements made in “any statement of material fact made to the Commission in any context.” (emphasis added). The CFTC has increased its prosecution of false statement actions in recent years. For example, in a 2012 fraud action against an Illinois resident registered as a CPO and CTA, and his company, the CFTC used its new Dodd-Frank “civil perjury” authority to charge the defendant with making material false statements to the CFTC during its investigation of this matter. The penalties that entities and individuals can face for making false statements to the CFTC have also increased. As recently as February 2013, the CFTC announced that a federal court imposed over $2.8 million in sanctions against a Florida resident and his company for making false statements to the National Futures Association, a self-regulatory organization responsible, under CFTC oversight, for certain aspects of futures and swaps regulations.

C. Expanded Prohibitions of Disruptive Trading Practices

The Dodd-Frank Act amends the CEA to prohibit “disruptive practices”, making it unlawful for market participants to (A) violate bids or offers; (B) intentionally or recklessly disregard the orderly execution of transactions during the closing period; or (C) engage in “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution). One especially important aspect of this legislation that could dramatically expand liability is that the prohibition on violating bids or offers, contained in CEA Section 4c(a)(5)(A), does not contain an intent requirement. Recognizing the vagueness of these prohibitions, the CFTC has proposed an interpretive order relating to the new disruptive trading practices prohibitions in CEA Section 4c(a)(5)(A). The CFTC’s proposed interpretation of CEA Section 4c(a)(5)(A) would prohibit any person from buying a contract at a price higher than the lowest available price and/or selling a contract at a price that is lower than the highest available price. The CFTC asserts that because Congress did not include an intent requirement, it is therefore a “per se” offense. Under the proposed interpretive order, the CFTC may not be required to show that a defendant intended to disrupt fair and equitable trading.

Unlike failure to honor bids or offers, the orderly execution prong of CEA Section 4c(a)(5)(B) requires the CFTC to prove recklessness. While the CFTC’s proposed interpretive order considers CEA Section 4c(a)(5)(B) to encompass any trading, conduct, or practices occurring inside the closing period, potential disruptive conduct outside that period may nevertheless form the basis for an investigation of potential violations. For example, the CFTC explains that with respect to swaps executed on a swap execution facility, a swap would be subject to Section 4c(a)(5)(B) if a closing period or daily settlement price exists for the particular swap.

“Spoofing” is a bid or offer placed with the intention of cancellation before execution. In the CFTC’s view, a “spoofing” violation of CEA Section 4c(a)(5)(C) does not require proof of a pattern of activity – the CFTC has suggested that even a single instance of trading activity can be disruptive of fair and equitable trading. Additionally, the CFTC has said that it has significant discretion in deciding what constitutes “spoofing” behavior. The proposed interpretive order states that to determine whether a “spoofing” violation has occurred, the CFTC will evaluate “market context, the person’s pattern of trading activity (including fill characteristics), and other relevant facts and circumstances.” These factors give the CFTC broad discretion and do not lend themselves to a bright line test. Thus, while the CFTC has proposed that the legitimate, good-faith cancellation of partially filled orders would not violate CEA Section 4c(a)(5)(C), it has also proposed that a partial fill would not be exempt. Therefore, it is difficult to predict how the CFTC may choose to evaluate a particular type of conduct.

D. The CFTC’s Anti-Evasion Authority

Under the Dodd-Frank Act, transactions that are willfully structured to evade the requirements of the Dodd-Frank Act will be treated as swaps. Here too, the agency has sought to retain discretion and has abjured a standardized bright line test as to what constitutes evasion. Instead, the CFTC has said that it will consider the extent to which the entity has a “legitimate business purpose” for its actions. As a result, the CFTC “will retain the flexibility, via an analysis of all relevant facts and circumstances, to confirm not only the legitimacy of the business purpose of those actions but whether the actions could still be determined to be willfully evasive.”

III. What to Expect from the CFTC Going Forward

The CFTC has shown that it will seek serious financial penalties and given its expanded authority under the Dodd-Frank Act, it can be expected that the agency will continue this trend. At a recent conference organized by the Securities Industry and Financial Markets Association Legal & Compliance Society (“SIFMA C&L”), CFTC officials indicated that the agency will prioritize investigations that involve some of the new anti-fraud provisions granted to the agency under its increased Dodd-Frank authority, such as the false reporting authority discussed above. Another aspect of the CFTC’s anti-fraud authority is its expanded ability to bring enforcement actions against tippers of material non-public information.

We also anticipate that the CFTC will use its new recklessness theories of liabilities in many of its actions. Supervision is another likely area of focus. In bringing an enforcement action, the CFTC will often look if there has been a violation of CFTC Regulation 166.3, requiring Commission registrants to “diligently supervise” the activities of its partners, officers, employees, and agents. Additionally, the CFTC, like the SEC, has a whistleblower program with attendant statutory protections. While the CFTC does not receive the same volume of tips as the SEC, CFTC staff has indicated that some of the biggest enforcement investigations currently in progress are derived from whistleblower tips.

With respect to implementation of new Dodd-Frank rules, CFTC enforcement staff noted at the recent SIFMA C&L conference that it places a great emphasis on candor between market participants and the Division of Enforcement. If a participant is unable to comply with a rule, and proactively communicates with the CFTC promptly following that rule’s enactment with an explanation and steps taken to comply, the CFTC may be less likely to bring an enforcement action. However, if, for example, a participant waits until a year after a rule’s enactment, does not put sufficient resources towards compliance, and then asks for an extension, an enforcement action is more likely.

Budget constraints will, however, require the CFTC to be selective in its enforcement activities. Chairman Gensler recently testified before the Senate that the CFTC’s team “is less than 10 percent more in numbers than at our peak in the 1990s. Yet since that time, the futures market has grown five-fold, and the swaps market is eight times larger than the futures market…” When questioned whether the CFTC has adequate oversight resources, Chairman Gensler replied “No, we absolutely do not. We are currently shelving enforcement [cases]…we just have to because of limited resources.” “Shelving” does not mean closing, and, while CFTC resources may remain limited, this scarcity may induce the agency to seek more severe relief in those actions it does commence to maximize their deterrent value.

IV. Conclusion

With the passage of Dodd-Frank and the support of an administration which believes in its mission, the CFTC’s days of relative obscurity are over. Because its authority to regulate swaps affects all market participants, the agency’s regulatory and enforcement actions warrant scrutiny not only by financial markets participants, but all businesses engaging in hedging transactions.

 

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