Following Bench Trial, Southern District Of New York Finds That CFTC Failed To Prove Artificiality And Enters Judgment For Defendants In Market Manipulation Action
On November 30, 2018, Judge Richard J. Sullivan of the United States Court of Appeals for the Second Circuit, sitting by designation on the United States District Court for the Southern District of New York, issued a decision following a 2016 bench trial presided over by Judge Sullivan before his elevation to the Second Circuit in an action brought by the United States Commodity Futures Trading Commission (“CFTC”) against DRW Investments LLC (“DRW”) alleging that DRW had manipulated the price of a certain swap future in violation of the Commodities Exchange Act (“CEA”). U.S. Commodity Futures Trading Commission v. Donald R. Wilson, et al., No. 1:13-cv-07884 (S.D.N.Y. Nov. 30, 2018). The Court entered judgment for DRW on all claims, finding that the CFTC failed to prove that DRW’s challenged bids were at artificial prices.
The CFTC alleged that DRW, a company that specializes in trading financial derivatives, manipulated the price of an exchange-traded interest rate swap futures contract known as the IDEX USD Three-Month Interest Rate Swap Futures Contract (the “Three-Month Contract”). Because the Three-Month Contract traded on a futures exchange and was cleared by a clearinghouse, each party to a trade was required to pay its counterparty on a daily basis to the extent the current value of its position deteriorated. Those funds could then be reinvested, which created a convexity effect, i.e., an imbalance such that payments to the “long” side of the swap — who received payments as interest rates moved higher — were more valuable than payments to the “short” side, because in the former case the payments were made in high-interest rate environments in which money was more valuable. The margin payments were calculated daily by the clearinghouse based on factors including submitted bids and offers during a settlement period, the prices of consummated trades, and published rates for equivalent over-the-counter (“OTC”) markets.
The CFTC alleged that DRW placed bids during the settlement period in order to artificially inflate the price of the Three-Month Contract, which in turn increased the margin payments received by DRW on its existing long positions. DRW responded that the bids it placed were not “artificial,” but were instead based on its own internal modeling and valuations, which led it to be willing to continue bidding the price up in the hopes of enticing new market entrants, while still turning a profit if those trades were consummated. Slip op. at 7.
The Court agreed with DRW, finding that the CFTC failed to establish the four elements of “market manipulation” required in the Second Circuit: that a defendant had the ability to influence market prices, that an artificial price existed, that defendant caused the artificial price, and that defendant specifically intended to cause the artificial price. Id. at 15. The Court emphasized five areas in which the CFTC had failed to establish key facts: (1) that DRW ever made a bid that it thought might be unprofitable; (2) that DRW ever made a bid that it thought could not be accepted by a counterparty; (3) what the fair value of the contract actually was at the time DRW was making its bids; (4) that DRW’s bidding practices ever scared off would-be market participants; and (5) that DRW ever made a bid that violated any rule of the exchange. Id. at 13-14. As a result, although DRW undisputedly had the power to influence the clearinghouse’s settlement price based on placing above-market bids, the Court found no evidence that these bids were at “artificial” prices that did not reflect supply and demand. Slip op at 16.
The Court also rejected the CFTC’s argument that any price influenced by DRW’s bids was necessarily illegitimate and artificial because DRW intended that the bids would affect the settlement prices. Id. at 18. The Court found this logic untenable because it would “effectively bar market participants with open positions from ever making additional bids to pursue future transactions” and would also effectively read out of Second Circuit precedent the elements requiring proof of an artificial price. Id.
Moreover, while emphasizing that defendant was under no obligation to do so, the Court found that DRW had put forward credible evidence supporting the existence of the convexity premium, including from DRW’s trading activity with counterparties at prices far above the OTC rates and those counterparties’ attempts to avoid and unwind trades after coming to realize the value of convexity. Id. DRW also established that its trading strategy was to acquire as many long positions as it could in the Three-Month Contract as long as they were below DRW’s internal valuation, and all the bids it submitted were below that valuation (id. at 19) and were open on the market for long periods of time (id. at 22).
The Court likewise rejected the CFTC’s theory of “attempted market manipulation” for failing to establish artificiality. The Court noted that the CFTC’s only substantive evidence of intent to manipulate was the fact that the DRW failed to consummate trades during the period in question. The Court found, however, that this “hindsight observation” was insufficient, particularly where the CFTC admitted that counterparties could accept DRW’s bids if they were artificially high; one sophisticated counterparty did reach an agreement with DRW before backing out after realizing, essentially, that the bids were not high enough; and the winding-up of two other counterparties’ open positions with DRW confirmed that DRW’s bids were market-based and reflective of its honest appraisal of the contracts’ value. Id. at 23. As Judge Sullivan observed, “[i]t is not illegal to be smarter than your counterparties in a swap transaction.” Id. at 26.
This decision highlights that claims for market manipulation under the CEA will be scrutinized to determine whether a reasonable economic rationale exists for the trading activity, even where that activity does affect pricing. In this regard, the Court’s rejection of what it described as the CFTC’s “tautological fallback argument” — “conflat[ing] artificial prices with the mere intent to affect prices” — appears to constitute a categorical rejection of a key argument that has been advanced by the CFTC in other recent matters.