Dodd-Frank Lowers Market Manipulation Standard, Easier for CFTC to Prove

The U.S. Commodity Futures Trading Commission is on the hunt. The target: market manipulators.

On May 24, 2011 the CFTC filed its biggest market manipulation case ever in CFTC v. Parnon Energy, Inc., et al. On May 25, 2011, CFTC Commissioner, Bart Chilton, confirmed in a press conference the agency’s vow to hunt down market manipulators by stating, “We’re watching and we’ll come and get you.” As if that’s not chilling enough, Dodd-Frank provisions could make it easier for the CFTC and other regulators to bring market manipulation cases by lowering the standard of intent.

Market manipulation is a deliberate attempt to create artificial market prices or market for a particular security, commodity, or currency. In the past, in order to prove a market manipulation claim, the CFTC had to prove (1) an individual actually intended to manipulate prices; (2) that individual had the market power to move the price of a commodity; and (3) that individual actually caused an artificial price in the market. This was a difficult standard to meet--evidenced by the fact that the CFTC only has successfully prosecuted and won one market manipulation case in the futures markets over the agency’s 36-year history.

However, Dodd-Frank sets forth a new standard under which the CFTC will now have to show that a market participant acted in a manner with the potential to disrupt the market. The effect of a lower standard will be two-fold: first, it should make it easier for the CFTC to prove its case, and second, it expands the CFTC’s enforcement jurisdiction by now allowing the agency to prosecute market participants who may have merely acted in a reckless manner to cause a price in the market that otherwise would not have occurred. This standard is analogous to the current SEC standard for market manipulation in securities markets.

Additionally, Dodd-Frank leaves much discretion to the CFTC to determine its own specific enforcement rules. Although final rules have not been approved, the CFTC has stated that it will “crack-down” on three areas under the market manipulator theory: “spoofing”, “banging the close”, and high-frequency trading/algorithmic strategies. “Spoofing” occurs where a trader makes a bid or offer and cancels it before it is carried out. “Banging the close” takes place when a trader acquires a substantial position leading up to the closing period, and then offsets the position before the end of the trading day in an attempt to manipulate closing prices. Finally, the CFTC plans to investigate high-frequency trades and algorithmic strategies to determine whether such techniques have the effect of disrupting markets. If so, then these types of trades will likely face more rules and be subject to the new market manipulation standard.

CFTC Proposes Draft Rule on Trading Restrictions

The Commodity Futures Trading Commission on Thursday, December 16, 2010, released a proposal that aims to curb speculative trading in commodities such as oil and precious metals. The proposal is part of the effort to increase oversight of the over-the-counter derivatives market as required of the CFTC under the Dodd-Frank bill passed in July. Specifically, the Dodd-Frank Act amended the Commodity Exchange Act to require, among other things, the Commission to limit the amount of positions, other than bona fide hedge positions, that may be held by any person with respect to commodity futures and option contracts in exempt and agricultural commodities traded on or subject to the rules of a designated contract market.

The draft plan would set a cap on spot-month positions (the month when a contract expires) to 25% of deliverable supply for a given commodity. Non-spot-month position limits will be set for each referenced contract at 10 percent of open interest in that contract up to the first 25,000 contracts, and 2.5 percent thereafter. The proposal is on position limits in 28 different commodities, among which are included gold, silver and platinum. The Commission estimates that at most seventy traders in referenced agricultural contracts, six traders in referenced base metals contracts, eight traders in referenced precious metals contracts, and forty traders in referenced energy contracts may be affected by the proposed spot-month position limits.

"Spot-month" limits are based on estimates of deliverable supply, which information is currently available from designated contract markets. On the other hand, the CFTC currently does not have the data available for the proposed formula to be used for position limits outside of the spot-month, which is based on the overall size of the physical commodity swap markets.

According to the CFTC, the proposed position limits would enable the Commission to combat excessive speculation and manipulation. However, there was some skepticism among the commissioners of the CFTC as to whether this proposal will be effective. Voting on making the proposal formal for public comment was postponed so that further deliberation can take place.

A copy of a Wall Street Journal article discussing the CFTC proposal can be found here. A CFTC fact sheet on the proposal can be found here, and a CFTC Q&A on the proposal can be found here.

FINRA Issues Regulatory Notice on Sales Practices for Commodity Futures-Linked Securities

On October 20, 2010, FINRA issued Regulatory Notice 10-51 regarding sales practice obligations for commodity futures-linked securities. FINRA notes that in recent years, securities that offer exposure to commodities have become increasingly popular to retail investors - presumably due to a low correlation with other asset classes and enhanced portfolio diversification. FINRA notes that commodity futures-linked securities can be an effective tool for gaining exposure to this asset class that in some cases can be difficult for investors to access.

FINRA recognizes, however, that in some cases the performance of the commodity futures-linked security can deviate significantly from the performance of the referenced commodity. This deviation can produce unexpected results for investors who are not familiar with futures markets, or who mistakenly believe that commodity futures-linked securities are designed to track commodity spot prices (i.e., the immediate delivery value of the commodity).

Therefore, FINRA issued Regulatory Notice 10-51 to remind firms that offer commodity futures-linked securities that they must ensure that communications with the public about these securities are fair and balanced, that recommendations to customers are suitable, and that their registered representatives adequately understand and are able to inform their customers about these securities before they recommend them. FINRA notes that under NASD Rule 2210, firms must ensure that all communications with the public are fair and balanced, and provide a sound basis for evaluating the facts about any particular security or type of security, industry or service.

FINRA states that firms should not suggest that a commodity-futures linked security offers direct exposure to the commodity's spot price, overstate the degree of correlation between the the spot price and the commodity-futures linked security, or understate the risks inherent in investing in commodity futures. Firms should also not overstate the hedging value value of commodity futures-linked products, or commodities generally, for, by example, implying that their performance is always negatively correlated with equities or other asset classes. That a prospectus may convey such information does not excuse the firm's duty to ensure that its communications regarding the product are fair, balanced and not misleading.

Moreover, FINRA notes that NASD Rule 2310 requires that, before recommending the purchase, sale or exchange or a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer. For commodity futures-linked securities, the registered representative and retail customer should discuss, among other things:

• The commodity, basket of commodities or commodities index that a given product tracks;
• The product's goals, strategy and structure;
• That commodities prices, and the performance of commodity futures-linked securities, can be volatile;
• That the use of futures contracts can affect the performance of the product as compared to the performance of the underlying commodity or index;
• The product's methodology, including its strategy, if any, for managing roll yield and other factors that may affect performance; and
• The product's tax implications. (Commodity pools have different tax implications than mutual funds or exchange-traded notes.)

In sum, due to the volatility of commodities prices and, correspondingly, the performance of commodity futures-linked securities, and due to the prospect that commodity futures-linked securities may produce unexpected results for investors who are not familiar with futures markets, firms should take the necessary precautions to ensure that the sales of commodity futures-linked securities comply with federal securities laws and FINRA rules. A complete copy of Regulatory Notice 10-51 can be found here.

The Murky Waters of State Commodity Laws

State commodity laws are notoriously antiquated and hard to follow. For many precious metals dealers, it can be difficult to navigate the applicable state laws in the various states where they do business.

This difficulty arises for several reasons. First, the Model State Commodity Code (“Model Code”) was drafted in the early 1980s, and it has not been updated since its inception to account for changes in technology that affect the way legitimate precious metals dealers do business. Second, the Model Code has only been enacted as it was written by a handful of states, so there is a lack of uniformity from state to state. Third, some states, like Arizona and Montana for example, have adopted substantive provisions of the Model Code, but these provisions have been incorporated into the state securities laws, instead of a separate Chapter or Act. Finally, there are states that have chosen not to regulate commodity transactions at all or that have decided to regulate them using a different approach than that set out in the Model Code.

The Model Code originally was drafted to provide state jurisdiction over generic commodities-themed frauds because the state securities acts were inadequate to address such schemes. As a result, the Model Code devised the concept of a “commodity contract”, which is defined as “a contract for the purchase or sale of commodities, primarily for speculative or investment purposes, and not for use or consumption by the offeree or purchaser.” Therefore, this new concept was intended to provide a better means of jurisdiction over only certain commodity transactions.

Unfortunately, for precious metals dealers, the two most common schemes at the time the Model Code was drafted were centered around the sale of precious metals that were never delivered or promises to store precious metals that were subsequently never purchased. Accordingly, there are stringent provisions defining and regulating the purchase of precious metals. However, the Model Code drafters included an exemption for transactions involving the purchase of precious metals if certain very specific requirements were met. One of those requirements is that delivery must be completed within 28 days, purportedly making it easier for retailers to avoid and regulators to identify unregistered futures contracts.

Essentially, the Model Code should have streamlined the process for determining whether illegal transactions have taken place. But though the Model Code may seem straightforward on its face, the inconsistency in adoption between the states and nuances among those states that have adopted the Model Code has created a veritable trap for unwary precious metals dealers and necessitates the need for experienced counsel who are aware of the these subtle differences.

The attorneys of Cosgrove Law, LLC have a unique knowledge and understanding of state and federal commodity regulations and exemptions, with an emphasis in the area of precious metals. Our firm is a member of the Industry Council for Tangible Assets that has compiled a 500-page, nationally recognized 50 state commodities survey. Our attorneys regularly provide advice to commodity dealers about relevant state and federal regulations and assist in internal review of company procedures. As part of our firm’s compliance services, we are also available to conduct audits or assist in developing an audit program to ensure ongoing compliance.