Friday, March 30, 2018

'Night market' trading of Korean index futures falls under Morrison's shadow

By John M. Jascob, J.D., LL.M.

Five Korean citizens who conducted overnight transactions in Korea Exchange (KRX) futures contracts plausibly alleged that a New York high-frequency trading firm and its founder injured them by engaging in spoofing in violation of the Commodity Exchange Act (CEA). Reversing the ruling below, a Second Circuit panel held that the complaint plausibly alleged that the trades were “domestic transactions” under the U.S. Supreme Court’s Morrison decision and Second Circuit precedent. Accordingly, application of the CEA to the defendants’ alleged conduct was not an impermissible extraterritorial application of the statute (Choi v. Tower Research Capital LLC, March 29, 2018, Walker, J.).

Night market trading and spoofing. The plaintiffs purchased on the so-called “night market” commodity futures contracts based on the KOSPI 200, a Korean stock index. On the KRX night market, traders enter orders in Korea, when the KRX is closed for business, whereupon their orders are quickly matched with a counterparty by CME Globex, an electronic trading platform located in Aurora, Illinois. The trades are then cleared and settled on the KRX when it opens for business the following morning.

In December 2014, the plaintiffs filed a class complaint alleging that Tower Research Capital LLC and its founder, Mark Gorton, utilized their algorithmic flash trading abilities to illegally manipulate prices of the KOSPI 200 futures during night market trading on the CME. Specifically, the plaintiffs alleged that Tower’s traders engaged in illegal spoofing by creating hundreds of fictitious buys and sells to artificially manipulate the price of the contracts by creating a false impression about supply and demand. Relying on the Supreme Court’s holding in Morrison v. National Australia Bank Ltd., (U.S. 2010), however, the Southern District of New York concluded that application of the CEA to the defendants’ conduct would be an impermissible extraterritorial application of the act and dismissed the complaint.

After the plaintiffs amended their complaint to add allegations about the domesticity of KRX night market transactions, the district court again granted the defendants’ motion to dismiss. Among other things, the district court concluded that the plaintiffs still failed to sufficiently allege that CME Globex is a “domestic exchange” under Morrison because it is not structured like other exchanges and is not registered as an exchange with the CFTC. The court also held that the trades on the KRX night market were not “domestic transactions” because KRX rules suggest that transactions become final only when they settle on the KRX, not when they match on CME Globex.

Irrevocable liability. On appeal, the Second Circuit reversed. The appellate panel began by noting that Morrison said nothing about the CEA’s territorial reach, and only once, in Loginovskaya v. Batratchenko (2d Cir. 2014), did the Second Circuit itself address the question. In Loginovskaya, the Second Circuit concluded that Morrison’s “domestic transactions” test applies to the CEA. In so holding, the panel adopted a rule established in the Section 10(b) case of Absolute Activist Value Master Fund Ltd. v. Ficeto (2d Cir. 2012), where the court concluded that a transaction involving securities is a “domestic transaction” under Morrison if “irrevocable liability is incurred or title passes within the United States.”

Here, the plaintiffs’ amended complaint alleged not only that KRX night market trades bind the parties on matching, it also alleged that the express view of CME Group is that matches on CME Globex are “essentially binding contracts” and that members are required to honor all bids or offers which have not been withdrawn from the market. Accordingly, the complaint plausibly alleged under the Absolute Activist rule that parties incur irrevocable liability on KRX night market trades at the moment of matching.

The appellate panel rejected the defendants’ contention that the KRX rules establish that irrevocable liability attaches only at settlement on the KRX the morning after matching on CME Globex. Although the rules give the exchange power to cancel or modify trades due to errors, the exchange’s power to rectify errors in the parties’ contracts does not render those contracts “revocable” in any meaningful sense, the court opined. And, although liability might ultimately attach between the buyer/seller and the KRX upon clearing, that does not mean liability does not also attach between the buyer and seller at matching prior to clearing. Before a subsequent transfer of liability takes place in Korea the next morning, the buyer and seller are first bound to each other when they enter a binding irrevocable agreement through matching on CME Globex. Accordingly, the plaintiffs sufficiently alleged that the parties incurred irrevocable liability for KRX night market trades in the United States.

The case is No. 17-648.