Tuesday, December 04, 2018

Failure to show artificial price dooms CFTC manipulation action against DRW

By Lene Powell, J.D.

Calling the conclusions of a CFTC expert witness “absurd,” “near religious,” and “circular,” the Southern District of New York dismissed the CFTC’s market manipulation case against proprietary trading firm DRW and its founder, Don Wilson. The court concluded that the defendants had merely savvily capitalized on a legitimate trading opportunity, not manipulated the market, because the CFTC did not show that the defendants created an artificial price (CFTC v. Wilson, November 30, 2018, Sullivan, R.).

Noting that the case involved the CFTC’s pre-Dodd Frank legal authority, CFTC Chairman J. Christopher Giancarlo said the agency was analyzing the decision and considering next steps.

Alleged manipulation. In 2010, DRW began to trade the IDEX USO Three-Month Interest Rate Swap Futures Contract, based on Wilson’s belief that the contract was mispriced in relation to the over-the-counter (OTC) swap rate. DRW submitted a large percentage of its bids during the settlement window, knowing that this trading practice would result in a higher settlement price, particularly since the market for the contract was highly illiquid. In August 2011, DRW placed its final bid on the contract and unwound all its open positions for approximately $20 million. As the CEO of Jeffries, LLC, one of DRW’s counterparties, stated in an email to Wilson, “You won big. We lost big.”

The CFTC alleged that the defendants had violated Sections 6(c) and 9(a)(2) of the Commodity Exchange Act, which prohibit market manipulation and attempted manipulation. The CFTC argued that the defendants’ trading practice in placing most bids during the settlement window was a type of disruptive trading practice called “banging the close.” Both sides moved for summary judgment, which the court denied and declined to reconsider.

No artificial price equals no manipulation. After a bench trial, the court concluded that the defendants had not engaged in market manipulation. Although the CFTC did establish the first element of price manipulation, that the defendants had the ability to influence the settlement price, the CFTC failed to show the second element, that the defendants had created an artificial price.

According to the court, the CFTC offered no evidence or explanation demonstrating that the contract settlement prices were artificially high. The court dismissed the testimony of the CFTC’s expert witness, who gave the opinion that the prices did not reflect the forces of supply and demand, as “conclusory and circular” and not based on evidence or settled economic principles. The defendants offered an “overwhelming” basis for concluding that the natural or fair market price for the contract was “well north” of the corresponding rates and also higher than DRW's bids.

The court also rejected the CFTC’s fallback argument that any price influenced by the defendants' bids was illegitimate and artificial because the defendants understood and intended that the bids would have an effect on the settlement prices. This was tautological and lacked any basis in law, said the court. Taken to its logical conclusion, this logic would effectively bar market participants with open positions from ever making additional bids to pursue future transactions.

In reaching its conclusion, the court found the following facts significant:
  • There was no evidence that DRW ever made a bid it thought might be unprofitable.
  • There was no credible evidence that DRW ever made a bid it thought could not be accepted by a counterparty.
  • The CFTC provided no credible evidence as to what the fair value of the contract actually was at the time DRW was making its bids.
  • There was no credible evidence that DRW's bidding practices ever scared off would-be market participants.
  • There was no evidence that DRW ever made a bid that violated any rule of the exchange.
Not a violation to be savvy. In dismissing the CFTC’s claims, the court concluded that Wilson’s trading strategy did not manipulate the market, but merely comprehended the true value of the contract better than else and capitalized on that knowledge.

“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 that product,” stated the court. “It is only the CFTC's Enforcement Division that has persisted in its 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. Clearly, that is not enough to prove market manipulation or attempted market manipulation, and the CFTC has simply failed to meet its burden on any cause of action.”

The case is No. 13 Civ. 7884 (RJS).