Tuesday, December 18, 2018

Willkie Farr attorneys discuss prevention and litigation of commodities insider trading

By Lene Powell, J.D.

In a new webinar sponsored by FIA Law & Compliance, Willkie Farr attorneys Paul Pantano, Athena Eastwood, and Neal Kumar explore commodities insider trading, more precisely known as “misappropriation of nonpublic information.” The webinar describes the elements of a misappropriation violation and differences from insider trading in the securities context, examines enforcement actions by the CFTC as well as other authorities and private actions, and recommends measures to prevent violations.

Misappropriation of nonpublic information. The Commodity Exchange Act (CEA) does not refer to “insider trading” but to “misappropriation of nonpublic information.” As Athena Eastwood explained, an important distinction from the securities context is that historically, commodity and derivatives market participants have been allowed to bring their own proprietary inside information to the markets to aid in price discovery, for example information relating to production or positions. Although the Dodd-Frank Act created new categories of violations, this is still true today. It is only misappropriation of inside information that is prohibited.

Before the Dodd-Frank Act, the CEA prohibited the following:
  • CEA Sections 9(c) and 9(d) prohibit CFTC commissioners and employees from trading based upon “nonpublic information.” 
  • CEA Section 9(e) prohibits “insider trading” by employees and members of the governing board or committee of a registered entity or National Futures Association (NFA). 
To address concerns that market participants were using confidential information of customers, counterparties and M&A targets to trade for their own benefit, Congress gave the CFTC new authorities in Section 6(c)(1) that are modeled on the SEC’s authority in SEC Rule 10b-5. The CFTC issued Rule 180.1, which prohibits trading on the basis of material nonpublic information (MNPI): (1) in breach of a pre-existing duty; or (2) if the MNPI was obtained by fraud or deception. The CFTC’s authority applies to futures, swaps, and cash commodity transactions, including spots and forwards. 

Elements of misappropriation violation. The misappropriation theory is based in fraud and relates to trading on the basis of MNPI in violation of a duty to keep the information confidential, as well as sharing MNPI with a third party for trading purposes (tipper and tippee). From the rule, preamble, and case law, the elements are: 
  1. Misappropriation. This involves the taking and use of confidential or non-public information.
  2. In breach of a pre-existing duty to keep the information confidential. This can be either a contractual duty like a non-disclosure agreement or a confidentiality provision in an M&A or commodity or derivative sale agreement, or a legal duty, including the obligation of swap dealers, FCMs, CPOs and CTAs to keep customer information confidential. It can also arise from company policy or a “relationship of trust and confidence.”
  3. Of material non-public information. Information is material if it would have a significant impact on the market price, rate, or level of a futures contract, swap or commodity transaction. Examples include the price of a commodity at a particular delivery point or in a geographic region or the price of a listed or OTC derivatives contract. Information that is available to others or that can be derived independently is not confidential.
  4. For the purpose of trading for your own benefit
“Relationship of trust and confidence.” A relationship of trust and confidence arises from an expectation, implied or explicit, that the information will be kept confidential. CFTC enforcement actions provide examples of this. 
  • In In re Motazedi, an employee executed trades in his personal account to the detriment of the employer’s account, in violation of company policies that prohibited misuse of proprietary or confidential information. Penalties included a $100K penalty, restitution, and trading ban.
  • Similarly, in In re Ruggles, an employee executed trades in his personal account opposite the employer’s account that he also controlled, in violation of company policies. This action resulted in a $1.75 million fine, restitution, and trading ban.
  • CFTC v. EOX Holdings LLC involves a broker-customer relationship rather than employer-employee. An AP of an IB used confidential information of other customers as the basis for trading a discretionary account. The AP also communicated trading activity of other customers to the customer holding the discretionary account. The CFTC alleges fraud-based manipulation against Gizienski and EOX, alleged supervision failures against EOX, and recordkeeping violations against EOX. In the continuing litigation, the CFTC is seeking civil monetary penalties, permanent registration and trading bans, and a permanent injunction against further violations. 
Other standards for non-public information. As Neal Kumar discussed, in addition to the CFTC, there have also been other investigations and prosecutions of misappropriation. Prudential regulator settlements in the FX markets have enforced violations of the protection of customer information, and criminal prosecutions have tackled front-running in the FX markets. There have also been private actions targeting misappropriation.

These developments have led to efforts to develop global standards, including the FX Global Code by the Bank of International Settlements (BIS), the Global Precious Metals Code by the London Bullion Market Association (LBMA), and the Statement of Good Practice by the FICC Markets Standards Board. Key principles from these global standards include:
  • Market participants should clearly and effectively identify and appropriately limit access to confidential information.
  • Market participants should not disclose confidential information to external parties, except under specific circumstances.
  • Market participants should have clear guidance on approved modes and channels of communication. 
The global codes provide some guidance on the difference between “market color” and confidential information, including that market color should be based upon information that is aggregated and anonymous. Firms should provide guidance to staff on how to appropriately share market color, which can be viewed on a spectrum in which staff should ask about gray areas in the middle. The more specific the information, including specific client names and strategies, the more potentially problematic the communication.

A new priority for the CFTC. As indicated by the CFTC’s creation of an insider trading task force in September 2018, this is a significant and expanding area of enforcement for the agency. According to Paul Pantano, the CFTC has moved beyond the low-hanging fruit of the early cases to investigations of whether various registered entities (SDs, FCMs, CTAs, CPOs) have disclosed MNPI about the trading activity of a customer to a third party (e.g., a hedge fund), which then uses that MNPI to trade for its own benefit. In Pantano’s view, this is a “sea change” and much more dangerous for clients than the obvious employer-employee types of cases. Investigation triggers involve whistleblower tips, complaints by current or former customers; unusual trading activity around large price changes; and discovery of problematic communications.

Minimize exposure. Registrants should consider the following steps to minimize their exposure to misappropriation violations.
  • Inventory confidentiality obligations, including NDAs and regulatory requirements. 
  • Inventory MNPI to which traders have access, and restrict this to a need-to-know basis or minimize the number of traders with access where possible.
  • Inventory the types of information that traders typically share with customers and third-parties, and train traders about the types of information that they are permitted to share or must keep confidential. 
  • Provide guidance about the difference between MNPI and market color, developing a spectrum of bright-line items versus gray areas in between, where traders should ask for help.
  • Avoid making proprietary trades based on information received from counterparties or other market participants unless it is obviously not confidential. Here, it should be distinguished between trading on your own MNPI and trading on MNPI obtained from another source.
  • Adopt and enforce written policies and procedures for how to handle MNPI. 
Get up to speed. Given the CFTC’s focus on this area, it is prudent for registrants to learn what constitutes misappropriation of inside information under the CEA, review global industry standards and guidance, study enforcement actions by CFTC and other authorities, and take steps to minimize their exposure to violations. The FIA’s recorded webinar and slides provide additional detail and are available here.

Keep up with future developments by following the WK Securities team on Twitter @WK_Securities and on LinkedIn.