CFTC rules point to crackdown on manipulation: John Kemp
— John Kemp is a Reuters market analyst. The views expressed are his own —
By John Kemp
NEW YORK, Nov 9 (Reuters) – Two proposed regulations published by the U.S. Commodity Futures Trading Commission (CFTC) clarify its power to take enforcement action in cases of market manipulation and are intended to lead to a tougher regulatory regime in future.
The Commission is giving effect to the sweeping provisions of Section 753 Dodd-Frank Wall Street Reform and Consumer Protection Act (PL 111-203) which give it strong new powers over market manipulation and spreading false information.
Section 753 has widened the CFTC’s mandate to include OTC swaps as well as futures and options traded on registered exchanges. It has also clarified and strengthened the Commission’s authority to prevent and punish attempted manipulation wherever it occurs, attempting to remedy some of the weaknesses in the existing law.
PATCHWORK OF LAW AND CASES
In theory, the Commission already has plenty of enforcement authority. The 1936 Commodity Exchange Act makes it a criminal offence, punishable by a fine or imprisonment, to manipulate or attempt to manipulate commodity prices — including cornering the market or disseminating false information (7 USC 13(a)(2)).
The Commission also has powers to issue “cease and desist” orders to manipulators backed by the threat of fines or prison (7 USC 13b).
Finally, there are broad reserve powers to penalise manipulators and attempted manipulators by banning them from trading; suspending their registration; levying a civil penalty up to three times the monetary gain from each offence; and requiring them to make customer restitution (7 USC 9, 15).
The Commission has not been short of legislative authority.
But while the CFTC has issued plenty of cease and desist orders and civil penalties since it was established in its current form in 1974, there has been only one successful prosecution.
In most cases the Commission has opted to bring civil and administrative proceedings because they are simpler and less contentious.
MANIPULATION ON TRIAL
Prosecutions have been so rare, some observers have labelled commodity market manipulation “the unprosecutable crime.” Part of the problem is that the concept of manipulation is so poorly defined, and nowhere is it spelled out in statute law.
Writing about the trial of the Hunt Brothers for manipulating the silver market in 1979-1980, Stanford Professor Jeffrey Williams, who testified for the defendants at trial in 1988, identified four types of manipulation:
(1) Corners and squeezes where someone establishes a large futures position amounting to all or a large part of the deliverable supply of a commodity and then threatens to insist on delivery.
(2) Rumour-based manipulations relying on spreading false reports about the state of the physical market to produce a sharp movement in prices.
(3) Investor-interest manipulations where a series of trades and statements by the manipulator convinces others of a broadly based desire to hold the commodity, thereby increasing its price.
(4) Price-effect manipulations in which a trader holding an opinion about the long-term direction of prices trades in sufficient quantity to influence the current price, knowing such an effect will occur.
None of these manipulations is well-defined, and there is considerable overlap in practice. In the case against the Hunts, brought by Peruvian silver miner Minpeco, a federal jury ruled the Hunts had been part of a conspiracy to manipulate the silver market; violated antitrust law; monopolised the silver market; and committed fraud and racketeering.
But that was a civil trial, not a criminal one. Even after the Hunts had lost, it was still not clear which type of manipulation they were actually supposed to have committed. The outcome left a lingering controversy about whether the Hunts manipulated the market at all in a legal or financial sense, as Williams explains (“Manipulation on Trial: Economic Analysis and the Hunt Silver Case”).
Some of the ambiguity was deliberate. The writers of the 1922 Grain Futures Act and the Commodity Exchange Act intended to create a broad and flexible definition because each manipulation case is different. As the U.S. Court of Appeals for the Eighth Circuit observed in the 1971 case of Cargill versus Hardin, “The methods and techniques of manipulation are limited only by the ingenuity of man.”
Section 753 of the new law still leaves the definition open — which will remain a source of problems as well as flexibility. But it does contain two important new powers:
(1) In directing the Commission to adopt rules prohibiting any manipulative or deceptive contrivance or device, it shifts the focus from cornering the market and defines manipulation to include any false or misleading or inaccurate report concerning crop or market information or conditions affecting commodity prices.
There are exceptions for good-faith mistakes and negligent errors. But reports which are knowingly or recklessly false or misleading will be unlawful under the new rules. Until now,
false reports had to be knowingly inaccurate, and were subject to the criminal parts of the statute rather than the more common administrative process.
(2) Section 753 contains a broad, catch-all prohibition designed to provide the Commission with a fall-back power for cases which fall outside the narrower definitions in other parts of the statute.
CFTC’S FOUR-PART TEST
The CFTC is simultaneously seeking to reduce its reliance on econometric studies in deciding whether price manipulation has occurred, which has arguably hampered it in bringing criminal prosecutions and civil actions.
In deciding whether to bring civil or criminal actions, the CFTC uses a four-part test which requires it to establish: (i) the accused had the ability to manipulate prices; (ii) they specifically intended to do so; (iii) artificial prices existed; and (iv) the accused caused the artificial prices. An artificial price has been defined as one that does not reflect basic forces of supply and demand.
All parts of the test create problems. Intent is notoriously hard to prove in the absence of a smoking-gun letter or email. As Minpeco’s attorneys observed: “No one would ever confess to having conspired to manipulate a commodity market so you have to show compelling proof through the circumstances.”
But the biggest problems centre on the econometric analysis used to determine whether prices are artificial rather than the result of supply and demand, and identify a causal connection between the price movements and the alleged manipulators’ trading pattern.
Finding econometric proof of manipulation has proved surprisingly hard. Some analysts therefore conclude manipulation has rarely or never occurred.
Others counter that absence of evidence is not the same as evidence of absence. The econometrics has been criticised for using poor and incomplete data, and being open to competing interpretations.
The CFTC has reaffirmed it will continue using the same four-part test in deciding whether to bring criminal and civil actions. But the new rules try to remedy some of the problems by lessening the reliance on econometric studies and focusing more on the behaviour of the manipulator itself:
“The Commission recognises that economic analysis may in some cases be appropriate to determine whether the conduct in question actually caused an artificial price. The Commission
stresses, however, that an illegal effect on price can often be conclusively presumed from the nature of the conduct in question and other factual circumstances not requiring expert economic analysis” (75 Fed Reg 67657).
Reducing the emphasis on econometrics and the effects of manipulation to focus more on the actual conduct of alleged manipulators should make it easier to bring cases in future.
Section 753 and the Commission’s proposed new rules suggest the CFTC will be more active bringing cases after almost two decades in which it often seemed to put manipulation cases in the “too hard” box.
(Editing by Dale Hudson)
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