Signaling its intent to utilize the sweeping new powers granted to it by Dodd-Frank,1 on July 14, 2011, the Commodity Futures Trading Commission ("Commission") unanimously adopted two final rules to prohibit fraud and manipulation, and attempted fraud and manipulation, in connection with any swap, commodity contract for sale in interstate commerce ("cash contract") or futures contract on or subject to the rules of a registered exchange ("futures contract").2 New Rules 180.1 and 180.2 were adopted pursuant to Section 753 of Dodd-Frank, which grants the Commission broad new authority to implement Section 6(c) of the Commodity Exchange Act ("CEA"), as amended. Section 6(c) and these implementing rules augment the Commission's pre-existing fraud and manipulation enforcement authority.
New Rule 180.1, implementing CEA Section 6(c)(1), and new Rule 180.2, implementing CEA Section 6(c)(3), have been adopted virtually unchanged from the Commission's earlier rule proposal.3 The new rules, which will not apply retroactively, are effective on August 15, 2011.
CEA Section 6(c)(1) broadly prohibits the use or attempted use of "any manipulative or deceptive device or contrivance," "in connection with" a swap, future or cash contract, in contravention of the rules and regulations required to be promulgated by the Commission within one year after Dodd-Frank's enactment. As explained more fully below, this new authority expands the Commission's antifraud authority under CEA Section 4b which itself was broadened by Dodd-Frank. In addition, Section 753 expands the Commission's anti-manipulation authority under CEA Section 9(a)(2).
Given the similarities between CEA Section 6(c)(1) and Securities Exchange Act ("Exchange Act") Section 10(b), the Commission expressly modeled new Rule 180.1(a)(1)-(3) on Exchange Act Rule 10b-5.4 Consistent with Rule 10b-5 precedent, Rule 180.1 includes recklessness as satisfying the scienter required to prove a violation. However, as we discuss more fully below, these sections of Rule 180.1(a) are significantly broader than Rule 10b-5 in two important respects: (1) Rule 180.1(a), unlike Rule 10b-5, covers attempts, and (2) Rule 180.1(a) reaches a far broader range of conduct than does Rule 10b-5.
New Rule 180.2, which covers non-fraud-based price manipulation, adopts the text of new CEA Section 6(c)(3) verbatim and provides that:
It shall be unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity.
The scope of new Rule 180.2 differs from the CEA's pre-Dodd Frank anti-manipulation authority by prohibiting manipulation and attempted manipulation that is either direct or indirect. It also clearly and distinctly applies to swaps.
However, the Commission has indicated that its application of new Rule 180.2 will not depart from current standards of proving a manipulation. The Commission will look to "the traditional four-part test for manipulation that has developed in case law arising under [CEA Sections] 6(c) and 9(a)(2)"5 in its interpretation of Rule 180.2. Under this test, (1) a person must have had the ability to influence market prices; (2) he or she must have specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand (recklessness will not be sufficient); (3) artificial prices must have existed; and (4) the person must have caused the artificial prices. Attempted manipulation under Rule 180.2 may be found if a person has the requisite intent and commits an overt act in furtherance of that intent.
Section 753 of Dodd-Frank contains a number of additional provisions, including a prohibition against false reporting or provision of false information to the Commission and additional enforcement authorities. These provisions were automatically effective upon the effective date of Title VII of Dodd-Frank (July 16, 2011) and do not require implementing rules.
New Rule 180.1 – Prohibition on the Employment, or Attempted Employment, of Manipulative or Deceptive Devices
Rule 180.1 prohibits fraud and fraud-based manipulation, as well as attempted fraud or manipulation, by any person, acting intentionally or recklessly, directly or indirectly, in connection with any swap or cash or futures contract. Specifically, Rule 180.1(a) makes it unlawful to:
(i) use or employ, or attempt to use or employ, any "manipulative device, scheme or artifice to defraud";
(ii) make, or attempt to make, any "untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statements made not untrue or misleading";
(iii) engage, or attempt to engage, in any "act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person"; or
(iv) knowingly or recklessly deliver or cause to be delivered a "false or misleading or inaccurate6 report concerning crop or market information or conditions that affect or tend to affect the price" of a commodity.
Rule 180.1(b), in turn, provides that the rule may not be construed to require disclosure to another person of material nonpublic information unless disclosure is necessary to make any statement to that person "in or in connection with the transaction" not materially misleading.
Scope of Rule 180.1
The Adopting Release emphasizes that Section 6(c)(1) and Rule 180.1 augment the Commission's existing authority to prohibit fraud and manipulation (and attempted fraud and manipulation) in the swaps, cash, and futures markets. The new authority does not, however, supersede the existing Section 4b antifraud authority or the existing Section 9(a)(2) anti-manipulation authority.7
Rule 180.1, in fact, substantially broadens the Commission's existing authority. First, as noted above, Rule 180.1 extends the Commission's antifraud and anti-manipulation authority to swaps. Second, whereas in a case brought under CEA Section 4b (prior to its amendment by Dodd-Frank), the Commission had to establish that the fraud was in connection with a swap or cash or futures contract made, or to be made for, on behalf of, or with the victim of the fraud, Section 6(c)(1) and Rule 180.1 contain no similar limitation. Third, the new rule expands the scienter standard for a violation to include recklessness. Before adoption of Rule 180.1, specific intent to defraud or manipulate the market was required for the Commission to bring a case. While Section 6(c)(1) does not explicitly include a recklessness standard, new Rule 180.1 adopts such a standard consistent with Rule 10b-5 precedent. Expanding scienter to include recklessness is likely to make Commission cases alleging fraud and manipulation significantly easier to prove.
Although, as discussed above, the Commission has modeled Rule 180.1 on Rule 10b-5 under the Exchange Act, there are important differences between the two rules. First, unlike Rule 10b-5, Rule 180.1, consistent with the language of CEA Section 6(c)(1), covers attempted as well as actual fraud or manipulation. The Commission's guidance confirms that the rule is explicitly intended to capture situations in which a person attempts to employ a manipulative device or artifice to defraud.
Second, unlike Rule 10b-5, Rule 180.1 is not limited to transactions, i.e., purchase or sale, but prohibits deceptive devices or contrivances in connection with any swap, cash contract, or futures contract. The new rule thus applies to conduct or attempted conduct in connection with activities well beyond the purchase or sale of a covered instrument. While some nexus with a covered instrument must be shown, the Commission interprets the term "in connection with" expansively to reach all manipulative or deceptive conduct "in connection with the purchase, sale, solicitation, execution, pendency, or termination of any swap or cash or futures contract."8 Thus, for example, the Commission interprets Rule 180.1 to cover all of the payment and other obligations under a swap.9
Noting the differences between the securities markets and the derivatives markets, the Commission states that it intends to be guided, but not controlled, by the substantial body of Exchange Act Section 10(b) and Rule 10b-5 judicial precedent. Indeed, those market differences, together with the significantly broader reach of Rule 180.1, leave market participants with little clarity about how the Commission will enforce the new rule in practice. It is likely, however, that Rule 10b-5 precedent will be instructive with respect to the Commission's expansion of the scienter standard to include recklessness.
The Commission notes that it intends to interpret and apply CEA Section 6(c)(1) Rule 180.1 "not technically and restrictively, but flexibly to effectuate its remedial purposes."10 For example, the Commission states that it expects to exercise its authority not only "to cover transactions related to futures or swaps markets, or prices of commodities in interstate commerce," but also "where the fraud or manipulation has the potential to affect cash commodity, futures, or swaps markets or participants in those markets."11 In connection with making this statement, the Commission specifically declined to interpret Rule 180.1 as requiring a market or price effect. While such an effect may be an indication of the use of a manipulative or deceptive device or contrivance, a violation of Rule 180.1 may exist in the absence of such an effect.
CEA Section 6(c)(1) provides that "no rule or regulation promulgated by the Commission shall require any person to disclose to another person nonpublic information that may be material to the market price, rate, or level of the commodity transaction, except as necessary to make any statement made to the other person in or in connection with the transaction not misleading in any material respect." Thus, Rule 180.1 does not create an affirmative duty of disclosure (unless, as required by Section 6(c)(1), disclosure is necessary to make a statement not materially misleading).
Responding to concerns raised by commenters about how securities law precedents will be applied to the swaps, futures and cash markets with respect to disclosure obligations, the Commission affirms that Rule 180.1 does not impose "any new affirmative duties of inquiry, diligence, or disclosure" and notes that it is not a violation of Rule 180.1, by itself, to withhold information that a market participant lawfully possesses about market conditions. Unlike in the securities markets, "derivatives markets have long operated in a way that allows for market participants to trade on the basis of lawfully obtained material nonpublic information."12 Thus, silence, absent a pre-existing duty to disclose, is not deceptive within the meaning of the rule, and "no comment" statements will usually be interpreted as functionally equivalent to silence.
At the same time, however, the Commission emphasizes that a person could violate Rule 180.1 if he or she traded on the basis of material nonpublic information obtained through fraud or deception or in breach of a pre-existing duty to disclose (established by another law, rule, agreement, understanding, or some other source). Noting that the derivatives markets are not caveat emptor markets, the Commission points to various existing provisions in the CEA containing disclosure requirements applicable to registered persons or entities and notes that, depending on the facts and circumstances, a violation of these duties could also be a violation of Rule 180.1.13
Fraud by partial omission or half-truths could also constitute a violation of Rule 180.1 under certain facts and circumstances. Rule 180.1 does not require that misstatements or omissions distort, or in the case of an attempted violation, are likely to distort, market conditions because the statute does not impose a price or market effect limitation.
Rule 180.1 will not be interpreted to require a showing of reliance or harm to market participants in an action brought by the Commission under Section 6(c)(1) and Rule 180.1 (consistent with judicial interpretations of Exchange Act Section 10(b) and Rule 10b-5). The Commission makes explicit, however, that it is not expressing a view on the required elements of a private right of action under Section 6(c)(1) and Rule 180.1.
Scienter Under Rule 180.1
As discussed above, Rule 180.1 prohibits intentional or reckless conduct or attempted conduct. Proof of actual knowledge is not required. The Commission defines recklessness generally as an act or omission that "'departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing'."14 Section 6(c)(1)(C) creates an explicit good faith mistake exception, but the exception only applies to the provision of false, misleading, or inaccurate information to a price reporting service. Because the statute limits the exception to information provided to a price reporting service, the Commission has declined to extend it to other parts of Rule 180.1, or to Sections 6(c) and 9(a)(2) more generally. However, because the other parts of Sections 6(c) and 9(a)(2) require scienter, the good faith mistakes exception should in fact not be necessary as inadvertent mistakes or negligence will not be enough to constitute a violation. Indeed, the Commission notes that "good faith mistakes or negligence will not constitute a violation of the final Rules under any circumstances."15 While the Commission has adopted the Rule 10b-5 scienter standard for Rule 180.1, it reiterates that it will be guided, but not controlled by the securities-related precedent.
The Commission declined to reject "collective knowledge" as a basis for scienter. Instead, it intends to consider the totality of the facts and circumstances to determine whether scienter in a specific case can be based on collective corporate knowledge (i.e., the combined knowledge of different corporate agents). While the Commission recognizes that there is disagreement among the circuits regarding whether scienter may be premised on collective knowledge, and is moreover unaware of any judicial decision applying the collective knowledge theory in a Section 10(b) case brought by the government, it nonetheless holds open the possibility of basing scienter on the combined knowledge of different individuals.
Final Rule 180.2 – Prohibition on Price Manipulation
Before enactment of Dodd-Frank, the Commission brought manipulation and attempted manipulation cases under previous CEA Section 6(c) as well as Sections 6(d) and 9(a)(2). Section 6(c) as amended by Section 753 of Dodd-Frank provides an explicit statutory prohibition on direct or indirect price manipulation and attempted manipulation of prices of swaps and cash and futures contracts. As noted in the Proposing Release, the Commission intends to "continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to influence the price of a swap, commodity, or commodity futures contract that is intended to interfere with the legitimate forces of supply and demand in the marketplace."16
Under new Rule 180.2, it is unlawful for a person, (1) directly or indirectly, (2) to manipulate or attempt to manipulate (3) the price (4) of any swap or futures or cash contract. Unlike Rule 180.1, Rule 180.2 requires a showing of specific intent; recklessness will not suffice. The term "directly or indirectly" describes the level of involvement necessary to establish a violation of the rule. "Indirectly," for example, includes a circumstance where a person uses a third party to execute a trade designed to manipulate.
As noted above, the Commission intends to apply the traditional four-part test for manipulation that has grown out of case law under Sections 6(c) and 9(a)(2) to determine whether a violation of Rule 180.2 has occurred, i.e., whether (1) the person had the ability to influence market prices; (2) he or she specifically intended to create or effect a non-legitimate price or price trend; (3) artificial prices existed; and (4) the person caused the artificial prices. In some circumstances, an artificial price may be presumed, for example, if it is a "reasonably probable consequence" of the intentional misconduct.
Manipulation cases generally tend to be dependent on a facts and circumstances analysis and in the past have been very difficult to prove. It remains to be seen whether manipulation cases brought under the new authority will be as difficult to prove as previously. The Commission does not apply the last two prongs of the four-part test with respect to attempted manipulation, and requires only (1) the requisite intent; and (2) an overt act in furtherance of that intent. Accordingly, it is clear that under either the existing anti-manipulation authority or the new anti-manipulation provisions, it should be easier for the Commission to bring and sustain a case for attempted manipulation.
CEA Section 6(c), as amended by Dodd-Frank, gives the Commission sweeping new powers to craft and enforce new antifraud and anti-manipulation rules. While the Commission has largely modeled new Rule 180.1 on SEC Rule 10b-5 jurisprudence, both it and new Rule 180.2 are substantially broader than Rule 10b-5 because of their inclusion of attempted fraud or manipulation. New Rule 180.1 also represents a clear departure from the transaction-based limitation of Rule 10b-5, where the violation must be in connection with the purchase or sale of a security. In addition, the inclusion of recklessness in Rule 180.1's scienter standard represents a significant expansion of the Commission's enforcement authority. How aggressive the Commission will be in interpreting and enforcing these new rules remains to be seen.
4 Rule 10b-5 makes it unlawful for any person "directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange," and in connection with the purchase or sale of any security, (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. Dodd-Frank amended Section 10(b) explicitly to apply to and extend any rules thereunder to security-based swaps.
7 Before Dodd-Frank, Section 4b made it unlawful for any person, in or in connection with any order to make, or the making of, a futures contract, to cheat or defraud, or attempt to defraud, a counterparty or a person for whom or on whose behalf the order or contract was made. Dodd-Frank amends Section 4b to reach swaps and also adds new subsection (e) to make it unlawful, in connection with any order to make, or the making of, any covered instrument, to engage in a fraud. Subsection (e) does not contain the "for," "on behalf of," or "with" qualifications. Section 9(a)(2), expanded by Section 741(b) of Dodd-Frank to extend to swaps, makes it a felony for "[a]ny person to manipulate or attempt to manipulate the price of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, or of any swap, or to corner or attempt to corner any such commodity or knowingly to deliver or cause to be delivered for transmission through the mails or interstate commerce by telegraph, telephone, wireless, or other means of communication false or misleading or knowingly inaccurate reports concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, or knowingly to violate the provisions of section 4, section 4b, subsections (a) through (e) of subsection 4c, section 4h, section 4o(1), or section 19 of this title."
9 On the securities side, Dodd-Frank also created new Section 9(j) of the Exchange Act, which makes it unlawful for any person "to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security-based swap in connection with which such person engages in any transaction, practice or course of business which operates as a fraud or deceit upon any person." The Securities and Exchange Commission has proposed new Rule 9j-1 to implement Section 9(j). Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps, 75 Fed. Reg. 68560 (Nov. 3, 2010). Proposed Rule 9j-1 incorporates language from Section 10(b) and Rule 10b-5, but expands that language to include all rights and obligations during the life of a security-based swap, even though Section 9(j) explicitly applies only to purchases and sales.
13 Examples of existing disclosure requirements include risk disclosure obligations under 17 CFR Part 155, and disclosure obligations of Commodity Pool Operators under 17 CFR 4.20-27. See Adopting Release at note 55.
15 Id. We note that while Exchange Act Section 10(b) (and thus Rule 10b-5) require a showing of scienter, Sections 17(a)(2) and (3) of the Securities Act of 1933 require only a showing of negligence. These sections prohibit the offer or sale of any securities in interstate commerce, directly or indirectly, "to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading" (subsection (a)(2)), or "to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser" (subsection (a)(3)). The CEA has no parallel negligence provision.