Milbank discusses “Spoofing” in Financial Markets

Section 4c(a)(5)(C) of the Commodities Exchange Act (CEA), 7 U.S.C. § 6c(a)(5)(C), newly added to the CEA by the Dodd-Frank reform legislation, prohibits spoofing as well as activity that is “of the character” of spoofing. The statute defines “spoofing” but does not spell out what conduct may be “of the character of spoofing.” The outer boundaries of that conduct remain unclear. The Commodity Futures Trading Commission (CFTC) has said that the four types of behavior listed in its 2013 guidance on the new spoofing statute are not exclusive. See CFTC, Antidisruptive Practices Authority, 78 Fed. Reg. 31890, 31896 (May 28, 2013). Although a number of cases have been filed, only one court (the Northern District of Illinois, in Michael Coscia’s criminal case) has made any significant legal pronouncements regarding the statute, as discussed below.

Many spoofing cases involve some form of high-frequency trading. For a trader’s behavior to qualify as spoofing, she must place her bids with the intent of cancelling them before they are filled. But there are plenty of legitimate reasons to cancel orders soon after placing them. In a world where 90 percent or more of all high-frequency trading bids are cancelled, it can be difficult to distinguish spoofing behavior from legitimate, “good-faith” trading. This leads to problems of proof.

  1. In cases involving algorithmic trading, the CFTC has sought to use the contents of the algorithms themselves as evidence of intent.
  2. In cases involving manual trading, emails, instant messages, and phone recordings may help to establish intent, but such evidence will not always be available.
  3. Accordingly, there are likely to be cases in which the only evidence is circumstantial—namely, the trading data itself—which could present challenges for government agencies seeking to prove forbidden intent.
  4. In certain markets, traders are likely to offer a series of legitimate reasons for rapidly cancelling orders, including rapid changes in market conditions. Manual traders may argue that at the time they placed an order, they specifically intended that it be executed immediately or not at all—as with a “fill or kill” or “immediate or cancel” order. Such an order would be exposed for less time than a manual trader would have to react to market conditions—but that would not necessarily mean that the trader’s intent was to cancel. The intent in such a situation would rather be to get a fill immediately upon placing the order, or not at all. Traders may also say that they are using their subsequently cancelled orders to gather information. That is, the trader may say that he wished to observe how other market participants would respond to the order – would the order be filled or not, and at what price? – which is not the same thing as placing an order with the sole intent to cancel it.
  5. The government, if put to its proof, may need to demonstrate forbidden intent on an order-by-order basis. This evidentiary challenge is further enhanced when, as will often be the case, challenged orders have been culled from a much larger universe of trading data.
  6. In the Coscia criminal case, the District Court allowed the defendant to use the existence of certain market rules, and his compliance with them, as evidence of his good faith and to negate prohibited intent. Coscia was permitted to introduce evidence that the exchanges he traded on, among other things: allowed orders to be placed simultaneously on both sides of the market; did not require orders to be kept open for any minimum length of time before being cancelled; had maximum order-to-cancellation ratios that Coscia was shy of reaching; had position limits (e., limits on the number of open contracts that a trader may hold at a given time) that Coscia did not breach; and allowed “laddered” and “ping” orders. See Memorandum Opinion and Order, United States v. Coscia, 14 CR 551 (N.D. Ill. Oct. 19, 2015), pages 2-3; Defendant’s Response to the Government’s Consolidated Motions in Limine, United States v. Coscia, 14 CR. 551 (N.D. Ill. Oct. 12, 2015), pages 1-5.

Related to the points above, the CEA’s statutory definition (“bidding or offering with the intent to cancel the bid or offer before execution”) arguably leaves additional room for interpretation and argument in that it could encompass legitimate and common practices.

  1. For instance, many traders hedge with the use of stop loss and other types of orders that are put in place as a precaution but that the trader hopes and expects to unwind without execution.
  2. Moreover, there is an argument that any order genuinely exposed to the market (and thus to a risk of execution) is inherently legitimate. In this way of thinking, spoof orders are unlike (for example) wash sales or other classic market manipulation techniques that create the illusion but not the reality of a change of ownership. That the spoofing trader intended to cancel his orders does not change the fact that his orders each represented actual – and potentially actionable – market activity.

The possibility of a due process challenge.

  1. “A fundamental principle in our legal system is that laws which regulate persons or entities must give fair notice of conduct that is forbidden or required.” C.C. v. Fox Television Stations, 132 S. Ct. 2307, 2317 (2012). In other words, vague criminal laws offend due process. Criminal spoofing defendant Michael Coscia argued that the definition in Section 4c(a)(5)(C) is unconstitutionally vague. In a similar vein, Navinder Sarao has asserted that penalizing him would violate his due process rights because Sarao “lacked reasonable notice during the Relevant Period that his trading activity – which was indistinguishable from widely-accepted and permissible practices – would be deemed to violate the Act.” Answer of Defendant Navinder Sarao, CFTC v. Nav Sarao Futures Ltd. PLC, No. 15 Civ. 3398 (N.D. Ill. July 6, 2015).
  2. In April 2015, a District Judge rejected Coscia’s vagueness claims. See United States v. Michael Coscia, No. 14-cr-00551, 2015 U.S. Dist. LEXIS 50344 (N.D. Ill., April 16, 2015). Still, Coscia is likely to appeal, and Sarao or other future spoofing defendants may press a version of this argument.[1] The Coscia court held that the statute was not void for vagueness as applied to the (relatively egregious) allegations against Coscia. The ruling, therefore, even if upheld on appeal, may not foreclose vagueness challenges where the allegations are less egregious and can be characterized as extending to arguably legitimate practices.

To what extent is spoofing actionable under the CEA’s amended general anti-manipulation prohibition, Section 6(c)?

  1. CFTC v. Nav Sarao Futures Ltd. PLC and CFTC v. Igor B. Oystacher appear to be the only post-Dodd Frank spoofing cases that the CFTC has charged under Section 6(c) as well as Section 4c(a)(5)(C). Those cases are pending.
  2. CEA § 6(c)(3), 7 U.S.C. § 9(3) (2012) likely requires “intent to cause artificial prices,” In re Amaranth Natural Gas Commodities Litig., 730 F.3d at 170, 173, 183 (2d Cir. 2013). In all probability, an intent to cause artificial prices will be harder to demonstrate than that an order was placed with the intent to cancel it.
  3. The CFTC may take the position that, because a Section 6(c)(1)/CFTC Rule 180.1 violation can be established by recklessness, the agency faces a relaxed intent standard under these provisions as compared with the anti-spoofing prohibition or with CEA § 6(c)(3), 7 U.S.C. § 9(3) (2012).

However, Section 6(c)(1) and Rule 180.1 were modeled on Securities Exchange Act Section 10(b) and Rule 10b-5, and the courts interpreting those provisions generally define market manipulation as “practices . . . that are intended to mislead investors by artificially affecting market activity.” Santa Fe Indus. v. Green, 430 U.S. 462, 476 (1977). Accordingly, those targeted by a CFTC or DOJ spoofing probe may argue that the agency, even under Section 6(c)(1), must show “artificial[] . . . market activity.” And, as noted above, an accused spoofer will often have a potentially plausible explanation for his cancelled orders that has nothing to do with artificial activity. For the government, therefore, proving “manipulation” may not be much different from proving specific intent to create artificial conditions.

Beyond that, even to show “recklessness,” the government as a practical matter may need to prove that an order was not bona fide. The CFTC’s definition of recklessness draws on the case law defining recklessness in the context of Section 10(b) / Rule 10b-5. See CFTC, Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 Fed. Reg. 41398, 41404 & n.87 (July 14, 2011); see also CFTC v. Equity Financial Group LLC, 572 F.3d 150, 160 n.17 (3d Cir. 2009). The type of recklessness required for a Section 10(b) / Rule 10b-5 violation is not far from full-blown intent. E.g., SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992) (“The kind of recklessness required [under Section 10(b)], however, is not merely a heightened form of ordinary negligence; it is an ‘extreme departure from the standards of ordinary care, . . . which presents a danger of misleading buyers or sellers that is either known to the defendant or so obvious that the actor must have been aware of it.’”); see also 76 Fed. Reg. at 41404 (“Consistent with long-standing precedent under the commodities and securities laws, the [CFTC] defines recklessness 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.’” (citing Drexel Burnham Lambert Inc. v. CFTC, 850 F.2d 742, 748 (D.C. Cir. 1988))).

A “danger of misleading buyers” by definition can exist only where an order is not bona fide – if it were bona fide, no one can have been misled by it. Similarly, showing that the actor must have been “aware of what he or she was doing” necessarily implies that the actor was “doing” something wrong – which is impossible if the order was placed with bona fide intent to have it filled.

Is there a private right of action for spoofing?

  1. In at least two recent civil suits, plaintiffs have asserted causes of action for spoofing under CEA § 4c(a)(5)(C). See Complaint, HTG Capital Partners, LLC v. John Doe(s), No. 15-cv-2129 (N.D. Ill.); Complaint, Mark Mendelson v. Allston Trading LLC and John Does Nos. 1-10, No. 15-cv-4580 (N.D. Ill). Both cases also include certain claims under CEA § 6(c), 7 U.S.C. § 9 (2012).
  2. The CEA authorizes a private suit where a person has been harmed through a violation of the CEA that constitutes “the use or employment of, or an attempt to use or employ, . . . any manipulative device or contrivance in contravention of” CFTC-promulgated rules or “a manipulation of the price” of a commodity, future, or swap. See CEA § 22(a)(1)(D), 7 U.S.C. § 25(a)(1)(D) (2012). In the Mendelson case, a defendant moved to dismiss, arguing that the private right of action authorized by the CEA does not extend to a violation of CEA § 4c(a)(5)(C), or to an asserted violation of CEA § 6(c) that was simply a recasting of the spoofing allegations. See Allston Trading LLC’s Motion to Dismiss, Mendelson, No. 15-cv-4580 (July 22, 2015).
  3. The Mendelson plaintiff voluntarily dismissed his case before the Court could rule on the question of a private right of action for spoofing. If the issue comes up again, it may tie into larger questions about the extent to which spoofing can be characterized as “manipulation.”
  4. In the securities arena, the private right of action under SEC Rule 10b-5 should be available to a plaintiff alleging harm from alleged manipulation, provided the plaintiff can satisfy the various damages, causation, and reliance requirements. See, e.g., Fezzani v. Bear, Stearns & Co., 716 F.3d 18, 22-23 (2d Cir. 2013).

ENDNOTES

[1] See also Gary DeWaal, Coscia files motion to dismiss criminal spoofing indictment, Lexology (Dec. 21, 2014), http://www.lexology.com/library/detail.aspx?g=6a310a42-c501-4e4e-8c76-242e10589c6c (arguing that the statutory definition of spoofing is problematic because it encompasses both legitimate and illegitimate trading activity).

The preceding post is based on a more comprehensive guide to the law surrounding spoofing produced by Milbank, Tweed, Hadley & McCloy LLP on November 4, 2015, which is available here.