The CFTC, SEC and Market Manipulation
Open market manipulation cases present difficult issues regarding what constitutes market manipulation. Regulators, such as the SEC, CFTC and FERC, tend to focus on the element of intent. Defendants frequently argue that the transactions claimed to be manipulative are lawful in and of themselves and therefore cannot be manipulative. Courts tend to struggle with these cases, searching for the dividing line between the lawful and the unlawful. While the statutes on which the charges are typically based vary, many trace back to Exchange Act Section 10(b) and/or are based on concepts which flow from cases interpreting that Section. One of recent examples of these cases is CFTC v. Kraft Foods Group, Inc., Civil Action No. 1:15-cv-02881 (N.D. Ill.).
The case centers on the alleged misconduct of Kraft in purchasing and selling wheat futures. The complaint alleges that the firm engaged in manipulative or deceptive conduct in violation of CEA Section 6(c)(1) and Reg 180.1 thereunder, manipulation in violation of CEA Sections 9(a)(2) and 6(c)(3), violated the speculative position limits and engaged in wash sales and fictitious trading, contrary to CEA Sections 4c(a)(1) & (2). Defendants moved to dismiss the first two claims regarding market manipulation. The court denied the motion.
Kraft is one of the largest domestic users of #2 Soft Red Winter Wheat, the type of wheat involved here, according to the court’s opinion. The company has two options for obtaining this wheat. One is to purchase it in the cash market. The second is to stand for delivery on CBOT futures contracts such as those involved here. Typically Kraft purchases its wheat in the spot markets within a reasonable proximity to Toledo, Ohio where its processing plant is located rather than through the futures markets for a variety of reasons which made the CBOT wheat unattractive. Kraft typically uses the futures market to hedge and rarely takes delivery.
In 2011 the cash price of #2 Soft Red Winter Wheat around Toledo increased significantly more than that on the futures market. Plaintiff CFTC claims that resulted in Kraft developing the scheme which is at the center of this action. Specifically, Kraft decided to leverage its status as a large commercial hedger to lower the price in the cash market. This would be accomplished, according to company emails, by taking a huge long position in December 2011 wheat futures to induce sellers to believe that “Kraft would take delivery, load out, and use that wheat in its Mill.” The futures market would react by increasing the price while the spot market price would drop. The firm could then secure its wheat in the spot market as usual.
To implement this plan Kraft purchased $90 million of December 2011 wheat futures. Kraft did not have a bona fide commercial need for this quantity of wheat which amounted to about 15 million bushels – a six month supply for its Toledo mill. Indeed, Kraft never before had that much wheat and its “wheat storage facility at the Mill [in Toledo] . . . could accommodate only 5 million bushes . . . [and] was already more than 80% full.” The complaint thus claims that Kraft never intended to take delivery. In addition, Kraft’s position exceeded the speculative position limit of 600 contracts set by the CFTC and constituted 87% of the open interest in that contract.
Ultimately Kraft took delivery of just 660,000 bushels of wheat or about 132 contracts – less than 5% of its contracts. After the prices in the cash market fell the company resold portions of its position and off-set the balance. Kraft did not purchase a quantity of wheat in the cash market that approximated its futures position. As a result of Kraft’s actions, prices increased in the futures market but declined in the cash market, according to the complaint.
The key question on the motion to dismiss involved the impact of the transactions in the market place. Section 6(c)(1) (implemented through Regulation 180.1) was added to the CEA by Dodd-Frank to expand the CFTC’s arsenal of weapons. The language of the Section largely mirrors that of Exchange Act Section 10(b). While the CFTC claimed that the Section created a claim for manipulation and a separate one for fraud, the court rejected the contention. To the contrary, the Section creates one claim prohibiting any manipulative device or scheme to defraud, consistent with its Section 10(b) roots.
After concluding that Plaintiff had to plead its claim with particularity under Rule 9(b), Federal Rules of Civil Procedure, the court held that the allegations of the complaint were adequate, finding that: “(1) Kraft took a huge wheat futures position; (2) that it did not intend to use in production; (3) but instead intended that the position would signal Kraft’s demand for wheat in the relevant time period; (4) in a way that would mislead others in the market into thinking that Kraft would take delivery of its futures position and not buy cash wheat; (5) which was intended to, and I fact did, cause cash wheat prices to decrease and the price for futures to increase.” The court rejected Kraft’s claim that the CFTC must plead and prove that the market received “a message from Kraft” that was different from its true intent because “Kraft sought to create the false appearance of demand . . .” and in fact did.
While the scope of Sections 9(a)(2) and 6(c)(3) are more limited, the analysis in this case is similar. Those Sections prohibit only manipulation, not fraud. Generally a four part test is used to determine if there is a violation of the statute. It focuses on the ability of the defendant to influence prices, if there was an artificial price, whether defendants caused it and if they specifically intended to cause such a price. The key is if an artificial price existed in the market place. Since that price is generally defined as one which results from an interference with normal market forces and deceives investors, it is effectively inserting deception into the market place – the same question the court considered in analyzing the first claim.
Again the court concluded that the CFTC alleged a claim. Specifically, the court concluded that Kraft had the ability to influence the price in view of its huge, dominant position and did influence the price by “holding futures positions (3,150 contracts). More specifically, on December 2, 5, 6, 7 and 8 Kraft held a long position that exceeded the [speculative position] limits by 2,110, 2106, 1,666, 1226 and 226 contracts, respectively.” Stated differently, Kraft established a dominant position and influenced the price by violating the law.
The critical question in most open market cases is market place deception. Whether the issue is presented under the Exchange Act Section 10(b), CEA Sections 6(c)(1), 6(c)(3) and 9(a)(2) or other similar statutes such as those administered by FERC, the question is if the defendants somehow injected false information into the market place that was capable of deceiving other investors. Yet typically regulators focus on the question of intent rather that market place deception as the CFTC did here in its brief. Similarly, defendants frequently contend that their transactions were lawful in and of themselves and therefore cannot be viewed as manipulative.
While the arguments advanced by the regulators and the defendants in these cases deal with aspects of the claims, they do not address the central question. Indeed, they really take the “market” out of market manipulation: Intent cannot create deception in the market place and standing alone is not a violation of the statutes; moving the price up or down is not a violation of the statute; and purchasing or selling futures contracts, securities or other instruments, when viewed in isolation, is not a violation of the statutes. It is only when the totality of the facts demonstrates that deception was injected into the market place so others might be deceived that there is market manipulation and a cause of action.
Here the court held that the complaint sufficiently alleged not just the requisite intent and, correspondently a lack of valid business purpose for the purchases which can inform any decision on intent, but also market place deception. At the same time the court took care to note that discovery may well demonstrate otherwise.