Streetwise Professor

CFTC Chairman Gary Gensler and Commissioner Bart Chilton have mooted the idea of replacing the CFTC’s specific intent standard in manipulation cases with the SEC’s weaker recklessness standard:

Gensler asked securities and commodities experts whether it would be appropriate for the CFTC to use the SEC’s less stringent “recklessness” standard for evaluating manipulation cases, rather than the CFTC’s “specific intent” standard. He noted that the CFTC has only once in its 35-year history successfully won a manipulation case in court.

Other CFTC commissioners also are interested in exploring the issue. CFTC Commissioner Bart Chilton said, “I like the SEC’s manipulation standard. For them, it just has to be reckless (to investigate). We have to prove an intent to manipulate.”

The CFTC’s record in manipulation cases is, not to put too fine a point on it, a mess.  To prove manipulation, it is necessary to prove: (a) the existence of an artificial price, (b) the accused had the ability to cause an artificial price, (c) the accused did cause the artificial price, and (d) the accused had the specific intent to cause an artificial price.  The “specific intent” standard means that the artificial price was more than a foreseeable consequence of actions intended to achieve some other objective (e.g., a firm takes delivery pursuant to a marketing program, and as a result of this action the price is distorted).  Instead, under the specific intent standard, the accused must have deliberately intended to create the artificial price and profit therefrom.

As I wrote about 15 years ago in an article in the Washington & Lee Law Review, these criteria for manipulation are in fact sensible.  It’s the Commission’s application and interpretation of these criteria that have been woeful, not to say idiotic.  The silliest Commission decisions were in re Cox & Frey, and especially in re Indiana Farm Bureau.  Both cases are monuments to economic ignorance, for reasons too numerous to detail here.  (The law review article was upwards of 50 single spaced pages.)

Indiana Farm Bureau is the worst offender.  In this case, a split Commission spelled out its interpretation of specific intent, and made a complete hash of it.  Again I’ll spare you the details, but the most important error the Commission made was to make the accused trader’s intent at the time he initiated a position decisive in determining intent.  Unfortunately, in a corner (the most common and important form of manipulation), it is a trader’s actions when he liquidates a position that are crucial.  A cornerer liquidates too few positions and takes too many deliveries; the latter action distorts prices by forcing the market up the supply curve.

So, under IFB, a trader can enter in a position as a hedge or speculation, and then as the contract nears expiration, squeeze the hell out it if the opportunity presents itself, and escape scott-free.

So, it’s not specific intent that is objectionable.  It is the Commission’s boneheaded interpretation of the concept that needs fixing.  The Commission needs to focus on intent at the time the price distortion takes place, not long before.

As currently interpreted, the Commission essentially gives traders a manipulation option.  Enter into a position for any legitimate commercial purpose (e.g., hedging or speculation) and you have the option to squeeze later on.  It’s like saying that murder is OK, as long as you don’t plan it too far in advance, but just take advantage of any opportunity to knock off somebody who bugs you when it comes up.

A recklessness standard is, in my view, too loose, and too subject to abuse by regulators.  A coherent specific intent standard, rather than the current incoherent one, is preferable.

Gensler raised the possibility of going to Congress to get additional authority:

“It may well be that we can do something within our current authority” to boost enforcement against fraud and manipulation, Gensler said. “It may be that we recommend some changes to Congress.”

That would be advisable.  In my 1996 book on manipulation (#2,217,310 on Amazon!  Available in Kindle format!) I laid primary responsibility for the pathetic state of manipulation jurisprudence squarely on Congress’s shoulders for its failure to define manipulation with sufficient clarity, and failing to set out more specific standards/criteria to prove manipulation.  In its desire to create a statute so broad as to encompass every type of manipulation, Congress created one so vague that it was incapable of being used to combat the most serious forms of this conduct, most notably market power manipulations.  (I made a similar suggestion to Sen. Richard Lugar when he was chairman of the Senate Ag Committee in 1996.)

The sad part about all this is that the effects of manipulation are quite distinct, and the kinds of conduct that can cause these effects are very straightforward.  By failing to apply some basic economic reasoning, Congress and the Commission have made things far harder than they need to be.

So, it is indeed about time for the Commission to get serious about addressing its past failures–and getting Congress to address its failings as well.

Gensler and Chilton spoke glowingly of the SEC’s manipulation standards.  I should point out, though, that the SEC has hardly been that successful in prosecuting manipulation, even given its weaker recklessness standard.

And speaking of reckless, one suggestion made at the CFTC-SEC meeting by Columbia Law Professor John Coffee was to make insider trading illegal in commodity futures markets, as it is in securities markets:

Fraud in the derivatives market may be reduced if the CFTC had SEC-like powers to enforce insider-trading and market- manipulation cases, Columbia University securities law professor John Coffee said in prepared remarks to be delivered today.

The CFTC “needs legislation prohibiting insider trading on commodities and transactions within its jurisdiction” and should be able to impose financial penalties in cases of violations. The SEC “is armed with a greater enforcement club” and can impose penalties without going to court, Coffee said.

“The bottom line here is that it would make sense to harmonize these penalty levels so that both agencies had equivalent powers,” he said.

This suggestion, and the reasoning behind it, are inane. There are substantial differences between securities and commodities markets.  Sanford Grossman summarized the key issue in the Journal of Business in 1986:

In securities law, which regulates insider trading, an insider is a corporate employee or some other person with a fiduciary responsibility to the shareholders of the corporation.  The mere possession of valuable private information by a person who owes no fiduciary duty to the shareholders of a company does not make the person an insider under the securities law.

. . . .

It is important to realize that securities law prohibitions against insider trading are not prohibitions against informed trading . . . These laws are designed to prevent corporate officers from violating their fiduciary responsibility to shareholders, for example, by preventing trade by an insider that increases the wealth of the insider at the expense of shareholders.  A futures contract is not a “security” issued by a commercial trader.  The commercial trader is not under any fiduciary obligation. . . . Hence the rationale for regulating insider trading is absent in the case of futures markets.

In the absence of fiduciary duty as the guiding principle behind any regulation of insider trading by a market with no “insiders” as defined in securities markets, it is likely that any inside trading regulation in commodities markets would attempt to restrict some kinds of informed trading.  This would be a disaster.  It would wreak havoc with the price discovery process, deter some market participants from participating, and create a game of regulatory Russian roulette because any attempts to draw lines between “good” informed trading and “bad” informed trading would be inherently arbitrary.

What was Coffee thinking?  I have no idea, but I must say it’s not the first time I have asked myself that question.  It seems that he’s a guy who knows a lot about securities, and virtually nothing about derivatives, but assumes that they are effectively the same even though there are important differences.  A foolish consistency, Mr. Coffee . . . [And no, I’m not talking about Joe Dimaggio.]