Streetwise Professor

November 5, 2010

The William Clayton Memorial Manipulation Rule

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:21 pm

Testifying before the Senate in 1928, Texas cotton broker William Clayton responded to an accusation that he had manipulated the market with this drily arch remark: “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

I’m sure Mr. Clayton is long dead, but his spirit lives on in the CFTC’s just proposed manipulation rule.  It is broad, sweeping–and maddeningly vague.  It basically promulgates a we’ll-know-it-when-we-see-it-and-tell-you-when-we-do-(with-a-subpoena) “standard.”

The rule itself just regurgitates the language of Frank-n-Dodd.  The explanation of the rule contained in the Federal Register provides ample evidence that the Commission views the rule as a fishing license to catch pretty much anything that damn well strikes its fancy.  Some key quotes:

Likewise, the Commission proposes to interpret CEA section 6(c)(1) as a broad, catch-all provision reaching fraud in all its forms–that is, intentional or reckless conduct that deceives or defrauds market participants. [Emphasis added.]

. . . .

The Commission proposes to continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to improperly [sic] influence the price of a swap, commodity, or commodity futures contract. [Emphasis added.]

. . . .

Consistent with judicial interpretations of the scope of SEC Rule 10b-5, the Commission proposes that subsection (c)(1) be given a broad, remedial reading, embracing the use or employment, or attempted use or employment, of any manipulative or deceptive contrivance for the purpose of impairing, obstructing, or defeating the integrity of the markets subject to the jurisdiction of the Commission. [Emphasis added.]

. . . .

The Commission proposes 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.   The Commission reaffirms this broad reading of the term “manipulation” with respect to new CEA section 6(c)(3), while also recognizing that manipulation cases are fact-intensive and that the law in this area will continue to evolve largely on a case-by-case basis.

It is quite clear from all this that the Commission wants broad authority, and the maximum discretion and flexibility, to reach any operation of the market that does not suit it at the moment.  Willie Clayton lives.

I’ve written before that by attempting to craft anti-manipulation rules that are so broad to catch everything, Congress and the Commission in fact make it very difficult to catch anything, including the most egregious manipulative conduct.  That is a real risk under the new rule, which just compounds the vagaries and definitional imprecision of the existing laws, regulations, and precedents by adding new ones.  What is a manipulative contrivance or device?  I have no clue–and the proposed rule provides none.

The Commission gives itself an out by saying that manipulation cases are fact intensive, and that “the law in this area will continue to evolve largely on a case-by-case basis.”

Well, that’s the problem, isn’t it?  Anti-manipulation laws have been on the books since 1922, and there have been quite a few cases brought under the laws.  But to characterize the result of this process as “evolution” would be far too charitable. “Chaos,” “confusion,” “muddle,” and/or “devolution” would be far more apposite.  And it got that way precisely, exactly, because Congress and the various regulators charged with enforcing the law did not provide any real structure or guidance, again acting under the misguided notion that a broader, less precise law would be a more effective one.  The problem is not that the CFTC has not possessed the powers to reach truly damaging manipulative conduct; it’s that it has employed these powers in a scatterbrained way.  And that has happened, in large part, because the relevant statutes are vague and provide no structure or guidance.

I’ve written ad nauseum for almost two decades on the problems in the law relating to market power manipulation.  Despite the fact that economics provides the logical and empirical basis to permit determination with considerable precision whether a market power manipulation has occurred; who committed it; and whether he intended to do so, the Commission has never succeeded in bringing a successful market power manipulation case.  (As the discussion in the Federal Register notice makes clear, the CFTC’s much ballyhooed victorious DiPlacido case was not a market power manipulation case.)  That is particularly disturbing because market power manipulation is likely to be the most damaging and socially costly type of manipulation that can occur in derivatives markets.

I’ve advanced recommendations as to how it would be possible to craft fairly specific rules that would make it easier to prosecute market power manipulations.  More specificity would make it more likely that the CFTC could actually crack down on truly damaging conduct.  Laying new broad, vague terms on top of old broad, vague terms won’t do that.

Just how, exactly, will the new rule address the problems that have stymied the Commission in cases like in re Indiana Farm Bureau? How does it correct the problems (most notably vagueness) that Judge Miller tellingly identified in Radley?  (It does address some of the issues relating to jurisdiction.)  Answer: not at all.  Meet the new rule, same as the old rule–at least in its defects.

Moreover, the vagaries of the new rule will inevitably create uncertainty in the minds of market participants about what conduct is and what conduct is not a “manipulative contrivance or device.”  More legal risk is not exactly what the markets need right now.

In other words, the new rule will raise the frequency of both Type I and Type II errors.  Truly manipulative conduct will continue to go unpunished, and perhaps aggressive but legitimate conduct will not suit some enforcement guy at some moment.  The new rule threatens to make all too real the old lawyer’s joke: “I won half the cases I should have lost, and lost half the cases I should have won, so justice was done.”  Not really.

In brief, the new rule doesn’t fix the well-known problems with the existing regulations, statutes, and decisions: it just repeats them, and arguably adds some more.  Since the reach of the new rule will be far greater than the old one–extending to every swap, for instance–the potential for damage is commensurately greater as well.

I found one part of the FR notice particularly amusing.  Specifically, there’s this “we don’t need no steekin’ economists” language:

The conclusion that prices were affected by a factor not consistent with normal forces of supply and demand will often follow inescapably from proof of the actions of the alleged manipulator.

. . . .

Cases of this nature, where distorted prices foreseeably follow from the device employed by the manipulator, do not require detailed economic analysis of the effect on prices.

Yeah.  And then there are all those other cases where conduct is not sufficient to infer price distortion.  Which happen to be the far most important ones.

I understand that a lot of lawyers don’t like to have to rely on economists.  I will pass over in silence why that’s true.  Suffice it to say that the lawyers would be more successful if the laws and regulations reaching economic conduct were based on coherent, precise economics, rather than gassy generalities about “devices” and “contrivances.”

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  1. […] This post was mentioned on Twitter by Craig pirrong, Craig pirrong. Craig pirrong said: Updated my SWP blog post: The William Clayton Memorial Manipulation Rule ( ) […]

    Pingback by Tweets that mention Streetwise Professor -- — November 5, 2010 @ 9:38 pm

  2. As one of those “steeking” lawyers, who has also read your articles and also unfortunately has PhD in choice theory, I believe that your explanation of non fraud market manipulation is both correct and important.

    But, the main problem is one of psychology. Market manipulations will strike many people -that is jurors- as clever, and even if immoral, not illegal.

    It is too hard to push a “fraud on the marketplace theory” when disclosure is not an issue.

    In essence,the legal case requires an explanation of why it is wrong to ask for delivery of X amount of commodity Y from a group Z, when you have no real interest in taking delivery of X and only want to blackmail Z into paying you off.

    My problem here is I don’t see the canonical story that we as litigators would use.

    What would you suggest?

    Comment by michael webster — November 5, 2010 @ 10:57 pm

  3. Professor:

    Unless I’m mistaken, position limits (to curb speculation that caused price volatility) came about after one of the CFTC’s predecessors looked for evidence of speculators having caused grain price volatility, and couldn’t find any.

    They concluded instead that unintentional manipulation could have caused the volatility. So they legislated on that basis, hence where we now are.

    Regulation of trading based on a nebulous case for illegality is pretty well SOP, not an aberration.

    I share your dissatisfaction with the implied government view that market abuse is so nebulous it defies methodical description. On the contrary: manipulative behaviour **must** have characteristic patterns – of trading; of position-building; of supporting activity that’s out of whack with fundamentals; of IMs and phone calls; and maybe of price effect. Why? Because otherwise it wouldn’t work.

    Go on, try it. Try the above with settlement squeezes, for example. Would – say – a copper squeeze have a noticeable trail in terms of trading pattern, position size, inventory movements, and incriminating phone calls, for example? Sure it would.

    Instances of this are all there on the CFTC website, in the BP propane and Amaranth close-banging cases, for example.

    So, get a few lawyers, economists, regulators and recently-retired market participants together in a room with a whiteboard, and brainstorm as many as they can think of.

    A better-framed law could then say “Here’s a list of 25 things we think are not legitimate trading at all, and simply aim to screw your counterparty or indeed the entire market”, with number 25 being “Anything that isn’t but looks fishily close to one of 1 to 24 above”.

    Admittedly, there is always the risk of someone inventing a completely new form of market abuse that becomes #26. What I observe in practice, though, is a succession of newbies mistaking themselves for trading geniuses, and repeating previous abuses as though they were the first person ever to think of doing them. Manipulators are such because they aren’t clever enough to trade their way to an honest fortune. So they’re dumb enough to catch, or should be.

    It’s a bit depressing that lawmakers are unable to learn from the wealth of information that regulators have, and frame laws against previously-seen abuses that can be minutely described. Perhaps, even if the law were framed as I have just suggested, they’d still rely on #25 all the time anyway.

    @ Michael: is that not introducing a slightly different question? There is the issue of whether manipulation can be described more closely (I think it can). Then there is the issue of convincing juries that a specific manipulation is bad. If you haven’t described it properly, then you do have the issue you describe, but if you have, isn’t that beside the point, if it’s illegal?

    Comment by Occasional Reader — November 8, 2010 @ 6:39 am

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