Commodity Exchange Act: Key Decisions From 2018 And Enforcement Trends To Monitor In 2019 - Commodities/Derivatives/Stock Exchanges

2018 was an interesting year for market participants subject to the Commodity Exchange Act ("CEA"), with federal appellate courts issuing three noteworthy decisions involving claims under the CEA. The Commodity Futures Trading Commission ("CFTC") also issued public statements in 2018 expressing new (or at least renewed) interest in insider trading and market manipulation.

This Jones Day White Paper reviews significant 2018 developments regarding CEA claims and identifies issues and trends to monitor in 2019.

INTRODUCTION

TRIO OF FEDERAL CIRCUIT COURT DECISIONS ALTER THE CEA LANDSCAPE IN 2018

The Territorial Reach of the CEA

In early 2018, the U.S. Court of Appeals for the Second Circuit issued a significant decision concerning claims under the CEA for commodities transactions with substantial foreign ties. In Choi v. Tower Research Capital, LLC, 890 F. 3d 60 (2d Cir. 2018), the Second Circuit was called upon to determine whether applying the CEA to allegedly manipulative futures transactions on a Korean derivatives and securities exchange would violate the general presumption against applying U.S. statutes extraterritorially. The plaintiffs alleged that the defendants, a high frequency trading firm and its founder, violated Section 6(c) of the CEA by engaging in hundreds of thousands of manipulative "spoofing" transactions on the "night market" of the Korea Exchange ("KRX"). This "night market" allowed market participants to place futures orders on the KRX system in Korea during overnight hours when the exchange was closed, have their orders electronically matched on the CME Globex trading platform in the United States, and then have their transactions settled and cleared on the KRX when it reopened for business the following morning.

The Second Circuit began its extraterritoriality analysis by summarizing the two-part test articulated by the U.S. Supreme Court in Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010), for determining the reach of the U.S. securities laws. In Morrison, the Court concluded that claims under Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") could only be applied to: (i) "transactions in securities listed on domestic exchanges"; and (ii) "domestic transactions in other securities." The Second Circuit in Choi first noted that, in light of statutory differences between the Exchange Act and the CEA, the "domestic exchange" prong of Morrison might not apply to claims under the CEA. The Second Circuit then proceeded to analyze whether the alleged spoofing transactions on the KRX "night market" were properly considered "domestic transactions" under the second prong of Morrison and the "irrevocable liability" test previously established by the Second Circuit in Absolute Activist Value Master Fund, Ltd. v. Ficeto, 677 F. 3d 60 (2d Cir. 2012). In Absolute Activist, the Second Circuit held that a securities transaction is properly considered "domestic" if "the parties incurred irrevocable liability [for the transaction] within the United States."

In Choi, the Second Circuit concluded that the plaintiffs plausibly alleged that parties to futures transactions on the KRX "night market" incurred "irrevocable liability" for their transactions when their orders were matched on the CME Globex platform in the United States, rather than when they settled and cleared in Korea the following trading day. The Second Circuit, therefore, concluded that the plaintiffs' allegations were sufficient to plead the existence of "domestic transactions" under Morrison and denied the defendants' motion to dismiss.

The Choi decision was an unexpected victory for investors seeking to assert CEA claims for transactions with significant foreign ties, particularly given that: (i) the futures orders at issue in Choi were placed in Korea (and related to the price of a Korean stock index); (ii) the named plaintiffs were all Korean citizens; and (iii) the futures transactions at issue all settled and cleared in Korea. In reaching its conclusion that the transactions at issue in Choi qualified as "domestic transactions" under Morrison, the Second Circuit did not mention its prior decision in Parkcentral Global HUB, Ltd. v. Porsche Automobile Holdings SE, 763 F. 3d 198 (2d Cir. 2014). In Parkcentral, the Second Circuit concluded that even though the securities-based swap agreements at issue likely qualified as "domestic transactions" under Morrison and Absolute Activist, the plaintiffs' claims were nonetheless so "predominantly foreign" that the CEA could not be applied. The same result should have been obtained in Choi. In light of the court's failure to mention Parkcentral in Choi, there is still uncertainty in the Second Circuit about how broadly the trial courts should interpret the "domestic transactions" prong of Morrison, and how "foreign" a transaction must be before it qualifies as "predominantly foreign" and, therefore, outside the reach of the U.S. commodities and securities laws.

Pleading Actual Injury Under the CEA

The Second Circuit issued a second significant decision regarding the pleading requirements for claims under the CEA in Harry v. Total Gas & Power North America, Inc., 889 F. 3d 104 (2018). In Harry, the Second Circuit was called upon to determine whether the plaintiffs adequately pled that they were injured by the defendants' alleged conduct, which involved the alleged manipulation of natural gas derivatives during the 2009 to 2012 time period. In particular, the plaintiffs alleged that the defendants manipulated the market for natural gas swaps and futures that were based on the price of natural gas traded at several regional hubs in the western United States. These derivatives were traded over-the-counter rather than on an exchange. The plaintiffs, on the other hand, only traded natural gas derivatives that were based on the price of natural gas traded at the major hub in the United States (the "Henry Hub"), and those derivatives were traded on major national exchanges. Although the plaintiffs acknowledged that they did not trade the same derivatives as the defendants, they argued that the defendants' alleged manipulation at the smaller hubs harmed them as it "reverberated through to trading at the Henry Hub."

The Second Circuit first evaluated whether the plaintiffs had adequately alleged the "injury-in-fact" element of Article III standing, which it characterized as being a "lower threshold" than the standard for pleading a substantive cause of action under the CEA. The court concluded that the plaintiffs' allegations were sufficient to make its manipulation claim "within the realm of possibility," which it determined was sufficient for Article III standing purposes. The Second Circuit then assessed whether the plaintiffs adequately pled that they suffered an "actual injury" under Section 22 of the CEA, which required facts demonstrating that their alleged injuries were "plausible, not just colorable." The Second Circuit concluded that the plaintiffs failed to meet this higher threshold, primarily because the plaintiffs traded in different natural gas derivatives than the ones that were allegedly manipulated. While the plaintiffs asserted that the defendants' alleged manipulation of derivatives based on regional hub prices resulted in distortion of the prices of derivatives based on the Henry Hub, the Second Circuit held that the plaintiffs failed to plead a plausible connection between the two markets. In reaching this conclusion, the Second Circuit relied heavily on the size disparity between the regional hubs and the Henry Hub, which made it unlikely that the alleged manipulation of derivatives based on prices at the much smaller regional hubs would have any impact on derivatives based on prices at the much larger Henry Hub.

The Harry decision was welcome news to parties seeking to defend market manipulation claims under the CEA, as it will make it more difficult for plaintiffs to assert attenuated claims based on derivatives that are not directly linked to the product that was allegedly manipulated. However, the Henry decision makes clear that the burden for pleading the actual injury element of CEA claims is not particularly high where the plaintiff traded in the product that was allegedly manipulated, so it may not meaningfully reduce the number of CEA claims that are filed in the future.

Proving Proximate Causation for Restitution Claims

The U.S. Court of Appeals for the Eleventh Circuit also issued an important decision involving CEA claims in 2018. In U.S. Commodity Futures Trading Commission v. Southern Trust Metals, Inc., 894 F. 3d 1313 (11th Cir. 2018), the Eleventh Circuit addressed whether the defendants' alleged violations of the CEA proximately caused investors' losses and, therefore, permitted an award of restitution to the victims of the alleged fraud. In Southern Trust, the CFTC alleged that the defendants, a commodities investment firm and its CEO, engaged in two fraudulent schemes in violation of the CEA. First, the defendants accepted money from customers who wanted to invest in futures, but then indirectly invested those funds in futures through foreign brokerage firms because the defendants were not registered to engage in such trading activities themselves (the "unregistered-futures scheme"). Second, the defendants represented to other customers that their funds would be invested in precious metals, but then actually invested those funds in metals derivatives (the "metals derivatives scheme"). The district court concluded that the defendants had engaged in two fraudulent schemes and ordered them to pay restitution to the victims, but in doing so, the district court relied on a definition of proximate cause that was later rejected by the U.S. Supreme Court in Bank of America Corp. v. City of Miami, 137 S.Ct. 1296 (2017).

On appeal, the Eleventh Circuit analyzed the standard that should be applied for proximate causation for restitution claims under 7 U.S.C. § 13a-1(d)(3), which the court indicated had not yet been addressed by any other circuit court. The court concluded that in the absence of direction from Congress, common law rules governing proximate cause should apply to the CEA, and that under such principles, the fraud must be a "substantial" or "significant contributing cause" of the alleged losses. Applying these principles, the Eleventh Circuit concluded that the unregistered futures scheme was not the proximate cause of any investor losses because the defendants' investment strategy, rather than their failure to register as futures commission merchants, was the more likely cause of those losses. Conversely, the Eleventh Circuit concluded that the metals derivatives scheme did proximately cause investor losses because the defendants took investor funds intended for one product and invested them in an entirely different product (which the National Futures Association forced defendants to sell once the fraud was uncovered). The court also expressly rejected the defendants' argument that market fluctuations were an intervening cause of the investors' losses, concluding that such fluctuations were foreseeable and, therefore, did not break the chain of causation.

The Southern Trust decision is useful in that it provides some guidance regarding how the courts might apply the proximate cause requirement in 7 U.S.C. § 13a-1(d)(3) going forward. However, the Eleventh Circuit made several statements in its analysis that suggest that proximate cause determinations are fact specific and difficult to generalize. As a result, litigants will still have considerable room to argue about proximate and intervening causes in the years to come.

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