As we approach the sixth anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, “spoofing” - a type of disruptive trading that was specifically prohibited in the Act - remains in the spotlight. Indeed, spoofing continues to generate headlines, most recently with the conviction of Michael Coscia (for alleged spoofing on the Chicago Mercantile Exchange) and the order requiring the extradition of a U.K. resident - Navinder Sarao - to face a combination of criminal and civil charges in the United States for alleged spoofing in the S&P 500 E-mini futures contract.
Spoofing is defined in the Commodity Exchange Act as “bidding or offering with the intent to cancel the bid or offer before execution.” More broadly speaking, this type of trading is part of a new antidisruptive trading practices provision that makes it “unlawful for any person to engage in any trading, practice or conduct on or subject to the rules of a registered entity” that is “of the character of, or is commonly known to the trade as, 'spoofing.'”
While spoofing is now part of the everyday vocabulary of traders and compliance professionals in the commodities and derivatives markets, that wasn't always the case. Six years ago, initial reactions to the spoofing provision focused on its ambiguity. On its face, spoofing seemed to capture a wide range of activities, including legitimate trading.
Interpretive guidance by the U.S. Commodity Futures Trading Commission (CFTC) - along with proposed rules that were never finalized - arguably exacerbated the confusion by introducing examples of prohibited conduct that CFTC staff acknowledged could fall within or outside the statutory definition. Placing “multiple bids or offers to create an appearance of false market depth," based on highly subjective factors, is one example of such prohibited conduct.
Even with the CFTC's guidance, it was unclear how market participants could objectively determine whether such activity was legitimate (e.g., stop-loss orders used to mitigate risk) or merely an attempt “to create an appearance of false market depth.” Many observers therefore argued that spoofing was impossibly vague and, as a practical matter, unenforceable.
But times have changed. There are now clear indications that spoofing cases will remain a priority for prosecutors and regulators in the United States and elsewhere. For companies and individuals trying to comply with the spoofing provisions, the focus is now shifting from interpretation of this new prohibition to implementation of effective compliance programs based on the prohibition as applied in practice.
A New Perspective
The passage of time and progress of several prominent spoofing cases through various stages of litigation have provided a degree of perspective. In Coscia, the U.S. Department of Justice (DOJ) distilled the statutory definition of spoofing down to a simpler formula: “bidding or offering with the intent to cancel the bid or offer before execution.” This omitted the more general statutory language (i.e., the language referring to activity that “is of the character of, or is commonly known to the trade as, 'spoofing'”), and the DOJ's working definition survived the defendant's vagueness arguments.
Defendants and respondents, generally, continue to challenge the claim of spoofing under the CEA as unconstitutionally vague. (See, e.g., U.S. CFTC v. 3 Red Trading LLC et al., C.A. No. 15-cv - 09196 [N.D. Ill. 2016] [Docket No. 164].) However, contrary to speculation by many observers, the DOJ's approach in the Coscia case was successful with a jury. Despite the technical nature of the alleged violation, the jury convicted Coscia on all counts after just over an hour of deliberation.
Enforcement officials appear to be generally following the roadmap used in Coscia in other spoofing cases, including the CFTC's civil case against Igor Oystacher and his company - 3Red Trading - and the DOJ's criminal case against Navinder Sarao - the trader allegedly behind the 2010 “flash crash.”
Based on the fact patterns that have come to light, regulators appear to be going after alleged conduct that, from their perspective, jumps off the page because the alleged spoofing involves large volume orders and repeated patterns of activity that appear to be timed to take advantage of market movements. Moreover, according to statements by senior government officials, there are enough of these types of cases to keep enforcement attorneys busy for the foreseeable future.
Regulators Take Aim at Spoofing
Spoofing has become an increasingly common cause of action for the CFTC and other financial regulators. This trend is likely to continue for several reasons:
- Regulators believe that spoofing is a common practice and readily identifiable. In a recent conference focusing on enforcement trends in the financial markets, the head of the DOJ's Securities & Financial Fraud Unit expressed his view that spoofing is widespread in the commodities and derivatives markets.
The CFTC's Director of Enforcement has made similar statements, suggesting that spoofing is pervasive in the financial markets. Coupled with this expectation, regulators appear increasingly comfortable with where to look, what to look for and how to look for it.
- Regulators are increasingly confident in their ability to prevail in spoofing cases. The Coscia conviction will likely embolden civil and criminal authorities to believe that they can withstand further legal challenge to the claim of spoofing and successfully delineate illegitimate from legitimate activity before a finder of fact.
- Exchanges and regulators are enlisting companies to more actively police their employees. The Financial Industry Regulatory Authority (FINRA) recently made available to member firms supervision “report cards” that identified potential spoofing or layering in equities by (1) the firm; or (2) entities to which the firm provides market access. As FINRA made clear, the purpose in giving members access to its “sophisticated automated surveillance technology” is to augment the members' own surveillance and supervisory processes so that members can “take appropriate action to address the activity even before FINRA can complete a formal investigation.”
FINRA is giving its members additional tools to combat allege spoofing, and it is reasonable to assume that the regulator expects its members to use those tools. Failure to do so could lead to charges of supervisory failures. What's more, it is possible that the National Futures Association and other exchanges will pursue a similar approach in the commodities and derivatives markets.
- Whistleblowers are contributing to spoofing cases. Whistleblowers have, in fact, taken prominent roles in several recent spoofing cases, including the DOJ's case against Coscia and CFTC's case against 3Red. With whistleblower awards becoming larger and more common, it is reasonable to expect that competitors and even third-party market observers will report suspected spoofing to regulators.
- Spoofing cases allow regulators to hold both individuals and companies liable. Because spoofing typically involves individual traders, spoofing cases allow regulators to hold individuals liable - an explicit priority of the DOJ. In addition to standard employer-employee liability, firms also may face charges of failure to supervise, particularly where regulators find their compliance controls and systems to be deficient.
What's Next, and How to Proceed
Given the real risk that allegations of spoofing may lead to both civil and criminal penalties, traders and compliance departments should embrace an approach to spoofing that is both active and practical. The following steps offer a good start:
- Accept that the legal claim of spoofing is real and serious, and is not going to fade away. Even though the concept of spoofing may continue to be ambiguous and vague, especially in certain circumstances, it will still be pursued by regulators. Traders and compliance departments should not rest their collective heads on vagueness as a defense.
- Respond to the ambiguity by taking an unambiguous position on this issue. Develop written policies and procedures that establish a clear standard for traders to follow. Then, implement and support these policies and procedures with practical training and compliance support that ensures that the lines of communication between the trading floor and the compliance/legal department are open and used.
- Go on the offensive to meet potential spoofing activity at its source. Consider targeted audits of trading data to identify spoofing retroactively -- or implement a surveillance program to identify spoofing on a more proactive basis.
Taking these initial steps before an investigation begins provides companies with the opportunity to position themselves most effectively (and successfully) to respond to a regulatory investigation and potential enforcement action. Conversely, taking a wait and see approach to spoofing risks not only liability for spoofing but may lead to failure to supervise claims, should an enforcement action arise.
Anthony Mansfield is a partner at Cadwalader, a NYC-based law firm. He is focused on commodities; securities and related derivatives litigation; complex commercial litigation; and regulatory/enforcement matters. He represents clients on matters of regulation, compliance, enforcement and litigation matters involving the Commodity Futures Trading Commission, the Federal Trade Commission, the Federal Energy Regulatory Commission, the UK Financial Conduct Authority and the European Commission.
Jonathan Flynn is an associate at Cadwalader, focused on commodities, derivatives and related regulatory, compliance and litigation matters. He represents clients in the commodity and derivative markets, including investment banks, major oil companies, hedge funds, energy marketers, market intermediaries and industry trade associations.
