Regulation
Thursday, June 23, 2016
By Anthony Mansfield and Jonathan Flynn
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:
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:
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.
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