Introduction: On November 30, 2018, the Southern District of New York issued an opinion reaffirming the long-standing rule that traders cannot be found liable for illegal market manipulation when their trading was motivated by a good-faith economic analysis and reflected a bona fide interest in transacting on the terms submitted to the market, or where their trading did not create an “artificial” price. The court summarized the case by stating, “It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented the product.”1
Background: This decision arises out of the Commodity Futures Trading Commission's (CFTC) long-running action against Donald R. Wilson and his firm, DRW Investments, LLC (together, DRW).2 The CFTC alleged that DRW manipulated and attempted to manipulate the price of the IDEX Three-Month Interest Rate Swap Futures Contract (the Three-Month Contract) in violation of Sections 6(c) and 9(a)(2) of the Commodity Exchange Act (CEA) by placing orders during the Three-Month Contract’s settlement period with the intent of moving the settlement price in its favor.3 The CFTC alleged that these actions met the traditional, four-part test of manipulation:
(1) that the accused had the ability to influence market prices;
(2) that [the accused] specifically intended to do so;
(3) that artificial prices existed; and
(4) that the accused caused the artificial prices.4
The facts were largely undisputed. At the time that IDEX listed the Three-Month Contract in August 2010, market participants treated the contract as economically equivalent to bilateral over-the-counter (OTC) interest rate swaps. However, DRW discovered that a long position in the contract was statistically more valuable than an equivalent OTC swap because the holder was expected to receive interest on daily margin payments required by the central clearinghouse.5 Accordingly, DRW acquired a position in the contract intending to profit when the market identified this discrepancy and bid up the price of the Three-Month Contract. When the product continued to track the price of the OTC swap, DRW began placing orders during the contract’s settlement window, with the understanding that the prices of the open orders would influence the settlement price to more accurately reflect DRW’s view of the contract’s actual value.6 The CFTC alleged that this activity was manipulative.
Decision: Following a bench trial and extensive post-trial briefing, Judge Richard J. Sullivan, of the Southern District of New York, held that the CFTC had not proved that DRW had created an artificial price or intended to manipulate the market. He found that, although DRW had the ability to influence, sought to influence, and had in fact influenced the settlement price of the Three-Month Contract, there was no evidence that the resulting price was artificial or did “not reflect the basic forces of supply and demand.”7 To the contrary, the court found that the Three-Month Contract had been undervalued8 and that “virtually every market participant” and entity, other than the CFTC’s Enforcement Division, had come to agree with DRW’s valuation theory.9 The court further found that there was no evidence DRW intended to create an artificial price because DRW had a bona fide interest in fulfilling every order it submitted, was able to credibly explain its trading strategy, and its orders were consistent with its valuation model.10
Conclusion: The court held that because “[DRW] made bids with an honest desire to transact at those posted prices, and … fully believed the resulting settlement prices to be reflective of the forces of supply and demand,” its “trading pattern [was] supported by a legitimate economic rationale” and could not be “the basis for liability under the CEA.”11 It appears that this decision is a significant setback for the CFTC Enforcement Division’s effort to lower the bar on establishing market manipulation or attempted manipulation. Manipulation cases will continue to be difficult to sustain under the traditional four-part test, especially if relying only upon market data and without affirmative evidence of manipulative intent.12 Moreover, it is not clear that Regulation 180.1 provides the CFTC with a significantly lower burden for establishing manipulation.13
However, it should also be borne in mind that DRW was able to establish both that it acted in good faith and that its market analysis was correct. Although the court’s reasoning was broadly stated, it is unclear whether the court would have viewed DRW’s intent with more skepticism had its view of the market ultimately not been vindicated.
