Legitimate Yet Manipulative: The Conundrum of Open-Market Manipulation

Gina-Gail S. Fletcher is Associate Professor of Law at Indiana University Maurer School of Law. This post is based on her recent article, published in Duke Law Journal.

On November 30, 2018, the Commodity Futures Trading Commission (“CFTC”) lost its bid to hold Don Wilson and DRW Investments, LLC (collectively, “DRW”) liable for open-market manipulation. In so doing, the court rejected the CFTC’s intent-based theory of liability without additional proof of price artificiality or market inefficiency resulting from the defendant’s conduct. The court’s scathing opinion is yet another blow to the Commissions’ efforts to hold traders liable for open-market manipulation based on their inherently flawed, intent-centric theory of liability. And, it is further evidence that the CFTC’s intent-centric theory of liability for open-market manipulation is incomplete because it divorces liability for open-market manipulation from market harm.

Open-market manipulation presents knotty practical and theoretical questions for courts, lawmakers, and regulators because it does not involve misstatements, fraud, fictitious trades, or deceit. Rather, the transactions are facially legitimate, involve no bad acts, and are executed on the open-market. In the absence of traditional markers of manipulation, the CFTC & SEC (collectively, the Commissions) have adopted the position that bona fide, open-market trades are manipulative if the trader has a manipulative intent at the time of the transaction. However, this theory of liability fails in a key regard—it does not articulate how allegedly manipulative open-market transactions harm the market. Indeed, this was a key critique underlying the court’s dismissal of the suit against DRW.

In an article recently published in the Duke Law Journal, Legitimate Yet Manipulative: The Conundrum of Open-Market Manipulation, I examine the phenomenon of open-market manipulation with the goal of answering two fundamental questions. First, can facially legitimate transactions manipulate the market? Second, if yes, how do we identify open-market manipulation? In theory, facially legitimate transactions executed on the open-market should not distort the markets because, by definition, they are permissible trades. However, this view of market manipulation and the impact such trades can have on the market fails to reflect market realities and trading possibilities. In the Article, I examine four examples of alleged open-market manipulation to demonstrate that, from a practical standpoint, traders can and do use open-market trades to distort the markets. Relying on strategies such as aggressive short selling (i.e., selling a borrowed security and repurchasing said security at a lower price) and marking the close (i.e., large, high-volume transactions close to the end of the trading day), traders are able to distort the securities and commodities markets through facially legitimate transactions. Despite the feasibility of open-market manipulation and the negative impact these schemes have on the market, the Commissions have mixed results in holding traders liable primarily because of their reliance on intent to prove culpability.

In response to the second question the Article poses, I argue that identification of open-market manipulation requires additional considerations beyond just the scienter of the trader. The Commissions’ exclusive focus on intent conflates scienter with harm and fails to adequately protect the markets against injurious conduct that impairs market efficiency and integrity. Intent alone has proven to be an incomplete basis of liability and courts are less willing to hold traders, like DRW, liable for market manipulation without a showing of something more. That “something more” must be a showing of harm to the market. A cogent and convincing framework for holding traders accountable for open-market manipulation, therefore, must assess liability in terms of the trader’s intent and the negative consequences of her conduct on the market, i.e., the harm of her conduct.

Given the saliency of harm to determining whether legitimate transactions constitute market manipulation, the Article proposes a harm-based approach to identifying and analyzing how open-market transactions injure the markets. This approach focuses on whether open-market transactions impede the market’s efficiency and undermine its integrity to ascertain whether they are legally manipulative. By emphasizing efficiency and integrity, the proposed harm-based approach links liability for legitimate transactions to the purpose underlying anti-manipulation laws in the securities and commodities markets—i.e., promoting market efficiency and enhancing market integrity. Indeed, to the extent open-market transactions impose these harms on the markets, they are functionally equivalent to traditional forms of market manipulation.

Of the two proposed bases of harm the Article proposes, harm to market efficiency is the most obvious and familiar one for courts and the Commissions. Proving harm to market efficiency requires demonstrating that a defendant has used open-market trades to interfere with the market’s ability to efficiently and accurately establish the asset’s price. Based on prior case studies, I identify three market conditions that may suggest asset price distortion, despite the legitimacy of the transactions: (1) market domination, (2) market volatility, and (3) market illiquidity. The presence of any of these three conditions, whether singularly or collectively, may be indicative of open-market manipulation, thereby signaling a need for greater investigation or econometric analysis on the part of the Commissions.

The second proposed basis for assessing harm under the Article’s harm-based approach is to consider how open-market manipulation impairs market integrity or how it makes the markets unfair for traders. Here, the Article proposes recognizing harm to market integrity as a separate basis for assessing liability for open-market manipulation. Recognizing the imprecise nature of fairness, the Article defines it as the absence of unjust wealth transfers, which allows for a parity of opportunity among counterparties of loss and gain. This is not the notion of a risk-free market, but rather a market in which a trader does not create market conditions through her transactions that improperly reduces the likelihood of her counterparties’ success.

The harm-based approach the Article proposes provides a coherent and cogent basis on which to ground liability for open-market manipulation. The Article’s harm-based approach to open-market manipulation adds needed clarity to prosecution of facially legitimate transactions and, importantly, ensures that the Commissions target those traders whose open-market trades impair the functioning of the market. By embracing the proposed harm-based approach to open-market manipulation, the Commissions are likely to increase their chances of success in prosecuting this form of manipulation and decrease the ire of courts, such as the DRW court, when reviewing these cases as they search for evidence of harm stemming from the open-market trades.

The complete article is available here.

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