LONDON By extracting a $13 million penalty and imposing tough restrictions on future oil trading by Arcadia and others, the U.S. Commodity Futures Trading Commission (CFTC) this week sent a powerful signal that laws against market manipulation still have teeth.
The case challenges a now famous view expressed in 1991 by commodities lawyer Jerry Markham that manipulation of commodity futures prices had become an unprosecutable crime. (“Manipulation of commodity futures prices: the unprosecutable crime”)
“Under present law the crime of manipulation is virtually unprosecutable, and remedies for those injured by price manipulation are difficult to obtain,” Markham wrote in an article published in the Yale Journal of Regulation.
“Even where a prosecution is successful, the investigation and effort necessary to bring a case will involve years of work, enormous expenditures, as well as an extended trial,” Markham lamented.
The real significance of the CFTC’s punitive settlement with trading company Arcadia, its subsidiary Parnon and traders Nicholas Wildgoose and James Dyer is not the headline amount but the fact the CFTC managed to compel a settlement at all.
CYCLE OF MANIPULATION
In a civil complaint filed with the U.S. District Court for the Southern District of New York in May 2011, the CFTC alleged the defendants “unlawfully manipulated and attempted to manipulate the NYMEX WTI financial contract prices”.
Against a backdrop of tight supplies of crude oil at the NYMEX delivery point at Cushing, Oklahoma, the complaint alleged that the defendants operated a cycle of manipulation.
By amassing a dominant long position in physical WTI at the delivery location and holding on to it, “even though they had no commercial need for crude oil”, the defendants gave “other market participants the impression that the supply would remain tight”.
Simultaneously, the defendants established a large long position in WTI futures contracts “with the intention to artificially inflate the value of that position by driving WTI prices higher.”
Once prices had moved higher, to what the CFTC said was an artificial level, the futures contracts were sold and the defendants established a short position before “completing the cycle by surprising the market with an unexpected sell-off of their WTI physical position”.
The CFTC alleged the entire manipulative cycle was attempted several times in early 2008 until the defendants learned that the CFTC was investigating their conduct.
Rather than speculating on the outright price of oil, the CFTC’s complaint alleged the defendants attempted to manipulate the calendar spread, the difference between the price of oil delivered in one month and the next.
The alleged manipulation came at an especially sensitive time in late 2007 and early 2008. Crude oil prices had already risen to around $100 per barrel and were accelerating towards their ultimate peak over $140 per barrel in July 2008.
Scarce supplies of crude around the Cushing delivery point and the stiff backwardation in the market during the winter months contributed to a sense that oil supplies were scarce globally and could have helped propel prices higher.
ADULT SUPERVISION ORDER
In settling the lawsuit without going to trial, the defendants “neither admit nor deny the allegations contained in the complaint”, according to the settlement order.
But they agreed “neither the defendant, nor any of its or his agents or employees under its or his authority or control, shall take any action or make any public statement denying, directly or indirectly, any allegation in the complaint, or creating, or tending to create, the impression that the complaint is without factual basis”.
The settlement requires the defendants “jointly and severally” to pay a civil monetary penalty amounting to $13 million.
In a piece of standard boilerplate, the order also grants a permanent injunction prohibiting the defendants from violating the market manipulation sections of the Commodity Exchange Act.
But the more interesting and novel features of the settlement are the additional limitations and undertakings that the defendants accepted.
For three years, the defendants are prohibited from taking delivery on cash crude positions at Cushing amounting to more than 3 million barrels.
For three years, the defendants must also report all physical and financial positions relating to Cushing to the CFTC on a weekly basis.
Documents related to Cushing oil trading must be retained and made available to the CFTC on request for the same period, and all telephone conversations must be recorded and made available to the Commission’s enforcement staff.
Finally, the defendants must “engage the services of an independent consultant to review and evaluate defendants’ compliance, internal control, and risk management policies, procedures and practices designed to detect, deter, discipline and/or correct potential violations” of the Commodity Exchange Act and other CFTC regulations.
Collectively, these prohibitions and monitoring requirements amount to what might be termed an adult supervision order requiring unique oversight over and complete transparency about everything the defendants do in connection with Cushing for the next three years.
PRECEDENT AND DETERRENT
The $13 million penalty is not especially large in comparison with the net profits which the defendants are alleged to have made, which the CFTC estimated were around $35 million.
Nor is the penalty large compared with the massive settlements that the Federal Energy Regulatory Commission has extracted for attempts to manipulate electricity markets, or that the Securities and Exchange Commission and U.S. bank regulators have extracted for mortgage-related and money laundering offences.
The fact the CFTC agreed to a modest penalty and that it was finally accepted by the defendants reflects the uncertainty on both sides about whether they would prevail at trial.
But the CFTC has notched up a clear victory and delivered a powerful reminder to market participants that manipulation laws are not entirely toothless.
In theory, the case does not create a legal precedent, since it was settled rather than taken to a formal judgment.
There was no finding about whether the facts outlined in the complaint were actually unlawful under the Commodity Exchange Act.
Arcadia and the other defendants have not admitted or denied that what they did was unlawful under the Act. Only a court could determine that, and the settlement means the case will never reach that stage.
In practice, compliance professionals and lawyers will take careful note of the outcome, and it is likely to deter similar behavior in future.
The “manipulative scheme” alleged in the CFTC complaint was once relatively common and thought to be lawful if not entirely reputable in the rough and tumble world of physical oil trading.
The settlement order sends a strong signal that physical-plus-financial strategies, which dominant cash and futures markets and others like them, could lead to legal jeopardy and substantial financial penalties.
The reporting requirements, in their unusual intrusiveness, are humiliating and express the CFTC’s strong disapproval of the conduct outlined in the complaint and its determination to ensure it is not repeated, either by the defendants or other firms still heavily involved in the market.
What is most important, the settlement underscores that the CFTC can still win substantial penalties despite all the obstacles in the way of proving market manipulation to the standard demanded by the courts.
Markham’s views, though now almost 25 years old, have come to represent the consensus thinking among commodity market professionals.
In forcing a settlement in a high-profile case, however, the CFTC proved market manipulation was not quite so unprosecutable after all.
(editing by Jane Baird)