Maryland Criminal Attorney Blog
Generally, regulation of the U.S. financial markets is divided between the Securities and Exchange Commission (“SEC”), with authority over securities, and the Commodity and Futures Trading Commission (“CFTC”), with authority over futures/derivatives. See Gary Rubin, CFTC Regulation 1.59 Fails to Adequately Regulate Insider Trading, Note, 53 N.Y.L. SCH. L. REV. 599, 606 (2008-09). The Commodity Exchange Act (“CEA”) of 1936 was the first major congressional initiative aimed at regulating derivatives. See Commodity Exchange Act of 1936, ch. 545, 49 Stat. 1491 (1936) (codified as amended at 7 U.S.C. § 1 (2006)); see also id. at 604. Generally, the CEA expanded upon prior acts by increasing the Secretary of Agriculture’s authority and making it “unlawful to engage in commodity brokering without first registering with the secretary.” Rubin, supra, 53 N.Y.L. SCH. L. REV. at 605 (citing CEA § 5, 49 Stat. at 1492-97).
The CFTC was established by the Commodity Futures Trading Commission Act (“CFTCA”) of 1974, which granted the CFTC the exclusive authority to regulate futures contracts. See 7 U.S.C. § 2(a)(2). The CFTC is a federal regulatory body that regulates the entire commodities futures industry. In its mission statement, the CFTC describes its main purposes as preventing fraud and promoting competition, stating, “[t]he CFTC’s mission is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets.” CFTC, About the CFTC, http://www.cftc.gov/About/MissionResponsibilities/index.htm.
Prior to the enactment of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act” or “the Act”), the CFTC was viewed as “a regulatory agency with a small bark and even less bite.” Peter J. Henning, C.F.T.C. Is Set to Get Tougher on Fraud, New York Times, Dealbook, available at http://dealbook.nytimes.com/2010/11/01/c-f-t-c-is-set-to-get-tougher-on-fraud/. However, with the enactment of the Dodd-Frank Act, the CFTC has gained new authority to regulate derivatives, credit default swaps and the exchanges that will trade these contracts.
II. Insider Trading Prior to the Dodd-Frank Act – SEC vs. CFTC
Insider trading refers to the practice of trading based on material, non-public information. In general information will be considered material if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); see also 17 C.F.R. § 1.59(a)(5). Information is non-public if it has not been disseminated in a manner making it generally available to the public. See 17 C.F.R. § 1.59(a)(6).
When it comes to insider trading, until recently, there has been a wide variety of differences in enforcement authority and overall approach among the SEC and the CFTC with respect to insider trading in their respective areas. The SEC bans insider trading under section 10(b) of the Securities Exchange Act (“SEA”) of 1934 and Rule 10b-5 as promulgated thereunder. The provisions of securities law prohibiting insider trading are premised on a corporations duties to disclose material information to protect shareholders from corporate insiders who have access to non-public information. See Jerry W. Markham, ‘Front-Running’ – Insider Trading Under the Commodity Exchange Act, 38 CATH. U. L. REV. 69, 81-87 (Fall 1988); A Joint Report of the SEC and the CFTC on Harmonization of Regulation, U.S. Commodity Futures Trading Commission & U.S. Security Exchange Commission, Oct. 16, 2009, p. 7, [hereinafter, “Joint Report”]. Specifically, corporate officials and personnel of a firm who trade that firm’s securities on the basis of inside information are viewed as breaching a fiduciary duty to the shareholders of those securities. See Markham, supra; Joint Report, supra.
The language of section 6b of the CEA, generally referred to as the “anti-fraud provision”, tracks the language of section 10(b) of the SEA. Specifically, section 6b of the CEA provides that is shall be unlawful “for any person, in or in connection with any order to make, . . . any contract of sale of any commodity for future delivery, or other agreement, contract, or transaction . . . to cheat or defraud or attempt to cheat or defraud the other person.” 7 U.S.C. § 6b(a)(2)(A).
However, prior to the enactment of the Dodd-Frank Act, the CEA’s insider trading prohibitions were focused on employees and agents of the CFTC and of Self-Regulatory Organizations (“SROs”) and the markets that are regulated by the CFTC. See Joint Report, supra. Sections of the CEA which prohibit insider trading specifically, only cover three general categories of persons. First, the statute prohibits CFTC Commissioners, employees and agents from trading on non-public information. See 7 U.S.C. § 13(c). The statute also prohibits Commissioners and CFTC employees from delivering non-public information to third parties with the intent to assist them in conducting trades; and the CEA forbids individuals who receive such information from trading in it. See 7 U.S.C. § 13(d). Finally, the CEA prohibits employees and board/committee members of a board of trade, registered entity, or registered futures association, from willfully and knowingly trading for their own or on behalf of any other account, futures or options contracts on the basis of any material non-public information obtained through special access to information related to the performance of their duties. See 7 U.S.C. § 13(e). While these provisions have a limited scope, any violation is considered a felony and is punishable by fines of up to $500,000, plus the amount of any profits realized from the trading. See 7 U.S.C. §§ 13(c)-(e). Additionally, violations of these provisions may result in criminal prosecutions with a maximum sentence of five (5) years. Id.
There are generally two reasons why the concept of insider trading has had limited applicability in the futures industry: (1) because hedging, which can be seen as a form of insider trading, is a desired purpose of futures trading, and (2) unlike securities trading, which recognizes a fiduciary relationship between the issuer of the security and other purchasers and sellers, futures transactions have not been recognized to create a corresponding fiduciary relationship. See Markham, supra, 38 CATH. U. L. REV. at 105-06; Kenneth W. Raisler and Barbara J. Morgen, Insider Trading Under the Commodity Exchange Act, 667 PLI/Corp. 115, 117 (1989).
III. Insider Trading After the Dodd-Frank Act – Increase in CFTC Authority and Rulemaking
As a result of the 2008 financial crisis, Congress enacted and President Obama signed into law the Dodd-Frank Act on July 21, 2010. The Act institutes a wide-range of changes to the banking, securities, derivatives, and financial services industries. Under the Act the CFTC has gained new enforcement authority to regulate derivatives and the exchanges that will trade those contracts.
Of particular relevance here is the expansion of the CFTC’s authority to pursue those who “engage in fraud and manipulative conduct in connection with over-the-counter and exchange-traded swaps and commodity and futures contracts”, including forms of insider trading. See Scott E. Early, Kathryn M. Trkla, & Ellen M. Wheeler, The CFTC and SEC Propose New Anti-Fraud, Anti-Manipulation Rules, Nov. 8, 2010, available at http://www.lexology.com/library/detail.aspx; Advisory|Dodd-Frank Act, Dodd-Frank Beefs Up SEC and CFTC Enforcement, Covington & Burling, LLC, July 21, 2010.
In statements made by CFTC Chairman Gary Gensler during the course of debate on the Act, Gensler repeatedly asked Congress to expand the insider trading laws in the securities arena to the futures arena by making it illegal to trade on non-public information from agencies like the U.S. Treasury, Federal Reserve and Department of Agriculture. See Top Futures Regulator Wants ‘Eddie Murphy’ Rule, Financial Advisor, January 29, 2010, available at http://www.fs-mad.com/fa-news/5152-top-futures-regulator-wants-eddie-murphy-rule.html; Bruce Carton, CFTC: Billy Ray and Winthrop Were Not Insider Traders, Compliance Week, January 29, 2010, available at http://www.complianceweek.com/cftc-billy-ray-and-winthrop-were-not-insider-traders/article.html. Gensler repeatedly cited the hit-movie “Trading Places” as an example of why this new law should be implemented; stating that under current law the actions of Murphy and Aykroyd in “using such misappropriated government information actually is not illegal under our statute. To prevent misappropriation and misuse of such information, [the CFTC has] recommended what we call the ‘Eddie Murphy’ rule to ban insider trading using nonpublic information acquired from a government source.” Id.
Gensler was ultimately successful in having the so-called “Eddie Murphy Rule” included in the Act that was signed by President Obama on July 21, 2010. See Bruce Carton, ‘Eddie Murphy Rule’ Among Provisions in Dodd-Frank, Compliance Week, July 22, 2010, available at http:// www.complianceweek.com/eddie-murphy-rule-among-provisions-in-dodd-frank/article/188327/. The provision adopted in the Act states as follows:
SEC. 746. INSIDER TRADING.
Section 4c(a) of the Commodity Exchange Act (7 U.S.C. 6c(a)) is amended by adding at the end the following:
‘(3) Contract of sale. It shall be unlawful for any employee or agent of any department or agency of the Federal Government who, by virtue of the employment or position of the employee or agent, acquires information that may affect or tend to affect the price of any commodity in interstate commerce, or for future delivery, or any swap, and which information has not been disseminated by the department or agency of the Federal Government holding or creating the information in a manner which makes it generally available to the trading public, or disclosed in a criminal, civil, or administrative hearing, or in a congressional, administrative, or Government Accountability Office report, hearing, audit, or investigation, to use the information in his personal capacity and for personal gain to enter into, or offer to enter into-
‘(A) a contract of sale of a commodity for future delivery (or option on such a contract);
‘(B) an option (other than an option executed or traded on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or ‘(C) a swap.
‘(4) Nonpublic information.-
‘(A) Imparting of nonpublic information. It shall be unlawful for any employee or agent of any department or agency of the Federal Government who, by virtue of the employment or position of the employee or agent, acquires information that may affect or tend to affect the price of any commodity in interstate commerce, or for future delivery, or any swap, and which information has not been disseminated by the department or agency of the Federal Government holding or creating the information in a manner which makes it generally available to the trading public, or disclosed in a criminal, civil, or administrative hearing, or in a congressional, administrative, or Government Accountability Office report, hearing, audit, or investigation, to impart the information in his personal capacity and for personal gain with intent to assist another person, directly or indirectly, to use the information to enter into, or offer to enter into-
‘(i) a contract of sale of a commodity for future delivery (or option on such a contract);
‘(ii) an option (other than an option executed or traded on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or ‘(iii) a swap.
‘(B) Knowing use. It shall be unlawful for any person who receives information imparted by any employee or agent of any department or agency of the Federal Government as described in subparagraph (A) to knowingly use such information to enter into, or offer to enter into-
‘(i) a contract of sale of a commodity for future delivery (or option on such a contract);
‘(ii) an option (other than an option executed or traded on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or ‘(iii) a swap.
‘(C) Theft of nonpublic information. It shall be unlawful for any person to steal, convert, or misappropriate, by any means whatsoever, information held or created by any department or agency of the Federal Government that may affect or tend to affect the price of any commodity in interstate commerce, or for future delivery, or any swap, where such person knows, or acts in reckless disregard of the fact, that such information has not been disseminated by the department or agency of the Federal Government holding or creating the information in a manner which makes it generally available to the trading public, or disclosed in a criminal, civil, or administrative hearing, or in a congressional, administrative, or Government Accountability Office report, hearing, audit, or investigation, and to use such information, or to impart such information with the intent to assist another person, directly or indirectly, to use such information to enter into, or offer to enter into-
‘(i) a contract of sale of a commodity for future delivery (or option on such a contract);
‘(ii) an option (other than an option executed or traded on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or ‘(iii) a swap.
Provided, however, that nothing in this subparagraph shall preclude a person that has provided information concerning, or generated by, the person, its operations or activities, to any employee or agent of any department or agency of the Federal Government, voluntarily or as required by law, from using such information to enter into, or offer to enter into, a contract of sale, option, or swap described in clauses (i), (ii), or (iii).’.
S. 3217, 111th CONGRESS, 2nd Session (emphasis added).
In summary, this portion of the Act creates increased insider trading prohibitions regarding information emanating from Federal government departments and agencies that may affect or tend to affect the price of any commodity in interstate commerce and persons who receive and trade in this information. This portion of the Act will become effective on July 21, 2011, or 60 days after the CFTC adopts the final rules necessary for its implementation. Currently, the CFTC is in the process of promulgating rules for the implementation of this and other portions of the Act, which are available for public comment at http://comments.cftc.gov/FederalRegister/Proposed.aspx. While the full impact of the Act and the CFTC’s promulgated rules are unknown, one commentator has noted “[p]ublic companies, regulated entities, and hedge funds, as well as their offices, directors, and employees should brace themselves and prepare for a significant increase in enforcement activity by both the SEC and the CFTC.” Dodd-Frank Beefs Up SEC and CFTC Enforcement, Covington & Burling, LLC, supra.