Neal Kumar is an associate in the corporate and financial services department of Willkie Farr & Gallagher. He represents financial institutions, energy and agricultural companies, trade associations, and hedge and private equity funds, in a variety of regulatory, enforcement, and transactional matters involving commodities and derivatives. Before going into private practice, he worked at the Commodity Futures Trading Commission as a counsel in the Office of the General Counsel.
In the United States, two different legal regimes govern trading in securities and derivatives, each complete with its own language. These legal regimes evolved differently because the two markets at their core serve different purposes—capital formation on the one side, and price discovery and risk management on the other. In some cases, it can be easy to translate the language from one market to the other. However, one phrase from the securities world that does not translate accurately into the derivatives markets is “insider trading.”
As it turns out, there is a good reason for this. Trading based upon a trader’s own proprietary (“inside”) information can be detrimental to securities markets, but instrumental to creating well-functioning derivatives markets. Insider trading is prohibited in the securities markets to ensure that corporate insiders uphold their obligations to shareholders and to promote investor confidence when trading securities. In contrast, in the derivatives markets, trading on the basis of one’s own proprietary information has long been encouraged because it promotes sound risk management and aids in price discovery.
For example, farmers use futures to hedge the risks associated with the crops they produce. The farmer obviously has “inside” information about the size of the expected harvest, but the law governing the derivatives markets has always allowed the farmer to go into the futures markets to hedge his/her risks without disclosing those risks. As another example, airlines use swaps to hedge their fuel costs. An airline obviously has “inside” information about how many planes it will put into the air and how much fuel it will burn, but again, airlines have always been permitted to trade derivatives on the basis of this information without disclosing it to the broader public. To require disclosure of these types of information prior to trading in the derivatives markets would negatively impact one of the core purposes of these markets—to provide an efficient means to hedge risk.
If the farmer has to worry that trading on the basis of his crop production, or the airline has to worry that trading on the basis of its need for fuel could lead to a CFTC enforcement action, that fear has real-life consequences.
The closest parallels to insider trading in the derivatives markets are the prohibitions in the Commodity Exchange Act on the trading of derivatives by employees of the Commodity Futures Trading Commission and the exchanges. Another example is the so-called “Eddie Murphy Rule,” which prohibits market participants from trading on the basis of stolen government information.1 Rather than supporting a broad prohibition against insider trading, these prohibitions showcase the limited boundaries of prohibited “insider” trading in the derivatives markets.
Until recently, the derivatives industry thought that the Commodity Futures Trading Commission, the U.S. government agency charged with regulating this industry, fully supported the notion that market participants are encouraged to trade on the basis of their own proprietary information. However, in September 2018, the CFTC’s Division of Enforcement announced the formation of an “Insider Trading & Information Protection Task Force” as a means to police the derivatives markets. The Insider Trading Task Force “is a coordinated effort across the Division [of Enforcement] to identify and charge those who engage in insider trading or otherwise improperly use confidential information in connection with markets regulated by the CFTC” (emphasis added).2 Although the CFTC did not announce a change in policy, the name of the task force and the reference to insider trading run the risk of confusing market participants and chilling legitimate trading activity. After all, no market participant wants to accidentally trigger the attentions of this task force.
The background of the Insider Trading Task Force starts with the Dodd-Frank Act in 2010, where Congress expanded the CFTC’s anti-fraud and anti-manipulation authority to include fraud-based manipulation. When the CFTC adopted a final rule in 2011 implementing its expanded authority, it put the industry on notice that it could pursue a claim for “trading on the basis of material nonpublic information in breach of a pre-existing duty (established by another law or rule, or agreement, understanding, or some other source)” or “trading on the basis of material nonpublic information that was obtained through fraud or deception.”3 The claims referenced in the final rule all involve the misuse of material nonpublic information in violation of a duty owed to the source of that information.
The concept of misusing material nonpublic information in violation of a duty is very different from insider trading when a market participant trades on the basis of its own proprietary information. Importantly, there is already a name for the potential fraud involved with misusing material nonpublic information in violation of a duty—“misappropriation.” When the CFTC adopted its final rule in 2011, the preamble to the rule highlighted the fact that claims for misappropriation are different from trading on the basis of “insider” information: “[U]nlike the securities markets, derivatives markets have long operated in a way that allows for market participants to trade on the basis of lawfully obtained material nonpublic information.”4
Prior to the announcement of the Insider Trading Task Force, the CFTC’s Division of Enforcement settled claims consistent with the misappropriation claim described in the 2011 final rule. For example, in September 2016 the CFTC published a speaking order settling charges against Jon P. Ruggles.5 According to the order, Ruggles developed and executed his employer’s fuel hedging strategy, and through his role as employee, had a duty to act in the employer’s best interest. However, Ruggles used his knowledge of his employer’s trading activity to execute futures trades in a personal account for personal financial benefit, but to the detriment of his employer, and in violation of his employer’s internal policies. In connection with the Ruggles order, the CFTC imposed a sizeable fine, ordered Ruggles to pay disgorgement, and imposed a lifetime ban from the industry. Prior to the Ruggles order, in December 2015, the CFTC entered a speaking order settling similar charges against Arya Motazedi.6 The Ruggles and Motazedi orders are prime examples of a misappropriation claim.
Unfortunately, by using the term “Insider Trading” in the name of its new task force, the Division of Enforcement is blurring the distinction between misappropriation and insider trading. Words matter to the derivatives market. When re-reading the summary description of the task force, there is cause for concern: “[The Insider Trading Task Force] is a coordinated effort across the Division [of Enforcement] to identify and charge those who engage in insider trading or otherwise improperly use confidential information in connection with markets regulated by the CFTC” (emphasis added).7 This language suggests that the CFTC’s Division of Enforcement distinguishes between insider trading and misappropriation, and could pursue claims for both. What the CFTC’s Division of Enforcement means when it says it will pursue “insider trading” is left to one’s imagination.
Notwithstanding the casual reference to “insider trading,” other aspects of the description of the Insider Trading Task Force suggest that the CFTC’s Division of Enforcement is focused on misappropriation: “The [CFTC] will thoroughly investigate and, where appropriate, prosecute instances in which individuals have abused access to confidential information—for example, by misappropriating confidential information, improperly disclosing a client’s trading information, front running, or using confidential information to unlawfully prearrange trades.”8
If the goal of the Insider Trading Task Force is truly to pursue misappropriation, the Division of Enforcement should change the name and narrative of the task force because the casual references to “insider trading” raise concerns. If the farmer has to worry that trading on the basis of his crop production, or the airline has to worry that trading on the basis of its need for fuel could lead to a CFTC enforcement action, that fear has real-life consequences. A market participant may decide not to hedge a significant risk facing its business, which, in turn, will inject more risk into the derivatives markets. Any hesitancy to hedge risk or participate in price discovery may reduce liquidity for the entire market. These real concerns should form the basis for a constructive dialogue with the CFTC about the name and mission of, perhaps, a more aptly named Misappropriation Task Force.
1 The term refers to the role played by Eddie Murphy in the 80s movie Trading Places, and in particular, to his scheme to use a stolen government report about orange juice production to profit from trading in frozen concentrate orange juice futures.
3 76 Fed. Reg. 41398, 41403 (July 24, 2011).
4 Supra note 3.
5 See In Re Ruggles, CFTC Docket No. 16-34 (Sept. 29, 2016).
6 See In Re Motazedi, CFTC Docket No. 16-02 (Dec. 2, 2015).
7 Id. (emphasis added).
8 Insider Trading Task Force Press Release.