Open-Market Manipulation Under SEC Rule 10b-5 And Its Analogues: Inappropriate Distinctions, Judicial Disagreement And Case Study: FERC's Anti- Manipulation Rule

  1. INTRODUCTION

    1. Overview

      Regulators have addressed market manipulation with Rule 10b-5 since its promulgation under the Securities Exchange Act in 1942. While Section 9 of the Securities Exchange Act addresses manipulation of securities prices, it requires the specific intent "for the purpose of inducing the purchase or sale of such security by others"1 or "for the purpose of creating a false or misleading appearance [of market activity] . . .."2 It is likely for that reason that prosecutors rarely use Section 9, choosing instead to bring manipulation proceedings under Rule 10b-5.3 But as the tools available for accomplishing market manipulation have evolved, the judicially narrowed contours of Rule 10b-5 may be such that certain new schemes escape liability. With modern advances in trade execution, market platforms and derivatives, it is now possible to accomplish a profitable market manipulation without engaging in any overtly fraudulent or illegal behavior. Several courts have elected to distinguish between these alleged schemes and schemes which do include illegal behavior, employing a higher level of scrutiny and requiring proof of additional elements in the former situation. Manipulative schemes are referred to as "open market manipulations" when the alleged scheme is accomplished solely through the use of facially legitimate open market transactions. That is, where the manipulator has not engaged in any conduct that is inherently or otherwise illegal, such as fictitious transactions, wash sales or by disseminating false reporting. The transactions are seemingly legitimate, but for their manipulative intent and effect in combination. Because these schemes are comprised of facially legitimate transactions, a number of courts have refused to impose liability, some categorically so. This refusal is inappropriate and operates to the detriment of honest market participants. Furthermore, refusal to impose liability on a categorical basis unnecessarily and improperly places conduct that intentionally distorts prices outside the scope of Section 10(b). In 2005, the Federal Energy Regulatory Commission's anti-manipulation rules were modified to mirror the language of SEC Rule 10b-5, and the Commission considers existing Rule 10b-5 precedent when hearing manipulation cases. In late 2010, the Commodity Futures Trading Commission proposed rules to implement its expanded and clarified anti-manipulation authority under Section 753 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.4 The CFTC's analysis of alleged market manipulation claims has historically differed from the Securities and Exchange Commission's under Rule 10b-5.5 The proposed language of the new rule mirrors that of Rule 10b-5 and FERC's anti-manipulation rules, and the scope of prohibited behavior may be changed and expanded as a result.

      This paper will examine the application of Rule 10b-5 and FERC's anti-manipulation rules to instances of open-market manipulation and advance the argument that although a number of courts have been hesitant to accept it as being so, market manipulation can be accomplished solely through an arrangement of legitimate transactions, and such arrangements should give rise to liability under Rule 10b-5.

      In 2006, the Federal Energy Regulatory Commission (FERC) promulgated its own anti-manipulation rules for the natural gas and electricity markets. While regulators have encountered difficulty prosecuting open-market manipulations under Rule 10b-5 in the federal courts, FERC has been relatively successful with its anti-manipulation rules, despite considering the same case law and dealing with similar behavior. A number of courts considering open-market manipulation claims under SEC Rule 10b-5 have distinguished them from other types of manipulation, applying a different, more stringent analysis.6 While it is true that open-market manipulations can correctly be conceptually distinguished from other types of manipulation, they should be subject to the same legal standards as these other "traditional" manipulations. By employing a heightened level of scrutiny, requiring additional elements to be proved, or categorically refusing to impose liability, courts will allow behavior that intentionally distorts prices to escape the proscriptions of Rule 10b-5. Not only is this type of behavior proscribed by the language of the statute and regulations, it is also proscribed by their spirit. FERC, in applying its anti-manipulation rule which is explicitly based on Rule 10b-5, has taken a much healthier, more holistic approach in considering alleged open market manipulations.

      The first part of this paper will explore what open market manipulation is and what makes it different from, and more dangerous than, traditional manipulations. The second part will discuss the language of Rule 10b-5, its historical application to market manipulation generally, FERC's anti-manipulation rule and its relationship with Rule 10b-5, and the CFTC's proposed rule. The final part of the paper will explore open market manipulation precedent in the securities and energy markets.

    2. Introduction

      The flexibility and expanded availability of derivatives makes possible an increasingly broad spectrum of manipulative market behavior. The leverage afforded through the use of derivatives is what makes "open-market manipulation" possible and profitable. By using derivatives to gain the economic exposure of a large position, but at a small cost, a manipulator is able to capture more profit from his price moving activity than ever before. In the past, a successful manipulation would often require the manipulator to engage in behavior that, if discovered, was objectively ascertainable as being illegal. Absent such illegal activity, the manipulator's profits would likely be overshadowed by transaction costs. However, with the modern expansion of the types and availability of derivatives, illegal acts are no longer necessary to accomplish a successful and lucrative manipulation. Indeed, it is now possible to create and profit from price movement without engaging in any overtly illegal behavior. Such arrangements are classified as open-market manipulations, as opposed to "traditional" manipulations.7 The purpose of this article is to argue that while the distinction is valid as a matter of taxonomy, both species of manipulation should be equally prohibited.

      As set forth above, open-market manipulations are schemes in which both intentional price-movement and profit capture are accomplished entirely using facially legitimate transactions. The designation "open-market" refers to the fact that the price moving trades consist of, aside from their volume and ability to affect prices, otherwise unremarkable purchases, sales or short sales. Unfortunately, it is this attribute that makes both detection and prosecution so difficult. Despite the market gaming potential these activities embody, courts have not been uniform in their condemnation; indeed, a number of courts have proceeded quite cautiously, likely due in part to an expressed reticence to impose liability for acts which are not themselves illegal.8

      The legislature has drafted broadly to combat manipulation in all its forms. Indeed, preventing manipulation is one of the central purposes of the Securities Exchange Act of 1934, as well as the Commodities Exchange Act.9 Although the Securities Exchange Act contains several provisions written to advance that goal in various ways, Section 10(b), and Rule 10b-5 thereunder, have become the Securities and Exchange Commission's principal tool in addressing market manipulation.10 In 2005, in the wake of Enron and the California energy crisis, congress passed the Energy Policy Act of 2005 ("EPAct 2005"). In it, they amended the Federal Power Act and the Natural Gas Act to include provisions granting authority and directing FERC to promulgate rules to prohibit manipulation in the electricity and natural gas markets.11 That statutory grant explicitly contemplated that FERC's treatment of market manipulation be based on Section 10(b) of the Securities Exchange Act.12 The electricity and natural gas anti-manipulation statutes in EPAct 2005 provide that the terms "manipulative or deceptive device or contrivance" are to be used "as those terms are used in Section 10(b) of the Securities Exchange Act of 1934."13 Accordingly, in 2006, the Commission issued Order No.670, setting forth FERC's policies regarding market manipulation.14

      In practice, FERC's policing of market manipulation has been built almost entirely around Rule 10b-5 precedent.15 Although Rule 10b-5 is entitled "Employment of Manipulative and Deceptive Devices," it speaks in terms of fraud and deception.16 Consequently, the scope of the rule, the elements of proof required thereunder, and especially its application to various types of allegedly manipulative conduct, have been matters some controversy over the years.17 While the proscriptions of Rule 10b-5 are stated broadly, courts have not been so broad applying them, particularly to the subject of our concern, open-market manipulation. A textual interpretation of the rule suggests that it would prohibit any form of intentional manipulation, regardless of how it is accomplished. Regarding open-market manipulations, some courts considering allegations under Rule 10b-5 maintain that because the transactions are all objectively legitimate, there is no deception, and thus the behavior is beyond the scope of the rule.18

      The age of derivatives has made possible an ever increasing spectrum of manipulative behavior. Manipulative schemes that once required the equivalent of a smoking gun may now appear relatively innocuous. Nonetheless, the end result is the same, and open-market manipulations should be swiftly addressed for the same reasons as their traditional counterparts. In their fear of improperly imposing liability, a number of courts have been unduly...

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