United States: Seventh Circuit Upholds First Criminal Conviction For Spoofing

Last Updated: August 21 2017
Article by Robert Zwirb

Most Read Contributor in United States, September 2017

A three-judge panel of the U.S. Court of Appeals for the Seventh Circuit unanimously upheld the criminal conviction of a high-frequency trader, Michael Coscia, for engaging in spoofing and commodities fraud in the futures markets. The spoofing and fraud resulted in earnings of $1.4 million in 2011.

Mr. Coscia was the first person criminally charged under the anti spoofing provision of the Dodd-Frank Act. He was sentenced to a three-year prison term for his trading misconduct. In upholding the conviction of Mr. Coscia, the Court of Appeals rejected arguments that the anti-spoofing law was unconstitutionally vague and, therefore, did not give him adequate notice of what conduct was prohibited, and that both his spoofing and commodities fraud convictions were not supported by the evidence.

The appellate court held that the anti‐spoofing provision provided clear notice of the prohibited conduct. The Court found that Mr. Coscia committed fraud when he designed a trading program that used an algorithm to submit bids and offers that were cancelled before execution. The algorithm allowed him to "artificially skew [the] market[] and accordingly, make a profit." The Court dismissed the argument that Mr. Coscia's high order cancellation rate should not be considered a factor because HFT traders commonly cancel 98% of orders before execution stating that Mr. Coscia cannot complain of vagueness of law as applied to the conduct of others. The Court also distinguished between legal order cancellations, such as "stop-loss" and "fill-or-kill" orders, which are "designed to be executed upon the arrival of certain subsequent events," and the kind of orders that Mr. Coscia placed, which "are never intended to be filled at all."

In holding that Mr. Coscia's conviction was adequately supported by the evidence, the Court cited the large disparity between the high cancellation rate of his large orders and the low cancellation rate of his small orders, noting that while nearly 36% of Mr. Coscia's small orders were filled, only 0.08% of his large orders were. This discrepancy, according to the Court, suggested Mr. Coscia's orders were placed "not with the intent to actually consummate the transaction, but rather to shift the market toward the artificial price at which the small orders were ultimately traded." The Court further noted that the scheme allowed Mr. Coscia "to buy low and sell high in a market artificially distorted by his actions," and at "a price equilibrium that he created."

Commentary / Bob Zwirb

The Seventh Circuit does a very good job in clarifying the distinction between legal and illegal order cancellations. However, we still are left with an area of law that remains somewhat opaque (if not constitutionally vague). Notwithstanding the Court's view that "[t]he statute clearly defines the term spoofing," that definition, which is specified in a parenthetical, "(bidding or offering with the intent to cancel the bid or offer before execution)," is still problematic since it seems to encompass trading conduct that is well-accepted to be perfectly legal. (Note that the Court apparently concedes that 98% of orders are cancelled without execution, which would certainly suggest that there is little expectation that most orders will not be executed.) Further, if the statute were clear on its face, there presumably would be no need for the CFTC and the exchanges to issue serial interpretive guidance over the years in the form of policy statements, fact sheets, questions and answers, and Federal Register releases, and to hold roundtables to further flesh out what the written materials haven't. See, e.g., Antidisruptive Practices Authority, 78 Fed. Reg 31890 (May 28, 2013) (Interpretive guidance and policy statement); Federal Register: CFTC Interpretive Guidance and Policy Statement; CFTC Interpretive Guidance and Policy Statement on Disruptive Practices; CFTC Q&A – Interpretive Guidance and Policy Statement on Disruptive Practices; CFTC Staff Roundtable to Discuss Disruptive Trading Practices; New CME Rule on Disruptive Trading Practices Summary Chart.

Moreover, it doesn't help matters that the spoofing provision added by Dodd-Frank, as the Court observes, "has almost no legislative history." Court Op. at p. 5, n. 7 (noting that "[t]he only meaningful reference reads as follows: "The CFTC requested, and received, enforcement authority with respect to insider trading, restitution authority, and disruptive trading practices." 156 Cong. Rec. S5992 (daily ed. July 15, 2010) (statement of Sen. Lincoln) (emphasis added)).

One way to read the case is that the Court essentially defined "spoofing" as a form of what is traditionally understood to mean market manipulation. Thus, for example, the Court states that "it is clear that the purpose of spoofing is to artificially skew markets and accordingly make a profit"; that Mr. Coscia's large orders were placed, "not with the intent to actually consummate the transaction, but rather to shift the market toward the artificial price at which the small orders were ultimately traded"; that Mr. "Coscia made money by artificially inflating and deflating prices"; and that those who traded with Mr. Coscia "were always harmed by the artificial shift in market price." (emphasis added). Given all the ink that has been spilled over the years trying to describe what constitutes spoofing, and the angst that it has caused, if "spoofing" just means market manipulation, Congress would have done better not to add the spoofing language to the CEA, as it is both duplicative and confusing.

There is one point in the Court's decision that seems directly at variance with the approach followed by the CFTC. The calculation endorsed by the Court here for determining the losses attributable to Mr. Coscia's conduct – employment of "probable loss" for that of "loss" because "all losses could not be calculated reasonably," contrasts with the obligation of the CFTC in the civil context to establish such numbers with "reasonable precision." See In re R&W Technical Services, Inc. CFTC Docket No. 96-3 (Aug. 6, 2000) (interpreting Division's burden of proof under Section 6(c)'s treble monetary gain approach to determining maximum allowable civil money penalties as requiring it "to establish net profits with reasonable precision based on actual revenues and actual expenses").

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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