I. 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 stringent in considering claims of open-market manipulation.19 A small number of courts have recognized the import of these schemes, and have analyzed them under a more flexible framework.20 This is a better solution than adhering to a bright line rule that allows most open market manipulations to escape liability. The truly correct approach, the one that FERC has taken, is to simply analyze these cases as they would any other manipulation, with the same elements and burdens of proof. The burdens and standards normally applied are more than sufficient to capture the bad behavior we want to prevent, while avoiding the improper imposition of liability. Federal courts, specifically the Second and Third Circuits, would be wise to take a similar approach; until such action is taken, substantial incentives exist to engage in this type of market gaming.

Irrespective of the scope of Section 10(b) and the resultant scope of FERC's anti-manipulation authority, open-market manipulations are very real. If Rule 10b-5 is interpreted not to prohibit open-market manipulation, it is not due to its text. Rather, judicially imposed additional requirements have narrowed its application beyond a literal reading of the language. Courts hearing allegations of open-market manipulation should, to the extent they can, reverse this narrowing and explicitly state that open-market manipulation gives rise to liability under Rule 10b-5. These schemes should be recognized as harmful behavior that ought to be prohibited. Ultimately, if it is decided that such behavior does not give rise to liability under Rule 10b-5 or any other provision, some action should be taken to ensure that this behavior is unlawful. Before a successful argument can be made regarding the behavior, it is necessary to further consider the nature of open market manipulation and what makes it worth discussing.

II. WHAT IS OPEN-MARKET MANIPULATION?

1. Introduction and Traditional Manipulations

The definition of manipulation itself is somewhat controversial, as is its relationship with the concept of fraud, thanks to the language of Rule 10b-5.21 Much depends on the nature of the behavior in question. Some courts have conceptually separated what can be characterized as a traditional manipulation from an alleged "open-market manipulation."22 The distinction lies primarily in how the manipulator accomplishes the price movement necessary to profit. It will be helpful to briefly discuss how an actor accomplishes a traditional manipulation.

Traditional manipulations involve behavior that, if discovered, is inherently illegal; thus, once the behavior is discovered, the actor may be prosecuted merely for having completed the behavior in question. One way of characterizing these behaviors, compared to what you would find in an open-market manipulation, is a requirement of a "bad act." Several of these behaviors are explicitly proscribed under Section 9(a)(1) of the Exchange Act, which forbids certain manipulative practices, but which has a specific intent requirement to create a false or misleading appearance of active trading.23 The behavior enumerated in Section 9(a)(1) includes wash sales, matched orders, and fictitious trading.24 In the context of a Rule 10b-5 proceeding, such behaviors are considered clearly indicative of the manipulator's deceptive intent.25 For the courts that require one, they also satisfy the element of a fraudulent or deceptive "bad act."26 These types of transactions were widely criticized as inherently misleading even before the Exchange Act's passage in 1934, as such nonexistent trading activity would be reported by organizations purporting to report only real trades.27 These methods were employed because they were often necessary in order to accomplish a successful manipulation. Their effect is akin to fraud through a course of conduct; the representation of actual trading where there is none is analogous to making an affirmative false statement.28 To achieve a successful manipulation generally requires two conditions: 1) the manipulator must move the price of the security; and 2) the manipulator must be able to sell at a higher price than his purchase price, plus transaction costs.29 The objectively fraudulent behavior discussed above causes price movement without the difficulty of overcoming the forces of supply and demand.30 Because the trades are either completely fake, or matched, the manipulator employing such devices does not subject himself to the risk that he will exhaust his own supply of shares attempting to move the price. Indeed, without employing such devices, it is likely that upon closing his market position, the manipulator would cause the price to move back towards the "correct" level; using real trades without fraudulent behavior, it is quite difficult to satisfy both conditions at once, and thus it can be argued that a scheme without fraudulent behavior would be self-deterring.31 But that synopsis assumes the use of only purchases or sales in the security whose price is to be moved. The old reality did not include the possibility that other contractual rights might be affected as a result of price movement of a security. Growth in the derivatives market has changed all that. Consequently, it is now possible to engage in a manipulative scheme, without the use of objectively "bad" or fraudulent behavior, and make a great deal of money. This type of scheme is referred to as an open-market manipulation.

2. Open-Market Manipulations

Open-market manipulations involve no objectively fraudulent or bad acts. The entire course of conduct consists entirely of facially legitimate transactions. This taxonomy can be subdivided into "trade- based manipulations" and "contract-based manipulations."32 A trade-based manipulation involves an attempt by the manipulator to increase the price of a security or commodity by trading, and to sell at a profit before the price returns to its "correct" level. A trade-based open-market manipulation is essentially a traditional manipulation without any bad acts. For the reasons discussed above, such schemes are historically difficult to successfully accomplish and even self deterring. Thus, manipulative schemes in the past often included objectively bad behaviors such as wash sales and matched orders. Contract-based manipulations, on the other hand, do not suffer from the same shortcomings as the trade-based manipulation because the manipulator's profit comes not from the price-moving trades, but from some other contractual right or benefit. Because this paper is primarily focused on open-market manipulations involving the use of derivatives, "open-market manipulation" should be understood to refer to contract-based open-market manipulation.

Contract-based manipulations are also completed with facially legitimate open market transactions. Yet rather than deriving their intended profitability from the manipulative trades themselves, the price moving trades are intended to trigger or benefit some other contractual right. The contractual right can take many forms. First, a simple example: consider an executive at a public company with low trading volume. In this executive's compensation agreement, it is agreed that he will receive a $5 million bonus if the company's share price reaches $25; the price is currently at $24.15. What would happen if the executive purchased shares on the open-market until the price reached $25, collected his bonus, and then sold that stock back into the market? He may lose money when he sells his shares back into the market due to transaction costs or price movement;33 but here, because of his compensation agreement, the executive comes out ahead so long as his bonus is large enough to offset the losses he incurred while trading.

A similar but more pronounced effect can be achieved using derivatives. The prospect of a successful open-market manipulation using derivatives should be more alarming than the above example. Although there are a limited number of executives with the necessary compensation structure and the desire to manipulate, there are a large number of actors with the ability to assume large derivative positions. Let us consider an example of an open-market manipulation using derivatives.

An investor takes a very large long position in an over-the-counter ("OTC")34 total return swap.35 In this type of contract, the investor has economic exposure equivalent to what he would have if he had gone out into the market and purchased a total amount of stock equivalent to the "notional" value of the long position. The notional value is the market price of the number of shares we are pretending the investor owns in the swap. But the investor does not actually invest the total value of the notional; the price of taking the position depends on various factors relating to the underlying security, but is typically between 300 and 600 basis points (3–6%). The counterparty in the swap is often an investment bank. By taking the swap position, the investor assumes the economic exposure commensurate with an investment equal to the notional; thus, with a long position, he stands to profit if the price goes up, and loses if the price declines. The investor receives the "total return" that he would receive if he actually owned the notional value of the security, hence the designation "total return swap." Note that the swap agreement itself involves no physical trading; the entire arrangement is on paper. Because OTC derivatives transactions do not involve physical trading of securities, the trades the investor makes in the swap do not affect the market price. Thus, it is possible to accumulate large positions and make large trades without creating price fluctuations. Moreover, the swap is the investment vehicle and is dynamic; the swap agreement is valid for a set duration, and the investor can actively trade within the swap, buying and selling as though he were doing so in the actual market. The investor and the investment bank have opposite sides of a bet; if the price goes up, the bank pays the investor, and vice-versa. Such a position exposes the investment bank to investment risk; if the price increases, they will lose money. They can eliminate that risk, however, if they: A) go out into the market and purchase the security themselves in order to pass the cash flows on to the investor, or B) enter into another derivatives transaction with someone else in the opposite direction, or C) some combination of A and B. These options all provide a hedge and eliminate the bank's risk associated with the price movement, but the bank still collects fees from the derivatives transaction. This is how the bank makes money, and why it doesn't care what else the investor is doing. By hedging its price risk, but collecting fees for its services from investors, the bank facilitates the investor's open-market manipulation, without exposing itself to any risk. The result for the investor is that for a very small relative cost, lets call it a four percent down payment, he now has the economic exposure an investor would have if he had invested many times as much money in the underlying security; thus the position is highly leveraged. The investor stands to gain as if he had made a much more substantial investment.36 There is nothing inherently wrong with this type of transaction. In the context of manipulation, it is merely enabling. The manipulative part comes next.

The investor then goes into the public securities market aggressively purchasing large quantities of the security. He buys as much as he can. He takes every offer. He bids above the prevailing offer price. He concentrates his trading at the end of the day.37 These actions and characteristics all have the effect of raising the market price. Once he has raised the market price as much as he can, he sells off his shares in the swap and unwinds38 the swap. Once he has closed out the long swap positions at a large profit, he begins selling the securities he actually purchased back into the public market. The investor is not likely to profit from his physical39 trading for the reasons, discussed above, that trade-based manipulations are unlikely to succeed. But because the swap position is highly leveraged, the profits realized from the swap transaction will likely substantially outweigh any transaction costs or losses from the investor's physical sales. Leverage is how derivatives make open-market manipulations possible and profitable. By taking a leveraged position that will benefit from the price-moving trades, behavior that might ordinarily be self-deterring becomes potentially very profitable.

The use of a total return swap is but one possible tool of many. Indeed, as the oft cited Eighth Circuit quote goes, "The methods and techniques of manipulation are limited only by the ingenuity of man."40 Any derivative that creates leverage can be used to the same effect. Options, synthetic trading and other derivatives can be used in the same way. This breed of scheme is the open-market manipulation that is truly cause for concern.

3. What is the Real Difference Here, and Why is a Discussion Even Necessary?

Open-market manipulations differ from traditional manipulations primarily in that they are accomplished without employing any objectively bad behavior. The price-moving trades are facially unremarkable, and equity swaps and other derivatives are neither illegal nor inherently suspicious. The innocuous appearance of all of the component parts of the scheme is what makes the possibility of open-market manipulation so dangerous. To make matters worse, observers, even market regulators, can only see at most half of what is going on. The vast majority of derivatives transactions, like the total return equity swap arrangement discussed above, are over-the-counter ("OTC") bilateral contracts, as opposed to exchange traded derivatives.41 Because they are not exchange traded, OTC derivatives transactions are not reported on an exchange. Thus, until internal records which would show all of the investor's trading activity are subpoenaed, the only observable behavior (that is, observable by anyone but the bank and the investor) are the price-moving trades in the public market. This structure makes it difficult for regulators to identify these type of schemes in the first place. Some practices used by manipulators to move prices are known to regulators; concentrated end of day trading, also known as "marking the close," for example, is recognized by regulators as a potentially manipulative practice.42 Even so, this practice is not inherently illegal.43 Regulators often become aware of open-market manipulations by observing this type of questionable, though legal, behavior and investigating further, or investigating in response to complaints of manipulation from other market participants. However, even when regulators come to the conclusion that they have detected an open-market manipulation, many courts have been hesitant to impose liability under Rule 10b-5 where the allegedly manipulative trades are all facially legitimate. Some courts, including the Second and Third Circuits, have categorically excluded open market manipulation from the reach of Rule 10b-5. Indeed, it seems that currently controlling precedents in both Circuits dictate that open-market manipulations do not give rise to liability.44 These rulings beg the question of whether Rule 10b-5 is the appropriate tool to address open market manipulation. It is. However, courts need to stop worrying so much about capturing innocent investors. The burden of proof exists for a reason. It is the prosecutor's burden to prove the defendant's actions and intent with respect to the charges alleged. In the context of an alleged open-market manipulation, if the evidence can be explained away, it will be. It is very difficult to prove scienter if it does not actually exist. The possibility of engaging in these manipulative schemes does exist; if courts continue to refuse to impose liability under the framework of 10b-5, the SEC must promulgate a new rule, or congress must delegate new authority. Inaction will undermine the integrity of the markets, and will increasingly do so as these practices become more widely known. 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"45 or "for the purpose of creating a false or misleading appearance [of market activity] . . .."46 It is likely for that reason that prosecutors rarely use Section 9, choosing instead to bring manipulation proceedings under Rule 10b-5.47 Despite this general preference, prosecutors and courts have often looked to the proscriptions of Section 9 for guidance as to the behavior and end results that congress intended to prohibit.48

III. PROSECUTION OF MARKET MANIPULATION UNDER SECTION 10(B) AND RULE 10B-5

1. Section 10(b) and Rule 10b-5

The Securities Exchange Act of 1934 was intended in large part to address the problem of speculation in the securities markets.49 It is the home of Section 10(b), the authority under which the SEC promulgated Rule 10b-5. Market manipulation is nowhere defined in the Act. By the language of Section 10(b), the SEC was to regulate the use of "manipulative or deceptive devices or contrivances." Accordingly, the SEC promulgated a series of rules to do that, the one with which we are concerned being Rule 10b-5. Rule 10b-5, entitled "Employment of Manipulative and Deceptive Devices," states:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

  1. To employ any device, scheme, or artifice to defraud,
  2. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  3. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.50

Neither the word "manipulative," nor "manipulate" are found in the text of the rule. Furthermore, it speaks in terms of fraud, and specifically outlaws conduct "which operates or would operate as a fraud."51 Most controversies about the scope of Rule 10b-5 have centered on whether to conceptually divorce it from traditional fraud doctrine and the various constraints which arise thereunder.52 Starting with Ernst & Ernst v. Hochfelder in the 1970's, the Supreme Court has narrowed the scope of the rule several times as it relates to manipulation.53 Ernst & Ernst is often cited in manipulation cases for the narrowing language contained. The central holding and reason the Supreme Court took the case, however, was that Rule 10b-5 only extends to willful conduct; negligent conduct does not give rise to liability. The case arose out of a fraudulent securities scheme perpetrated by the head of a brokerage house.54 The plaintiffs, defrauded investors, sought to hold the brokerage house's accounting firm liable for the damages on a theory of negligent nonfeasance for failing to conduct proper audits.55 The court found the use of the word "manipulative" in Rule 10b-5 particularly informative in its decision on the issue. In its discussion of the significance of the inclusion of the term "manipulation" in Section 10(b), the Supreme Court stated that "[manipulation] is and was virtually a term of art when used in connection with securities markets. It connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities."56 By extension, the reach of Rule 10b-5 is constrained to intentional or willful conduct. In addition to its importance for establishing the requirement of scienter, several open market manipulation cases have cited the language above in connection with an argument that a manipulation claim requires that the price of a security be "artificially" affected, as opposed to affected by open market transactions. For additional discussion on that point, see the section on Rule 10b-5 open market manipulation case law, below.

In Santa Fe v. Green, the Supreme Court again connected the concept of "manipulation" to the overtly deceptive practices discussed above, explaining that market manipulation "generally refers to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity."57 This language, in Santa Fe, and repeated elsewhere,58 illustrates the court's conceptual tether between manipulation under 10b-5 and illegal or inherently deceptive conduct. Indeed, that judicially imposed element has been the primary stumbling block preventing parties alleging open-market manipulation from achieving favorable outcomes. Nonetheless, the limiting language remains susceptible to a liberal construction that would include open market manipulation within the bounds of Rule 10b-5. Arguably, in an open market manipulation, the price moving trades are entered into for the purpose of artificially affecting market activity; the trades do not represent the natural interplay of supply and demand, rather they are entered into for the purpose of benefiting a related derivatives position.

Several courts addressing alleged market manipulations under Rule 10b-5 have reinforced the idea that manipulation claims require some inherently deceptive conduct. The Northern District of Illinois stated in In re Olympia Brewing Co. Sec. Litigation that "[r]egardless of whether market manipulation is achieved through deceptive trading activities or deceptive statements as to the issuing corporation's value, it is clear that the essential element of the claim is that inaccurate information is being injected into the marketplace."59 The deceptive trading practices alleged by the plaintiffs in Olympia Brewing included naked short selling, the taking of substantial short positions, and concerted end of day trading allegedly designed to lower the market price. In that case, the court held that the defendant's aggressive short sales were not manipulative under Rule 10b-5, because they did not inject artificial information into the marketplace.60 The court reached that conclusion not on the basis that aggressive short sales cannot be manipulative, but rather that in this case the defendant acted on his genuine belief that the shares were overpriced, and that any resulting decline in the market price was a natural and appropriate result.61 Accordingly, the court granted the defendant's motion for summary judgment. However, although Olympia Brewing has been cited for the above propositions, its extension to other scenarios may be inappropriate because here the defendant engaged in no other transactions at all; the defendant argued that he sold the stock short because he believed it was overpriced, and there was no evidence to suggest any other motive, nor did the price-moving short sales benefit any other positions.62 Thus, citing Olympia Brewing for the proposition that short sales cannot be manipulative in themselves is inapposite.

One of the reasons the court in Olympia Brewing and others have resisted imposing liability for short sales alone is that short selling is a common, legitimate method of both hedging and acting on a belief that an instrument is overpriced.63 There is nothing inappropriate about employing short sales, even aggressively, to those ends. It is when short sales are conducted for the purpose of benefiting a related position that an issue arises. In such an instance, inaccurate information is being injected into the market place. Short sales indicate that an actor either believes a security is overvalued or is using such short sales to hedge. Neither potential inference would be valid where the purpose of the short sales was to affect the security's price for the benefit of a related derivatives position. Thus, in such a scenario, the short sales would be injecting inaccurate information into the market place. It is clear that the Olympia Brewing court did not consider the possibility that short sales could be used to benefit a related position, as the court continued, stating that "short sales are simply not unlawful, even in large numbers and even if the trading does negatively affect the purchase price."64 The court's position on short sales would likely have been less absolute had the scenario been more suspicious, like an actor engaging in aggressive short sales that just happened to make it a fortune on a related derivatives position. But the court was simply not confronted with those facts. Nonetheless, the Third Circuit accepted Olympia Brewing as standing for these propositions regarding short sales in GFL Advantage Fund v. Colkitt, an open-market manipulation claim that is controlling precedent in the Third Circuit, discussed further below.65

An important consideration in a manipulation claim is whether the alleged manipulative activity can be fairly characterized as "deceptive."66 Despite the statutory language of "manipulative or deceptive",67 the Supreme Court, and many lower courts in turn, have interpreted "manipulative" in Section 10(b) to inherently require deception; that is, some courts have assumed that a practice cannot be "manipulative" unless it is "deceptive."68 For open-market manipulations, then, a critical question is whether concerted open market trading, not for investment or even speculative purposes, but rather for affecting some other contractual right, is considered "deceptive" to the market. A number of courts have held that it is not.69 Those courts are wrong. All trading sends pricing signals to the market. But the signal is inherently false if the only purpose of the trading is to send the signal. There are only several logical steps necessary to get to the correct conclusion. The necessary questions are: (1) can concerted trading move the price of a security?; (2) do derivatives create leverage?; (3) can derivatives enable a trader to capture returns from price movement?; and (4) if a trader knows the direction of future price movement, can he enter transactions to profit from it? The answer to all these questions being yes, it is possible that an actor could engage in a scheme that uses concerted trading to create price movement to benefit a related derivatives position. Regardless of whether such an intentional scheme has come before the courts, the existence of the possibility renders these courts' categorical exclusions from liability inappropriate. Their position legitimizes the behavior, and puts the integrity of the market at risk. A fact that has made imposing liability difficult for some courts is that because the transactions themselves are not illegal, it simply seems inequitable to punish an actor for legal conduct engaged in with prohibited intent.70 This concern rings hollow. The criminal law has a rich doctrine of inchoate offenses, giving rise to liability without any inherently illegal conduct. The common law crimes of conspiracy and attempt may consist of otherwise legitimate conduct made illegal only because of the actor's prohibited intent.71 Similarly, with an open market manipulation, it is the combination of transactions and the surrounding circumstances that render the arrangement illegal. Concerted trading that affects the price of a security, even were there a robust prohibition of open market manipulation, would never give rise to liability unless performed with the prohibited intent. Rule 10b-5 is adequate in this regard, for it requires proof of scienter. If there is no contractual right to receive leveraged benefit as a result of the price movement, that absence would surely cut against a finding of scienter and make the imposition of liability unlikely.

2. The Commodity Futures Trading Commission and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

The Commodity Futures Trading Commission (CFTC) has long possessed broad statutory authority to prohibit and prosecute fraud, deception, price manipulation and false reporting in the commodity and associated derivative markets.72 Title VII of the Dodd-Frank Act contains expanded and clarified authority to prohibit manipulative behavior.73 Section 753 of the Dodd-Frank Act amends Section 6(c) of the Commodity Exchange Act (CEA) to expand the authority of the Commission to prohibit fraudulent and manipulative behavior.74 New Subsection (c)(1) broadly prohibits fraud-based manipulative schemes, adopting language mirroring that of Securities Exchange Act Section 10(b).75 New CEA Section 6(c)(1)(B), entitled "Effect on Other Law," provides that nothing in the Dodd-Frank Act shall be construed to affect the applicability of CEA Section 9(a)(2), which prohibits, among other things, market manipulation and false reporting.76

In November 2010, the CFTC proposed for comment CFTC Rules 180.1 and 180.2 under Dodd-Frank Section 753 to address manipulative behavior in accordance with the mandates discussed above.77 CFTC Rule 180.1 is promulgated under new CEA Section 6(c)(1), which is patterned after Securities Exchange Act Section 10(b).78 Just as Exchange Act Section 10(b) has been interpreted to be a "catch-all" provision for fraudulent and manipulative behavior in the securities markets, the CFTC's proposed rule states that its interpretation of new CEA Section 6(c)(1) will be similar. The language of the CFTC's proposed rule 180.1 is substantially similar to SEC Rule 10b-5, with linguistic changes to reflect the CFTC's distinct regulatory mission, including additional language referring to the rule's application to swaps, futures and other commodity derivatives.79 The proposal specifically acknowledges the similarity of the FERC anti-manipulation statute and rule, which suggests that the Commission's application of these proposed rules may be similar as well.80

The CFTC's proposal includes an additional rule, CFTC Rule 180.2, under new CEA Section (6)(c)(3), making it illegal to manipulate or attempt to manipulate the price of any swap, commodity, or commodity futures contract in interstate commerce that is intended to interfere with the legitimate forces of supply and demand.81 Proposed CFTC Rule 180.2 seems largely duplicative of proposed CFTC Rule 180.1, and will likely be more narrowly construed for the same reasons regulators have historically favored the use of SEC Rule 10b-5 over Exchange Act Section 9(a)(2). Because the rule has a specific intent requirement of "intended to interfere with the legitimate forces of supply and demand," the CFTC's proposed rule may be of narrower scope and less use than intended.

In its discussion of the two proposed rules, the CFTC specifically addresses the issue of open market manipulation.82 In its discussion of what evidence may be necessary to establish an "artificial price" under the pre-Dodd-Frank Act CFTC market manipulation analysis, the Commission stresses that "the conduct giving rise to a market manipulation charge need not be itself fraudulent or otherwise illegal," and refers to several CFTC open market manipulation cases (under the old CFTC rules) in which charges were sustained.83 All indications are that the CFTC's market manipulation enforcement program, including its application to situations involving open-market manipulation, will be robust.

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Footnotes

1 Securities Exchange Act § 9, 15 U.S.C.A. § 87 (2000).

2 Securities Exchange Act § 9, 15 U.S.C.A. § 87 (2000).

3 See, e.g. U.S. v. Mulheren, 938 F.2d 364, Fed. Sec. L. Rep. (CCH) P 96082 (2d Cir. 1991); Markowski v. S.E.C., 274 F.3d 525, Fed. Sec. L. Rep. (CCH) P 91650 (D.C. Cir. 2001); S.E.C. v. Masri, 523 F. Supp. 2d 361, Fed. Sec. L. Rep. (CCH) P 94526 (S.D. N.Y. 2007).

4 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111- 203, § 753, 124 Stat. 1376 (2010).

5 Compare Prohibition of Market Manipulation, 75 Fed. Reg. 212 (proposed Nov. 3, 2010) (to be codified at 17 C.F.R. Pt. 180) (section containing discussion of CTFC market manipulation analysis) with In re College Bound Consolidated Litigation, 1995 WL 450486, *15 (S.D. N.Y. 1995) (discussion of elements of SEC market manipulation claim).

6 See, e.g. GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, Fed. Sec. L. Rep. (CCH) P 91634 (3d Cir. 2001) (noting that the alleged scheme consisted of legal transactions, requiring additional proof).

7 U.S. v. Mulheren, 938 F.2d 364, 370, Fed. Sec. L. Rep. (CCH) P 96082 (2d Cir. 1991) (Discussing the absence of the "traditional badges of manipulation," wash sales, fictitious transactions, etc.); GFL Advantage Fund, at 204–205.

8 See Id.; ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 101, Fed. Sec. L. Rep. (CCH) P 94363 (2d Cir. 2007) (citing GFL Advantage).

9 Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 433–34 (1988).

10 Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 382 (1988).

11 Energy Policy Act of 2005, §§ 315, 1283 (2005).

12 Energy Policy Act of 2005, §§ 315, 1283 (2005).

13 Energy Policy Act of 2005, §§ 315, 1283 (2005).

14 See Order No. 670, Prohibition of Energy Market Manipulation, 114 FERC ¶ 61,047 (2006).

15 See e.g., Order Denying Rehearing, Motions for Stay, and Motions for Summary Disposition, and Establishing Hearing Procedures, U.S. v. Amaranth Advisors, LLP, 124 FERC ¶ 60,050 (July 17, 2008) (Docket No. IN07-26-000).

16 See Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 382 (1988).

17 See e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S. Ct. 1375, 47 L. Ed. 2d 668, Fed. Sec. L. Rep. (CCH) P 95479 (1976); Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480, Fed. Sec. L. Rep. (CCH) P 95914 (1977); Chiarella v. U. S., 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348, Fed. Sec. L. Rep. (CCH) P 97309 (1980).

18 See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 101, Fed. Sec. L. Rep. (CCH) P 94363 (2d Cir. 2007); Nanopierce Technologies, Inc. v. Southridge Capital Management, 2008 WL 250553 (S.D. N.Y. 2008), adhered to, 2008 WL 1882702 (S.D. N.Y. 2008).

19 See ATSI; GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, Fed. Sec. L. Rep. (CCH) P 91634 (3d Cir. 2001).

20 See Markowski v. S.E.C., 274 F.3d 525, Fed. Sec. L. Rep. (CCH) P 91650 (D.C. Cir. 2001), S.E.C. v. Masri, 523 F. Supp. 2d 361, Fed. Sec. L. Rep. (CCH) P 94526 (S.D. N.Y. 2007), S.E.C. v. Kwak, Fed. Sec. L. Rep. (CCH) P 94579, 2008 WL 410427 (D. Conn. 2008).

21 See Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 382.

22 See e.g., U.S. v. Mulheren, 938 F.2d 364, 370–71, Fed. Sec. L. Rep. (CCH) P 96082 (2d Cir. 1991) (noting that none of the "traditional badges of manipulation" were present, in discussion of why the defendant's behavior did not constitute manipulation).

23 Securities Exchange Act Section 9(a)(1), 15 U.S.C.A. § 87; Markowski at 529.

24 Securities Exchange Act Section 9(a)(1), 15 U.S.C.A. § 87; Markowski at 529.

25 See Mulheren at 371; ATSI at 99.

26 See Mulheren at 371; ATSI at 99.

27 See Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 402.

28 Fischel, Should the Law Prohibit "Manipulation" in the Financial Markets, 105 Harv. L. Rev. 503, 510–11 (1991).

29 Fischel, Should the Law Prohibit "Manipulation" in the Financial Markets, 105 Harv. L. Rev. 503, 512–513 (1991). This is assuming, of course, that the manipulator is attempting to cause the price to move upward. He could similarly attempt to move the price downward, in which case he would have to be able to purchase at a lower price than he sold, plus transaction costs.

30 Fischel, Should the Law Prohibit "Manipulation" in the Financial Markets, 105 Harv. L. Rev. 503, 513–514 (1991).

31 Fischel, Should the Law Prohibit "Manipulation" in the Financial Markets, 105 Harv. L. Rev. 503, 515–519 (1991).

32 Fischel, Should the Law Prohibit "Manipulation" in the Financial Markets, 105 Harv. L. Rev. 503, 512–518 (1991).

33 Considered in isolation from his contractual right to a bonus, his concerted open-market purchases would be a trade-based manipulation. If his bonus provision did not exist, it would make no sense to engage in this course of conduct, because he would likely lose money.

34 Over the counter transactions are not conducted on the open-market. They are private bilateral transactions between two counter parties. They are not reported or registered; thus, the two counter-parties are the only ones who necessarily know of the transaction. Such transactions are not illegal, and are employed for many legitimate reasons, such as hedging or honest speculation.

35 A total return swap is an arrangement where one counterparty pays a fixed fee in return for the other counterparty's economic exposure relating to a certain amount of securities. That economic exposure includes any gain or loss from price movements, selling) those securities. Total return swaps are highly leveraged; the fixed fee is very small compared with the nominal value of the securities represented. See ISDA Equity Derivatives Definitions.

36 But note, he also stands to lose as if he had invested much more money. The leverage applies to downside risk as well as upside potential. When manipulating, however, that is less of a concern.

37 S.E.C. v. Masri, 523 F. Supp. 2d 361, 369, Fed. Sec. L. Rep. (CCH) P 94526 (S.D. N.Y. 2007).

38 Closes out.

39 The trading he did in the public securities market, as opposed to the derivatives trading within the swap.

40 See Cargill, Inc. v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971) ("The methods and techniques of manipulation are limited only by the ingenuity of man. The aim must be therefore to discover whether conduct has been intentionally engaged in which has resulted in a price that does not reflect basic forces of supply and demand.").

41 In the forth quarter of 2009, the global notional value of OTC derivatives outstanding was $614,674 billion, compared with a global notional value of only $24,764 billion for exchange traded derivatives during the same period. See BIS Quarterly Review, Table 19: Amounts outstanding of over-the-counter (OTC) derivatives, Bank for International Settlements, available at http://www.bis.org/statistics/otcder/dt1920a.pdf (June 2010); BIS Quarterly Review, Table 23A: Derivative financial instruments traded on organised exchanges, Bank for International Settlements, available at http://www.bis.org/publ/qtrpdf/r_qa1006.pdf (June 2010).

42 See e.g., S.E.C. v. Masri, 523 F. Supp. 2d 361, 369, Fed. Sec. L. Rep. (CCH) P 94526 (S.D. N.Y. 2007).

43 See e.g., S.E.C. v. Masri, 523 F. Supp. 2d 361, 369, Fed. Sec. L. Rep. (CCH) P 94526 (S.D. N.Y. 2007).

44 See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, Fed. Sec. L. Rep. (CCH) P 94363 (2d Cir. 2007); GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, Fed. Sec. L. Rep. (CCH) P 91634 (3d Cir. 2001).

45 Securities Exchange Act § 9, 15 U.S.C.A. § 87.

46 Securities Exchange Act § 9, 15 U.S.C.A. § 87.

47 See e.g., U.S. v. Mulheren, 938 F.2d 364, Fed. Sec. L. Rep. (CCH) P 96082 (2d Cir. 1991); Markowski v. S.E.C., 274 F.3d 525, Fed. Sec. L. Rep. (CCH) P 91650 (D.C. Cir. 2001); SEC v. Masri. (all market manipulation prosecutions under Rule 10b-5).

48 See e.g., U.S. v. Mulheren, 938 F.2d 364, Fed. Sec. L. Rep. (CCH) P 96082 (2d Cir. 1991); Markowski v. S.E.C., 274 F.3d 525, Fed. Sec. L. Rep. (CCH) P 91650 (D.C. Cir. 2001); SEC v. Masri. (all market manipulation prosecutions under Rule 10b-5).

49 H.R. Rep. No. 73-1383, 2d Sess.

50 17 C.F.R. § 240.10b-5.

51 17 C.F.R. § 240.10b-5.

52 See Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 382 (1988).

53 See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199, 96 S. Ct. 1375, 47 L. Ed. 2d 668, Fed. Sec. L. Rep. (CCH) P 95479 (1976); Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 359, 384–5 (1988).

54 Ernst & Ernst v. Hochfelder at 188.

55 Ernst & Ernst v. Hochfelder at 188.

56 Ernst & Ernst v. Hochfelder at 199.

57 Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 476, 97 S. Ct. 1292, 1302, 51 L. Ed. 2d 480, Fed. Sec. L. Rep. (CCH) P 95914 (1977).

58 See e.g., GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 204–5, Fed. Sec. L. Rep. (CCH) P 91634 (3d Cir. 2001).

59 See In re Olympia Brewing Co. Securities Litigation, 613 F. Supp. 1286, 1292 (N.D. Ill. 1985) (emphasis in original).

60 See In re Olympia Brewing Co. Securities Litigation, 613 F. Supp. 1286, 1292 (N.D. Ill. 1985) (emphasis in original). at 1294).

61 See In re Olympia Brewing Co. Securities Litigation, 613 F. Supp. 1286, 1292 (N.D. Ill. 1985) (emphasis in original). at 1294).

62 See In re Olympia Brewing Co. Securities Litigation, 613 F. Supp. 1286, 1292 (N.D. Ill. 1985) (emphasis in original). at 1294).

63 GFL Advantage Fund at 209 (In fact, the Third Circuit refused to even accept facially legitimate short selling as evidence of market manpulation; "Once again, short selling, even in large volumes, is not in and of itself unlawful and therefore cannot be regarded as evidence of market manipulation."); Olympia Brewing at 1292.

64 Id. at 1296.

65 See GFL Advantage at 207.

66 ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 100, Fed. Sec. L. Rep. (CCH) P 94363 (2d Cir. 2007); GFL Advantage Fund at 204–205, Nanopierce Technologies, Inc. v. Southridge Capital Management, 2008 WL 250553, *8 (S.D. N.Y. 2008), adhered to, 2008 WL 1882702 (S.D. N.Y. 2008).

67 17 C.F.R. § 240.10b-5; 15 U.S.C.A. § 88 (2010) (emphasis added).

68 Schreiber v. Burlington Northern, Inc., 472 U.S. 1, 105 S. Ct. 2458, 86 L. Ed. 2d 1, Fed. Sec. L. Rep. (CCH) P 92056 (1985); Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480, Fed. Sec. L. Rep. (CCH) P 95914 (1977); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S. Ct. 1375, 47 L. Ed. 2d 668, Fed. Sec. L. Rep. (CCH) P 95479 (1976); Santa Fe Indus. v. Green; Thel, Regulation of Manipulation Under Section 10(B): Securities Prices and the Text of the Securities Exchange Act of 1934, 1988 Colum. Bus. L. Rev. 359, 388 (1988).

69 See ATSI v. Shaar Fund; GFL Advantage Fund v. Colkitt; Nanopierce v. Southridge.

70 See e.g. GFL Advantage Fund.

71 Cite crime law textbook or hornbook.

72 Commodity Exchange Act, 7 U.S.C.A. §§ 6-6(d) (2010).

73 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 753, 124 Stat. 1376 (2010).

74 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 753, 124 Stat. 1376 (2010).

75 "It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate by not later than 1 year after the date of enactment of the Dodd-Frank Act . . .." Dodd- Frank Act § 753.

76 Prohibition of Market Manipulation, 75 Fed. Reg. 212, at 4 (proposed Nov. 3, 2010) (to be codified at 17 C.F.R. Pt. 180).

77 See Prohibition of Market Manipulation, 75 Fed. Reg. 212, at 4 (proposed Nov. 3, 2010) (to be codified at 17 C.F.R. Pt. 180).

78 Compare Prohibition of Market Manipulation, 75 Fed. Reg. 212, with Securities Exchange Act § 10(b), 15 U.S.C.A. § 88.

79 See Prohibition of Market Manipulation, 75 Fed. Reg. 212 at 17.

80 See Prohibition of Market Manipulation, 75 Fed. Reg. 212 at 5.

81 See Prohibition of Market Manipulation, 75 Fed. Reg. 212 at 12.

82 See Prohibition of Market Manipulation, 75 Fed. Reg. 212 at 15.

83 See Prohibition of Market Manipulation, 75 Fed. Reg. 212 at 15.

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