By Benjamin J.A. Sauter, Jonathan D. Cogan & Lydia L. Halpern, Kobre & Kim LLP
Overreach by the U.S. Commodity Futures Trading Commission (CFTC) is an unfortunate reality. As we have written previously, the CFTC often tries to punch above its weight by asserting aggressive and untested legal theories, hoping to bulldoze companies into submission while generating precedent for new rounds of investigations, all with the predictable side effect of chilling legitimate trading activity.
Recent CFTC actions and anecdotal evidence suggest that the regulator is deploying this playbook once again, this time in the arena of so-called “fictitious” or “wash sale” trading activity. Individuals and companies confronting these types of investigations or enforcement actions should know that there is room to push back against the regulator’s aggressive theories.
Treading New (and Shaky) Ground in Spot Commodity Markets.
The CFTC’s authority over “fictitious” or “wash sale” trading is not as broad as it would like companies to believe. For one, the provision of the Commodity Exchange Act (CEA) that specifically prohibits such trading does not on its face apply to spot commodity markets. This means that most trading activity in spot markets, including most cryptocurrency trading, is not subject to the CEA’s express prohibition against wash sales.
The exclusion of spot commodities from the CEA’s wash sale prohibition was a deliberate choice by Congress. When Congress passed the Dodd-Frank Act in 2010, it broadened certain sections of the CEA to apply to spot commodity markets, but chose not to extend the wash sale prohibition in a similar manner. The statutory structure and history provides strong evidence that Congress did not want the CFTC policing wash-sale trading activity in spot commodity markets.
Despite this clear limitation on its regulatory authority, recent data points suggest that the CFTC is trying to circumvent its jurisdictional boundaries by charging self-match trading activity in spot commodity markets as “false reporting” or “market manipulation” violations. This overreach presents legal theories that have not yet been tested in court – and opportunities for targets of CFTC investigations to mount a resistance.
In particular, Congress has long treated wash sales as a unique type of conduct, regulated in a statutory section separate and apart from the CEA’s prohibitions against market manipulation and other trading infractions. Reflecting this statutory framework, CFTC regulations, exchange rules and industry practice have produced a complex web of guidance surrounding when self-match activity in derivatives markets is acceptable.
There is no evidence that Congress authorized the CFTC to cast aside these established understandings simply by charging self-match trades as a different type of legal violation. Companies should not assume that the CFTC has authority to shoehorn alleged wash sales into other legal theories just because it says so. This is particularly true in markets, like spot commodity and cryptocurrency markets, where the agency does not even have ongoing regulatory authority. If left unchallenged, the CFTC’s novel theories could perversely end up giving it broader enforcement authority in spot commodity markets than it has in regulated derivatives markets.
Not All Self-Matches Are Unlawful.
Even putting aside the statutory limitations on its authority, the CFTC’s novel theories prohibiting wash sales in spot commodity markets seem to disregard the specific intent element traditionally required to prove a wash-sale violation.
Not all transactions that might look like a wash sale or produce a wash result violate the CEA, at least under established understandings. In the derivatives markets, courts have held that a wash sale violation requires, among other things, specific intent to avoid taking a real market position. This means that if traders believe they are transacting in good faith, they have not engaged in prohibited wash conduct under the CEA. There is no reason to think any lower standard would apply in spot commodity markets that are, in any case, outside the CFTC’s ordinary purview.
The CFTC’s new enforcement theories, however, are pushing for precisely this sort of lower level of intent, threatening to contravene court precedent and longstanding industry understandings. As these theories are brand new, there is literally no way to know what conduct the CFTC might now deem lawful or unlawful. For example, it appears the CFTC may be applying its theories to effectively prohibit inadvertent self-matches in spot commodity markets, even though these types of matches have long been understood to be legitimate even in CFTC-regulated derivatives markets. If a self-match is unintentional and therefore not an unlawful “wash sale” under the CEA and other guidance, why would that self-match sustain a “false reporting” or “manipulation” infraction, as the CFTC’s current aggressive enforcement theories suggest? There is no answer to this question under current law.
Traders should not simply take the CFTC at its word and assume it has jurisdiction to police self-matches in the spot commodity markets. Nor should traders simply assume that the CFTC has the authority to circumvent its jurisdictional limitations by applying other legal theories, such as false reporting or manipulation, to self-matches in spot commodity markets. Traders who are willing to pursue options beyond surrender can enhance negotiated or litigated outcomes by calling out and standing up to the CFTC’s aggressive overreach.
Benjamin J.A. Sauter, a litigator at cross-border disputes and investigations firm Kobre & Kim LLP, defends entities in the cryptocurrency and commodity derivatives industries against government enforcement actions.
Jonathan D. Cogan, a litigator at cross-border disputes and investigations firm Kobre & Kim LLP, focuses on defending trading firms and other institutions against enforcement actions brought by the CFTC.
Lydia L. Halpern, a litigator at cross-border disputes and investigations firm Kobre & Kim LLP, represents clients in financial and trading industries against regulatory actions.