Prosecuting Energy Trading Fraud under the CEA

In the aftermath of Enron's collapse, attention turned to the accounting and other practices of energy companies. Numerous investigations and suits have been brought against traders and energy companies involved with supplying power to California and elsewhere during the 2000-2001 energy crisis. The government has focused on such practices as “round-trip trades,” in which energy companies entered into pre-arranged transactions, lacking market risk, to inflate reported trading volumes. Federal prosecutors in California and Texas have charged individuals with causing inaccurate or fictitious trades to be reported to trade journals.

In a speech last October entitled “Market Manipulation in the Energy Markets,” Commissioner Sharon Brown-Hruska of the Commodity Futures Trading Commission (CFTC) said the Commission was investigating 32 companies and their employees to determine whether they violated the Commodity Exchange Act (CEA) through wash trading, manipulation, and false reporting. She noted that the law views manipulation somewhat like an antitrust violation because “both require a showing of monopoly power in the relevant market and intentional anticompetitive conduct, and that proving these elements requires “a blend of both legal and economic analysis.”

A manipulative act is “one that is inherently capable of causing an artificial price.” It must be shown that the respondent intended to create that result. In other words, the government must prove specific intent to obtain an enforcement decree or criminal conviction. See transcript at http://www-lawjournalnewsletters.iproduction.com/Admin/cgi-bin/udt/www.cftc.gov/opa/speeches03/opabrown-hruska-08.htm. This article examines some of the issues raised by the government's use of the antifraud and manipulation provisions of the CEA in such cases.

History of the CEA

The CEA (7 U.S.C. '' 1-26) closely resembles the federal securities laws. Its anti-fraud provision (' 4b, 7 U.S.C. ' 6b(a)), in language similar to SEC Rule 10b-5, declares it to be unlawful for any person to deceive or defraud any other person “in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery.” Courts faced with interpreting the CEA's antifraud provisions “look to the more developed body of law addressing section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.” FDIC v. UMIC, Inc., 136 F.3d 1375, 1384 n.4 (10th Cir. 1998).

The CEA's roots extend to the Grain Futures Act of 1922, Pub. L. 67-331, 42 Stat. 998. The market crash of 1929 demonstrated, inter alia, that the Grain Futures Act didn't prevent fraud and manipulative conduct in those markets. This led Congress to enact the CEA in 1936 after it had reformed the securities laws.

Few Reported Criminal Decisions

In light of the CEA's comparatively long history, it is surprising that few criminal cases have been filed. A recent Westlaw search listed only 34 cases, and not all of these involved prosecutions based in part on alleged CEA violations. Scholars have attributed the rarity of prosecutions to the inherent difficulty of obtaining convictions under the CEA. See W. Perdue, Manipulation of Futures Markets: Redefining the Offense, 56 Fordham L. Rev. 345, 346-47 (1987) (“a satisfactory definition of manipulation has yet to emerge”); J. Markham, Manipulation of Commodity Futures Prices — The Unprosecutable Crime, 8 Yale J. On Reg. at 283; C. Pirrong, Commodity Market Manipulation Law: A (Very) Critical Analysis and a Proposed Alternative 51 Wash. & Lee L. Rev. 945, 945-46 (1994) (“[C]ommodity market manipulation law … is extraordinarily confused”).

Anti-Manipulation

Section 9(a) of the CEA (7 U.S.C. ' 13(a)(2)) criminalizes manipulation and attempts to manipulate through the transmission of “knowingly inaccurate reports concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce.” But because the CEA does not spell out the meaning of manipulation, courts have struggled over the years to develop a workable definition for the term.

An important early case, Volkart Brothers, Inc. v. Freeman, 311 F.2d 52, 58 (5th Cir. 1962), held that the term means more than charging unreasonably high prices. There “must be a purpose to create prices not responsive to the forces of supply and demand; the conduct must be 'calculated to produce a price distortion.'” More recently, the Eighth Circuit found insufficient evidence to establish manipulation of the market for live cattle because the plaintiffs failed to prove that the defendants “intended to and did produce an artificially low price.” Utesch v. Dittmer, 947 F.2d 321, 325 (8th Cir. 1991). Proving such elements beyond reasonable doubt presents a formidable obstacle prosecution.

Obstacles to Prosecuting Manipulation under the CEA

It is unclear whether these prosecutions can withstand a focused challenge. There has been considerable confusion about the extent of the Act's reach. In various publicly available documents and speeches, CFTC officials have consistently noted the historical and practical importance of distinguishing between forward and futures contracts, noting that the CFTC lacks jurisdiction over forward contracts. Because of this confusion about the scope and reach of the Act, the CFTC has issued numerous interpretations to clarify the distinctions under the Act between forward contracts and futures contracts. See, e.g., CFTC, “Statutory Interpretation Concerning Forward Transactions,” 55 Fed. Reg. 39188, 39190 (Sept. 25, 1990) (“the Act's regulatory scheme for futures trading should simply not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity”).

In 1993, after industry members called for more certainty that energy contracts weren't subject to the CEA, the CFTC generally exempted “certain contracts involving energy markets” from commodities regulation but specified that the CEA provisions prohibiting “manipulation of the market price of any commodity” would continue to apply. See 58 Fed. Reg. 21286, 21294 (April 20, 1993). Congress later substantially revised the CEA to provide more clarity in the Commodity Futures Modernization Act of 2000 (CFMA), App. E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).

Despite the agency's efforts, whether CEA's antifraud and manipulation provisions can be applied in criminal proceedings against companies and individual who work in the energy markets remains hard to grasp. For the purpose of CFTC jurisdiction, commodities fall into three categories: agricultural, financial and other (metals, energy, etc.). Agricultural commodities are within the CFTC's jurisdiction; financial commodities are not; metals and energy are “exempted.” The Commission theoretically retains antifraud and anti-manipulation jurisdiction over exempted commodities. However, as CFTC Commissioner Thomas J. Erickson explained in testimony given on July 10, 2002, “through other provisions in the law, the vast majority of OTC swap transactions in energy and metal commodities” are not subject to the Commission's fraud or manipulation authorities and in most cases are beyond the reach of any other federal financial regulator.

Assuming these obstacles can be overcome, other difficult issues remain. One is whether the CEA's antifraud and manipulation provisions reach private energy trades (ie, trades negotiated off regulated exchanges), as most of the energy trades were during the recent energy crisis. Historically, Congress, regulators, and the courts have accorded different treatment to forward contracts, which generally aren't within the CEA's reach, in contrast to futures contracts, which are covered. Yet energy contracts have the essential hallmarks of forward contracts because they aren't standardized and contemplate actual delivery of energy — a commodity that cannot be stored. See CFTC, Characteristics Distinguishing Cash and Forward Contracts and Trade Options, 50 Fed. Reg. 39656-57 (Sept. 30, 1985).

Conclusion

Whether these issues will ultimately have to be determined by the courts remains to be seen. In the interim, legislative fixes have been proposed to correct perceived problems with the CEA and may provide a better solution than trying to expand a statute to fit situations that it does not readily fit.

In the aftermath of Enron's collapse, attention turned to the accounting and other practices of energy companies. Numerous investigations and suits have been brought against traders and energy companies involved with supplying power to California and elsewhere during the 2000-2001 energy crisis. The government has focused on such practices as “round-trip trades,” in which energy companies entered into pre-arranged transactions, lacking market risk, to inflate reported trading volumes. Federal prosecutors in California and Texas have charged individuals with causing inaccurate or fictitious trades to be reported to trade journals.

In a speech last October entitled “Market Manipulation in the Energy Markets,” Commissioner Sharon Brown-Hruska of the Commodity Futures Trading Commission (CFTC) said the Commission was investigating 32 companies and their employees to determine whether they violated the Commodity Exchange Act (CEA) through wash trading, manipulation, and false reporting. She noted that the law views manipulation somewhat like an antitrust violation because “both require a showing of monopoly power in the relevant market and intentional anticompetitive conduct, and that proving these elements requires “a blend of both legal and economic analysis.”

A manipulative act is “one that is inherently capable of causing an artificial price.” It must be shown that the respondent intended to create that result. In other words, the government must prove specific intent to obtain an enforcement decree or criminal conviction. See transcript at http://www-lawjournalnewsletters.iproduction.com/Admin/cgi-bin/udt/www.cftc.gov/opa/speeches03/opabrown-hruska-08.htm. This article examines some of the issues raised by the government's use of the antifraud and manipulation provisions of the CEA in such cases.

History of the CEA

The CEA (7 U.S.C. '' 1-26) closely resembles the federal securities laws. Its anti-fraud provision ( ' 4b, 7 U.S.C. ' 6b(a)), in language similar to SEC Rule 10b-5, declares it to be unlawful for any person to deceive or defraud any other person “in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery.” Courts faced with interpreting the CEA's antifraud provisions “look to the more developed body of law addressing section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.” FDIC v. UMIC, Inc. , 136 F.3d 1375, 1384 n.4 (10th Cir. 1998).

The CEA's roots extend to the Grain Futures Act of 1922, Pub. L. 67-331, 42 Stat. 998. The market crash of 1929 demonstrated, inter alia, that the Grain Futures Act didn't prevent fraud and manipulative conduct in those markets. This led Congress to enact the CEA in 1936 after it had reformed the securities laws.

Few Reported Criminal Decisions

In light of the CEA's comparatively long history, it is surprising that few criminal cases have been filed. A recent Westlaw search listed only 34 cases, and not all of these involved prosecutions based in part on alleged CEA violations. Scholars have attributed the rarity of prosecutions to the inherent difficulty of obtaining convictions under the CEA. See W. Perdue, Manipulation of Futures Markets: Redefining the Offense, 56 Fordham L. Rev. 345, 346-47 (1987) (“a satisfactory definition of manipulation has yet to emerge”); J. Markham, Manipulation of Commodity Futures Prices — The Unprosecutable Crime, 8 Yale J. On Reg. at 283; C. Pirrong, Commodity Market Manipulation Law: A (Very) Critical Analysis and a Proposed Alternative 51 Wash. & Lee L. Rev. 945, 945-46 (1994) (“[C]ommodity market manipulation law … is extraordinarily confused”).

Anti-Manipulation

Section 9(a) of the CEA (7 U.S.C. ' 13(a)(2)) criminalizes manipulation and attempts to manipulate through the transmission of “knowingly inaccurate reports concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce.” But because the CEA does not spell out the meaning of manipulation, courts have struggled over the years to develop a workable definition for the term.

An important early case, Volkart Brothers, Inc. v. Freeman , 311 F.2d 52, 58 (5th Cir. 1962), held that the term means more than charging unreasonably high prices. There “must be a purpose to create prices not responsive to the forces of supply and demand; the conduct must be 'calculated to produce a price distortion.'” More recently, the Eighth Circuit found insufficient evidence to establish manipulation of the market for live cattle because the plaintiffs failed to prove that the defendants “intended to and did produce an artificially low price.” Utesch v. Dittmer , 947 F.2d 321, 325 (8th Cir. 1991). Proving such elements beyond reasonable doubt presents a formidable obstacle prosecution.

Obstacles to Prosecuting Manipulation under the CEA

It is unclear whether these prosecutions can withstand a focused challenge. There has been considerable confusion about the extent of the Act's reach. In various publicly available documents and speeches, CFTC officials have consistently noted the historical and practical importance of distinguishing between forward and futures contracts, noting that the CFTC lacks jurisdiction over forward contracts. Because of this confusion about the scope and reach of the Act, the CFTC has issued numerous interpretations to clarify the distinctions under the Act between forward contracts and futures contracts. See, e.g., CFTC, “Statutory Interpretation Concerning Forward Transactions,” 55 Fed. Reg. 39188, 39190 (Sept. 25, 1990) (“the Act's regulatory scheme for futures trading should simply not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity”).

In 1993, after industry members called for more certainty that energy contracts weren't subject to the CEA, the CFTC generally exempted “certain contracts involving energy markets” from commodities regulation but specified that the CEA provisions prohibiting “manipulation of the market price of any commodity” would continue to apply. See 58 Fed. Reg. 21286, 21294 (April 20, 1993). Congress later substantially revised the CEA to provide more clarity in the Commodity Futures Modernization Act of 2000 (CFMA), App. E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).

Despite the agency's efforts, whether CEA's antifraud and manipulation provisions can be applied in criminal proceedings against companies and individual who work in the energy markets remains hard to grasp. For the purpose of CFTC jurisdiction, commodities fall into three categories: agricultural, financial and other (metals, energy, etc.). Agricultural commodities are within the CFTC's jurisdiction; financial commodities are not; metals and energy are “exempted.” The Commission theoretically retains antifraud and anti-manipulation jurisdiction over exempted commodities. However, as CFTC Commissioner Thomas J. Erickson explained in testimony given on July 10, 2002, “through other provisions in the law, the vast majority of OTC swap transactions in energy and metal commodities” are not subject to the Commission's fraud or manipulation authorities and in most cases are beyond the reach of any other federal financial regulator.

Assuming these obstacles can be overcome, other difficult issues remain. One is whether the CEA's antifraud and manipulation provisions reach private energy trades (ie, trades negotiated off regulated exchanges), as most of the energy trades were during the recent energy crisis. Historically, Congress, regulators, and the courts have accorded different treatment to forward contracts, which generally aren't within the CEA's reach, in contrast to futures contracts, which are covered. Yet energy contracts have the essential hallmarks of forward contracts because they aren't standardized and contemplate actual delivery of energy — a commodity that cannot be stored. See CFTC, Characteristics Distinguishing Cash and Forward Contracts and Trade Options, 50 Fed. Reg. 39656-57 (Sept. 30, 1985).

Conclusion

Whether these issues will ultimately have to be determined by the courts remains to be seen. In the interim, legislative fixes have been proposed to correct perceived problems with the CEA and may provide a better solution than trying to expand a statute to fit situations that it does not readily fit.