The CFTC's Changing Interpretation and Application of the Law Regarding Misappropriation of Information

Many people associate the phrase “insider trading” with company executives buying or selling the company’s stock before news hits the market. The underlying problem government authorities point to in those cases is the use material nonpublic information about the company for personal benefit.[1]  Although the phrase is commonly used in related to securities laws, there have been cases in the commodity and derivative markets using the same theory. Even more recently, the “insider trading” language involving the use of material nonpublic information has even been used in cases involving commodity and derivative traders.

There is an “insider trading” prohibition in the derivative markets, but that prohibition is limited in its potential application.[2] For example, employees of registered entities such as futures exchanges may not use “any material non-public information” gained through their employment “to trade for such person’s own account” or even disclose such information for any purpose unrelated to the performance of the person’s job duties.[3] That prohibition was used to pursue alleged violations by two employees of NYMEX, a registered commodity futures and options exchange. 

In CFTC v. Byrnes, et al., the Commodities Futures Trading Commission alleged that two employees of the exchange provided material non-public information they learned through the course of their employment to a broker.[4]  It was agreed that the two employees “disclosed, among other things, the identities of counterparties to specific options trades, whether a particular counterparty purchased or sold the option, whether it was a call or a put, the volume of contracts traded, the expiry, the strike price, and the trade price.”[5]   

As the prohibition against “insider trading” in the Commodity Exchange Act (CEA) does not apply to anyone other than the persons and entities specified, the CFTC changed course when it accused a broker in CFTC v. EOX Holdings, L.L.C. of disclosing nonpublic information concerning “the identities, positions, orders and trading interests” of other customers’ block futures orders as part of providing “market color.”[6]  The CFTC accused the broker of “tipping material, non-public information” about customers “in breach of a preexisting duty” to those customers.[7]  The CFTC also alleged that the broker had used this information to trade in a managed account.[8]  The provisions in the statute and regulations relied upon, however, do not prohibit “insider trading” by brokers; they prohibit fraud.[9]  

The court in EOX Holdings noted that the CFTC had previously recognized that “unlike securities markets, derivatives markets have long operated in a way that allows for market participants to trade on the basis of lawfully obtained material non-public information.”[10]  The CFTC nevertheless maintained that “trading on the basis of material non-public information in breach of a pre-existing duty (established by another law or rule, or agreement, understanding, or some other source), or by trading on the basis of material non-public information that was obtained through fraud or deception” may be fraudulent and in violation of this prohibition.[11]  The court in EOX Holdings then found that the CFTC had to establish that the broker “(1) misappropriated confidential information in breach of a preexisting duty of trust and confidence to the source of the information; (2) intentionally or recklessly, i.e., with scienter; (3) in connection with a contract for sale or purchase of a commodity in interstate commerce; (4) for personal benefit.”[12]

The CFTC’s prior guidance appeared to focus on trading in breach of a duty, while the standard adopted by the court in EOX Holdings suggests that the misappropriation of information contrary to a preexisting duty was problematic. In any event, both the CFTC guidance and EOX  require that the preexisting duty be based on particular source, which could be an agreement or even an “understanding.” Neither the previous guidance or the court’s opinion provide any specific bounds for the industry to follow, and the CFTC’s terminology in cases involving alleged misappropriation of information, as well as its application, continues to evolve. 

In CFTC v. Xie, the consent order indicates that Xie was a quantitative trader who had access to his employer’s “options and futures positions and associated order for feeder cattle.”[13]  The CFTC believed that the trader “had a duty of trust and confidence” to the employer to which he owed “a duty to act in its best interests, keep confidential [its] material non-public information, and not misappropriate this information for his own financial or personal benefit.”[14]  The consent order also indicates that Xie traded “through his personal trading account as counterparty” to his employer.[15]  The Xie consent order alleged that he committed a violation by “misappropriating … material non-public information” and trading “for his personal benefit in breach of a pre-existing duty.”[16] 

The statute and regulation cited in Xie were not the “insider trading” prohibitions in the CEA and corresponding regulations, as he was a trader and not subject to them.  Rather, the CFTC alleged that Xie engaged in fraud.[17]  The CFTC’s curious use of the phrase “material non-public information” in a case that was not an “insider trading” case in the traditional sense drew the criticism of one Commissioner.[18]  In addition to the use of terminology more commonly associated with securities markets, the CFTC cited no source for Xie’s alleged duties to his employer.  Perhaps such documented source of the duties existed, but the industry would have benefitted from understanding the basis for the CFTC’s allegations.