The White Collar Appeal: Second Circuit Eliminates Barriers to Prosecuting Overseas Conduct Under the Commodities Exchange Act

• In a case of first impression in the Courts of Appeals, the Second Circuit recently examined when the government may prosecute extraterritorial conduct under the Commodities Exchange Act. 
• In applying that standard, the court held that manipulation of a foreign-exchange swap had a sufficient U.S. nexus based on the mere facts that (1) the overseas hedge fund used the London branch of JPMorgan as its prime broker; and (2) the party bearing the economic risk of the swap counterparty was Morgan Stanley Capital, a U.S.-based financial institution.
• United States v. Phillips thus sets an extremely low bar for U.S. prosecutors to target alleged manipulation of the derivatives markets anywhere in the world. Anyone who trades derivatives should review their compliance programs immediately and otherwise ensure that their overseas conduct complies with the Commodities Exchange Act.

Background

Neil Phillips was a U.K. citizen and hedge fund manager.  In 2017, his fund, Glen Point Capital, entered into “one-touch barrier options”—essentially bets that the exchange rate between the U.S. Dollar (USD) and the South African Rand (ZAR) would reach certain thresholds within certain time periods. For the price of USD 2 million, Glen Point purchased an option that would pay out USD 20 million if the ZAR/USD exchange rate dipped below 12.5/1. 

The structure of the transaction was not straightforward.  The London office of Morgan Stanley International (a subsidiary of U.S.-based Morgan Stanley) initially sold the option to a U.K.-based broker called JB Drax Honoré.  Glen Point then purchased the option from JB Drax through the London branch of JPMorgan (Glen Point’s prime broker).  In the meantime, Morgan Stanley International had entered into an identical offsetting option with Morgan Stanley Capital, a different, U.S.-based Morgan Stanley entity. The upshot was that, if the ZAR/USD exchange rate fell below 12.5/1, then (1) Glen Point could claim USD 20 million from JPMorgan, who (2) could claim USD 20 million from JB Drax, who (3) could claim that amount from Morgan Stanley International, who (4) then could claim it from Morgan Stanley Capital.  Phillips had no idea (or interest in) who was on the other side of JB Drax.  All he knew was that he could claim USD 20 million from JPMorgan, who could get the same from JB Drax, who presumably could get the same from someone, located somewhere, on the other side of the transaction.

The manipulation was, by comparison, simple. The ZAR/USD rate was hovering at 12.55/1, stubbornly sitting five basis points from Glen Point’s payday.  So Phillips had Glen Point traders buy Rand (more than USD 700 million worth) until the exchange rate dropped below 12.5/1.  That triggered the option, and Glen Point received its payout. 

Phillips ultimately was arrested and then convicted of market manipulation in violation of the Commodities Exchange Act. 

Holding

The Second Circuit affirmed the conviction, addressing a number of arguments that Phillips raised on appeal.  This post focuses on the court’s resolution of whether the Commodities Exchange Act reaches overseas conduct like Phillips’s.  The central question was two-fold:  (1) how to interpret the statutory language of the CEA; and (2) whether Phillips’s conduct met that standard. 

Statutory Interpretation.  The statute provides that the CEA reaches activities outside the United States that “have a direct and significant connection with activities in, or effect on, commerce of the United States.”  7 U.S.C. § 2(i)(1).  The district court had instructed the jury that a connection is “direct” only if “the activity outside the United States directly and immediately affected activity in commerce of the United States without deviation or interruption,” and that “[a]n indirect or attenuated connection to commercial activity that occurs in the United States is not sufficient.” (emphases added).  As for “significant,” the district court instructed that “the relationship between the activity outside the United States to the commercial activity in the United States must be of importance.  It is not sufficient if the relationship … is random, fortuitous, attenuated or merely incidental.  The conduct in the United States must be integral rather than ancillary.” (emphases added).

As a matter of first impression in the Courts of Appeals, the Second Circuit found no error with these instructions.  The court said specifically that it was appropriate to instruct the jury that “a connection is ‘direct’ only if it ‘directly and immediately affected activity in [U.S.] commerce . . . without deviation or interruption,’ and ‘significant’ only if ‘meaningful or consequential’ and ‘of importance’ to ‘commercial activity in the United States.’”

Application.  The court held that two aspects of the one-touch barrier scheme supplied sufficient basis to find “direct and significant” connections to “activities in” U.S. commerce:  (1) JPMorgan, whose London branch acted as Glen Point’s prime broker, is a U.S. financial institution; and (2) Morgan Stanley Capital, which held the ultimate economic counterparty risk, is also a U.S. financial institution. 

As to directness, it didn’t matter that Glen Point purchased the option from JPMorgan London branch, because the legal party to the contract was a U.S.-based JPMorgan entity.  It also didn’t matter that Morgan Stanley Capital, the U.S.-based Morgan Stanley entity, was several steps removed from the Glen Point transaction, because “the relationship between a defendant and a fraud victim is usually not rendered indirect just because a broker facilitated the transaction.”  Nor must a direct effect under the CEA be foreseeable.

As to significance, the court held that even if a “run-of-the-mill swap between a foreign and U.S. entity may not in all circumstances be ‘significant’ to activities in U.S. commerce under the CEA,” the jury was entitled to find that it was so in this case.  The court also rejected Phillips’s argument that Morgan Stanley Capital’s involvement in the transaction owed purely to Morgan Stanley International’s unique risk management processes, a “random,” “attenuated,” and “incidental” factor.  Citing witness testimony that such arrangements are “standard practice in the business,” the court held that it was “unlikely that Congress intended for the meaning of ‘significant connection’” when it enacted that language as part of the Dodd-Frank Act “to turn on whether the foreign conduct was connected to a U.S. company – as opposed to a subsidiary of a U.S. company.”

Key Takeaways

Foreign traders should assume that their overseas derivatives trades are now fair game for investigation and prosecution in the Southern District of New York.  The Second Circuit’s message is clear—foreign commodities trading that has even unforeseeable connections to the United States is subject to prosecution in the United States.  If an overseas counterparty’s subsequent hedging activity, entirely unknown to the trader, results in a U.S. person obtaining economic exposure to the trade, that apparently suffices for U.S. prosecutors to haul foreigners to the United States to be prosecuted.  Anyone who trades derivatives should review their compliance programs immediately to ensure they are taking adequate steps to bring their overseas activity into compliance with the CEA.

International cryptocurrency traders should take special note.  The CFTC has long taken the position that it has jurisdiction over cryptocurrency futures and other derivatives—a market that continues to expand in size and global significance at a dizzying pace and remains a frequent target for investigation and prosecution.  Phillips thus will embolden both the Department of Justice and the CFTC to pursue overseas crypto traders who previously might have seemed to be beyond the reach of U.S. law enforcement.

Nevertheless, Phillips does not foreclose many of the arguments the defense pursued.  No doubt courts within the Second Circuit will adopt the instructions blessed in Phillips.  But Phillips is not the be-all and end-all on these issues.  Many of the defense arguments are compelling and remain viable notwithstanding the decision.  In particular, the Second Circuit acknowledged that “significance depends on context” and that not every swap transaction is “significant” to U.S. commerce. Just because the evidence in Phillips’s case met the low threshold for sufficiency doesn’t mean that similar arguments in future cases won’t be persuasive to juries or even future appeals panels.  So too with the attenuated relationship between Glen Point and Morgan Stanley Capital. Phillips certainly does not foreclose jury arguments that the connection was too indirect to qualify under the standard.  Even one of Phillips’s legal arguments—that significance should be framed with respect to U.S. commerce, not with respect to the transaction in question—arguably survives, as the court applied only plain-error review, not de novo.  Defense counsel may wish to press that argument in future cases too.