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August 17, 2017

7th Circuit Upholds First Ever Conviction and Sentence for Commodities “Spoofing”

What This Case May Tell Us About Future Spoofing Prosecutions

In 2015, commodities trader Michael Coscia became the first person ever convicted of commodities “spoofing.” Generically, spoofing—which was criminalized in 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act—is the practice of artificially manipulating securities or commodities prices by bidding or offering transactions that the trader intends to cancel. Coscia’s scheme involved using a computer algorithm to simultaneously place thousands of small and large orders in fractions of seconds on opposite sides of the commodities market to create illusory supply and demand, thereby artificially inducing market movement from which Coscia derived millions of dollars in profits.

Coscia was tried and convicted of spoofing and commodities fraud in 2015, and he was sentenced to a prison term of 36-months. On August 7, 2017, the 7th Circuit Court of Appeals affirmed Coscia’s convictions and sentence. In doing so, the 7th Circuit not only legitimized the first ever spoofing conviction, but it may have also offered key insights into future white collar criminal spoofing investigations and provided a roadmap future prosecutors and investigators may use to charge and try spoofing cases. Here are the four key takeaways from the decision and what they may tell us about future spoofing investigations and prosecutions.

1. The 7th Circuit’s rhetoric in affirming Coscia’s conviction and sentence, and rejecting his arguments that the anti-spoofing law is unconstitutional, are likely to embolden prosecutors across the country to bring future spoofing cases.

In 2015, when federal prosecutors in Chicago won the first ever spoofing conviction against Coscia, it was believed that their victory could set the stage for further spoofing investigations and prosecutions across the country. Now that the 7th Circuit has affirmed both Coscia’s conviction and his 36-month prison sentence, an increase in government scrutiny of potential securities and commodities spoofing is even more likely.

But even more important to the likelihood of future spoofing prosecutions than the 7th Circuit’s substantive decisions may be the rhetoric the Court employed in categorically rejecting all of Coscia’s challenges to the constitutionality of the anti-spoofing law. In finding that the anti-spoofing law was not unconstitutionally vague (as Coscia asserted), the Court of Appeals made two critical findings. First, the Court found that Congress had, in fact, sufficiently defined spoofing in the Dodd-Frank Act even though the language defining the critical element of intent—i.e., that spoofing requires “bidding or offering with intent to cancel the bid or offer before execution”—is relegated to a parenthetical section of the statute. Second, the Court found that because the anti-spoofing provision was specifically enacted to stop that practice, the absence of any external guidance on spoofing (e.g., a recognized industry definition, a Commodity Futures Trading Commission, SEC, or other agency rule, or Congressional legislative history) did not render the provision unconstitutionally vague.

Although the Court’s constitutionality determinations are not binding outside of the 7th Circuit, these decisions and the strong language the Court employed in delivering them are still likely to embolden other prosecutors to pursue spoofing cases under the belief that other federal courts’ constitutionality analyses will yield the same reasoning and result.

2. The key evidence of intent in a spoofing case is not limited to the records of transactions offered and executed; the testimony of individuals who designed, maintained, and executed the algorithm or trading strategy is just as critical.

In his appeal, Coscia also advanced the argument that the evidence presented at trial was insufficient to convict him, particularly as it related to the necessary element of his intent “to cancel the bid[s] of offer[s] before execution.” As is typically the case in a white collar criminal prosecution, virtually all of the prosecution’s evidence of Coscia’s intent was circumstantial. Thus, much of the 7th Circuit’s decision focuses on the nature and weight of that circumstantial evidence, ultimately determining that it was sufficient to support the jury’s conviction.

The circumstantial evidence the government presented against Coscia touched on all facets of the algorithm he used to execute his spoofing scheme. This included, most basically, records of the transactions offered and executed by the algorithm that showed both a high volume of offered transactions, and a high volume of cancelled orders. However, the Court was clear that these high volumes, standing alone, did not constitute spoofing per se. Thus, more circumstantial evidence was required to prove intent.

To fill that gap, the prosecution presented direct testimony from several of the individuals who designed, maintained, and implemented Coscia’s algorithm and trading strategy that led to those transactions. This testimony—which focused on, among other things, the purpose of the algorithms and the intent behind certain offered orders—appears to have been critical to both the prosecutors’ trial strategy and to the 7th Circuit’s evaluation of the sufficiency of the government’s evidence. For example, the individual who designed the programs Coscia used to execute his scheme testified that those programs were specifically intended to act “[l]ike a decoy…to pump [the] market” and to “get a reaction from the other algorithms [used by other traders].” The program designer likewise testified that the large-volume orders Coscia placed—that had the direct effect of artificially altering the price of the commodity in question—were specifically designed to be avoid being executed.

These inferences—which could not, necessarily, be presumed from the transaction records standing alone—went to the heart of the issue of Coscia’s intent. Because the Appeals Court affirmed Coscia’s conviction based at least in part on this type of circumstantial evidence, prosecutors may well seek to replicate it in future spoofing prosecutions.

3. Key evidence of intent in spoofing cases may also come in the form of statistical evidence concerning an individual trader’s transaction and trading histories, especially if it reveals patterns or identifies the individual as an industry outlier.

A second category of evidence that both the prosecution and the 7th Circuit appeared to rely heavily upon to prove/find Coscia’s intent was statistical evidence analyzing his trading history and revealing him as an industry outlier in many respects. For example, at trial Coscia’s director of compliance testified that during the time of the spoofing scheme Coscia placed nearly 25,000 large orders but executed only 0.5% of them, while at the same time placing nearly 7,000 small orders and executing 52%. This type of spread between the cancellation rates of large and small orders, he testified, was highly unusual in the industry. Similarly, Coscia’s compliance director also testified that Coscia’s order-to-fill ration (i.e., the average size of the order showed to the market divided by the average size of the orders actually filled) was 1,600%. This was also well outside industry norms which typically fall in the 91%-264% range.

The prosecutors also offered statistical evidence concerning Coscia’s performance as measured against certain markets or exchanges when viewed as a whole. For example, there was evidence that during the time of his spoofing scheme Coscia’s cancellations represented 96% of all cancellations in the futures markets of a particular commodity in which he traded.

This type of statistical evidence will likely be available in any spoofing investigation. And although the 7th Circuit was quick to acknowledge that none of these statistics, on its own, established Coscia’s intent to cancel orders, this case shows that such statistics can be key pieces of the puzzle for both a jury and an appellate court analyzing the sufficiency of the evidence on which a conviction is based.

4. Notwithstanding its affirmation of Coscia’s convictions, the 7th Circuit was clear that not all high-frequency trading strategies—even those that utilize large volumes of cancelled orders—are criminal or constitute spoofing.

Although the 7th Circuit affirmed Coscia’s convictions and sentence, the news was not all bad for securities or commodities traders who use strategies that employ high-frequency trading, large volumes of cancelled orders, or other features that may bear superficial similarities to Coscia’s scheme. The Court, several times throughout its opinion, went out of its way to tout the legal applications of such trading strategies. For example, the Court wrote in no uncertain terms that “[a] number of legitimate trading strategies can make [high frequency trading] very profitable.”

Throughout its decision, the 7th Circuit repeatedly returned to this distinction between legitimate high-frequency trading strategies and “spoofing,” making clear each time that neither its decision nor the anti-spoofing provision of the Dodd-Frank Act prohibits the former. Toward the end of its opinion, the 7th Circuit even went so far as to list certain legitimate high-frequency trading practices that are distinguishable from illegal spoofing, including those that employ stop-loss orders (orders to sell once a security reaches a certain price) and fill-or-kill orders (orders that must be executed in full immediately or the entire order cancelled).

Unsurprisingly, the key concept on which the Court of Appeals relied in distinguishing legitimate strategies from spoofing was intent. As the Court noted, spoofing requires proof of intent to cancel orders at the time they were placed. But many legal trading strategies (including those discussed above) involve cancelling transactions upon the occurrence of a condition subsequent, i.e. the occurrence of a condition after the order is placed. When that is the case, the intent required for spoofing cannot exist. Thus, at least according to the analysis proffered by the 7th Circuit, it may be a full defense to spoofing allegations that the orders were cancelled only upon the occurrence of a post-order condition.

White collar criminal investigations and prosecutions involving spoofing have just begun, and the case law in this area of securities and commodities fraud will no doubt develop significantly over time. But the case of Michael Coscia provides valuable insights about how those prosecutions might proceed, and lessons securities and commodity traders can take to avoid spoofing liability altogether.


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