February 2011 - INSIDER TRADING IN COMMODITIES AND THE EDDIE MURPHY RULE

In the 1983 film Trading Places, Billy Ray Valentine and Louis Winthorpe, III (Eddie Murphy and Dan Aykroyd) get their hands on a confidential Department of Agriculture report about the orange crop and use it to make a killing by shorting the orange juice futures market. The Duke brothers (Don Ameche and Ralph Bellamy) acquire a phony report through bribery and are ruined as a result of their trading on the basis of the false report. Back then, the trade Billy Ray and Louis made based on a government report was probably not illegal.

Commodity Futures Trading Commission Chairman Gary Gensler cited the 28 year old movie to justify including the “Eddie Murphy Rule” in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Section 746 of Dodd-Frank makes it unlawful for a federal employee to knowingly disseminate information which has not been made public by the government that may affect the price of a commodity and for any person to misappropriate such information where that person knows, or recklessly disregards, that such information has not been disseminated or to use such information in a commodity transaction.

It’s not entirely clear that the Eddie Murphy Rule is needed to curb rampant trading based upon confidential government reports. Chairman Gensler didn’t cite any instances of trading on confidential official reports. But another little noticed provision of Dodd-Frank may have a broader impact. Section 753, modeled after Section 10b of the Securities Exchange Act of 1934, amends the Commodity Exchange Act to provide the CFTC with broad authority to combat manipulative schemes, and even the attempt to use fraudulent schemes, “in connection with any swap, or a contract of sale of any commodity in interstate commerce or for future delivery on or subject to the rules of any registered entity.”

To implement this expanded authority, the CFTC has proposed Rule 180.1, which closely tracks the Securities and Exchange Commission’s Rule 10b-5. Rule 180.1 makes it unlawful for any person, in connection with a swap, a sales contract for any commodity or any futures contract or related option to use or employ, or attempt to use or employ, any manipulative device, scheme or artifice to defraud; to make or attempt any untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statement made not untrue or misleading; to engage, or attempt to engage, in any act, practice or course of business, which operates or would operate as a fraud or deceit upon any person; to engage or attempt to engage in any act or practice which would defraud or deceive any person; or to deliver, or attempt to deliver, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, while knowing or acting in reckless disregard of the fact that such report is false, misleading or inaccurate.

Like Rule 10b-5, Rule 180.1 as proposed broadly prohibits fraud in all of its forms. One such form is insider trading. Illegal insider trading under our securities laws is generally understood to include buying or selling a security in breach of a fiduciary relationship or other relationship of trust or confidence.

The SEC’s authority to curb insider trading comes from a broad interpretation of Rule 10b-5, which has traditionally been used to crack down on the use of non-public information about public companies. The CFTC appears to have its eye on what it might consider parallel conduct in commodities trading. The results are certain to prove interesting in an industry where non-public information is the stock in trade of market participants and there is no requirement that information be made public, and no forum for publication.

It is difficult enough to figure out what amounts to insider trading when it comes to securities. In an October 25, 2010 column in The New York Times, Andrew Ross Sorkin cited a recent SEC insider trading case involving two employees of a Florida rail yard who apparently concluded that there would be a takeover of Florida East Coast Industries from an unusual number of visits to the yard by men in suits along with yard “scuttlebutt” that jobs might be lost.1 Once, you would have congratulated the employees for being observant. Now they are being prosecuted for buying call options on the rail company’s shares.

The proposed Rule 180.1 contains a hint of how difficult it will be to apply insider trading principles to commodity transactions. Subsection (b), which has no parallel in the securities laws, provides that the rule will not require anyone to disclose non-public information that is material to the market price of the commodity transaction, except if disclosure is “necessary to make any statement made to the other person in connection with the transaction not misleading in any material respect.”

So it’s clear that an oil company need not publicize, and may trade on, information about its own production. But when exactly does the company have to begin making disclosures that render its statements not misleading? And what else besides what the Eddie Murphy Rule prohibits could amount to illegal insider commodity trading? We’ll see.

  1. SEC v. Steffes, Case No. 1:10-08-06266 (N.D. Ill. Sept. 30, 2010).