U.S. Commodity Futures Trading Comm'n v. Wilson

• Decision Date: 26 June 2014
• Docket Number: No. 13 Civ. 7884AT.,13 Civ. 7884AT.
• Court: U.S. District Court — Southern District of New York
• Parties: UNITED STATES COMMODITY FUTURES TRADING COMMISSION, Plaintiff, v. Donald R. WILSON and DRW Investments, LLC, Defendants.

27 F.Supp.3d 517

UNITED STATES COMMODITY FUTURES TRADING COMMISSION, Plaintiff

v.Donald R. WILSON and DRW Investments, LLC, Defendants.

No. 13 Civ. 7884AT.

United States District Court, S.D. New York.

Signed June 26, 2014.

A. Daniel Ullman, Jason Andrew Mahoney, Sophia Siddiqui, U.S. CFTC, Paul G. Hayeck, Washington, DC, Michael Robert Berlowitz, U.S. Commodity Futures Trading Commission, New York, NY, for Plaintiff.

Michael Sangyun Kim, Jason Maurice Manning, Melanie Lisa Oxhorn, Kobre & Kim LLP, New York, NY, Andrew C. Lourie, Kobre & Kim, LLP, Washington, DC, for Defendants.

MEMORANDUM AND ORDER

ANALISA TORRES, District Judge:

Plaintiff, the United States Commodity Futures Trading Commission (the “CFTC”), brings this action against Donald R. Wilson (“Wilson”) and his company DRW Investments, LLC (“DRW” and collectively, “Defendants”), alleging violations of Sections 6(c) and 9(a)(2) of the Commodity Exchange Act (the “CEA”), 7 U.S.C. §§ 9 and 13(a)(2). Defendants move to dismiss the complaint pursuant to Federal Rules of Civil Procedure 12(b)(2), 12(b)(3), and 12(b)(6) or, in the alternative, to transfer venue to the District Court for the Northern District of Illinois, Eastern Division pursuant to 28 U.S.C. § 1404(a). For the reasons stated below, Defendants' motion is DENIED.

BACKGROUND

The following facts are taken from the complaint and accepted as true for the purposes of this motion. See ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir.2007).

I. The Parties

The CFTC is a federal regulatory agency charged with responsibility for administering and enforcing the CEA, 7 U.S.C. §§ 1 et seq., and the regulations promulgated thereunder, 17 C.F.R. §§ 1.1 et seq.

DRW is an Illinois limited liability corporation with its principal place of business in Chicago, Illinois. DRW was registered with the National Futures Association as a Commodity Trading Advisor until January 23, 2013. DRW is a wholly-owned subsidiary of DRW Holdings, LLC. DRW Holdings, LLC, maintains an office for DRW Commodities, a business affiliated with DRW, in New York, New York. Compl. ¶ 13.

Donald R. Wilson, a resident of Illinois, served at all times relevant to this action as CEO and Manager of DRW. Id. ¶ 15.

II. The Three–Month Contract

A. Exchange–Traded Interest Rate Futures Contracts

As a general matter, an interest rate futures contract is an agreement executed between two parties, in which the parties agree to make cash payments based on an interest rate. The party who is “long” the futures contract will pay a fixed rate for the duration of the contract, whereas the party who is “short” will pay a floating rate. For this reason, the long party generally profits when interest rates rise, and the short party profits when rates decline. The price of such an interest rate futures contract is typically expressed is terms of interest rates, and its value is based on the difference between the net present values of the fixed and estimated floating cash flows. At the time the contract expires, the parties make cash payments to settle any difference between the fixed and floating rates. Id. ¶¶ 2, 17, 26.

In the United States, futures contracts must be negotiated and cleared on a CFTC-registered futures exchange, sometimes referred to as a Designated Contact Market (“DCM”), which serves as an intermediary between contracting parties.¹ As described in the complaint, one recognized method for parties to a futures contract to mitigate credit risk is to use a CFTC-registered intermediary known as a Derivatives Clearing Organization (“DCO”). A DCO is a clearinghouse that enables each party to a futures contract to substitute the credit of the DCO for the parties' own, becoming, in effect, a “middle man” that guarantees that each party's financial obligations under the contract will be satisfied. Id. ¶ 18.

Each exchange-traded futures contract has a daily official settlement price recorded every trading day at the close of trading on the exchange that lists the contract. On a daily basis, each party's open futures contract positions are “marked to market,” such that the daily settlement price is applied to determine the value of the party's position. Id. ¶ 19. After a party's position has been marked to market, the party with a position with a negative value makes a payment to the counterparty with a positive value. These daily payments of profits and losses are referred to as “variation margin” or “maintenance margin.” These payments are made to and by the exchange rather than directly between the parties themselves. Id. ¶ 20. Variation margin payments are a transfer of ownership, and, accordingly, any such payments received may be reinvested by the recipient. Id. ¶ 21.

In light of the manner in which the value of futures contracts is determined, the party that is long has a predictable advantage over the party that is short, and this advantage is referred to as “convexity bias.” As the CFTC explains, because the long party receives interest rate payments when interest rates increase and makes payments when interest rates decrease, the long party will, over time, benefit relative to the short party, who receives payments when interest rates decline. Id. Parties who are short a futures contract may seek to counteract this convexity bias by demanding a higher fixed rate in compensation at the time they negotiate the contract. The resulting higher rate is referred to as the “convexity effect.” According to the complaint, a convexity effect will likely not appear in the price unless there is (a) market knowledge of the convexity bias, (b) collective action by shorts demanding higher rates, or (c) liquidity in the market. Id. ¶ 22. The convexity bias can also be counteracted by a rule or an adjustment known as a “Price Alignment Interest” (“PAI”) that can be applied by the exchange on which the futures contract is listed. Id. ¶ 23.

B. The IDEX USD Three–Month Interest Rate Swap Futures Contract

This case involves an exchange-traded interest rate futures contract called the IDEX USD Three–Month Interest Rate Swap Futures Contract (the “Three–Month Contract”). The Three–Month Contract, as described in the complaint, was marketed as “an instrument designed to hedge against or speculate on interest rate movements.” Id. ¶ 2.

The Three–Month Contract was listed by the International Derivatives Clearinghouse (“IDCH”), which was registered with the CFTC as a DCO in 2008. Id.

¶¶ 2, 18. IDCH is a wholly-owned subsidiary of the International Derivatives Clearing Group (“IDCG”), which is itself a subsidiary of the NASDAQ OMX Group, Inc. (“NASDAQ”). Id. ¶ 24. The Three–Month Contract was offered on the NASDAQ OMX Futures Exchange (“NFX”), a recognized DCM under the CEA. Id. ¶¶ 2, 24. IDCH, IDCG, NASDAQ, and NFX were at all times relevant to this action headquartered in New York, New York. Id. ¶ 24.

Market participants could obtain the Three–Month Contract by either (1) executing a bilateral agreement and clearing the contract through IDCH or (2) placing a bid (if the party desires to place a long position) or an offer (if the party decides to place a short position) through IDCH and having that position accepted by a counterparty. Id. ¶¶ 25, 26. The Three–Month Contracts were listed each trading day in fourteen different maturities ranging from two to thirty years. The NFX trading hours for the Three–Month Contract were from 7:00 a.m. and 5:00 p.m. Eastern Time (ET). Id. ¶ 27.

C. IDCH Rules Governing the Three–Month Contract's Settlement Price

In the complaint, the CFTC refers to the September 1, 2010 version of an IDCH rulebook (the “Rulebook”), which describes, among other things, how ICDH calculates settlement prices and values any party's open position in listed IDCH contracts, including the Three–Month Contract. Id. ¶ 27.

The Rulebook set forth the method used by the IDCH to calculate, on a daily basis, the net present value of a party's open positions in the Three–Month Contract, which determines the variation margin that each party was obligated to pay or entitled to receive. The value of a party's position depended on what was known as an “IDEX Curve,” a line graph plotting interest rates versus maturities for fourteen maturities of the Three–Month Contract ranging from two years to thirty years. The Rulebook stated that the net present value of each open position was calculated based on “ ‘valuing each leg of the cash flows of the contract (fixed and floating) according to the discount factors generated by the IDEX Curve’.” IDCH populated the relevant IDEX Curve with interest rates twice per day: once, between 10:45 a.m. and 11:00 a.m. ET (the “Morning Settlement Period”), and once between 2:45 p.m. and 3:00 p.m. ET (the “Afternoon Settlement Period”). Id. ¶ 28. The Afternoon Settlement Period was then used to determine the daily settlement rates of the fourteen maturities. Id. ¶ 29. More specifically, if any bids were placed during the Afternoon Settlement Period, IDCH would set as the settlement rate for each of the fourteen maturities either (a) the exact rate that was bid or (b) a similar rate generated using a curve-smoothing calculation.Id. ¶ 30. Importantly, bids placed during the Afternoon Settlement Period did not have to be executed in order to factor into the settlement rate. Id. ¶ 57. If no bids were placed during the Afternoon Settlement Period, IDCH would use widely available public information about substantially similar bilateral interest rate markets (“Corresponding Rates”) to set the daily settlement rates for the Three–Month Contract. Id. ¶¶ 3, 29.

The CFTC provides the following example to illustrate how one such settlement rate would be determined under the IDCH rules:

[I]f a 5% bid for the Three–Month Contract with a 30–year maturity was electronically placed during the PM Settlement period, and no other bids were placed, the IDEX Curve would generally reflect a settlement rate of 5% for the 30–year contract, even if the prevailing Corresponding

...