Last month, the U.S. Court of Appeals for the Seventh Circuit, in an opinion issued by Judge Frank Easterbrookin in Brian Barry et al. v. Cboe Global Markets Inc., et al., affirmed the dismissal of a lawsuit brought by private plaintiff traders against the Chicago Board Options Exchange and its affiliates (Cboe) for Cboe’s alleged failure to curb manipulation of prices related to Cboe Volatility Index contracts (VIX®) in violation of the Commodity Exchange Act (CEA). 1
In doing so, the Seventh Circuit made it more difficult for plaintiffs challenging the conduct of futures exchanges, other entities registered with the Commodity Futures Trading Commission (CFTC or Commission), and national futures associations (collectively “registered entities” or self-regulatory organizations (SROs)). Under the CEA, a plaintiff can recover actual damages for violations of the CEA committed by a registered entity only if the plaintiff can establish that the registered entity acted in “bad faith.”
In 1987, the Seventh Circuit in Bosco v. Serhant adopted the position that “bad faith” could mean merely negligence in some circumstances. 2 Some 35 years later, the Seventh Circuit in Barry nixed that position by rejecting it as incorrect dicta. Instead, the Seventh Circuit adopted the Second Circuit’s interpretation of “bad faith” as requiring more than mere negligence in a private action brought against a registered entity under CEA section 22(b). 3 Under the Second Circuit standard that the Seventh Circuit embraced, a plaintiff alleging a CEA violation must establish that a registered entity’s enforcement of its rules or failure to enforce its rules not only caused actual damages but also was motivated by “self-interest or other ulterior motive[s] unrelated to proper regulatory concerns.” 4
The Barry decision is significant because the CEA private right of action, which Congress established against registered entities in 1982, reflected a careful balance of competing considerations. Under the CEA, the futures exchanges, derivative clearing organizations, and other registered entities subject to oversight by the Commodity Futures Trading Commission (CFTC) play a critical role in regulating conduct in the derivatives markets. Their self-regulatory responsibilities include screening applicants for membership in their organizations, issuing rules applicable to their members and markets, conducting market surveillance, and investigating and enforcing violations of their respective rules in the futures and derivatives industry. The importance of these self-regulatory functions is captured in the CEA, which adopts “a system of effective self-regulation of trading facilities, clearing systems, market participants and market professionals under the oversight of the Commission” in order to ensure the financial integrity of derivatives transactions, avoid systemic risk, protect market participants from abusive practices, and promote responsible innovation and fair competition. 5
Given the centrality of SROs in the CEA’s design, when Congress decided to create a private right of action for market participants, it added a special pleading and proof requirement for claims against SROs. Under CEA section 22(b)(4), a plaintiff must establish that the SRO “acted in bad faith in failing to take action or in taking such action as was taken.” 6 The legislative history reflects that Congress intended the bad faith requirement to restrain actions against SROs so that such suits would “supplement[], but. not substitute, for the regulatory and enforcement program of the CFTC and self-regulatory agencies.” 7 Congress also wanted to make clear that, given the CFTC’s oversight role and the SROs’ own regulatory responsibilities, there was no need “to rely on private litigants as a policeman of the [CEA].” 8 Accordingly, while Congress decided to allow private CEA claims against SROs, it counterbalanced that authorization by ensuring that the standard for pleading and proving such claims would be highly exacting to protect the SROs’ functions from being distorted by the threat of liability for mere mistakes or difficult regulatory judgments.
The balance that Congress struck in adopting a bad faith standard embraced the position of the then-CFTC chairman, who advocated limiting an SRO’s liability to circumstances where it engaged in fraud or “the exchange’s action is motivated by a conflict of interest or self-dealing.” 9 The Second Circuit construed the “bad faith” standard consistently with the CFTC chairman’s conception of it, requiring proof that “self-interest or other ulterior motive unrelated to proper regulatory concerns. constitute[s] the sole or dominant reason for the exchange action.” 10 By contrast, the Seventh Circuit in Bosco articulated a low bar for the bad faith standard, stating that “negligence in failing to enforce a [registered entity’s] nondiscretionary rule constitute[s] bad faith.” 11
The plaintiffs in Barry sought to take advantage of Bosco’s low bar, alleging that Cboe engaged in bad faith by negligently failing to enforce its rules against manipulation. Relying on Bosco, the district court held that their allegations met the bad faith standard (the district court held that the complaint was fatally deficient in other respects). On appeal, however, the Seventh Circuit in Barry rejected the Bosco standard, aligning itself instead with the Second Circuit, which “understands ‘bad faith’ in § 25(b)(4) in the traditional way.” 12 Judge Easterbrook explained that the court could find no basis to depart from the traditional meaning of the term, which “implies a deliberate wrong rather than just failing to come up to an objective standard of care….” 13 Judge Easterbrook further reasoned that the panel was not bound by Bosco because the court there was not interpreting the CEA’s private cause of action, but a precursor implied cause of action, and because there was an alternative ground for the decision.
In “disapprov[ing]” Bosco, 14 the Seventh Circuit substantially reduced the threat of CEA lawsuits used as a means to second-guess SROs’ regulatory investigation and enforcement decisions based on the theory that the SRO should have or could have done more to prevent alleged misconduct. Going forward, plaintiffs in the Seventh Circuit will have to plead and prove that a CFTC-registered entity knowingly acted or failed to act based on an “ulterior motive,” one that does not reflect legitimate regulatory concerns. As Judge Easterbrook observed, short of such a showing, “[r]emedies, if any are appropriate, lie with the SEC, the CFTC, and the National Futures Association (which could expel or discipline its members) rather than the judiciary at the behest of private litigants.” 15
Client Alert 2022-214