Lead Article: Is Hedging Market Manipulation? A Review of the Second Circuit’s Decision in Set Capital LLC v. Credit Suisse Group AG

Investors throughout the world use “hedging” activities to reduce risk in their investment portfolios.  But can “open-market” hedging activity constitute market manipulation under the Securities Exchange Act of 1934?  According to a recent decision from the Court of Appeals for the Second Circuit, the answer appears to be yes, if the hedging activity is specifically intended or designed to manipulate the price of a security.  

In April, the Court of Appeals for the Second Circuit revived investors’ market manipulation claims against Credit Suisse Group AG (“Credit Suisse”) arising from its open-market hedging activities.  Set Capital LLC v. Credit Suisse Group AG, 996 F.3d 64 (2d Cir. 2021).  Specifically, the Second Circuit issued an order vacating and remanding, in significant part, the Southern District of New York’s dismissal of a securities class action alleging that Credit Suisse, among other things, manipulated the market for certain exchange-traded notes.  

The plaintiffs in Set Capital alleged that Credit Suisse engaged in a scheme to manipulate the market for the VelocityShares Daily Inverse VIX Short-Term ETN (“XIV Notes”), which were exchange traded notes issued by Credit Suisse.  The XIV Notes were designed to track the inverse of the S&P 500 VIX Short-Term Futures Index, which was designed to track the VIX Index.  The VIX Index, commonly referred to as Wall Street’s “fear index,” is designed to measure the amount of expected volatility in the market.  The VIX Index increases as the market expects higher volatility and decreases as the market expects less volatility.  

Because the XIV Notes were designed to track the inverse of the VIX Futures Index, investors in XIV Notes would profit from low volatility in the market and would experience losses from high volatility.  To hedge the volatility risk associated with the XIV Notes, Credit Suisse bought the underlying VIX futures contracts.  However, purchasing VIX futures contracts, even as a legitimate hedge, could drive up the value of the VIX Futures Index, thereby driving down the value of XIV Notes.

The complaint alleges that after observing prior episodes of market volatility in 2011, 2015, and 2016, Credit Suisse determined how to depress prices for XIV Notes by purchasing VIX futures contracts on days when volatility spiked, to hedge against the decline in the price of XIV Notes when volatility increased.  Each time volatility spiked, Credit Suisse’s hedging contributed to a liquidity squeeze in VIX futures contracts that depressed the value of XIV Notes.  In the offering documents for the XIV Notes, Credit Suisse stated that it “had no reason to believe” that any impact of its hedging activity would be “material.” 

According to plaintiffs, Credit Suisse—with knowledge of how to manipulate the price of the VIX  Futures Index—engaged in a scheme to sell millions of XIV Notes before engineering a significant collapse in their price through Credit Suisse’s own open market “hedging activity.”  By offering 5,000,000 XIV Notes on June 30, 2017 and another 16,275,000 Notes on January 29, 2018, the complaint alleges that Credit Suisse both created the need to hedge and created conditions in which it knew that its hedging trades would destroy the value of XIV Notes during the next volatility spike. When a spike occurred one week later on February 5, 2018, Credit Suisse purchased more than 105,000 VIX futures contracts, which caused the price of XIV Notes to crash by more than 96%.  Credit Suisse declared an Acceleration Event to redeem the XIV Notes at the depressed price, resulting in significant profit to Credit Suisse and substantial losses to investors.   

The plaintiffs brought claims for, among other things, violations of Section 10(b)-5(a) and (c) of the Exchange Act and Rule 10b-5 for defendants’ alleged scheme to manipulate the market for XIV Notes.  Defendants moved to dismiss the complaint in its entirety, arguing that the plaintiffs failed to allege a “manipulative event” under Section 10(b)-5(a) and (c), and failed to plead a strong inference of scienter as required by Section 10(b).  They argued further that Credit Suisse’s hedging trades were “done openly” in order to “manage risk” and not to deceive investors.  

In September 2019, U.S. District Judge Analisa Torres agreed with the defendants and dismissed the plaintiffs’ claims, holding that the plaintiffs did not plead facts supporting a strong inference of scienter, and that Credit Suisse had simply taken advantage of market conditions, engaged in typical hedging activities, and was not trying to defraud investors.  The plaintiffs appealed. 

In a noteworthy victory for the plaintiffs, the Second Circuit reversed, in significant part, finding that the plaintiffs did adequately allege both a manipulative act and a strong inference of scienter in support of their market manipulation claim, thereby permitting market manipulation claims against an issuer arising from its open-market hedging activities.  

The Second Circuit explained that a “manipulative act” is one that is “intended to mislead investors by artificially affecting market activity,” and requires a determination “whether the transaction or series of transactions sends a false pricing signal to the market or otherwise distorts estimates of the underlying economic value of the securities traded.”  Applying that standard, the Court determined that Credit Suisse’s actions constituted market manipulation because they were designed to cause the price of the XIV Notes to plummet. 

Perhaps most notably, the Court rejected Defendants’ argument that Credit Suisse’s hedging activities could not be actionable under the federal securities laws since they were done openly and therefore could not have caused an “artificial” impact on the price of XIV Notes.  Although the Court acknowledged that “it is generally true that short selling or other hedging activity is not, by itself, manipulative—even when it occurs in high volumes and even when it impacts the market price for a security,” it ruled that “the complaint alleges more than routine hedging activity.”  Specifically, the Second Circuit pointed to the plaintiff’s allegation that Credit Suisse’s decision to flood the market with millions of additional XIV Notes was done for the precise purpose of enabling its hedging activity to collapse the price of the XIV Notes.  Thus, the Court reasoned that “it is no defense that Credit Suisse’s transactions were visible to the market and reflected otherwise legal activity” because such transactions can still “constitute manipulative activity when accompanied by manipulative intent,” as was alleged in the complaint.  Indeed, the Court observed that “[i]n some cases, as here, ‘scienter is the only factor that distinguishes legitimate trading from improper manipulation.’”   

With respect to scienter, the Second Circuit ruled that the allegations of scienter were at least as compelling as any competing inferences, holding that the plaintiffs alleged “circumstantial evidence of conscious misbehavior or recklessness that, when viewed holistically and together with the allegations of motive and opportunity, supports a strong inference of scienter.”  In reaching this conclusion, the Court noted that (1) the defendants had the opportunity to observe volatility spikes on three prior occasions (2011, 2015, and 2016) and the impact of their hedging trades in futures contracts during those spikes, combined with the defendants’ responsive actions following those spikes, supported a strong inference of scienter; (2) the defendants knowingly or recklessly exacerbated the liquidity squeeze they observed in the VIX futures market by increasing the number of XIV Notes outstanding despite its knowledge that it would then have to make additional hedges that would have a significant impact on the value of the XIV Notes it just issued; and (3) the plaintiffs set forth additional allegations and circumstantial evidence that bolstered an inference of manipulative intent.    

The Second Circuit’s articulation of market manipulation in Set Capital appears to bring market manipulation under the Exchange Act more in line with market manipulation under the Commodities Exchange Act and the Energy Policy Act, which grant the Commodity Futures Trading Commission (“CFTC”) and Federal Energy Regulatory Commission (“FERC”) authority to pursue market manipulation claims within their respective jurisdictions.  

For example, in In re Amaranth Natural Gas Commodities Litigation, the court sustained a market manipulation claim under the Commodities Exchange Act, reasoning that an otherwise “legitimate transaction”—there, the buying and holding of large energy contracts—could “constitute manipulation” if combined with “wrongful intent.”  587 F. Supp. 2d 513, 535 (S.D.N.Y. 2008), aff’d, 730 F.3d 170 (2d Cir. 2013).  Similarly, in In re ETRACOM LLC, FERC recognized that it “has consistently found to be manipulative ‘cross-market’ schemes in which market participants improperly trade in one market with the intent to move prices in a particular direction to the benefit of positions in a related market.”  2016 WL 3405304 (F.E.R.C. Jun. 17, 2016), at *22.  Thus, the Second Circuit appears to be extending the rationale of “open market” market manipulation under the Commodities Exchange Act and Energy Policy Act to the Securities Exchange Act.

This extension was previously advocated for by Solus Alternative Asset Management LP—represented by Quinn Emanuel—in its high-profile action against, among others, GSO Capital Partners and Hovnanian Enterprises, Inc., for market manipulation under the Securities Exchange Act.  There, Solus alleged that GSO offered Hovnanian below-market cost financing in exchange for Hovnanian’s agreement to default on a small portion of Hovnanian’s debt in order to benefit GSO’s positions in credit default swaps referencing Hovnanian.  In response, GSO argued, like the Defendants in Set Capital, that the alleged manipulation—providing below-market financing in order to benefit GSO’s position in the credit default swap market—could not constitute market manipulation because, even if intended to impact the credit default swap market, it was an “open market” transaction.  Solus argued—relying on, among other authorities, market manipulation cases under the Commodities Exchange Act and the Energy Policy Act—that an “open market” transaction done with the intent to impact the price of a security can constitute market manipulation.  Solus’ case was resolved before the Court issued a decision on GSO’s motion to dismiss.  However, Solus’ (at the time) novel argument is consistent with the position adopted by the Second Circuit in Set Capital.  

Although it remains to be seen what impact the Second Circuit’s decision will have on market manipulation cases going forward, it may have significant implications for certain trading practices that are becoming more common.  For example, the decision may have implications for recent trading activity in “meme stocks,” such as GameStop, where groups of investors engaged in trading for the stated purpose of causing a “short squeeze” that was intended to inflate the price of the stock.  In light of the Second Circuit’s decision, such “open market” activity could arguably be deemed “manipulative” if the Court determines that the trades were made with the “manipulative intent” of impacting the stock price.