July 15, 2021

By Michael B. Eisenkraft

A recent ruling by the Second Circuit Court of Appeals in Set Capital LLC v. Credit Suisse Group AG, 996 F.3d 64, 77–78 (2d Cir. 2021) revived claims that financial giant Credit Suisse Group AG (“Credit Suisse”) had manipulated the market for a popular security that, oddly enough, allowed investors to bet against an index reflecting expectations of upcoming stock market volatility. Significantly for investors, the April 2021 decision created positive jurisprudence for investors seeking to bring so-called “scheme liability” claims under Sections 10b-5(a) and (c) of the Securities Exchange Act of 1934 (“Exchange Act”), an area where case law has been sparse. Cohen Milstein Sellers & Toll PLLC serves as co-lead counsel for the putative class in this case and briefed and argued the case before the Second Circuit.

A Product Whose Popularity Created Problems

Credit Suisse issued and sold a very popular Exchange Traded Note (“ETN”) formally named the VelocityShares Daily Inverse VIX Short-Term ETN, but more commonly known by the nickname XIV. XIV was a volatility-linked financial product associated with the VIX Index, sometimes referred to as Wall Street’s “fear index” or “fear gauge.” The value of XIV is derived from the inverse value of the daily returns of the S&P 500 VIX Short-Term Futures Index (“VIX Futures Index”), which tracks a portfolio of first- and second month VIX futures contracts. Generally speaking, when the relevant VIX futures contracts underlying the VIX Futures Index decrease in value by 1%, the XIV notes increase in value by 1%, and vice versa. So, when VIX goes one way, XIV goes the other—hence its clever nickname, VIX spelled backwards. To remove some of this volatility risk from its books, Credit Suisse decided to hedge the risk. And the more XIV Credit Suisse issued, the more it needed to hedge. One way to hedge the risk was to buy the underlying VIX futures contracts. The problem for Credit Suisse was XIV’s popularity. XIV became a huge product, which correspondingly increased Credit Suisse’s need to hedge. The danger was that one of the main ways to hedge that risk, purchasing VIX Futures, could drive up the value of the VIX Futures indexes if done in high enough volume, thus further driving down the value of XIV and creating a vicious cycle.

According to the complaint investors filed in this matter, that is exactly what happened, in dramatic fashion. On June 30, 2017, Credit Suisse offered an additional 5,000,000 XIV notes to investors. On January 29, 2018, Credit Suisse offered an additional 16,275,000 notes on top of the 10,793,880 XIV notes already outstanding. This dramatically increased Credit Suisse’s need to hedge. On February 5, 2018, XIV prices dropped due to an increase in volatility—a drop that accelerated due to a massive purchase of VIX futures. In a single day, the price of XIV crashed by 96%. Credit Suisse then declared an Acceleration Event that effectively delisted the security. The Complaint alleged that Credit Suisse knew, based on prior events and other data, that its massive sales of XIV would create a correspondingly massive need to hedge that, in a time of volatility, would force buying of large amounts of VIX futures that, in turn, would drive down the price of XIV even further. To quote Adam Levine, who pithily described the allegations in his Bloomberg column: “1. [Credit Suisse] sold notes that would go down when VIX futures went up. 2. Then [Credit Suisse] bought a ton of VIX futures, pushing their prices up. 3. Investors in the notes lost everything. 4. [Credit Suisse] made a bunch of money.”1 In the Offering Documents for these XIV notes, while Credit Suisse acknowledged that its hedging activity “could affect” the value of VIX Futures index, it also stated that it “had no reason to believe” that any impact would be “material.”

Investors filed suit, alleging violations of Rules 10b-5(b) of the Exchange Act of 1934 for false and misleading statements made by Credit Suisse, Section 11 of the Securities Act of 1933 for false and misleading statements in the prospectus, and 10b-5(a) and (c) of the Exchange Act for the entire manipulative scheme. The District Court dismissed the claims in their entirety, but the Second Circuit, in an opinion issued April 27, 2021, largely reversed the District Court, allowing most of the claims to move past the motion to dismiss. See Set Cap., at 68–69 (2d Cir. 2021).

The most important part of this opinion, from the perspective of an investor, is likely its ruling on the 10b-5(a) and (c) or “scheme liability claims.” 10b-5(a) and (c) claims are broader than 10b-5(b) claims in that they do not require misrepresentations or omissions. Despite being broader than 10b-5(b) claims, they are brought far less frequently, resulting in sparse case law regarding scheme liability claims. The key quotation from Set Capital is the following holding:

Credit Suisse argues that the complaint fails to allege any “artificial” impact on the price of XIV Notes because its hedging trades were “done openly” for the legitimate purpose of “manag[ing] risk,” not deceiving investors. To be sure, 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. But here, the complaint alleges more than routine hedging activity: It alleges that Credit Suisse flooded the market with millions of additional XIV Notes for the very purpose of enhancing the impact of its hedging trades and collapsing the market for the notes. In this context, it is no defense that Credit Suisse’s transactions were visible to the market and reflected otherwise legal activity. Open-market transactions that are not inherently manipulative may constitute manipulative activity when accompanied by manipulative intent. In some cases, as here, “scienter is the only factor that distinguishes legitimate trading from improper manipulation.” To the extent Credit Suisse claims it hedged for a legitimate purpose, its position contradicts the complaint. As we discuss in detail below,

Set Capital specifically alleges that Credit Suisse executed its hedging trades on February 5 for a manipulative purpose—to trigger a liquidity squeeze that would destroy the value of XIV Notes. Set Cap. at 77–78 (internal citations omitted).

This is important for three reasons. It re-affirmed the flexibility and adaptiveness of 10b-5(a) and (c) to cope with novel schemes, it illustrated that scheme liability can protect investors in non-traditional investments, and it expanded the concept of open market fraud to the Second Circuit.

Recently, in Lorenzo v. SEC, 587 U.S. ___ (2019), the Supreme Court also made clear that the scheme liability provisions “capture a wide range of conduct[,]” id. at 6; “even a bit participant in the securities market may be liable under [Rule] 10b-5 so long as all the requirements for primary liability . . . are met[,]” id. at 12 (internal quotation marks and citations omitted); and in drafting and passing the federal securities laws, “Congress intended to root out all manner of fraud in the securities industry[,]” id. at 13. In Set Capital, Credit Suisse was alleged to have executed a novel scheme that harmed investors because of the relationship between two securities—XIV and VIX futures— both of which were recent creations. Set Capital, one of the first circuit decisions to address scheme liability post-Lorenzo, reaffirms that securities fraud, no matter how novel, still falls under the remit of 10b-5.

In their papers, Credit Suisse also argued that XIV was an extraordinarily risky product designed for professional traders and that investors essentially assumed the risk that the product would fail abruptly and they would lose their entire investment. In reviving investors claims, the Second Circuit in Set Capital reaffirmed the principal that securities fraud is unacceptable and actionable for any securities— no matter how esoteric or risky.

Finally, in Set Capital the Second Circuit adopted the concept of open-market fraud. Whether or not otherwise legal conduct can constitute manipulation if the intent is to manipulate is a question that is currently actively being debated amongst the Courts. See, e.g., Legitimate Yet Manipulative: The Conundrum of Open-Market Manipulation by Gina Gail S. Fletcher Duke Law Journal. https://dlj.law.duke.edu/article/ legitimate-yet-manipulativefletcher-vol68-iss3/ at 485 (noting divergence of views in the Courts on this issue). Set Capital moves the Second Circuit into line with the D.C. Circuit and out of sync with the Third Circuit. See, e.g, Koch v. S.E.C., 793 F.3d 147, 153–54 (D.C. Cir. 2015), cert. denied, 577 U.S. 1235, 136 S.Ct. 1492, 194 L.Ed.2d 586 (2016) (holding that a “burst of trading” on the open market, combined with manipulative intent, was enough to violate the Exchange Act); GFL Advantage Fund, Ltd., 272 F.3d at 205 (explaining that market manipulation depends on the activity rather than the intent). Given the circuit split, there is a chance that this will be an issue eventually settled by the Supreme Court.

For all these reasons, Set Capital is both an important decision and a positive step for investors.


1 https://www.bloomberg.com/opinion/articles/2021-05-04/under-armour-earni...