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Court To Consider Commodities Futures Trading Question

Today the Court granted cert. in Klein & Co. Futures, Inc. v. Board of Trade of the City of New York, No. 06-1265, a case involving the commodities futures trading market. In a prior post, we discussed the petition as an example of what practioners can do when their case does not directly implicate a circuit split. The now-granted petition poses the following question : “Whether the court of appeals erred in concluding that futures commission merchants lack statutory standing to invoke that right of action because, in the court’s view, they do not engage in such transactions, despite the statutory requirement that the merchants enter into and execute their transactions on, and subject to the rules of, a board of trade and the fact of the merchants’ financial liability for the transactions.”

For those interested, here is the petition, brief in opposition, cert. reply brief, and amicus brief of the Futures Industry Association, Inc. in support of the petitioner.

For those unfamiliar with commodities futures markets, a little background may be helpful. A commodities future is a contract to sell a particular commodity (say, frozen concentrated orange juice, as in the movie “Trading Places”) at a price set in the contract. The seller of the contract becomes obligated to provide the buyer with the promised amount of the commodity atthe promised price on a set date in the future (say, 15,000 pounds of frozen concentrated orange juice for $1,500 on July 1, 2007). Someone who believes that the market price for frozen concentrated orange juice will be $2,000 per 15,000 pounds might buy this hypothetical futures contract for $250, since if the guess about the future price turns out to be correct, the contract will save the purchaser $500 off the market price. Even people who don’t really want 15,000 pounds of frozen orange juice might buy such a contract, because they can then turn around and sell the money-saving contract to someone who actually does want it, and make a profit. The futures market is thus a place where some people buy futures contracts as a way of making money based on their bets about the future prices of commodities, and others buy contracts in order to protect themselves against fluctuations in the prices of commodities they need to run their businesses.

Futures contracts are sold in commodity exchanges, which are operated by a board of trade such as the respondent in this case, the Board of Trade of the City of New York. Much like the stock market, actual trades on the commodity exchanges are conducted through intermediaries, in this case, a commodity futures merchant. The merchant, like a stock broker, takes orders from customers and purchases or sells futures contracts on its customers’ behalf.

This whole process is governed by the rules of the relevant board of trade, which is required by the Commodities Exchange Act to promulgate and enforce rules governing exchanges on its market. The Act also provides a cause of action for violations of the Act, including suits against the boards themselves for failing to enforce their rules.

Among other things, the boards enact rules governing the sale of futures contracts “on margin.” As in the stock market, merchants can allow customers to buy futures contracts while giving the merchant only a small percentage of the full cost of the transaction. If the market price changes too much during the life of the contract, the customer may be subject to a “margin call” and required to pay the merchant more money in order to reduce the risk that the customer will not have enough money to pay any possible loss on the contract when it becomes due. If the margin call is not met, the merchant may immediately liquidate the customer’s holdings.

Whether or not a margin call is required is determined by the daily “settlement price” for the commodity. The settlement price approximates the market price for that day and is set by the board of trade. Because some commodities are infrequently traded, it is not always possible to simply look at the price for the commodity in that day’s trading in calculating the settlement price. Accordingly, some degree of judgment and expertise is required, a process that is subject to manipulation, which leads us to the facts of this case.

The lawsuit in this case arose from the alleged manipulation of the futures market process by an official of the respondent Board of Trade of the City of New York. According to the plaintiffs, the chairman of one of the board’s divisions owned a company that had purchased a lot of a specific futures contract through petitioner Klein & Co. Futures, a futures merchant on the Board of Trade of the City of New York. It turns out that this was a bad investment. When it looked like his company was going to be required to come up with substantial “margin call” payments or risk having their contracts liquidated at a lost, the chairman manipulated the daily settlement price for the futures. This worked for a while, but the scheme eventually fell apart, the settlement price readjusted to accurately reflect market conditions, and a $700,000 margin call was issued. The chairman’s company didn’t have the money to make the margin call, so Klein was forced to sell the futures, at a huge loss which Klein was required to absorb, leading to the collapse of that company as well.

Klein subsequently brought suit against the Board of Trade for failing to enforce its rules that should have prevented the chairman from manipulating the daily settlement price.
The issue before the Supreme Court is whether the Commodities Exchange Act permits a merchant (as opposed to its customers) from suing a board of trade for failing to enforce its rules. Section 25(b)(1) of the Act provides that “a licensed board of trade that fails to enforce any bylaw, rule, regulation, or resolution that it is required to enforce by the Commission, … by a person who engaged in any transaction on or subject to the rules of such registered entity to the extent of such person’s actual losses that resulted from such transaction and were caused by such failure to enforce or enforcement of such bylaws, rules, regulations, or resolutions.” The court of appeals held that merchants cannot sue under this provision because they do not “engage[] in any transaction” on the exchange; only their customers do, the court concluded. Klein contests this proposition, arguing that merchants in fact engage directly in exchanges in commodities markets on behalf of their customers and that Congress intended the Act to extend to both customers and their brokers. The Board of Trade has argued that Congress carefully worded the statute to limit the scope of the private right of action in a way that excludes merchants.

Petitioner is represented by Drew Days of Morrison & Forrester. Respondent is represented by Edmund R. Schroeder of Cadwalader, Wickersham & Taft.

The case will be briefed over the summer and argued in the fall.