Do futures commission merchants, who guarantee their customers' trades on the commodities market, engage in the type of "transactions" required to sue a commodities board of trade under the Commodity Exchange Act?
Klein & Co. Futures, Inc. was a futures commission merchant ("FCM"), serving as a middleman in futures trading. Norman Eisler, the Chairman of the New York Futures Exchange, a subsidiary of the Board of Trade of the City of New York, allegedly engaged in a price fixing scheme that caused Klein & Co. to go out of business. Klein & Co. argues that it should have standing to sue the Board of Trade under 7 U.S.C §25(b)(1) for damages resulting from the Board's initial failure to take action against Eisler. The Board of Trade successfully argued in the District Court for the Southern District of New York and the Court of Appeals for the Second Circuit that Klein & Co. should not have standing because Congress intended standing under the statute to be limited to buyers and sellers of commodities. This case will have an important impact on the $1.1 billion futures industry because FCMs provide the financial backing for all investors in the commodities market. If FCMs are denied the right to sue, the risk of lending will increase and board members will remain insulated from civil law suits.
Questions as Framed for the Court by the Parties
The Commodity Exchange Act provides an express private right of action for actual losses to a person who "engaged in any transaction on" or "subject to the rules of" a commodity board of trade against that board of trade if the board, in bad faith, engaged in illegal conduct that caused the person to suffer the actual losses, 7 U.S.C. § 25(b)(1).
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.
An Explanation of Futures Trading
The following explanation is taken from the
Kansas City Board of Trade's Explanation of Basics of Futures and Options. Futures are contracts involving commodities which are paid for when the contract is formed, and delivered at a predetermined future date. Futures markets allow buyers and sellers to hedge against the risk created by price fluctuations. Buyers who need a certain resource several months in the future, and fear that the price of that commodity will rise, can buy a futures contract to lock in the current price of the commodity. Sellers who fear that the market price for their commodities will fall in coming months can sell them for the present market price. The futures market also involves middlemen - futures commission merchants ("FCM") - who finance the investors.
Investors are required to establish margin accounts with FCMs to trade futures. FCMs act as brokers by guaranteeing the obligations of their customers, and facilitating trades. FCMs require investors to make a deposit, called an initial margin, before each trade. In exchange, the FCM extends credit to the investor to cover the transaction costs. The value of commodities changes every trading day. The value of frequently traded commodities is usually determined by the price of the last trade. Less frequently traded commodities are assigned a value by a board or commission at the end of each trading day. This value, called the settlement price, is used by firms and investors to calculate their net worth. Firms and investors use this net worth figure to calculate how much money to deposit into their margin accounts. The investor's account is automatically credited when a futures sale results in a profit, and debited when a sale yields a loss. The account must maintain a minimum amount, called a maintenance margin, which is established by the trading commission. If the funds in the account fall below the maintenance margin, the FCM will issue a margin call. A margin call requires investors to deposit money to bring the account back to the amount of the initial margin. If an investor fails to deposit enough money to meet the margin call, the FCM can seize all of the funds in the account. Margins allow FCMs to cover losses that the investor's account incurs.
Klein & Co.'s Failure
The following facts are taken from the Brief for Klein & Co. Futures, Inc., Out of Options (Business Week), and Former Futures Chairman Settles Charges (NY Times). For approximately nine months, Norman Eisler, the chairman of the New York Futures Exchange ("NYFE"), a subsidiary of The Board of Trade of the City of New York (NYBOT), allegedly used his position on the P-Tech Futures and Options Settlement Committee to artificially increase the value of P-Tech futures and options. Eisler's company, First West Trading, Inc., bought and sold contracts in P-Tech futures and options. As a result, First West appeared to have more money than it actually had.
The Board of Trade became aware of the price fixing scheme two months before its initial investigation. After the scheme was uncovered, however, Eisler's membership in the NYBOT was revoked and the P-Tech Futures and Options Settlement Committee recalculated the settlement prices of P-Tech futures and options. After the adjustment, Klein & Co. issued a margin call to First West to cover the $4.5 million account debit. Klein & Co. was forced to make up the difference when First West failed to meet the margin call. This payout caused Klein & Co.'s net capital to fall below regulatory requirements, and its trading license was suspended. Klein & Co. quickly went out of business.
Klein & Co. filed a lawsuit under 7 U.S.C § 25(b)(1), a portion of the Commodities Exchange Act, against both the New York Futures Exchange and the Board of Trade. Under 7 U.S.C§ 25(b)(1), any licensed board of trade that violates the statute or any Commission rule is liable for damages to any person who engaged in a transaction on, or was subject to the rules of, the board of trade.
The Board of Trade successfully argued in the United States District Court for the Southern District of New York that Klein & Co., as an FCM, was not a buyer or seller of futures. Therefore, Klein & Co. did not "engage in transactions" under the statute, and lacked standing to bring suit.
The Second Circuit affirmed, but for slightly different reasons. The Second Circuit reasoned that 7 U.S.C. § 25(b)(1) was subject to limitations set forth in §25(a)(1). Standing is granted under § 25(a)(1) to firms or individuals who receive trading advice for a fee, purchase or sell P-Tech futures contracts, or own those futures contracts. Klein & Co. did not engage in any of these activities, and therefore, lacked standing under §25(a)(1).
The Supreme Court granted certiorari in this case to clarify an issue of statutory construction. There is no question that the Commodity Exchange Act ("CEA") gives a private right of action to purchasers and sellers of futures. This case presents the issue of whether this right extends to futures commission merchants ("FCMs"), who facilitate commodity trading.
Application of the CEA
The Second Circuit in Klein & Co. v. Board of Trade of City of New York, 464 F.3d 255, 259 (2d Cir. 2005) decided that in order to qualify for standing under Section 22(b) of the CEA, the plaintiffs must be in one of the four relationships described in Section 22(a). The Futures Industry and the United States Department of Justice agree with Klein & Co. that the Second Circuit erred in applying the standing requirements of Section 22(a) to Klein & Co. They assert that Klein & Co.'s lawsuit against the Board of Trade should be governed by Section 22(b), which describes the standing requirements for lawsuits against registered entities Klein & Co., citing Russello v. U.S., 464 U.S. 16, 23 (1983), claims that since Congress included specific language in Section 22(a) requiring one of four relationships for a plaintiff to have standing, and omitted the language from Section 22(b), one of the canons of statutory construction creates a presumption that Congress omitted the language intentionally.
The Board of Trade for the City of New York (NYBOT) and the New York Clearing Corporation (NYCC) do not advance any arguments in support of the Second Circuit's application of Section 22(a) to Klein & Co. Rather, they argue that Klein & Co.'s activities do not qualify as "transactions" under 22(b) because the economic gains or losses affected only First West, not Klein & Co. NYBOT contends that Klein & Co. sought to recover the margin debt, worth $4.5 million, that was left unpaid by First West. According to NYBOT, such expenses are the type of "consequential damages" that are not recoverable under the CEA.
Further, NYBOT claims that Klein & Co. acted solely as an agent for customers actually engaged in trading. Therefore, they should not be granted standing under the CEA. NYBOT supports its position on standing with a case from the Seventh Circuit. In American Agricultural Movement, Inc. v. Board of Trade of Chicago, 977 F.2d 1147, 1153 (7th Cir. 1992), the court held that "transactions" refers to exchange trades, and Section 22(b) grants standing only to traders harmed in the course of trading. According to NYBOT, the same standard should apply in this case.
Klein & Co. Futures, Inc. claims that the Second Circuit's holding that FCMs are not "engaged in transactions" is incorrect. Klein & Co. also argues that the plain meaning of the words "engaged" and "transactions" should apply because neither word is explicitly defined in the CEA. According to Klein & Co., FCMs would be granted standing if the plain meaning of the phrase "engaged in transactions" was applied. These transactions were clearly "on or subject to the rules of" a contract market, and therefore fall under the ambit of the CEA.
Klein & Co. contends that Federal Trade Commission v. Ken Roberts Co., 276 F.3d 583, 589 (D.C. Circ. 2002) supports standing because the court in that case gave exclusive jurisdiction to the Commodities Future Trade Commission over all transactions "involving contracts of sale of a commodity for future delivery, traded or executed on a contract market" by any board of trade or exchange. The term "transactions," as used in the statute, refers to activities reciprocally affecting or influencing each other. Therefore, the term should encompass arrangements directly related to a commodities future sale.
The Futures Industry agrees with Klein & Co. that its activities are sufficient to warrant standing under Section 22(b)(1) of the CEA. Further, the U.S. Department of Justice argues that granting standing to Klein & Co. would be consistent with Congressional intent to limit standing under 25(b)(1) to plaintiffs who have "engaged in" regular commodities trading.
The NYBOT and the NYCC agree with the Second Circuit that Klein should be denied standing because it does not satisfy the requirements for a private right of action under the CEA. They rebut Klein's assertion of standing by invoking the legislative history of Section 22. The legislative history cited by NYBOT and NYCC indicates that Congress enacted Section 22 to define the requirements for standing after the Supreme Court heard Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Curran, 456 U.S. 353, 388 (1982). In Merril Lynch the Court did not define standing under the CEA, and Section 22 was added to clarify the law.
Furthermore, NYBOT contends that "transactions" in 22(b) refer exclusively to exchange trades, i.e. "purchase or sale of futures contracts or options." Both Congress and executive agencies such as the Commodity Futures Trade Commission ("CFTC") use the word in this restrictive sense. Id. at 22-23. According to NYBOT's reading of the statute, Klein's reading of the word "transaction" is overly broad, and against the weight of precedent. .
NYBOT also rebuts Klein & Co.'s argument that their transactions were covered by the statute because they were subject to the rules of the contract market by looking past the plain language of the CEA and attempting to determine Congressional intent. NYBOT claims that the intent to exclude FCMs was clear because Congress did not reference the "rules of a clearing organization." This omission was relevant because Congress had mentioned "clearing organizations" just a few lines prior, and therefore would have mentioned them again if they had intended that they be covered by the statute.
is the latest in a long line of high-profile white-collar crime cases. White collar crime not only affects the parties to the case, but can also affect consumer and investor confidence, creating a chilling effect on the market resulting in higher prices or a drop in the value of commodities.
Klein & Co. argues that it should have standing on both statutory and policy grounds. Klein & Co. asserts that the Second Circuit improperly applied 7 U.S.C § 25(a)(1), instead of subsection 7 U.S.C § 25(b)(1). According to Klein & Co., FCMs meet the criteria of §25(b)(1) because they engage in transactions subject to board rules, which require that all traders of futures and options use FCMs to execute transactions, and require FCMs to bear financial liabilities for their customers.
The Board of Trade of the City of New York argues that FCMs such as Klein & Co. were not the intended beneficiaries of the statute. The court should limit standing to buyers and sellers, not FCMs. The Board of Trade supports its argument with the legislative history of 7 U.S.C § 25.
The Futures Industry Association asserts that a decision against Klein & Co. threatens to destabilize FCMs, whose capital provides the financial backbone for the futures industry. If FCMs like Klein & Co. cannot recover their losses, this will create a disincentive for these FCMs to finance the speculation and risk taking upon which the futures markets depend. The FCMs would then be forced to either raise prices to cover their losses or to scale back their participation in the market. Financial insecurity of the FCMs could create greater variations within the futures market.
A decision for Klein & Co. would increase the accountability of boards of trade. This would incentivize greater policing of settlement committees and faster action against violations of trading regulations. According to the Brief for Klein & Co., if boards of trade are more proactive about these problems, traders and FCMs alike can feel more secure in their transactions. Instituting extra protection against white collar crimes such as price fixing increases trader confidence and, thus, increases trading.
A decision for the Board of Trade of the City of New York, on the other hand, would uphold a narrow reading of 7 U.S.C §25. Buyers and sellers would be granted standing to sue boards of trade, but FCMs would not. Expanding trade boards' liability, as Klein & Co. is requesting, would destroy trade boards' protective barriers to liability and subject them to millions of dollars of liability. The potential liability may not be an effective deterrent to illegal board activity because many boards may be unaware of fraud conducted by board or committee. Also, as the Board of Trade points out in its brief, the Commodity Futures Trading Commission is already in charge of policing price fixing and other futures market white collar crime.
The impact of this case is not limited to commodities and futures traders. The wide variety of valuable commodities traded on the futures market - including corn, gold, livestock, and oil - makes the market essential to many major U.S. industries, such as manufacturing and agriculture.
In Klein & Co. Futures, Inc. v. Board of Trade of the City of New York, the Supreme Court will settle differences in the statutory interpretation of the Commodity Exchange Act. A decision for Klein & Co. will provide futures commission merchants with a security net to recover losses resulting from fraudulent purchases or price manipulation. On the other hand, a decision for the Board of Trade of the City of New York will keep board members insulated from the possibility of a lawsuit and may cause initial margin amounts to skyrocket as future commission merchants seek other ways to finance their potential losses.