When does driving a hard bargain with your suppliers cross the line into market manipulation?
Any company that requires raw goods, and relies on the commodities futures markets to procure those materials or hedge against price increases, should take heed of a recent enforcement action the Commodity Futures Trading Commission took against Kraft Foods Group and Mondelez Global. The surprise that makes the case notable, and perhaps alarming for companies, is that the CFTC based its action on a section of the Dodd-Frank Act believed by many to be a check against market manipulation by high-frequency traders—not something an end-user like Kraft would ever need to worry about.
“The case against Kraft-Mondelez shows that the new Dodd-Frank anti-manipulation rules are broad and cover both users and traders,” says Braden Perry, a former senior trial attorney at the CFTC now at the law firm Kennyhertz Perry. “Users are given special trading privileges, but this case shows that those privileges only go so far, and the alleged conduct crosses from hedging to price manipulation. The message is clear, that end users are subject to the same standards as traders when it comes to manipulative behavior, and the broad, fraud-based language covers both users and nonusers alike.”
The CFTC filed its civil enforcement complaint against Kraft and Mondelez on April 1, accusing the two of manipulation and attempted manipulation of the prices of wheat futures. Also added was an allegation that the companies violated speculative position limits established by the CFTC and the Chicago Board of Trade “without a valid hedge exemption or a bona fide hedging need.”
The CFTC is asking a federal district court judge in Chicago to direct Kraft to pay either a civil monetary penalty of triple the monetary gain resulting from the violations, or $1 million for each violation, and to order the company to disgorge all benefits derived from its actions.
“The case against Kraft-Mondelez shows that the new Dodd-Frank anti-manipulation rules are broad and cover both users and traders.”
Braden Perry, Former Senior Trial Attorney, CFTC
According to the CFTC, in response to high wheat prices in 2011, Kraft devised a strategy to buy $90 million of wheat futures (roughly a six-month supply). Kraft uses about 30 million bushels of wheat per year, purchases it on a daily basis throughout the year to ensure it always has sufficient supply, and strives to maintain at least a two-month supply in its inventory. (Mondelez, spun off from Kraft in 2012, is the company’s global snack and food brand.)
Kraft never intended to take delivery of the wheat, the complaint says; rather, it expected that the market would react to its “enormous long position” by lowering cash wheat prices and widening the spread between December 2011 and March 2012 wheat futures. That’s exactly what happened, and Kraft (and by extension the soon-to-be independent Mondelez) reaped more than $5.4 million in profits.
The CFTC claims that Kraft had no intention “of loading out, delivering, and using the majority of the wheat it stood to acquire.” As evidence, it cites an internal e-mail to Kraft’s CFO and other senior management: “We anticipate the futures curve will begin to flatten, reducing the profitability of wheat storage, thereby reducing the commercial wheat basis to Kraft. We will then have the option of redelivering the wheat acquired through the futures market. This will then quickly reverse the negative cash flow impact.”
At the heart of the case are changes to the Commodities Exchange Act required by Section 753 of the Dodd-Frank Act. That clause gives the CFTC more authority to prosecute manipulation by allowing a standard of “recklessness,” and it reinforced the agency’s authority to ban the manipulation of prices even in the absence of fraud.
KRAFT AND POSITION LIMITS
The following, an excerpt from the Commodity Futures Trading Commission’s complaint against Kraft Foods Group and Mondelez Global, details its claim that rules pertaining to speculative position limits were violated.
During the relevant time, the Commission specified the position limit levels for wheat futures. It published those levels in [2011 regulations] which provided that no person may hold or control a net long or net short position for the purchase or sale of wheat for future delivery traded on the Chicago Board of Trade in excess of 600 contracts in the spot month, or in excess of 5,000 contracts for any single contract month or 6,500 contracts for all months combined. These position limits are intended to protect the futures market from excessive speculation that could cause unreasonable or unwarranted price fluctuations.
Traders who are bona fide hedgers – such as producers or end-users of particular commodities, like Kraft – can apply for exemptions to speculative position limits based on a demonstration of bona fide hedging needs. Requests for hedge exemptions from exchange limits must be submitted to CME Group, which reviews the requests and, if approved, issues a letter setting out the specific additional limit it has approved for the entity. Hedge exemptions are valid for one calendar year and are renewable only through the submission of another application to the CME.
As a commercial end user of flour, Kraft is eligible to seek a hedge exemption to cover its wheat needs. In October 2010, Kraft submitted such an application to the CME. On Oct. 22, 2010, it received an exemption approval letter, permitting it to maintain wheat positions in excess of the speculative position limit, effective Dec. 1, 2010. The exemption approval letter noted that “positions in the last five days of trading of any futures contract may not exceed Kraft Foods, Inc.’s unfilled anticipated requirements of the same cash commodity for that month and the next succeeding month.”
The exemption approval specifically noted that exemptions must be renewed on an annual basis and that any application by Kraft to renew its exemption must be submitted to the CME by no later than Dec. 1, 2011.
Kraft did not submit a request for renewal of its hedge exemption until Dec. 28, 2011. Consequently, beginning on Dec. 2, Kraft no longer had a CME hedge exemption for the December 2011 wheat contract and it was bound by the 600 contract speculative position limit in that commodity.
“Most would have thought enforcement would have been directed at high-frequency traders and not actual users of commodities like Kraft,” says Steve Quinlivan of the law firm Stinson, Leonard and Street. He says the case is groundbreaking because it targeted a corporate end-user rather than a trader.
In a client advisory, Gary DeWaal, special counsel for the law firm Katten Muchin Rosenman, warned of the broad application of the Dodd-Frank’s anti-manipulation rule. The rule “is extraordinarily broad and provides little guidance as to what is precisely prohibited activity,” he says. The ban against using or employing “any manipulative device,” seems “limited on its face to activities to defraud,” he said. “It is not clear whom the respondents [Kraft] were endeavoring to defraud.”
Perry points out another aspect to the case that may worry companies that use commodity futures to hedge pricing. Given the size and global scope of Kraft and Mondelez, a $5 million savings is small potatoes when alleging fraud; even treble damages would still be minimal for the company. So why bargain with the CFTC for a settlement for so long, when Kraft could just as well have paid a few million and be done with it?
A Kraft spokesperson, citing pending litigation, declined to elaborate on the matter, but did say that: “At this time, we believe that any fine issued by a court, or the result of any settlement agreement, will not be material to investors.”
In a Form 8-K filing to the SEC on April 1, Kraft noted that the CFTC’s investigation was initiated in April 2013. In October 2014, the company was advised that the Commission intended to proceed with a formal action. Any fine would be borne by Kraft Foods Group in accordance with the 2012 spin-off agreement that created Mondelez.
By applying a rule intended for high-frequency traders to end users, the CFTC has given companies a lot to worry about, Quinlivan says, especially when they try to pressure suppliers with threats of taking their buying power elsewhere. Unfortunately for Kraft, the scope of its operation ensured that any such bluff would have broader market repercussions. “People thought you could drive a hard bargain with your vendors,” he says. “That’s what Kraft thought it was doing. When one vendor lowered its price it went with that vendor, a basic business negotiation tactic.”
Given the newness of this enforcement approach, “it’s hard to predict what would be ordinary and what is market manipulation in the eyes of the CFTC,” he adds. “I guess that means you are entitled to keep you intentions to yourself, but can’t mislead others as to those intentions. It is not clear, however, how Kraft did that other than for the traders who were trying to read tea leaves.”
The CFTC’s action could “result in regulation by hindsight,” Quinlivan says. “You enter into one transaction, the market perceives it one way, but it turns out that another transaction is ultimately more in your favor, so you go with that one and unwind the first,” he says. “Is everybody then going to be accused of, ‘You should have known it would happen,’ or that they were reckless in not knowing?”
His advice: Companies must avoid entering into transactions far in excess of their usual commercial needs. “The biggest thing going against Kraft was the size of the transaction. Hopefully ordinary hedging transactions don’t end up in the crosshairs of the CFTC, but here the sheer volume of the transactions led to a claim of price manipulation.”
The second standard: Don’t do anything where you believe you might be fooling market participants. “Every time you make a trade, you have to be asking yourself how this could affect other market participants and be considered manipulation,” Quinlivan says.