The CFTC has filed a complaint against Kraft and Mondelez Global, accusing the companies of manipulating the December, 2011 CBT Wheat Futures Contract. A few comments, based on what is laid out in the complaint (and therefore not on a full evaluation of all relevant facts and data):
A trader executes a market power manipulation (i.e., a corner or a squeeze) by taking excessive, and uneconomic, deliveries on a futures contract. This causes the calendar spread to increase, and the basis at locations where delivery does not (or cannot) occur to fall. The complaint alleges that Kraft took large deliveries. The relevant calendar spread (December-March) rose sharply, and according to Kraft emails cited in the complaint, the basis at Toledo declined. Thus, the facts in the CFTC complaint support a plausible allegation that Kraft and Mondelez executed a market power manipulation/corner/squeeze.
A cornerer takes uneconomic deliveries. That is, the deliveries taken are not the cheapest source of the physical commodity for the cornerer. The complaint does not provide sufficient detail to determine with precision whether this was the case here (but discovery will!), but it does include circumstantial evidence. Specifically, Kraft took delivery on the Mississippi, whereas it needed physical wheat at its mill in Toledo. Further, Kraft did not use most of the wheat it bought via delivery. Instead, it sold it, which is consistent with “burying the corpse.” In addition, given cash bids in Toledo and the futures price at which the defendants took delivery, it is highly likely that it was cheaper for Kraft to buy wheat delivered to its mill in Toledo than it was to take delivery (at an opportunity cost equal to the futures price) and pay load out and freight costs to move the wheat from the Mississippi to Toledo. Again, though, the complaint doesn’t provide direct evidence of this.
A cornerer liquidates a large fraction of its futures position: whereas it loses money on the deliveries it takes, it makes money by liquidating futures at a super competitive price. Kraft liquidated more than half its futures position. This provides further evidence that it did not establish its futures position as a means of securing the cheapest source of cash wheat, and is consistent with the execution of a corner/squeeze.
A processor hedging anticipated cash purchases doesn’t buy calendar spreads. The complaint quotes an email stating that Kraft did.
One clunker in the complaint is the allegation that Kraft’s actions “proximately caused cash wheat prices in Toledo to decline.” Market power manipulation when Toledo is not the cheapest to deliver location (as was evidently the case here, as deliveries did not occur in Toledo) would be expected to reduce the Toledo basis (i.e., the difference between the Toledo cash price and the December futures price), and there is some evidence in the complaint that this occurred. But this is different from causing the flat price of wheat to decline, which is what the CFTC alleges. Any coherent theory of market power manipulation implies that a corner or squeeze would increase, or at least not reduce, the cash price at locations where delivery does not occur, but that the rise in the cash price at these locations is smaller than the rise in the futures price (and in the cash price at the delivery location). This results in a compression of the basis, but a rise (or non-decline) in flat prices.
In sum, the complaint presents a plausible case that Kraft-Mondelez executed a market power manipulation.
But the CFTC doesn’t come out and allege a corner, squeeze, or market power manipulation: these words are totally absent. Instead, the agency relies on its shiny new anti-manipulation authority conferred by Frankendodd under section 6(c)(1) of the Commodity Exchange Act, and CFTC Rule 180.1 that it adopted to implement this authority. This is essentially a Xerox of the SEC’s Rule 10b-5, and proscribes the employment of any “deceptive or manipulative device.” That is, this is basically an anti-fraud rule that has nothing to do with market power and therefore it is ill-adapted to reaching the exercise of market power.
The CFTC no doubt is doing this because under 6(c)(1) and Rule 180.1 the CFTC has a lower burden of proof than under its pre-Frankendodd anti-manipulation authority. Specifically, it does not have to show that Kraft-Mondelez had specific intent to manipulate the market, as was the case prior to Dodd-Frank. Instead, “recklessness” suffices. Further, it does not have to demonstrate that the price of wheat was artificial. In my view, the straightforward application of economics permits determination of both specific intent and price artificiality, but earlier decisions like Indiana Farm and in re Cox make it difficult to for the CFTC to do so. Or at least that’s what CFTC believes.
Although I understand the CFTC’s choice, it has jumped from the frying pan into the fire. Why? Well, to mix metaphors, there is a square peg-round hole problem. As I’ve been shouting about for years, fraud-based manipulations and market power manipulations are very different, and using a statute that targets fraudulent (“deceptive”) actions to prosecute a market power manipulation is likely to end in tears because the legal concept does not fit the allegedly manipulative conduct. The DOJ learned this to its dismay in the Radley case (which grew out of the BP propane corner in 2004). Even though BP executed a garden variety corner, the DOJ alleged that the company engaged in a massive fraud. Judge Miller found this entirely unpersuasive, and shot down the DOJ in flames. The CFTC risks the exact same outcome. Tellingly, it asserts in a conclusory fashion that Kraft-Mondelez employed a “deceptive or manipulative contrivance” but doesn’t say: (a) what that device was, (b) how Kraft’s taking of a large number of deliveries deceived anyone, (c) who was deceived, and (d) how the deception affected prices.
It will be interesting to see what happens going forward. The CFTC is obviously using this as a test case of its new authority. Perhaps it thinks it is being crafty (or would that be Krafty?) but I fear that by using a law and rule targeted against fraudulent conduct to prosecute a market power manipulation, the agency will just be finding a new way to screw up manipulation law, thereby undermining, rather than strengthening, deterrence of market power manipulation.
