UNITED STATES OF AMERICA
COMMODITY FUTURES TRADING COMMISSION
|In the Matter of:||)||CFTC Docket No. 97-3|
|SOUTHERN THUMB CO-OP, INC.,||)|
ORDER MAKING FINDINGS AND IMPOSING REMEDIAL SANCTIONS
On November 13, 1996, the Commodity Futures Trading Commission ("Commission") filed a Complaint and Notice of Hearing (Complaint") against Southern Thumb Co-op, Inc. ("Southern Thumb"). The Complaint charges that Southern Thumb violated Section 4c(b) of the Commodity Exchange Act, as amended (the "Act"), 7 U.S.C. § 6c(b), and Commission Regulations 32.2 and 33.10, 17 C.F.R. §§ 32.2 and 33.10 (1998).
In order to dispose of the allegations and issues raised in the Complaint, Southern Thumb has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Without admitting or denying any of the allegations of the Complaint or the findings herein, Southern Thumb acknowledges service of this Order Making Finding and Imposing
Remedial Sanctions ("Order"). Southern Thumb consents to the use of the findings contained in this Order in this proceeding and in any other proceeding brought by the Commission or to which the Commission is a party.1
The Commission finds that:
From at least November 1993 through November 1996, Southern Thumb, a Michigan grain elevator, offered to farmers various grain contracts that operated as, and in fact were, off-exchange agricultural option contracts, in violation of Section 4c(b) of the Act and Regulation 32.2.2 Specifically, Southern Thumb's Option Offer and Mini-Max Contracts operated as, and in fact were, off-exchange agricultural call option contracts, and its Floor Price Contract operated as, and in fact was, an off-exchange agricultural put option contract. Southern Thumb fraudulently marketed the contracts by recklessly misrepresenting the risks involved in entering and using these contracts in violation of Section 4c(b) of the Act and Regulation 33.10.
Southern Thumb Co-op, Inc. is a Michigan corporation headquartered at 155 South Saginaw Street, Lapeer, Michigan 48446. Southern Thumb filed for Chapter 11 bankruptcy on January 2, 1997, and has ceased doing business as a grain elevator. While in operation, Southern Thumb operated elevators in Lapeer, Marlette, Richmond, Yale, and Imlay City, Michigan. Southern Thumb, among other business activities, bought grain from local farmers (also referred to as producers, patrons or customers) and sold grain to end users such as grain processors. Southern Thumb has never been registered in any capacity with the Commission.
1. Southern Thumb's Contracts
From at least November, 1993 through November 1996, Southern Thumb operated an Alternative Marketing Program which offered farmers Hedge-to-Arrive and Flex Hedge-to-Arrive ("HTA"), Option Offer, Floor Price and Mini-Max contracts.3
a. The Option Offer Contract
Under Southern Thumb's Option Offer contract, producers sold call options to the elevator. The Option Offer contracts were often offered in conjunction with HTAs. The elevator presented the call options in the Option Offer contract as a way for farmers to receive higher prices for their grain. Southern Thumb paid farmers a premium, or enhanced price, for Southern Thumb's right to purchase the bushel amount of grain stated on the Option Offer contract and added the premium to the producers' HTA prices. The bushel amounts stated on the Option Offer contract were often for two times the amount of grain stated on the HTA.
Southern Thumb was not obligated to buy and, conversely, the producers were not obligated to deliver the additional grain under the Option Offer contract, unless and until Southern Thumb exercised its rights. If the elevator did not exercise its rights, but instead let the call options in the Option Offer contract expire, producers did not have an obligation to deliver the grain.
Southern Thumb generally sold exchange-traded call options in the elevator's trading account for each call option in the producers' Option Offer contract. The expiration months, strike prices and premiums on the producers' Option Offer contracts corresponded to exchange parameters. When the exchange-traded call options were exercised against Southern Thumb, Southern Thumb exercised the call options in the Option Offer contract against the producers and wrote additional HTA contracts, obligating producers to deliver the amount of grain stated in the Option Offer contracts. The initial HTA remained in effect if it had not already been fulfilled. Southern Thumb's exercise of the call options in the Option Offer contract resulted in the multiplication of producers' delivery obligations to the elevator.
Southern Thumb did not adequately inform producers who had entered into the call options in the Option Offer contracts that the call options could be exercised against them, and that the exercise of the call options would result in additional delivery obligations. In many instances, producers' delivery obligations exceeded their annual grain productions.
b. The Mini-Max Contract
Under Southern Thumb's Mini-Max contract, producers sold call options in order to generate premiums to help them pay the premiums for the purchase of long put or long call options. In one form of the Mini-Max contract, Southern Thumb had the producer sell or attach short call options for bushel amounts which exceeded the bushel amounts in the Mini-Max or which exceeded the bushel amounts specified in the long put or long call component of the Mini-Max contract ("excess short call options"). When Southern Thumb exercised the excess short call options in the Mini-Max contract, the elevator created new obligations for producers to deliver additional grain under new HTA contracts, in a similar fashion to the Option Offer contract. As with the Option Offer contract, Southern Thumb did not adequately inform producers who had entered into call options in the Mini-Max contracts that the call options could be exercised against them, and that the exercise of the call options would result in additional delivery obligations. Producers against whom the excess Mini-Max short call options were exercised often did not have sufficient grain to deliver under the resulting HTAs.
c. The Floor Price Contract
Under Southern Thumb's Floor Price contract, producers paid premiums to Southern Thumb for the producers' right to sell, or "put," grain to the elevator at the price stated on the Floor Price contract. The producers' rights to sell the grain to Southern Thumb expired on the date stated on the contract. Southern Thumb presented the put options in the Floor Price contract as a way for farmers to establish a floor for their grain prices. The expiration months, strike prices and premiums on the producers' put option contracts generally corresponded to exchange parameters.
If a producer chose to exercise the put options in his Floor Price contract, the producer could deliver the grain to Southern Thumb at the strike price and expiration month listed on the Floor Price contract. However, producers could let the Floor Price contract expire and purchase additional put options with later expiration dates, or deliver the grain elsewhere. The premiums for the put options in the Floor Price contract, as well as other fees for the Floor Price contract, were debited from the producers' grain prices regardless of whether the producers exercised their rights under the Floor Price contract.
Southern Thumb offered the Floor Price contracts as a way for producers to establish a "floor," or minimum price, for their grain. However, Southern Thumb failed to adequately inform producers that once the put options in the Floor Price contract expired, the producers would have to purchase additional put options with later expiration dates in order to maintain the price protection. The premiums and fees for these additional puts were debited from the producers' grain prices as well.
2. The Events of 1995 and 1996
In late 1995 and early 1996, grain prices rose sharply. The market became inverted in February 1996, so that prices in nearby (old crop) contract months were higher than prices in the deferred (new crop) months. As grain prices rose, Southern Thumb's exchange-traded short call options, which the elevator had entered into for each short call option in the producers' Option Offer and Mini-Max contracts, were exercised against the elevator. This caused Southern Thumb to carry additional short futures positions in rising markets, and exposed Southern Thumb to larger margin requirements than in past years. Southern Thumb, in turn, exercised the call options in the Option Offer and Mini-Max contracts against the producers. Many producers did not have the additional grain to deliver under the exercised call options and, therefore, rolled their delivery obligations forward to later delivery months or crop years.
However, Southern Thumb did not adequately inform the producers of the likelihood of the calls being exercised and did not adequately inform producers of the effect the inverted market would have on the producers' delivery prices. Each roll in an inverted market reduced the producer's contract price by the dollar amount of the spread between the two contract months. The producers remained obligated to deliver the grain at lower prices as a result of a drop in prices in the inverted market.
When the 1995 HTA contracts that resulted from the exercise of short call options were rolled in the inverted market from month to month into the next crop year, producers suffered severe financial losses that would be deducted from the value of future production. Southern Thumb then recommended to producers that they purchase put options in Floor Price contracts to lock in a minimum price for their grain. However, Southern Thumb deducted the Floor Price contract put option premiums from the producers' grain prices, further reducing producers' grain prices. This chain of events created severe financial difficulties for certain of Southern Thumb's producers, who received less than their production costs for their crops and were required to settle their obligations by incurring debt or making cash payments.
D. VIOLATIONS OF THE ACT AND COMMISSION REGULATIONS
Southern Thumb Violated Section 4c(b) of the Act, and Regulation
By Entering Into Off-Exchange Agricultural Options
Section 4c(b) of the Act, 7 U.S.C. § 6c(b), and Regulation 32.2, 17 C.F.R. § 32.2 (1998), prohibit the short call options offered by Southern Thumb in its Option Offer and Mini-Max contracts and the long put options offered by Southern Thumb in its Floor Price contract. Section 4c(b) of the Act provides that "no person shall offer to enter into, enter into or confirm the execution of, any transaction involving any commodity regulated under this Act which is of the character of, or is commonly known to the trade as, an `option,'. . . contrary to any rule, regulation, or order of the Commission prohibiting any such transaction . . . ." Except when such transaction is undertaken on a designated contract market pursuant to Part 33 of the Commission's Regulations, 17 C.F.R. Part 33 (1998):
No person may offer to enter into, confirm the execution of, or maintain a position in, any transaction in interstate commerce involving wheat,. . . corn . . .[or] soybeans . . . if the transaction is or is held out to be of the character of, or is commonly known to the trade as, an "option". . . "put", [or] "call". . . .
17 C.F.R. § 32.2. Southern Thumb's short calls and long puts with certain producers violated these prescriptions.
A commodity option "confers upon the holder the right to buy . . . or to sell . . . either a specified amount of a commodity or a futures contract for that amount of a commodity within a certain period of time at a given price." CFTC v. U.S. Metals Depository Co., 468 F. Supp. 1149, 1154-55 (S.D.N.Y 1979); CFTC v. Crown Colony Commodity Options, Ltd., 434 F. Supp. 911, 913-14 (S.D.N.Y. 1977).4
Southern Thumb's Alternative Marketing Program offered the opportunity for producers to engage in several types of contracts, such as the Option Offer and Mini-Max contract, that included option components or option features that had the potential to create, and did create additional delivery contracts when exercised. Southern Thumb's Option Offer and Mini-Max contracts had all the characteristics of commodity options. British American Commodity Options Corp. v. Bagley, 552 F.2d 482 (2nd Cir. 1977), cert. denied, 434 U.S. 938 (1977).
The Commission's Office of General Counsel ("OGC") and Division of Economic Analysis ("DEA") have recognized that certain types of forward contracts having option characteristics are not considered prohibited option transactions. "Characteristics Distinguishing Cash and Forward Contracts and `Trade' Options," [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 22,718 at 31,028 (OGC Sept. 30, 1985) ("1985 Interp.") and DEA Interpretative Letter 96-23, "Request for Guidance Regarding Producer Option Contract" [1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 26,646 (March 14, 1996). However, the fact that Southern Thumb's contracts could and did create additional delivery obligations distinguishes these contracts from the examples of permissible forward contracts recognized in these interpretative letters.
Southern Thumb's Option Offer, Mini-Max and Floor Price contracts also did not have the kind of relationship to "actual delivery . . . in normal marketing channels" that would cause them to be viewed as an integral part of an exempt forward contract because the call and put options in Southern Thumb's contracts could be severed or marketed separately from the initial HTAs or underlying Mini-Max contracts, particularly from the delivery requirements of the initial HTA or underlying Mini-Max contracts. See 1985 Interp. at 31,030-31. In contrast to the two types of contracts discussed in the 1985 Interp., Southern Thumb's contracts could expire and did not typically result in delivery of grain the Southern Thumb. Exercise of the call options in Southern Thumb's Option Offer and Mini-Max contracts resulted in the creation of entirely separate and additional delivery obligations whether or not farmers had deliverable grain and whether or not delivery had been made on the initial HTAs or Mini-Max contracts. The put options in Southern Thumb's Floor Price contracts could be allowed to expire without delivery to Southern Thumb and producers could either purchase new puts with later expiration dates and different strike prices or deliver the grain elsewhere. Thus, Southern Thumb's call and put options were severable from the HTA delivery obligations.
Southern Thumb Violated Section 4c(b) of the Act and
Regulation 33.10 by Fraudulently Offering and Entering
Into Agricultural Options Contracts With Farmers
Section 4c(b) of the Act and Commission Regulation 33.10 prohibit fraud in connection with commodity option transactions. Proof of scienter is required to establish commodity option fraud. In re Staryk, [1996-1998 Transfer Binder], Comm. Fut. L. Rep. (CCH) ¶ 27,206 at 45,810 (CFTC Dec.18, 1997) (solicitation fraud involving options). That is, a finding of fraud requires that the wrongful acts "were committed intentionally or with reckless disregard to [a respondent's] duties under the Act." Hammond v. Smith Barney, Harris Upham & Co., [1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 24,617 at 36,659 and n.21 (CFTC Mar. 1, 1990). In general, all manner of omissions and misrepresentations of material fact regarding futures transactions violate the antifraud provisions of the Act, including omissions and misrepresentations concerning the likelihood of profit, the risk of loss, and other matters that a reasonable investor would consider material to his investment decisions. See, e.g., Clayton Brokerage Co. v. CFTC, 794 F.2d 573, 580 (11th Cir. 1986) (per curiam); First National Monetary Corp. v. Weinberger, 819 F.2d 1334, 1340 (6th Cir. 1987) (misrepresentations concerning the nature of risk violate the anti-fraud provisions of the Act); Chicoine v. Rosenthal & Co., [1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 21,075 (CFTC July 2, 1980), aff'd, Myron v. Chicoine, 678 F.2d 727 (7th Cir. 1982) (statements that options transactions are low-risk, high-yield investments constitute fraud).
Southern Thumb and its employees defrauded producers in connection with producers' sale of call options in the Option Offer and Mini-Max contracts by failing to inform producers adequately of the risks in such transactions. Southern Thumb failed to inform producers adequately that exercise of the call options would result in additional delivery obligations even after the producers satisfied their delivery obligations under the initial HTAs or underlying Mini-Max contracts. Southern Thumb also failed to inform producers adequately of the likelihood of such exercise in an inverted market and the effect the inverted market would have on the producers' delivery prices.
Southern Thumb and its employees defrauded producers in connection with the producers' sale of put options in the Floor Price contracts by misrepresenting the usefulness and costs of the contracts, and by failing to inform producers adequately of the risks in such transactions. Southern Thumb offered put options which expired in May, even though it was aware that the producers did not have sufficient grain to deliver under the Floor Price contracts in May. Southern Thumb then failed to inform producers that the price protection the put options offered in the Floor Price contract would expire in May and that producers would have to purchase additional put options with later expiration dates in order to maintain their price protection. The purchase of the additional put options resulted in additional premiums and fees, further reducing the producers' ultimate delivery prices.
OFFER OF SETTLEMENT
Southern Thumb has submitted an Offer in which, without admitting or denying the findings herein, it:
1. Admits the jurisdiction of the Commission with respect to all matters set forth in the Complaint and this Order;
2. Waives all post-hearing procedures; judicial review by any court; any objection to the staff's participation in the Commission's consideration of this Offer; any claim of Double Jeopardy based upon the institution of this proceeding or the entry in this proceeding of any order imposing a civil monetary penalty or any other relief; and all claims which it may possess under the Equal Access to Justice Act, 5 U.S.C. § 504 (1994) and 28 U.S.C. § 2412 (1994), as amended by Pub. L. No. 104-121, §§ 231-232, 110 Stat. 862-863, and Part 148 of the Regulations, 17 C.F.R. §§ 148.1 et seq. (1998), relating to, or arising from, this action, and it shall not assert any right under the Equal Access to Justice Act to seek costs, fees, or other expenses relating to, or arising from, this proceeding;
3. Stipulates that the record basis on which this Order is entered consists solely of the Complaint, this Order and findings to which it has consented in the Offer, which are incorporated in this Order; and
4. Consents to the Commission's issuance of this Order which makes findings and:
a. Orders Southern Thumb to cease and desist from violating the provisions of the Act that it is found to have violated;
b. Orders Southern Thumb to comply with its undertakings set forth below; and
c. Recognizes the appropriateness of restitution to producers of damages proximately caused by Southern Thumb's violations and a civil monetary penalty, but waives restitution and a civil monetary penalty based upon Southern Thumb's financial condition as represented in the verified bankruptcy petition and other financial statements it filed in bankruptcy.
FINDINGS OF VIOLATION
Solely on the basis of the consent evidenced by the Offer, and prior to any adjudication on the merits by the Commission, the Commission finds that from at least November 1993 through November 1996, Southern Thumb violated Section 4c(b) (1994), and Commission Regulations 32.2 and 33.10, 17 C.F.R. §§ 32.2 and 33.10 (1998).
Accordingly, IT IS HEREBY ORDERED THAT:
1. Southern Thumb shall cease and desist from violating Section 4c(b) of the Act, 7 U.S.C. § 6c(b) (1994) and Commission Regulations 32.2 and 33.10, 17 C.F.R §§ 32.2 and 33.10 (1998); and
2. Southern Thumb shall comply with the following undertakings:
a. Should Southern Thumb resume business as a grain elevator or grain marketer of any kind, under the name Southern Thumb or any other name, it shall retain a compliance consultant who shall review all new proposed types of grain contracts and any type of contract involving option features it plans to offer to producers for the legality of such contracts under the Act and Commission Regulations.
b. Neither Southern Thumb nor any of its agents or employees under its authority or control shall take any action or make any public statement denying, directly or indirectly, any allegation in the complaint or findings or conclusions in the Order, or creating or tending to create, the impression that the complaint or the Order is without a factual basis; provided, however, that nothing in this provision shall affect Southern Thumb's (i) testimonial obligations; or (ii) right to take legal positions in other proceedings to which the Commission is not a party. Southern Thumb will undertake all steps necessary to assure that all of its agents and its employees understand and comply with this agreement.
3. The Commission recognizes that restitution to producers of damages proximately caused by Southern Thumb's violations and a civil monetary penalty would be appropriate in this case, but waives restitution and a civil monetary penalty based upon Southern Thumb's financial condition. Southern Thumb acknowledges that the Commission's acceptance of this Offer is conditioned upon the accuracy and completeness of the verified bankruptcy petition and other financial statements it filed in bankruptcy. Southern Thumb consents that if at any time following the entry of the Order, the Division of Enforcement obtains information indicating that Southern Thumb's representations concerning its financial condition were fraudulent, misleading, inaccurate, or incomplete in any material respect at the time they were made, the Division of Enforcement may, at any time following entry of the Order, petition the Commission to: (1) reopen this matter to consider whether Southern Thumb provided accurate and complete financial information at the time such representations were made; (2) determine the amount of civil monetary penalty and restitution to be imposed; and (3) seek additional remedies that the Commission would be authorized to impose in this proceeding if Southern Thumb's offer had not been accepted. No other issues shall be considered in connection with this petition other than whether the financial information provided by Southern Thumb was fraudulent, misleading, inaccurate, or incomplete in any material respect, the amount of civil monetary penalty and restitution to be imposed, and whether any additional remedies should be imposed. Southern Thumb may not, by way of defense to any such petition, contest the validity of, or findings in, the Order, contest the allegations of the Complaint or assert that payment of a civil monetary penalty should not be ordered.
Unless otherwise specified, the provisions of this Order shall be effective on this date.
|By the Commission|
|Dated: October 7, 1999||Jean A. Webb|
|Secretary of the Commission|
|Commodity Futures Trading Commission|
Click here for: Abstention of Commissioner Barbara Pedersen Holum Offer of Settlement by Southern Thumb
1 Southern Thumb does not consent to the use of the Offer or this Order, or the findings consented to in the Offer, as the sole basis for any other proceeding brought by the Commission other than in a proceeding to enforce the terms of this Order, nor does it consent to the use of the Offer or this Order, or the findings in the Order consented to in the Offer, by any other person or entity in this or any other proceeding, including any proceeding to enforce or reopen any settlement agreement arising from the contracts referenced in the Order. The findings made in the Order are not binding on any other person or entity in any other proceeding.
2 The Commission does not express any opinion on the question of what obligations, if any, may exist and be enforceable as between the parties to any particular contract, including settlement agreements arising therefrom. The Commission views those issues as possibly affected by factors outside of the issues it addresses in this Order. The Commission takes no position on the relative equities between the parties to any particular contract.
3 HTAs are contracts which require delivery of grain on or before a specified date in the future and which usually base the price of the producers' grain on (1) the price of grain as reflected on the Chicago Board of Trade ("CBOT") (the futures reference price) and (2) basis, which is the difference between the futures reference price and the local cash price. The futures reference price component of the contract is set at the time the contract is made. The final contract price is usually set at the time the grain is delivered. The Commission notes that this Order relates solely to Southern Thumb's Option Offer, Mini-Max and Floor Price contracts and the contracts that resulted therefrom, and do not address Southern Thumb's use of HTAs generally. Southern Thumb's HTAs could be "rolled," allowing the HTA holder to defer delivery to later months. When producers rolled their HTAs, Southern Thumb offset its corresponding futures position and reestablished them at current futures prices in later months. Resulting accumulated gains and losses were then credited or debited to the final price that producers would receive on the HTAs.
4 The option buyer pays a premium for the right, but not the obligation, to exercise the option. Precious Metals Assoc. v. CFTC, 620 F.2d 900, 907 (1st Cir. 1980) (citation omitted). The seller of the options is obligated to perform by selling or buying the agricultural commodity or assuming a short or long futures position only if the option is exercised. "Characteristics Distinguishing Cash and Forward Contracts and `Trade' Options," [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 22,718 at 31,028 (Office of General Counsel of the CFTC Sept. 30, 1985).