UNITED STATES OF AMERICA
COMMODITY FUTURES TRADING COMMISSION
___________________________________ ) In the Matter of) ) FENCHURCH CAPITAL MANAGEMENT, LTD.,)CFTC DOCKET No. ) )ORDER INSTITUTING )PROCEEDINGS PURSUANT TO )SECTIONS 6(c), 6(d) AND )8(a) OF THE )COMMODITY EXCHANGE ACT )AS AMENDED AND FINDINGS )AND ORDER IMPOSING )REMEDIAL SANCTIONS Respondent.) ___________________________________)
The Commodity Futures Trading Commission ("Commission") has reason to believe that Fenchurch Capital Management, Ltd. ("Fenchurch") has violated Sections 6(c) and
9(a)(2) of the Commodity Exchange Act, as amended ("Act"), 7 U.S.C. 9 and 13(a)(2). The Commission, therefore, deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted to determine whether Fenchurch engaged in the violations as set forth in this Order and to determine whether any order should be issued imposing remedial sanctions.
In anticipation of the institution of these administrative proceedings, Fenchurch has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Without admitting or denying the findings in this Order, Fenchurch acknowledges service of this Order Instituting Proceedings Pursuant to Sections 6(c), 6(d) and 8(a) of the Commodity Exchange Act and Findings and Order Imposing Remedial Sanctions ("Order"). Fenchurch 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.
The Commission finds the following:
Fenchurch is a Delaware corporation and maintains its offices at 311 S. Wacker Drive, Suite 4825, Chicago, Illinois, 60606. Fenchurch is, and was at all times relevant to this matter, registered with the Commission as a commodity trading advisor and commodity pool operator, pursuant to Sections 4m and 4n of the Act, 7 U.S.C. 6m and 6n. Its principal business is to provide trading advice to two commodity pools. Fenchurch trades extensively in the U.S. government securities cash and futures markets, has held large positions in government securities futures contracts as part of arbitrage positions, and has taken large deliveries on several futures contracts.
In June 1993, Fenchurch stood for delivery on a large futures position on the June 1993 Ten Year U.S. Treasury Note futures contract ("June contract") traded on the Chicago Board of Trade ("CBT"). During the last four business days of the delivery period and after the last trading day on the June contract, Fenchurch intentionally gained and maintained control over a dominant portion of the available supply of the cheapest-to-deliver Treasury notes on the June contract. Fenchurch increased its position in the issue through a series of repurchase ("repo") market transactions at a time when the notes were in tight supply as indicated by low repo rates for the notes that eventually reached 0% and lower. Fenchurch exacerbated the tightness in the supply of the cheapest-to-deliver notes by increasing its position and intentionally withholding the notes from the market. As a result, shorts on the futures contract were unable to obtain sufficient quantities of the notes and had to deliver a more valuable security without offsetting compensation. The funds advised by Fenchurch received approximately $480 million of the more valuable security on approximately one-third of the futures position, thus enhancing the value of the position.
Through its conduct, Fenchurch increased and thus manipulated upward the value of its position on the June contract by cornering the available supply of the cheapest-to-deliver notes in violation of Sections 6(c) and 9(a)(2) of the Act.
2.The June 1993 10 Year Note Contract
On June 21, 1993, the last day of trading on the June contract, Fenchurch stood for delivery on a long futures position of about 12,700 contracts. Fenchurch's position was 76% of the open interest on the June contract. At that time, the total open interest was the third largest to be satisfied by delivery in the history of the CBT 10 Year Note contract. The terms of the June contract allowed shorts to deliver any Treasury security in a basket of notes having certain maturity characteristics. Typically, one note in the basket becomes the cheapest-to-deliver based principally on coupon rates and times to maturity, and the price of the contract converges with the cash market value of the cheapest-to-deliver issue. Throughout the month of June 1993, the cheapest-to-deliver note on the June contract was the 8 1/2% February 15, 2000 United States Treasury Note ("8 1/2% note"). Thus, the settlement price of the June contract at expiration reflected the value of the 8 1/2% note in the cash market.
Shorts on the June contract could make delivery anytime during the delivery month, with the last delivery day being on June 30. Because long term interest rates were higher than short term rates in June 1993, it was most economical for the shorts to delay delivery until the last delivery day, if possible. When the notes are readily available in the market, acquisition and delivery of the notes occurs quickly and easily through use of the Federal wire. If there is no indication that the cheapest-to-deliver note is in tight supply, shorts generally prepare for delivery within a few days prior to the last delivery day.
Shorts who do not already own the security use the repo market rather than the cash market to acquire the particular security needed for delivery on a futures contract. If the shorts own the notes, they generally are financing the notes in the repo market and prepare for delivery by attempting to reacquire the notes lent in the repo market. The repo market is, therefore, the common source of supply of notes for delivery on government securities futures contracts.
The repo market functions as a collateralized borrowing market where participants may borrow money to finance the purchase of Treasury securities or borrow Treasury securities against funds in order to cover a short position in a particular security. A repo consists of a sale of Treasury securities for cash and the simultaneous execution of an agreement to repurchase the same Treasury securities at a future date. The counterparty to this transaction is deemed to have engaged in a "reverse repo," obtaining Treasury securities in exchange for cash. The repo agreement sets both the sale and the repurchase price. Embodied in this price is a negotiated interest rate ("the repo rate"), payable by the repo seller on the cash that the repo seller receives in the transaction.
3.Market Conditions After Expiration Of The June Contract
In June 1993, there were no signs that the cheapest-to- deliver note, the 8 1/2% note, was in short supply until Friday, June 25, when the repo rate for the 8 1/2% note began falling substantially below general collateral rates. Most transactions in the repo market are negotiated without regard to the securities to be used as collateral and are called general collateral agreements. Repo rates for general collateral agreements tend to be stable and trade at rates very close to the daily Federal funds rate. Repo rates for transactions involving a specific security fluctuate in response to the supply and demand for the specific security. When repo rates for a specific security fall significantly below general collateral rates, the rates indicate that the security is becoming scarce relative to the demand and thus has increased value because of its scarcity. Between June 25 and 29, the 8 1/2% notes traded at rates as low as 0% and eventually at negative rates, while general collateral traded at rates as high as 3.20%. Repo rates of 0% and below are unusual and indicate that the specific security is extremely scarce relative to the immediate demand.
Also on Friday, June 25, 1993, the next cheapest-to- deliver issue in the basket of notes deliverable on the June contract, the 8 7/8% May 15, 2000 Treasury Note ("8 7/8% note"), became more valuable to receive on delivery on the June contract. The difference in value of receiving the 8 7/8% note rather than the 8 1/2% note on delivery on the June contract was approximately 5/32 of a point, which was a significant difference.
As of June 25, Fenchurch was in a position to benefit from the developing scarcity of the 8 1/2% notes and the increased value of receiving the 8 7/8% notes on delivery. Fenchurch already held a sizable pre-existing position in the 8 1/2% note. In addition to its large futures position, Fenchurch also had entered into several repo transactions using the 8 1/2% note as collateral. When Fenchurch engaged in these transactions, the 8 1/2% note was trading at or near general collateral rates. In three transactions, Fenchurch lent $542 million of the 8 1/2% notes to a counterparty that agreed not to relend the notes in the repo market through June 30. In a transaction with the Federal Reserve Bank of New York ("Federal Reserve") on June 24, Fenchurch, through a primary dealer, used approximately $837 million of the 8 1/2% notes as collateral. The transaction with the Federal Reserve had an end date of July 1, 1993. As market participants generally know, the Federal Reserve does not relend collateral to the repo market. Thus, as of June 25, Fenchurch controlled approximately $1.4 billion of the 8 1/2% notes through cash and repo transactions and had committed to take delivery of approximately $1.3 billion in satisfaction of its long futures contracts.
4.Fenchurch's Repo Transactions Between June 25 and 29
With the developing scarcity of the 8 1/2% notes and the increasing value of receiving the 8 7/8% notes, Fenchurch proceeded to increase its position in the 8 1/2% notes to over $2 billion and withheld the notes from the markets. Fenchurch knew that if it acquired and maintained control over a dominant portion of the available supply of the 8 1/2% notes until delivery on June 30, shorts would have to deliver the more valuable 8 7/8% note on the June contract. Between June 25 and 29, Fenchurch borrowed the notes in the repo market at the increasingly low repo rates for the 8 1/2% notes and entered into overnight repo transactions with several counterparties using the 8 1/2% notes as collateral in exchange for funds at the higher general collateral rates. Fenchurch was lending funds at lower interest rates than were available in the repo market and correspondingly borrowing funds at interest rates higher than those at which it was lending funds. In negotiating each repo transaction, Fenchurch's repo trader ensured that the counterparty would not relend the notes to the repo market.
At the same time that Fenchurch was entering into new repo transactions in which it lent the 8 1/2% notes to counterparties who would not relend them to the market, Fenchurch was intentionally "failing" on various repo transactions, i.e., failing to return the notes to counterparties from whom it had borrowed them. By failing to return the notes, Fenchurch gave up the interest it would have received on the transactions. Several of the counterparties on the transactions in which Fenchurch failed to return the security were preparing to make delivery on the June contract.
In addition, on Monday, June 28, Fenchurch decided not to make available to the market approximately $837 million of the 8 1/2% note. As a result of the apparent scarcity of the 8 1/2% note, as indicated by the very low repo rates, and the pending futures delivery, the Federal Reserve asked Fenchurch, through its primary dealer, to substitute collateral for the approximately $837 million worth of the 8 1/2% note it had received as collateral from Fenchurch on June 24. Fenchurch agreed to make the substitution. Instead of making the 8 1/2% note available to the repo market and profiting from the extremely attractive repo rates for the 8 1/2% notes when the notes were returned, Fenchurch used $800 million of the notes as collateral for an overnight repo transaction with its parent company and paid general collateral rates. As Fenchurch knew, its parent, a foreign company located in London, rarely, if ever, participated in the U.S. repo markets. In fact, the parent did not relend the 8 1/2% notes to the repo market. Fenchurch provided the remaining $37 million to an entity it controlled, which could not relend the securities unless Fenchurch did the trade. That entity did not relend the 8 1/2% Notes in the repo market.
Through its activities in the repo market, Fenchurch gave up the opportunity to borrow money interest-free and instead paid general collateral rates. As a consequence of Fenchurch failing to return the 8 1/2% notes it was holding as collateral, Fenchurch also gave up interest payments it would have received from counterparties.
5.Deliveries on the June Contract
As a result of Fenchurch's activities in the repo market, Fenchurch withheld from the markets a dominant portion of the available supply of the 8 1/2% notes. The original issue of the 8 1/2% was approximately $10.7 billion. Because the note was an old issue, a significant percentage of the 8 1/2% notes was no longer actively traded. By June 1993, a portion of the notes had been stripped to create zero coupon notes, the notes were being used for municipal financing, and the notes were held by long term investors. The scarcity of 8 1/2% notes available for delivery on the June contract was indicated to all market participants by the very low repo rates for the notes on June 25, 28 and 29.
Fenchurch received approximately $480 million of the
8 7/8% Notes on approximately 4,800 contracts, or about one-third of its position. As a result of Fenchurch's actions in the repo market, Fenchurch increased substantially the value of its futures position, thus benefitting itself and the two pools it manages.
On June 30, once the delivery process on the June contract was completed and Fenchurch's restrictive conduct in the repo market ceased, the supply of 8 1/2% notes returned to normal levels and repo rates for the 8 1/2% note returned to levels at or near general collateral rates.
C.VIOLATIONS OF THE ACT
1.Respondent Fenchurch Violated Sections 6(c) And 9(a)(2) Of The Act
In pursuing the course of action set forth above, Fenchurch attempted to manipulate and did manipulate upward the value of Fenchurch's long futures position in the June contract by attempting to corner and cornering the available supply of the cheapest-to-deliver notes on the June contract in violation of Sections 6(c) and 9(a)(2) of the Act, 7 U.S.C. 9 and 13(a)(2).
As the United States Court of Appeals for the Eighth Circuit stated,
We think the test of manipulation must largely be a practical one if the purposes of the Commodity Exchange Act are to be accomplished. The methods and techniques of manipulation are limited only by the ingenuity of man. The aim must be therefore to discover whether conduct has been intentionally engaged in which has resulted in a price which does not reflect basic forces of supply and demand.
Cargill, Inc. v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971).
The Commission has set forth the following elements of manipulation:
(1) that the [respondent] had the ability to influence market prices;
(2) that [respondent] specifically intended to do so;
(3) that artificial prices existed; and
(4) that the [respondent] caused an artificial price.
In re Cox, [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) 23,786 at 34,061 (CFTC July 15, 1987).
Although the conduct here occurred after the expiration of the contract, Fenchurch nonetheless engaged in intentional conduct through which it controlled a dominant portion of the cheapest-to-deliver notes available for delivery on the June Contract and thus restricted the available supply of the cheapest- to-deliver issue. Fenchurch's conduct resulted in the value of the futures contract being artificially altered.
Fenchurch intentionally acquired and maintained its dominant position in the 8 1/2% notes at a time of tight supplies and as a result the shorts had to deliver the more valuable 8 7/8% notes. By receiving the 8 7/8% notes on approximately one third of its futures position, the value of Fenchurch's position became artificially high. The Commission believes that Fenchurch's activities in the repo market did not have an economic or business rationale but for an intent to restrict the supply of the notes in order to obtain delivery of a more valuable security. Fenchurch was foregoing the opportunity to borrow money interest free by using the 8 1/2% notes as collateral and instead was paying general collateral rates in order to guarantee that the notes would not be relent to the market. By failing to return the notes to counterparties, Fenchurch also gave up the interest payments it would have received from the counterparties for use of its funds. Thus, the elements of manipulation, i.e., ability, intent, artificiality and causation, are met.
This case differs from prior decisions discussing manipulation. Here, Fenchurch's manipulative conduct did not commence until several days after trading had expired on the June contract. On June 21, the last trading day, the settlement price of the June contract was based on the price of the 8 1/2% note and the 8 1/2% note appeared to be readily available in normal market channels -- the repo market. In a market with adequate supplies, acquisition and delivery of notes can occur easily and quickly by wire within a day. It was not until June 25 that conditions changed significantly. Supplies of the 8 1/2% note became scarce and the difference in value between the 8 1/2% note and the 8 7/8% note increased to 5/32. Beginning on June 25, Fenchurch began to increase its position in the 8 1/2% note, which exacerbated the congestion and resulted in certain of the shorts delivering the more valuable security. In discussing the role of the longs in the markets, the Commission has held that "even if a dominant long played no role in the creation of a congested market, [the long] has a duty to avoid conduct that exacerbates the situation." In re Abrams, [Current Transfer Binder] Comm. Fut. L. Rep. (CCH) 26,479 at 43,136 (CFTC July 31, 1995).
In finding that Fenchurch controlled a dominant portion of the available supply of the 8 1/2% note, the Commission is mindful that the terms of the Ten Year Note Contract allow for delivery of any security in a basket of qualified issues, and that Fenchurch's conduct affected only one part of the total deliverable supply on the June contract, the 8 1/2% note. In Cox, the Commission held that if the terms of a contract permit delivery of premium grades of a commodity, then premium grades must be counted as part of the relevant supply, even if the premium does not fully compensate the shorts for delivery of the more valuable grade. Id. at 34,062. The facts of this case, however, are different from those addressed in Cox and therefore, require a different result. In particular, this case involves a pricing and delivery system that is distinct from that addressed in Cox. Those differences coupled with Fenchurch's exacerbating conduct allow the Commission to conclude that Fenchurch's conduct constitutes manipulation and cornering in violation of the Act. Further, the Commission does not intend that its determination that Fenchurch controlled the available deliverable supply of the Ten Year Treasury Note contracts by dominating a portion of that supply (i.e., control of the cheapest-to-deliver notes) necessarily should apply in determining available deliverable supply in markets other than those for futures on treasury securities.
This order does not limit or change in any way the legal obligations of shorts to make preparations for delivery on futures contracts consistent with the terms of the contract. See Indiana Farm Bureau, 21,796 at 27,286; Cox, 23,786 at 34,062. And, indeed, the Commisison makes no finding as to whether any or all of the shorts acted responsibly or not in this case. This order also is not intended to reflect any change in the Commission's view that positioning by shorts for delivery is a key aspect of the proper functioning of the futures markets.
It is the Commission's responsibility to ensure that futures markets remain free of illegitimate forces throughout the trading and delivery periods. If longs are allowed to engage in conduct of the type found in this case, the price discovery function of the futures markets could be jeopardized.
FINDINGS OF VIOLATIONS
Based on the foregoing, the Commission finds that Fenchurch violated Sections 6(c) and 9(a)(2) of the Act, as amended, 7 U.S.C. 9 and 13(a)(2).
OFFER OF SETTLEMENT
Fenchurch has submitted an Offer of Settlement in which, without admitting or denying the findings herein, it: admits the jurisdiction of the Commission with respect to the matters set forth herein; waives: 1) service of a complaint and notice of hearing; 2) a hearing; 3) all post-hearing procedures; 4) judicial review by any court; 5) any objection to the staff's participation in the Commission's consideration of the Offer; and 6) any claim of a punitive penalty based upon the settlement of this proceeding, including the imposition of any remedy or civil penalty herein; stipulates that the record basis on which this Order is entered consists solely of this Order and the findings consented to in the Offer which are incorporated in this Order; and consents to the Commission's issuance of this Order, which makes findings, as set forth above, and orders Fenchurch to cease and desist from violating the provisions of the Act it is found to have violated, to pay a civil penalty of $600,000; and to comply with the undertakings set forth below.
Accordingly, IT IS HEREBY ORDERED THAT:
1.Fenchurch shall cease and desist from violating Sections 6(c) and 9(a)(2) of the Act, 7 U.S.C. 9 and 13(a)(2).
2.Fenchurch shall pay a civil monetary penalty of $600,000 to the United States Treasury within five business days of this Order. In accordance with Section 6(e)(2) of the Act, if Fenchurch fails to pay the full amount of this penalty within fifteen days of the due date, Fenchurch shall be prohibited automatically from trading on all contract markets and Fenchurch's registration with the Commission as a commodity trading advisor and a commodity pool operator shall be suspended automatically until Fenchurch shows to the satisfaction of the Commission that payment of the full amount of the penalty with interest thereon has been made.
3.Fenchurch shall comply with the following undertakings:
a.If Fenchurch's futures position equals or exceeds 5,000 gross long futures contracts as of the close of the last trading day in an expiring futures month for any futures contract for Treasury securities, Fenchurch shall report to the Associate Director of Surveillance of the Division of Economic Analysis of the Commission its gross long positions in the cheapest-to-deliver security in all markets each business day, until the last delivery day of the expiring futures month. Fenchurch also shall make available immediately to the Division of Economic Analysis any information requested relating to Fenchurch's positions in the cheapest-to-deliver security. This undertaking shall remain in effect for two years following entry of this Order;
b.Fenchurch shall conduct a review of its policies and procedures to determine whether they are reasonably designed to deter, detect, discipline and correct conduct of the type found by the Commission in this matter to be violative of the Act and are reasonably designed to provide diligent supervision in accordance with Commission Regulation 166.3. With respect to any policies and procedures that Fenchurch determines are inadequate, Fenchurch shall formulate and implement reforms or augmentations of those policies and procedures;
c.Fenchurch shall deliver a report to the Commission's Division of Enforcement within 90 days of the issuance of this Commission Order accepting the Offer of Settlement. The report shall include the results of the review undertaken pursuant to this Order and identify specifically its conclusions as to each of the policies and procedures evaluated in the review and any reforms or augmentations of current policies and procedures formulated and implemented by Fenchurch; and
d.Fenchurch shall distribute to all its employees with trading or supervisory responsibilities a copy of this Order and have each employee sign a statement affirming that he/she has read and reviewed the Order.
By The Commission.
Jean A. Webb
Secretary to the Commodity Futures Trading Commission.
Dated: July 10, 1996