UNITED STATES OF AMERICA
Before the
COMMODITY FUTURES TRADING COMMISSION
________________________________
:
In the Matter of :CFTC Docket No. 97-3
:
SOUTHERN THUMB CO-OP, INC. :
a Michigan corporation :COMPLAINT AND NOTICE OF
155 South Saginaw Street : HEARING PURSUANT TO
Lapeer, Michigan 48446, : SECTIONS 6(c) AND 6(d)
: OF THE COMMODITY EXCHANGE
Respondent. : ACT, AS AMENDED
________________________________:
I.
The Commodity Futures Trading Commission ("Commission") has received information from its staff which tends to show, and the Commission's Division of Enforcement ("Division") alleges that:
Respondent
1.SOUTHERN THUMB CO-OP, INC. ("Southern Thumb") is a Michigan corporation headquartered at 155 South Saginaw Street, Lapeer, Michigan 48446. Southern Thumb is a co-operative grain elevator which, among other business activities, buys grain from local farmers (also referred to as producers, patrons, or customers), and sells grain to end users such as grain processors. The elevator operates branch offices in Marlette, Richmond, Yale, and Imlay City, Michigan. Southern Thumb has never been registered in any capacity with the Commission.
Southern Thumb's Alternative Marketing Program
2.From at least November 1993 to the present, Southern Thumb has marketed an "alternative marketing program" under which local area farmers could sell their corn, wheat, and soybeans, among other grains, to the elevator. Southern Thumb's alternative marketing program has included the following types of contracts, among others: Hedged-to-Arrive and Flex Hedged-to- Arrive ("HTA"), Option Offer, Floor Price and Mini-Max contracts.
3. Under Southern Thumb's HTAs, prices for the farmers' grain were based upon (1) a futures reference price, the price of grain as reflected on the Chicago Board of Trade ("CBT"), and (2) basis, the difference between the futures price and the local cash price at a time set prior to delivery. Under Southern Thumb's contracts, "producer[s] agree[d] to commit bushel amount[s] . . . for delivery to Southern Thumb at some point in time . . ." Also, producers were allowed to defer their delivery obligations by rolling their HTAs forward to later months with new futures reference prices.
4.When farmers entered into HTAs, Southern Thumb usually established short exchange-traded futures positions in the elevator's own name. When producers requested to roll their HTAs forward, Southern Thumb offset its corresponding futures positions and reestablished them at current futures prices in later contract months. Resulting accumulated gains and losses were then credited or debited to the HTA prices. Southern Thumb also debited HTA prices for service fees for rolling.
5. A key component of Southern Thumb's alternative marketing program was its practice of entering into option contracts with producers. Certain contracts enabled producers to sell call options (short calls) or purchase put options (long puts). Such transactions constituted prohibited off-exchange agricultural options.
Option Offer Contracts
6. Under Southern Thumb's Option Offer contracts, producers sold call options. Southern Thumb paid farmers premiums for Southern Thumb's right to purchase grain from the farmers, by a certain date, at the price stated on the Option Offer contract. 7.Southern Thumb presented the sale of call options as an opportunity for farmers to receive higher prices for their grain by adding the call premiums to the prices the elevator would pay to farmers for grain under HTAs or other contracts. The more bushels of grain farmers committed to sell under the call option feature of Option Offer contracts, the more premiums the farmers would receive. When calls expired without exercise, no further obligations accrued to the farmers. Also, farmers could terminate their call option obligations prior to exercise by buying calls. Gains or losses resulting from such termination would be credited or debited to the farmers' grain prices.
8. Southern Thumb often entered Option Offer contracts with farmers for twice the amount of grain that the farmers had committed under HTAs or other contracts. For example, if Southern Thumb and a farmer entered into an HTA or other contract for 10,000 bushels of corn for October to December 1995 delivery, the farmer would sell call options for 20,000 bushels of corn which, if exercised by Southern Thumb, would obligate the farmer to deliver an additional 20,000 bushels. The premiums received on the sale of the calls, less option service fees, could be added to the reference price of the initial 10,000-bushel contract.
9.Southern Thumb generally sold exchange-traded call options in the elevator's trading accounts for each short call option it confirmed to farmers. When the exchange-traded options sold by Southern Thumb were exercised, the elevator exercised the call options it had entered into with farmers.
10. When Southern Thumb exercised call options against the farmers, new HTA contracts were created with reference prices at the option prices and with "delivery" dates at the option expiration months. The initial HTAs or other contracts also remained in effect. Therefore, as a result of Southern Thumb's exercise of call options sold by the farmers, farmers often became obligated to deliver three times the amount of grain initially contracted for. In many instances, farmers' contractual obligations exceeded their annual grain production. Therefore farmers rolled their grain contracts forward to later dates in the same or later crop years.
11.Southern Thumb's Option Offer contracts operated as, and in fact were, call options on agricultural commodities.
Unpricing The Option Offer Contracts
12.As grain prices began to rise in late 1995 and early 1996, Southern Thumb, in a short futures position on the CBT, was exposed to larger calls for margin - a pledge of additional assets as security - than in past years. The elevator used its bank line of credit to fund the margin calls.
13.To prevent further losses in the elevator's exchange- traded short futures position, in February 1996, Southern Thumb recommended the unpricing of many HTA contracts that had resulted from exercised call options. Southern Thumb offset its corresponding futures positions, and debited the losses on the exchange-traded futures positions against the prices that would be set when the unpriced HTAs were eventually repriced. "Unpriced" HTAs are contracts without reference prices or delivery dates. The unpricing of HTA contracts that resulted from call exercise caused immediate and substantial reductions in the HTA prices. However, it also enabled producers to avoid additional losses on their HTA prices arising from further increases in old crop prices.
Floor Price Contracts
14.Under Southern Thumb's Floor Price contracts, farmers paid premiums to Southern Thumb for the farmers' right to sell grain to Southern Thumb by the dates and at the prices stated on the Floor Price contracts. The rights expired on the dates stated on the contracts. Under these contracts, farmers bought put options. Southern Thumb presented the purchase of put options as an opportunity for farmers to lock in a floor for their grain prices.
15.Southern Thumb's Floor Price contracts operated as, and in fact were, put options on agricultural commodities.
16.Exercise of producers' rights under the Floor Price contract could result, in some circumstances, in creating new contracts or, in other circumstances, in the repricing of unpriced HTAs. Producers could also terminate the put options by selling puts. Even if they had deliverable grain, producers could let the puts expire and sell the grain under HTAs or on the cash market.
17.In February 1996, a time when many farmers had insufficient grain to deliver under their existing contracts, Southern Thumb recommended to farmers that they purchase put options which would expire in May 1996, or other months during the same crop year, also a time when many of the farmers would have insufficient grain to deliver.
18.Southern Thumb charged the farmers premiums to purchase put options. To collect the premiums, Southern Thumb would deduct the premium amounts and option service fees from the prices of the farmers' other grain contracts, whether or not the farmers exercised the options.
Mini-Max Contracts
19. Under Mini-Max contracts, producers sold call options, among other transactions. Southern Thumb presented the sale of call options under Mini-Max contracts as a way for producers to help finance the premiums on option purchases. To the extent that farmers sold calls under Mini-Max contracts in bushel amounts exceeding the bushel amounts committed in the underlying Mini-Max contracts, such contracts operated as, and in fact were, options on agricultural commodities.
Southern Thumb's Options Are Not An Integral Part of Excluded Forward Contracts
20. Southern Thumb's short call and long put option contracts did not have the kind of relationship to actual delivery in normal marketing channels such that they were an integral part of a forward or spot contract. The long put options were separately marketed and the long put and short call options were severed from initial HTAs. Southern Thumb's short call options created obligations which, upon exercise, gave rise to additional HTAs. HTAs resulting from call exercise could and did exceed the farmers' production capacities. Southern Thumb's long put options, in some circumstances, could result in the creation of new contracts. In other circumstances, producers who did not have sufficient grain to deliver under existing unpriced HTAs could use put options to reprice the HTAs, if they did so prior to option expiration. Producers could also allow their put options to expire and either purchase new puts with later expiration dates and different strike prices or sell the grain at higher spot prices. Southern Thumb regarded each new put option as a separate transaction.
Misrepresentations and Omissions Concerning Risk
21.From at least September 1994 to the present, Southern Thumb omitted to state or failed to inform farmers adequately of the risks, and misrepresented the risks, involved in selling call options. Such omissions and misrepresentations include, but are not limited to, the following:
(a) Omitting to state or failing to explain adequately that when Southern Thumb exercised the call options, the farmers would be obligated to deliver the bushels of grain stated on the call option contracts, and that this obligation would continue even after the farmers delivered the grain under the HTA or other delivery contracts to which the option contracts were attached;
(b)Omitting to state that, in markets where grain prices are rising, buyers of call options could be expected to exercise, and exercise could result in farmers becoming obligated to deliver more grain than they could produce in one crop year;
(c)Omitting to state or failing to explain adequately that selling options could result in unlimited losses for farmers with insufficient grain to deliver at the time of exercise;
(d) Stating to one or more farmers who sold call options that "the options will never be exercised," or words to that effect;
(e) Statements to one or more farmers who sold call options that, "the worst that could happen would be that," or "it would not be so bad if," in selling a call option with a $3.00 strike price, "the farmer would sell corn at $3.00," or words to that effect;
(f) Statements to one or more farmers that rolling the obligations that resulted from selling call options is a "conservative strategy;"
(g) Omitting to state or failing to explain adequately that in inverted markets - markets where delivery prices for the nearest months are higher than delivery prices for deferred months - deferring delivery of grain, or rolling the HTA contracts resulting from the exercised call options to later delivery months, could result in successively lower delivery prices.
22.From at least February 1996 to the present, Southern Thumb omitted to state or failed to inform farmers adequately of the risks, and misrepresented the risks, involved in buying put options. Such misrepresentations and omissions include, but are not limited to, the following:
(a)Stating in a February 1996 letter distributed to farmers that, for farmers who had no 1995 crop to deliver, and those who had obligations to deliver new crop, unpricing grain contracts and buying put options would "lock in a bottom and provide protection from a lower market on [grain] contract[s]", and would "give [farmers] the chance to take advantage of the volatility and potentially higher prices of the new crop market, without incurring additional loss on current flex (rolled) contracts;"
(b)Misrepresenting the usefulness of buying old crop put options when such put options provided only limited protection against the downside risk associated with prices in later crop years;
(c) Recommending that producers buy put options for May 1996 delivery, knowing that producers did not have sufficient grain to deliver in May 1996; and omitting to state or failing to explain adequately that any downside price protection would cease at the expiration of the puts, and that producers could later purchase new puts for later expiration months, but with each new put producers would pay additional premiums and fees, to be deducted from their eventual HTA or other prices;
(d)Recommending that producers buy old crop put options, but failing to disclose the price risk involved in rolling across crop years;
(e)Recommending that producers buy old crop put options, but failing to disclose the price impact of rolling in inverted markets even though, by at least late February, the market inversion across crop years was already in place.
23.The omissions and misrepresentations referred to in paragraphs 21 and 22 were material to the farmers' decisions to enter into option transactions.
24.At the time of the omissions and misrepresentations referred to in paragraphs 21 and 22, Southern Thumb either knew of the risks or acted with reckless disregard for the risks of the transactions and whether or not the representations were true.
25.The parties to the option contracts described in paragraphs 5 through 24 included persons or entities that were not "eligible swap participants" as that term is defined in Part 35 of the Commission's Regulations, 17 C.F.R. 35.1 et seq.
COUNT ONE
VIOLATIONS OF SECTION 4c(b) OF THE ACT AND
REGULATION 32.2: ENTERING INTO
PROHIBITED OPTION TRANSACTIONS
26.Paragraphs 1 through 25 are realleged and incorporated herein by reference.
27.From at least November 1993 to the present, Southern Thumb offered to enter into, entered into, confirmed the execution of or maintained positions in transactions involving corn, wheat and soybeans that conform to the facts and circumstances described in paragraphs 1 through 25, which are of the character of, or are commonly known to the trade as, options, puts and calls, in violation of Section 4c(b) of the Act, 7 U.S.C. 6c(b)(1994), and Regulation 32.2, 17 C.F.R. 32.2 (1996).
COUNT TWO
VIOLATIONS OF SECTION 4c(b) OF THE ACT AND REGULATION 33.10:
FRAUD IN CONNECTION WITH OPTION TRANSACTIONS
28.Paragraphs 1 through 25 are realleged and incorporated herein by reference.
29.From at least September 1994 to the present, by the conduct alleged in this count, Southern Thumb cheated and defrauded, or attempted to cheat or defraud other persons in connection with offers to enter into, the entry into, the confirmation of the execution of, or the maintenance of, commodity option transactions, and thereby violated Section 4c(b) of the Act, 7 U.S.C. 6c(b) (1994), and Regulation 33.10, 17 C.F.R. 33.10 (1996).
II.
By reason of the foregoing allegations, the Commission deems it necessary and appropriate, pursuant to its responsibilities under the Act, to institute public administrative proceedings to determine whether the allegations set forth in Section I above are true and, if so, whether an appropriate order should be entered in accordance with Sections 6(c) and 6(d) of the Act, 7 U.S.C. 9 and 13b:
(A)Directing that Southern Thumb cease and desist from violating the provisions of the Act and Regulations set forth in Part I of the Complaint;
(B)Assessing against the Respondent a civil penalty as provided in Section 6(c) of the Act, 7 U.S.C. 9 (1994); and
(C)Requiring restitution as deemed equitable and appropriate to specific customers of damages proximately caused by such violations.
III.
WHEREFORE IT IS HEREBY ORDERED that a public hearing for the purpose of taking evidence on the allegations set forth in Section I above be held before an Administrative Law Judge in accordance with the Commission's Rules of Practice under the Act ("Rules"), 17 C.F.R. 10.1 et seq. (1996), at a time and place to be fixed as provided by Section 10.61 of the Rules, 17 C.F.R. 10.61, and that all post-hearing procedures shall be conducted pursuant to Sections 10.81 through 10.107 of the Rules, 17 C.F.R. 10.81-10.107.
IT IS FURTHER ORDERED that the Respondent shall file an Answer to the allegations contained in this Complaint within twenty (20) days after service pursuant to Section 10.23 of the Rules, 17 C.F.R. 10.23, and shall serve two copies of such Answer and of any documents filed in this proceeding upon Dennis M. Robb, Regional Counsel, and Camille M. Arnold, Trial Attorney, Commodity Futures Trading Commission, 300 South Riverside Plaza, Suite 1600-North, Chicago, Illinois 60606. If the Respondent fails to file the required Answer or fails to appear at a hearing after being duly served, it shall be deemed in default and the proceedings may be determined against it upon consideration of the Complaint, the allegations of which shall be deemed to be true.
IT IS FURTHER ORDERED that this Complaint and Notice of Hearing shall be served upon the Respondent personally or by registered or certified mail, pursuant to Section 10.22 of the Rules, 17 C.F.R. 10.22.
In the absence of an appropriate waiver, no officer or employee of the Commission engaged in the performance of investigative or prosecutorial functions in this or any factually related proceeding will be permitted to participate or advise in the decision in this matter except as a witness or counsel in a proceeding held pursuant to notice.
By the Commission.
___________________________
Jean A. Webb
Secretary to the Commodity Futures
Trading Commission
Dated: November 13, 1996