Ryder Energy Distribution Corp. v. Merrill Lynch Commodities Inc.

• Decision Date: 15 November 1984
• Docket Number: D,No. 12,12
• Parties: RYDER ENERGY DISTRIBUTION CORPORATION, Plaintiff-Appellant, v. MERRILL LYNCH COMMODITIES INC., E.F. Hutton & Co., Inc., and New York Mercantile Exchange, Defendants-Appellees. ocket 84-7226.
• Court: U.S. Court of Appeals — Second Circuit

Page 774

748 F.2d 774

RYDER ENERGY DISTRIBUTION CORPORATION, Plaintiff-Appellant, v. MERRILL LYNCH COMMODITIES INC., E.F. Hutton & Co., Inc., and New York Mercantile Exchange, Defendants-Appellees.

No. 12, Docket 84-7226.

United States Court of Appeals Second Circuit.

Argued Aug. 30, 1984.

Decided Nov. 15, 1984.

Richard A. Miller, New York City (Vincent J. Syracuse, Newman, Tannenbaum,

Helpern, Syracuse & Hirschtritt, New York City, of counsel), for plaintiff-appellant.

William T. Marshall, Jr., New York City (Jeffrey T. Letzler, New York City, of counsel), for defendant-appellee Merrill Lynch Commodities Inc.

William E. Hegarty, New York City (Henry G. Bisgaier, Peter Leight, Cahill, Gordon & Reindel, New York City, Charles S. Horgan, General Counsel, New York Mercantile Exchange, New York City, of counsel), for defendant-appellee New York Mercantile Exchange.

Before KAUFMAN, MESKILL and PIERCE, Circuit Judges.

MESKILL, Circuit Judge:

Ryder Energy Distribution Corporation (REDCO) appeals from a final judgment of the United States District Court for the Southern District of New York, Haight, J., dismissing all but one count of REDCO's complaint pursuant to Fed.R.Civ.P. 12(b)(6). In its complaint, REDCO alleges that the New York Mercantile Exchange (NYME), E.F. Hutton & Co. Inc. (Hutton) and Merrill Lynch Commodities Inc. (Merrill) violated various statutory and common law duties in connection with one of REDCO's commodity futures transactions. The district court granted defendants' motion to dismiss, concluding that defendants had breached no duty owed to REDCO. REDCO appeals this decision only as to NYME and Merrill. For the reasons that follow, we affirm with respect to NYME and reverse and remand with respect to Merrill.

BACKGROUND

A. Futures Trading

REDCO is a Florida corporation whose primary business is managing the fuel supply requirements of the other subsidiaries of its parent company, Ryder Systems, Inc. REDCO therefore deals and trades in a number of petroleum products, including No. 2 heating oil which can be used to fuel diesel powered engines. As part of its dealings in No. 2 heating oil, REDCO traded in the commodity futures market.

The mechanics of the futures market were explored in some detail in Leist v. Simplot, 638 F.2d 283, 286-88 (2d Cir.1980), aff'd sub nom. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Curran, 456 U.S. 353, 102 S.Ct. 1825, 72 L.Ed.2d 182 (1982). Therefore, we will keep our discussion of the market to a minimum and refer the reader to Leist for a more complete discussion of commodity futures trading.

Simply put, a commodity futures contract is a bilateral executory agreement for the purchase or sale of a designated commodity at a future date. All of the terms of the contract, except price, are established by the exchange on which the contract is traded. An individual wishing to trade in the futures market must utilize the services of a futures commission merchant (FCM). FCMs engage in soliciting or in accepting orders for the purchase or sale of a commodity for future delivery and are registered with the Commodity Futures Trading Commission (CFTC). When an FCM receives a customer's order, it relays the order to one of its floor brokers who enters into the desired transaction. Finally, when two traders have reached an agreement on the floor of the exchange, the exchange acts through its clearinghouse to provide a mechanism for the handling and transfer of futures contracts. The clearinghouse serves as seller to all buyers and buyer from all sellers. The FCMs are treated as principals in the trading and the clearinghouse collects margin payments from them. If an FCM is not a clearinghouse member it must deal through an FCM that is.

A customer who, through his FCM, agrees to deliver a commodity under a futures contract holds a "short" position. A customer who agrees to accept delivery of a commodity and make payment holds a "long" position. Under section 4 of the Commodity Exchange Act (CEA), 7 U.S.C. Sec. 6, futures contracts may be formed and discharged only on exchanges which comply with certain statutory requirements and which have been designated as "contract markets" by the CFTC.

A party's obligation under a futures contract may be discharged in one of three ways. First, the party may perform his obligation under the contract, i.e., deliver or accept delivery of the commodity. Only in rare instances does actual performance under a futures contract occur. Leist, 638 F.2d at 286 & n. 2. Second, a party seeking to liquidate his futures position may "offset." To offset, a party acquires an equal opposite position before the end of trading in the contract under which he is obligated. For example, a short would purchase an equal number of long contracts, or a long would sell an equal number of short contracts. The majority of futures contracts are discharged in this manner and money is made or lost on the difference between the original contract price and the offset contract price. Leist, 638 F.2d at 286-87. Finally, a party may discharge his obligation by engaging in a transaction known as an exchange of futures for physical (EFP).

To effect an EFP, parties with opposite futures positions negotiate a private contract covering the commodity involved. After completion of the negotiations, the parties report the existence of their private contract to their respective FCMs. The FCMs in turn report the contract to the exchange which then treats the futures positions of the parties as having been liquidated. By using an EFP, the long and the short are able, in effect, to offset through a privately negotiated transaction rather than the more common practice of acquiring an equal opposite position through the competitive execution of orders on the floor of the exchange. The parties are relieved of the standardized obligations of their future contracts and assume the negotiated obligations of their private contract.

As a general rule, the private negotiations that take place in an EFP violate CEA's prohibition against pre-arranged and non-competitive transactions. Sec. 4c(a), 7 U.S.C. Sec. 6c(a); 17 C.F.R. Sec. 1.38. However, EFPs conducted in accordance with the rules of an exchange are exempt from the prohibition contained in section 4c(a). 7 U.S.C. Sec. 6c(a); 17 C.F.R. Sec. 1.38. These rules must be approved by the CFTC. NYME Rule 150.14, which has been approved by the CFTC, establishes the conditions under which an EFP involving No. 2 heating oil is permitted.

Rule 150.14 has three basic requirements. First, 150.14(A) provides that no EFP "shall be made by a seller who does not, at the time of such exchange, have in his possession the cash commodity to be delivered ...." Second, 150.14(B) provides that a report of the EFP must be submitted to the exchange and it must "contain the following information: a statement that the trade has resulted in a change of ownership, the kind and quantity of the cash commodity, the kind and quantity of the futures, the price at which the transaction is made, the names of the Clearing Members and such other information as the President may require." Third, 150.14(B) also provides that all documentary evidence including "evidence as to change of ownership and possession by the seller of the cash commodity shall be retained by the parties ...." Rule 150.17 states: "References in these Rules to the 'seller' and 'buyer' shall mean the short Clearing Member and the long Clearing Member respectively."

To implement Rule 150.14 and to comply with the recordkeeping requirements of CFTC regulation Sec. 1.35(e), 17 C.F.R. Sec. 1.35(e), NYME requires that two forms--EFP-1 and EFP-2--be submitted by the clearing members to involved in an EFP. EFP-1 requires the clearing members "certify" that the transaction is "bona fide" and that ownership and possession of the cash commodity "will be" transferred. J.App. at 118. In addition, the clearing member for the short must certify that the short owns and has possession of sufficient cash commodity to cover the contract. EFP-2, which is apparently filed subsequent to EFP-1, requires the clearing members to certify that payment and change of ownership and possession "has occurred." J.App. at 119. It is the alleged non-compliance with and non-enforcement of these EFP rules that form the basis of the complaint before us.

B. REDCO's Trading

Except where noted otherwise, the following facts are not in dispute. ¹

In March 1982 REDCO was long 87 futures contracts traded on NYME covering 87,000 barrels of No. 2 heating oil. Hutton was REDCO's FCM on 37 of these contracts and Merrill was REDCO's FCM on the other 50 contracts. Determined to extinguish its obligation under these contracts, REDCO decided to conduct an EFP with Two Oil Inc. (TOI). In order to conduct the EFP, TOI opened a commodity account with Merrill and established a short position mirroring REDCO's long position. Merrill was TOI's FCM on all 87 of these futures contracts.

On March 15, 1982, TOI "book transferred" 87,000 barrels of oil to REDCO. ² On March 16, 1982, REDCO wire transferred payment of $3,471,300 to TOI's account at Houston City Bank. On March 16, the EFP terms and specifications and the book transfer by TOI were reported by REDCO to Hutton and Merrill. Hutton and Merrill reported a portion of the total EFP transaction (37 contracts) to NYME and 37 of REDCO's futures contracts were extinguished. On March 17, Merrill reported the remainder of the EFP to NYME and REDCO's remaining 50 futures contracts were extinguished. On both March 16 and 17, Merrill filed Form EFP-1 certifying that TOI owned and had possession of 87,000 barrels of oil. REDCO alleges that Merrill made its certification without inquiring whether TOI actually owned and possessed the oil.

In early May 1982, REDCO sought actual delivery from TOI; TOI had no oil in May, had had none in March, and was now insolvent. Faced with the loss of almost...