First Commodity Corp. of Boston v. Commodity Futures Trading Commission
| Decision Date | 25 March 1982 |
| Docket Number | No. 81-1245,81-1245 |
| Citation | 676 F.2d 1 |
| Parties | FIRST COMMODITY CORP. OF BOSTON and Richard Badoian, Petitioners, v. COMMODITY FUTURES TRADING COMMISSION, Respondent, and John Ruddy, Respondent. |
| Court | U.S. Court of Appeals — First Circuit |
Jeffrey V. Boxer, Boston, Mass., for petitioners.
Joan L. Loizeaux, Special Counsel, Washington, D. C., with whom Gregory C. Glynn, Gen. Counsel, and Susan A. Arnold, Atty., Washington, D. C., were on brief for respondent Commodity Futures Trading Commission.
Before COFFIN, Chief Judge, DAVIS, * Judge, and BREYER, Circuit Judge.
This case raises the issue of what "scienter" requirement, if any, the Commodity Futures Trading Commission ("CFTC" or "Commission") must attach to its rule prohibiting fraud in the sale of foreign futures contracts in the United States. We conclude that the Commission here found that the broker committed fraud with a state of mind amounting to "recklessness," that the record supports that finding, and that the Commodity Exchange Act, 7 U.S.C. §§ 1-24 allows the Commission to predicate liability upon that state of mind. We therefore affirm the Commission's determination of liability.
To understand the facts of this case, it is well to have in mind three concepts elementary to those who work in the world of commodities trading but not necessarily clear to the rest of us.
First, one must understand the meaning of an "option," and, in particular, a "call option." A "call option" is a contract that gives one the right to buy a specified quantity of a given commodity at a particular price at any time until the option expires. Thus, a coffee call option with an expiration date of December 31, 1982, and a "strike price" of $1,000 per ton would give the holder the right to buy the specified number of tons of coffee at $1,000 per ton anytime during 1982. If the market price of coffee goes above $1,000 per ton at any time during 1982, the holder can exercise (or, as is more normally the case, simply sell) the option and make money. Of course, the holder had to pay something for the call option, so he must hope the market price exceeds the strike price by enough for him to recover the cost of the option itself as well as commissions. See generally British American Commodity Options Corp. v. Bagley, 552 F.2d 482, 484-85 (2d Cir.), cert. denied, 434 U.S. 938, 98 S.Ct. 427, 54 L.Ed.2d 297 (1978).
Second, one must understand what a "futures contract" is and, in particular, a "short futures contract." A futures contract is a firm commitment to deliver or receive a specified amount of a given commodity at a particular price and time in the future. A futures contract does not give one a mere option to buy or sell; rather, it is a purchase or sale. A December "short" coffee future, for example, obligates the holder to deliver the specified quantity of coffee in December for a price specified right now, say $1,000 per ton. The holder of the "short" futures contract hopes the price of coffee will fall below that $1,000 before he has to deliver. If so, he can buy the coffee for the future delivery he has promised at the lower price and he will be able to keep the difference between the $1,000 specified price and his lower purchase price (less any commissions). The lower the price of coffee falls, the greater the "short" party's profit. See generally Leist v. Simplot, 638 F.2d 283, 286-87 (2d Cir. 1980), cert. granted, 450 U.S. 910, 101 S.Ct. 1346, 67 L.Ed.2d 332 (1981).
Third, it is important to understand the way in which a short futures contract can offset or "hedge" a call option. If an investor holds a call option on coffee, every dollar that the price of coffee rises makes that option worth about a dollar more. At the same time, if an investor holds a short futures contract on coffee, every dollar that the price of coffee rises makes that short contract worth about a dollar less. When an investor holds both a call option and a short futures contract, these gains and losses cancel one another out. Thus, even if the price of coffee rises to $8,000 per ton, an investor holding a call option and a short futures contract (both covering, say, one ton of coffee at $1,000 per ton) will not make money. The call option gives him the right to buy that $8,000 coffee for $1,000. The short futures contract, however, obligates him to turn around and deliver that same coffee to a buyer who will pay only $1,000. In fact, because the call option and the short contract offset each other as the price of coffee rises, no matter how high the price goes the investor will not even recover the cost of the option and the trading commissions.
As the price of coffee falls, on the other hand, the value of the call option and the short futures contract do not precisely offset each other. This is so because the investor who buys a call option cannot lose more on that investment than the cost of the option itself. Since he holds only a right to buy, not an obligation to buy, if the price of coffee falls, his right becomes worthless and he simply does not exercise it. There is no corresponding limitation, however, on the amount one can gain on a short futures contract as the price of coffee falls. The only limiting factor on this profit is the specified sale price he is to receive on delivery. If the price of coffee falls to zero, the investor in our example will make $1,000 on the ton of coffee he sold short.
Thus, an investor who holds both a $1,000 1982 coffee call option and a matching short $1,000 futures contract has hedged in the following sense: if the price of coffee rises, the investor cannot make money; he will lose the cost of the call and trading commissions; but he will lose no more. If the price of coffee falls, however, his position is better: if it falls a little, he can lose some of the cost of the call and commissions; if it falls further, he may break even; and if the price falls far enough, he may even make money. See Flasman v. R. G. Wilson Commodities, Inc., (1977-1980 Transfer Binder) Comm.Fut.L.Rep. (CCH) P 20,572 (CFTC March 13, 1978). 1
With these concepts in mind, we turn to the facts of this case.
In June 1975, John Ruddy bought several call options on coffee through Richard Badoian, a sales representative at First Commodity Corporation of Boston ("FCCB"). The options cost Ruddy about $1,900 altogether and gave him the right to buy 15 tons of coffee at a price of about $1,080 per ton at any time before the end of the year. The nature of Ruddy's job, his low salary, his small amount of savings, as well as his correspondence with Badoian, suggest that he was very inexperienced in the world of commodities trading.
During June, Ruddy and Badoian corresponded and spoke several times by phone. The price of coffee began to fall. Ruddy wrote to Badoian, expressing concern. He noted,
from anything I get a hold of, there seems to be a lot of coffee around. However, I'm sure with you having first hand information, you can see things I can't. I can only ask that you take any action necessary to protect me the same as you would if it was your money.
Badoian then called Ruddy. According to Ruddy's testimony, which the ALJ and the Commission credited below, Badoian told Ruddy that FCCB expected a "temporary downtrend" in the market. Badoian advised Ruddy "not to worry," however, because Ruddy could "take advantage of this additional chance to make money by placing a hedge."
Badoian sought to explain to Ruddy over the phone what a "hedge" was, but Ruddy testified that he never fully understood it. He was left with the impression that the "hedge" would make money for him if the price of coffee fell, and that he could lose everything (the price of the calls, commission costs, and short sale deposit, or "margin") only if "coffee stayed within a very limited price range." Ruddy testified that he specifically asked Badoian if the "hedge" would "hurt" his "up position" and that Badoian responded,
Definitely not. You can pick up the extra money and when the coffee goes up, we just automatically pick up the hedge for (a) small fee.
Ruddy added that he told Badoian to "do nothing to hurt my up position," and that Badoian replied, Finally, Ruddy testified that he
was in no way made aware that (the hedges) were shorts, selling or anything else. I ... agree ... that these are probably quite familiar terms to (the brokers at FCCB) but to me, a hedge, you might as well have been talking about a hedge fence.... Mr. Badoian knew this.
In fact, what Badoian had in mind as a "hedge" was a short futures contract traded on the London futures market. He sold several such contracts for Ruddy's account, offsetting Ruddy's call options.
As the very fact that this case is before us no doubt suggests, the price of coffee then stopped its fall. Indeed, a "killer" frost in Brazil on July 17 led to a sharp price increase. Ruddy thought he was a "rich man." He called FCCB on July 21, was unable to reach Badoian, and spoke instead to a manager named John Howe. Howe told Ruddy that FCCB had decided it could not remove his "short" hedges when the price began to go up, because doing so would have been too expensive. Gradually, through subsequent conversations with a lawyer at the CFTC, it began to dawn on Ruddy that he was not rich. Indeed, because of the "hedge" he obtained no profit at all when the price of coffee went up.
Ruddy then filed a reparation complaint with the CFTC, see 7 U.S.C. § 18, seeking to recover from Badoian and FCCB the lost profits on his call options. The CFTC found that Badoian violated Rule 30.02, which makes it unlawful to "deceive or attempt to deceive" or to "make ... any false report or statement" to a customer in connection with the sale of commodity futures contracts on foreign...
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