Kohen v. Pacific Inv. Management Co. LLC

• Court: U.S. Court of Appeals — Seventh Circuit
• Writing for the Court: Posner
• Citation: Kohen v. Pacific Inv. Management Co. LLC, 571 F.3d 672 (7th Cir. 2009)
• Decision Date: 07 July 2009
• Docket Number: No. 08-1075.,08-1075.
• Parties: Josef A. KOHEN, et al., on their own behalf and that of all others similarly situated, Plaintiffs-Appellees, v. PACIFIC INVESTMENT MANAGEMENT COMPANY LLC and PIMCO Funds, Defendants-Appellants.

571 F.3d 672

Josef A. KOHEN, et al., on their own behalf and that of all others similarly situated, Plaintiffs-Appellees, v. PACIFIC INVESTMENT MANAGEMENT COMPANY LLC and PIMCO Funds, Defendants-Appellants.

No. 08-1075.

United States Court of Appeals, Seventh Circuit.

Argued April 1, 2009.

Decided July 7, 2009.

Christopher P. Lovell (argued), Lovell Stewart Halebian, LLP, New York, NY, Marvin A. Miller, Miller Law LLC, Chicago, IL, for Plaintiffs-Appellees.

Maureen E. Mahoney, Attorney, Latham & Watkins LLP, Washington, DC, Miles N. Ruthberg (argued), Latham & Watkins LLP, Los Angeles, CA, for Pacific Investment Management Company LLC, PIMCO Funds.

Blake T. Hannafan, Hannafan & Associates, Nicholas A. Pavich, Chicago, IL, Miles N. Ruthberg (argued), Latham &

Watkins LLP, Los Angeles, CA, for PIMCO Funds.

Before POSNER, EVANS, and TINDER, Circuit Judges.

POSNER, Circuit Judge.

The defendants in this class action suit have appealed from the district court's certification of a plaintiff class. Fed.R.Civ.P. 23(f). The suit, based on section 22(a) of the Commodity Exchange Act, 7 U.S.C. § 25(a), accuses the defendants, collectively "PIMCO," of having violated section 9(a) of the Act, 7 U.S.C. § 13(a), by cornering a futures market. A corner is a form of monopolization. See United States v. Patten, 226 U.S. 525, 539-42, 33 S.Ct. 141, 57 L.Ed. 333 (1913); Great Western Food Distributors, Inc. v. Brannan, 201 F.2d 476, 478-79 (7th Cir.1953); Peto v. Howell, 101 F.2d 353, 358-59 (7th Cir.1939); Robert W. Kolb & James A. Overdahl, Understanding Futures Markets 80 (6th ed.2006) ("a successful effort by a trader or group of traders to influence the price of a futures contract by intentionally acquiring market power in the deliverable supply of the underlying good while simultaneously acquiring a large long futures position").

The class consists of persons who between May 9 and June 30, 2005, bought a futures contract on the Chicago Board of Trade in 10-year U.S. Treasury notes. Earlier they had sold such notes short, and the purchases they made between May 9 and June 30 were pursuant to contracts they had with other investors, including PIMCO, to deliver to a commodity clearinghouse, for those investors' accounts, on June 30, a specified quantity of the notes at the price specified in the futures contracts. With rare exceptions, however, futures speculations are completed not by delivery of the underlying commodity (such as milk, or pork bellies, or in this case Treasury notes) to the clearinghouse, though that is an option, but by the making of offsetting futures contracts, as described in Kolb & Overdahl, supra, at 17; Mark J. Powers & Mark G. Castelino, Inside the Financial Futures Markets 20 (3d ed.1991); Jeffrey Williams, The Economic Function of Futures Markets 9-10 (1989); James M. Falvey & Andrew N. Kleit, "Commodity Exchanges and Anti-trust," 4 Berkeley Bus. L.J. 123, 127-28 (2007); see also C.B. Reehl, The Mathematics of Options Trading 15 (2005). The following table illustrates the process.

Futures Contracting
                ---------------------------------------------------------------------------
                Day     Price     Trade          SS's position          B's position
                ---------------------------------------------------------------------------
                1       $1,000    SS sells       SS deposits            B deposits
                                  contract       $100 (10% of           $100 in his
                                  (to            the value of           account
                                  deliver        the contract)          acquires the
                                  pork           in his account         right to require
                                  bellies)       with clearinghouse     delivery
                                  to B.          (required              of pork bellies
                                                 margin);               from clearinghouse
                                                 acquires
                                                 the obligation
                                                 to deliver
                                                 pork bellies to
                                                 clearinghouse
                ---------------------------------------------------------------------------
                2       $1,500    None           SS's account           B's account
                                                 falls to—$400,         increases to
                                                 so SS must             $600; B still
                                                 deposit $500           has the right
                                                 in his account         to require delivery
                                                 to maintain            of pork
                                                 his 10% margin;        bellies from
                                                 SS is                  the clearinghouse
                                                 still obligated
                                                 to deliver
                                                 pork bellies to
                                                 the clearinghouse
                ---------------------------------------------------------------------------
                3       $1,500    SS caps        SS's trade             B's trade
                                  his losses     extinguishes           extinguishes
                                  and            his original           his original
                                  buys           contract: his          contract: his
                                  contract       obligation to          right to require
                                  (to            deliver to the         delivery
                                  deliver        clearinghouse          from the
                                  pork           is offset by           clearinghouse
                                  bellies)       his right to           is offset by
                                  from B.        require delivery       his obligation
                                                 from the               to deliver to
                                                 clearinghouse.         the clearinghouse.
                ---------------------------------------------------------------------------
                

In the example in the table, a short seller, SS, sells a specified quantity of pork bellies to B (buyer) at a price of $1,000 for delivery in June (hence a "June Contract"). SS hopes the price will fall by then. But before the delivery date arrives the price rises to $1,500, and SS decides to cap his losses. The simplest way to do this, as in the table, is for SS to buy from B the same quantity of pork bellies as SS had sold to B, paying $1,500. SS now has offsetting contracts to sell and to buy the same number of pork bellies, and B now has offsetting contracts to buy and sell the same number of pork bellies, so neither has a delivery obligation. Neither wants to have such an obligation, because both are speculators rather than farmers or meat packers. (Notice in the table that losses and gains are debited and credited to the traders' accounts with the clearinghouse every day, to minimize the risk of loss to the clearinghouse, which guarantees the fulfillment of the futures contract. But this detail plays no role in this case.)

Changes in the demand for or the supply of the underlying commodity will make the price of a futures contract change over the period in which the contract is in force. If the price rises, the "long" (the buyer) benefits, as in our example, and if it falls the "short" (the seller) benefits. But a buyer may be able to force up the price by "cornering" the market—in this case by buying so many June contracts for 10-year Treasury notes that sellers can fulfill their contractual obligations only by dealing with that buyer. United States v. Patten, supra, 226 U.S. at 539-41, 33 S.Ct. 141; Zimmerman v. Chicago Board of Trade, 360 F.3d 612, 616 (7th Cir.2004); Board of Trade v. SEC, 187 F.3d 713, 724 (7th Cir. 1999) ("a person who owns a substantial portion of the long interest near the contract's expiration date also obtains control over the supply that the shorts need to meet their obligations. Then the long demands delivery, and the price of the commodity skyrockets. It takes time and money to bring additional supplies to the delivery point, and the long can exploit these costs to force the shorts to pay through the nose"); Roberta Romano, "A Thumbnail Sketch of Derivative Securities and Their Regulation," 55 Md. L.Rev. 1, 29-30 (1996); "United States Commodity Futures Trading Com-mission Glossary," www. cftc.gov/educationcenter/glossary/glossary_co.html (visited June 10, 2009).

Board of Trade v. SEC, supra, 187 F.3d at 725, remarks that since the possibility of manipulation "comes from the potential imbalance between the deliverable supply and investors' contract rights near the expiration date[,] . . . [f]inancial futures contracts, which are settled in cash, have no `deliverable supply'; there can never be a mismatch between demand and supply near the expiration, or at any other time." But while it is correct that most financial futures contracts are settled in cash, CFTC v. Zelener, 373 F.3d 861, 865 (7th Cir. 2004); Kolb, supra, at 16, and that if a cash option exists there is no market to corner (no one can corner the U.S. money supply!), futures contracts traded on the Chicago Board of Trade for ten-year U.S. Treasury notes are an exception; they are not "cash settled." Short sellers who make delivery must do so with approved U.S. Treasury notes; otherwise they must execute offsetting futures contracts. Chicago Board of Trade Rulebook, "Chapter 19: Long-Term U.S. Treasury Note Futures (6½ to 10-Year)," www.cmegroup. com/rulebook/CBOT/V/19/19.pdf (visited June 22, 2009); CME Group, "U.S. Treasury Futures Delivery Process," (4th ed.2008), w ww.cmegroup.com/trading/interest-rates/files/CL-100_TFDPBrochure-FINAL.pdf (visited June 22, 2009).

The note approved for delivery in this case was the "2/12 Treasury Note" (a Treasury note that expires in February 2012). The plaintiffs claim that PIMCO increased the percentage of these notes that it owned from 12 to 42 percent over a two-week span, with the result that they would have had to pay a monopoly price to get enough notes to close out their...