On Oct. 31, 2011, MF Global Holdings, Ltd. and certain affiliates (“MF Global”) declared the eighth largest bankruptcy in U.S. history, claiming assets of approximately $41 billion and debt of approximately $39.7 billion. Immediately thereafter, the Securities Investor Protection Corporation initiated a Securities Investor Protection Act (“SIPA”) liquidation proceeding against MF Global, Inc. The SIPA liquidation proceeding directly impacted over 150,000 customers of MF Global and sent shock waves throughout the futures industry.

The SIPA liquidation proceeding had an immediate and dramatic effect on many agricultural producers, grain elevators and processors who utilized MF Global as a clearinghouse for the hedging of their products. The inability of customers to access their accounts in the immediate aftermath of the liquidation proceeding temporarily prevented customers from entering or exiting hedging transactions and accessing equity in their accounts.

While MF Global’s SIPA trustee caused the transfer of customers’ open U.S. commodities positions to other Futures Commodity Merchants (“FCMs”), the trustee only allowed the transfer of a portion of the required collateral for such positions. This resulted in customers needing to quickly post additional margin collateral or liquidate their open hedging and trading positions.

In light of the MF Global liquidation, this article offers considerations for producers who rely on futures to manage their commodity price risks and for lenders who may be asked to quickly advance funds to cover margin calls.

Segregating and investing customer funds

The Commodity Futures Trading Commission (“CFTC”) regulates how FCMs use and invest customer funds. While FCMs are required to keep customer funds segregated on an accounting basis, the CFTC allows FCMs to maintain customer funds in a single account rather than maintaining a separate account for each of its customers. Also, in certain situations FCMs may deposit their own assets into such a combined account.

The CFTC permits FCMs to invest customer funds in certain investments described in CFTC Rule 1.25. At the time of the MF Global liquidation, Rule 1.25 authorized FCMs to invest in U.S. government securities, municipal securities, government sponsored enterprise securities, certificates of deposits, commercial paper, corporate notes or bonds, money market mutual funds and certain foreign government bonds. Not all foreign government bonds qualified as permitted investments. Such bonds must have been rated AAA by at least one rating agency, therefore any investments by MF Global of customer funds in bonds issued by Greece, Italy and certain other distressed European countries would have been prohibited by CFTC regulations.

Effective Feb. 17, 2012, the CFTC will no longer permit FCMs to invest customer funds in foreign government bonds. As a result of the MF Global liquidation, the CFTC adopted an amendment to Rule 1.25 which will only permit investments in U.S. government securities, municipal securities, U.S. agency obligations, certificates of deposits, money market mutual funds and commercial paper, corporate notes and corporate bonds guaranteed by the United States under the Temporary Liquidity Guarantee Program.

While the ability of FCMs to invest, and earn a rate of return on customer funds is an integral part of the futures system, it is important for participants in the futures markets to understand how FCMs are investing customer funds. The CFTC amendment to Rule 1.25 narrows the type of permitted investments, but customers may also want to review the specific investment policies of their FCMs and ensure they correspond with the customers’ risk management policies.

Credit structures and risk management strategies