On October 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 shockwaves 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 clearing house 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. Both producers and lenders have an interest in understanding why, and how, funds posted to a customer’s brokerage account may be segregated or invested by FCMs before those funds are used to settle trades.
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 February 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 U.S. 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
The SIPA liquidation proceeding of MF Global resulted in customers being required in many instances to post additional collateral to maintain their open commodity positions, and caused uncertainty as to the availability of funds already on deposit with MF Global. To give producers, grain elevators and processors additional liquidity and reduce their concentration of risk, the following credit structures and risk management strategies may be considered by producers, elevators, processors and their lenders:
Accordion and Protective Advance Features in Revolving Credit Facilities
The sudden and unexpected need to post additional collateral in the days after MF Global required quick action and coordination between producers and lenders. Credit facilities that featured “accordion” provisions — provisions that permit a borrower to request an increase to a credit facility on an expedited (and often paperless) basis — allowed producers to quickly increase the maximum amount of credit available to them. Accordion provisions can be drafted in a manner that permit quick lender approval and do not require a borrower to incur any additional fees until the accordion increase is exercised. Although lenders are not required to grant a borrower’s request for an increase, the accordion feature provides a structure for responding to rapid market changes and the need for increased liquidity, for example, to cover margin calls. In addition, syndicated credit facilities may also include provisions that allow an administrative agent to make protective advances exceeding the borrowing base in certain situations. Accordion and protective advance provisions are not only useful in unusual situations such as the MF Global liquidation, but can also be important tools during periods of market volatility.
Borrowing Base Advance Rates for Commodity Accounts
The net equity maintained in commodity accounts is an integral part of the borrowing base for many producers with revolving credit facilities. Producers should work with their lenders to ensure that the advance rates under their revolving credit facilities provide them with sufficient working capital. Lenders may want to review their valuations of various commodity accounts to ensure they are adequately protected in the event they need to foreclose on such accounts. In addition, lenders may want to explicitly reserve the discretion to reduce advance rates on accounts maintained at any “ineligible” FCM or remove such accounts from the borrowing base in their entirety.
Periodic Sweeps of Excess Equity
Many producers keep excess equity in their commodity accounts to avoid the time and expense associated with coordinating daily wires in and out of their commodity accounts. As described above, this excess equity may be a component of a producer’s borrowing base. To encourage producers to limit the amount of equity maintained in their commodity accounts, lenders may want to limit the maximum amount of net equity that may be valued in a borrowing base (or consider imposing a covenant wherein the producers agree they will not maintain net equity in excess of this maximum amount). Producers may also want to examine whether the convenience and cost savings of maintaining excess equity in their accounts is worth the additional risk, or whether they want to employ periodic sweeps of their excess equity.
Maintaining Additional Accounts
Being locked out of the futures markets for even a short period of time can expose producers to unacceptable levels of price risk. The ability to hedge inputs and outputs is a vital part of a producer’s business model and relying solely upon one FCM to serve this function can be risky. Producers should examine whether this risk can be reduced by maintaining commodity accounts with additional FCMs. Lenders may also want to consider whether to limit the percentage of futures contracts its borrowers may maintain with any one FCM.
Risk Management Policies
The MF Global liquidation should be a catalyst for producers to review their current risk management policies and ensure the policies are appropriate for their current business. Lenders should also review their borrowers’ risk management policies and work with their borrowers to revise any policies that may not be acceptable to the lender.
As part of producers’ risk management policies, producers should examine the financial condition of their FCMs to ensure they are financially stable. The MF Global liquidation has shown that conditions can deteriorate quickly and rating agencies and regulators may not necessarily be able to keep pace with the financial vagaries of the market. Early detection of financial instability could result in producers avoiding future problems.
Conclusion
While the causes of MF Global’s bankruptcy and related liquidation proceeding, and the $1.2 billion of missing funds, are still under review, these proceedings provide an opportunity for producers, elevators and processors to review their risk management strategies and FCM relationships. The CFTC has taken steps to limit the investments FCMs may make with segregated funds. Producers, elevators and processors should also review how their FCMs handle investments, and should work closely with their lenders to develop credit facilities that are flexible enough to handle both commodity price volatility and unforeseen shocks to the futures markets.
