Providing an Upside in a Down Market
Legal considerations for incorporating upfront premiums and contingent delivery obligations into grain origination programs
Market conditions faced by grain producers and merchandisers have earned a lot of attention in recent months. Despite multiple years of record profitability, waning export demand fueled by a strong U.S. dollar and weak energy markets have producers grappling with the prospect of considerable losses. Lenders have increased their scrutiny of cash flow projections; farm liquidations and early retirement of substantial operations are becoming more and more commonplace.
Producers are on the lookout for ways to improve cash flows, but in our capital intensive production systems there is often quite little low-hanging fruit from a cost savings standpoint. Reducing seed, fertilizer and other necessary production costs may lead to negative impacts on yields. Though cash rents may have eased to a certain degree, competition among producers has kept rents relatively high from a historical perspective. So producers find themselves looking to sweeten the price they receive for grain at the local elevator. Enter the local friendly grain merchandiser and his/her innovative and perhaps, somewhat complicated, grain marketing arrangements aimed at enhancing the sale price.
The concept of imbedding option-like premiums and contingent delivery obligations into grain purchase agreements has been around for several years. Large commercial grain buyers have utilized tools such as firm offers, maximum price contracts, and various other programs to allow sellers to realize additional premiums for initial delivery obligations, in exchange for limiting upside on subsequent obligations. For the most part, these arrangements have served producers and merchandisers well in the course of their usage, but they implicate a number of legal and practical considerations that merchandisers should understand and consider.
Periods of low prices followed by market runs tend to result in marketing alternatives being put to the test. Most will remember when Hedge-to-Arrive contracts (HTAs) became commonplace. In practice, they were, and continue to be, a valuable tool when appropriately managed in the right circumstances. They allow producers to hedge futures market risk while remaining open to basis risk, which tends to be somewhat more seasonal and predictable. Liberal rolling policies, however, which occasionally allowed rolling of contracts over multiple crop years, had the impact of permitting farmers to gamble on lower prices and defer the recognition of significant losses to later years. Rising grain prices exposed producers, and ultimately elevators, to severe losses.
In the mid to late 1990s, when it came time to enforce HTAs after significant losses had been incurred, an explosion of litigation ensued. A common theme advanced by producers was the claim that many HTAs were unenforceable as unregulated futures contracts in violation of the Commodity Exchange Act (CEA), among many other themes. Many courts thwarted these claims, viewing them as opportunistic behavior by producers, but the social costs and commercial disruption caused by the eruption of litigation as producers attempted to escape liability left a significant scar on many industry participants.
Lessons learned from the HTA fiasco can be applied to traders looking to work some premium and contingent delivery programs into their contract offerings, but they can also serve as a reminder to continually hone one’s strategies for managing counterparty risk generally. Because of the longer lead time associated with many of these contract offerings, substantial movements in market prices can occur between contract formation and delivery, which increases the incentive for a seller to breach or assert some excuse for nonperformance. Even more so than with other contracts, contingent delivery contracts require vigilance in obtaining signatures and exercising sound underwriting and due diligence practices.
Regulatory Considerations: Embedded Commodity Trade Options
Merchandisers should understand the regulatory framework for using option-like strategies in offering upfront premiums to producers. The Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over accounts, agreements and transactions involving contracts of sale of a commodity for future delivery, and over swaps. Excluded from the term “future delivery” is any sale of any cash commodity for deferred shipment or delivery. This is known as the forward contract exclusion. Thus, the intention to deliver is often significant to avoiding scrutiny by the CFTC.
Options are traditionally subject to regulation by the CFTC. There are three main exemptions, however.
1.Embedded Commodity Options. When they are embedded into forward contracts, options may or may not qualify for the forward contract exclusion depending upon whether both parties are obligated to make and take delivery or rather one party has the right but not the obligation to do so. CFTC regulatory guidance indicates that a forward contract that contains an embedded commodity option may, nevertheless, be treated as an excluded forward contract (and not an option) if three conditions are met: (1) the option may be used to adjust the forward price, but does not undermine the overall nature of the contract as a forward; (2) the option does not target the delivery term, so that the predominant feature of the contract is actual delivery; and (3) the option cannot be severed and marketed separately from the overall forward in which it is embedded.
2.Embedded Volumetric Commodity Options. Some contingent delivery obligations contained in some forward grain contracts may be construed by the CFTC as forward contracts with so called “volumetric optionality” and would also fall within the forward contract exclusion. The test for these “embedded volumetric commodity options” (i.e., which provide for variations in delivery amount) includes (i) the embedded optionality does not undermine the overall nature of the agreement, contract or transaction as a forward contract; (ii) the predominant feature is actual delivery; (iii) the embedded optionality cannot be severed and marketed separately; (iv) the seller intends at the time it enters into the agreement, contract or transaction to deliver the underlying nonfinancial commodity if the embedded volumetric optionality is exercised; (v) the buyer similarly intends to take delivery; (vi) both are commercial parties; and (vii) the embedded volumetric optionality is primarily intended to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity).
3.Trade Options: To qualify as a trade option, a commodity option must involve a physical commodity (i.e., an exempt or agricultural commodity) and meet three conditions: (1) the option is offered by either an “eligible contract participant” (generally speaking, a financially sophisticated entity) or a commercial participant (a producer, processor, commercial user of, or merchant handling, the underlying physical commodity); (2) the option is offered to a commercial participant; and (3) the option is intended to be physically settled so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery.
Regulatory Considerations: Intent to Deliver Compared with Actual Delivery
In many of the HTA cases, producers argued that an elevator’s failure to actually make and take delivery took the contract outside the forward contract exclusion. But courts have held that hedge to arrive contracts with rolling and cancellation features are not futures contracts, where the party offering them was in the commercial grain business, contracted for delivery of physical grain, the parties had the capacity to make and take delivery and expected to do so, and the contracts generally resulted in actual delivery even though a number of farmers exercised contractual cancellation provision. This is consistent with CFTC interpretations, which have provided, among other circumstances that “book out” transactions among commercial parties in a chain of delivery and supply arrangements for settling up their purchase/sale contracts qualify for the forward exclusion in certain circumstances.
Enforcement Considerations: Commodity Trade Association Rules and Arbitration
The lion’s share of transactions in the grain, oilseeds, ingredient and feedstuffs trade are governed by arbitration provisions established by the applicable commodity group, and for good reason. I have long advised clients to maintain access to these arbitration forums by maintaining appropriate membership and eligibility. The list of advantages these panels have over state or federal courts for enforcement is long, but subject matter expertise and understanding by the factfinder is one of the key advantages. As commodity contracts and pricing mechanisms become more and more complicated, the value of having evidence and arguments considered by trained and experienced grain merchandisers will be considerable, especially when compared to an arbitrator or judge not well versed in the grain or commodity business. The arbitration service administered by the National Grain and Feed Association (NGFA) is the preeminent example, but there are several others.
Embedded premiums and contingent delivery obligations will remain an important marketing alternative for merchandisers and growers for the foreseeable future. Being mindful of the unique legal issues that accompany them will allow you to more effectively and confidently incorporate them into your contract offerings, and may allow you a competitive advantage over competing grain buyers who do not yet offer them. As with any contracting alternative, be sure to consult competent legal counsel who can assist you in ensuring that your contracts work as intended for your specific situation.
Todd Langel is a lawyer with the firm of Faegre Baker Daniels and practices within its Food, Agriculture & Biofuels industry team. Todd is co-leader of the firm’s Animal Feed & Animal Health Products and Grain & Oilseeds industry segments.