CFTC Action Against Kraft May Be an Important Early Test of CFTC’s New Anti-Fraud Authority
In a civil enforcement action that may signal increased scrutiny of end users and hedgers in the commodities markets, the Commodities Futures Trading Commission has accused Kraft Foods Group, Inc. and its successor in interest, Mondelēz Global LLC, of engaging in a scheme to manipulate the price of wheat in violation of the Commodity Exchange Act and the Commission’s anti-manipulation rules. Kraft and Mondelēz split in 2012 when Kraft spun off its North American grocery operations to shareholders.
According to the CFTC’s four-count complaint, filed in the Northern District of Illinois on April 1, 2015, Kraft allegedly executed a scheme designed to lower the cost of procuring its physical wheat supply, while also benefitting its positions in the futures market. The CFTC further alleges that Kraft impermissibly held wheat futures positions in excess of speculative position limits and engaged in prohibited noncompetitive trades. The complaint seeks a permanent injunction barring Kraft from future violations, as well as disgorgement and a civil monetary penalty. The accusations are particularly notable because they target food processing companies, who typically receive hedge exemptions to help mitigate the price risk of buying raw materials like wheat, as opposed to speculative traders, who commonly have been the target of federal regulators’ manipulation investigations. A civil class action suit against Kraft also has been filed in federal court on behalf of futures traders holding positions that lost money as a result of the alleged scheme.
The CFTC complaint alleges that when wheat prices rose in the summer of 2011 due to droughts in Europe and Asia, Kraft developed a scheme to lower the price of wheat by sending false signals to the market through purchases in the futures market. The complaint alleges that Kraft typically used wheat futures contracts to hedge its cash wheat purchases, offsetting long futures positions as it bought physical wheat in the cash market to supply its Toledo, Ohio flour mill. However, Kraft allegedly acquired a “huge long position” in December 2011 wheat futures not to hedge, but for the purpose of inducing sellers to believe that it actually planned to take delivery of and use the wheat when, in fact, it had no intention of doing so. The Commission alleges that Kraft had no legitimate commercial need for so much wheat (equal to roughly 15 million bushels, a six-month supply for its Toledo mill) and that Kraft would have been unable to store such large quantities in its own facilities.
According to the complaint, Kraft’s scheme worked, depressing the price of wheat in the cash market, enabling Kraft to obtain its physical wheat supply at lower prices, and narrowing the spread between the December and March wheat futures contracts, which benefitted Kraft’s futures position. The complaint includes excerpts of emails that allegedly show Kraft’s senior executives explaining the scheme and confirming that the effect was “[a]s expected.” The CFTC alleges that Kraft’s strategy generated profits and savings in excess of $5.4 million.
The CFTC also contends that in building its long position in December 2011 wheat futures, Kraft on several days violated speculative position limits set by the Commission and the CBOT without having a valid hedge exemption in place or a bona fide need for such a large quantity of wheat. Further, the complaint challenges Kraft’s practice of using Exchange for Physical (EFP) transactions to offset its long and short positions. According to the CFTC, these transactions constituted “fictitious” noncompetitive, off-exchange transactions, which the complaint describes as wash sales. The transactions allegedly violated Regulation 1.38(a), which governs noncompetitive, off-exchange futures trades, because they did not involve the actual transfer of wheat between two independent parties at arm’s length.
The complaint is interesting for several reasons. First, the complaint alleges that Kraft was too aggressive in seeking lower raw materials costs and, therefore, cheaper prices for its customers. Many would assume this to be a valid business purpose and, indeed, a laudable goal in a competitive market, but the CFTC chooses instead to focus on the related futures position. Second, the complaint reads like a classic “market power” case, alleging that Kraft transacted in excessive quantities and created an artificial price—the traditional Rule 180.2 manipulation claim alleged in the second count. But the CFTC goes further and alleges a Rule 180.1 fraud claim, as well, accusing Kraft of “using a deceptive or manipulative device” in connection with its December 2011 wheat trading. The complaint does not explain, however, exactly what was deceptive or fraudulent about Kraft’s conduct. The CFTC comes closest to articulating a fraud theory in its allegations that Kraft acquired wheat in quantities far greater than it intended to use or take delivery of, and thereby sent false signals to the market. But the Complaint does not explain what the false signals were, why they were false, or how buying more than one can use, without more, is deceptive. Indeed, it seems that much of Kraft’s trading would have been transparent to the market, because market participants typically follow closely major hedgers like Kraft and likely were aware of how much wheat Kraft could take delivery of and store. Third, the allegations related to Kraft’s “enormous” futures position echo the manipulation allegations levied by the CFTC in the only other case it has brought pursuant to the Commission’s new enforcement authority under Dodd-Frank. Like that matter, where the CFTC alleged that trading volumes exceeded 90% of the market on at least one day, the CFTC alleges that Kraft’s position represented 87% of the CBOT futures open interest as of December 7, 2011. Finally, the complaint does not name any individuals, alleging instead that the procurement staff acted within the scope of their authority and with the approval of management.
In light of Enforcement Director Aitan Goelman’s recent comments about the Commission’s plans to rely more heavily on administrative adjudications, it is notable that the case was filed in federal court. Given that the fraud count specifically alleges that Kraft “acted recklessly,” the federal court case may provide an early opportunity for the CFTC to test the Dodd-Frank recklessness standard and to urge the endorsement of its broad interpretation of that new standard. The Kraft case could signal the Commission’s intent to be more aggressive and may prove an important early test of the CFTC’s anti-manipulation authority.
Paul Hastings’ Investigations and White Collar Defense practice group has extensive experience representing companies and individuals in matters involving commodities and derivatives trading, anti-manipulation and regulatory compliance, and investigations by the CFTC and other regulators. Please contact us if you have any questions concerning these developing issues.