Nagel, Dennis v. ADM Invester Serv ( 2000 )

In the
United States Court of Appeals
For the Seventh Circuit
Nos. 99-3236 to 99-3240, 99-3513 to 99-3517
Dennis Nagel, et al.,
Plaintiffs-Appellants,
v.
ADM Investor Services, Inc., et al.,
Defendants-Appellees.
Appeals from the United States District Court
for the Northern District of Illinois, Eastern Division.
Nos. 96 C 2675, 2741, 2879, 2972, and 5215--
Frank H. Easterbrook, Judge.
Argued May 8, 2000--Decided June 7, 2000
Before Posner, Chief Judge, and Bauer and Diane P.
Wood, Circuit Judges.
Posner, Chief Judge. This is another chapter in
the continuing saga of "flexible" or "enhanced"
hedge-to-arrive contracts (we’ll call these "flex
HTAs"); for the earlier chapters see Lachmund v.
ADM Investor Services, Inc., 191 F.3d 777 (7th
Cir. 1999), and Harter v. Iowa Grain Co., No. 98-
3010, 2000 WL 426366 (7th Cir. Apr. 21, 2000), in
light of which we can be brief.
The plaintiffs in these five consolidated cases
are farmers who entered into contracts to deliver
grain to grain elevators and other grain
merchants, the defendants, at a specified future
date. So far, we are describing an ordinary
forward (sometimes called "cash forward")
contract, a contract that provides for delivery
at some future date at the price specified in the
contract. Merrill Lynch, Pierce, Fenner & Smith,
Inc. v. Curran, 456 U.S. 353, 357 (1982). The
hedging feature that gives the HTA contract its
name comes from the fact that the contract price
is a price specified in a futures contract that
the merchant buys on a commodity exchange and
that expires in the month specified for delivery
under the merchant’s contract with the farmer
(the HTA contract). This arrangement hedges the
merchant against price fluctuations between
signing and delivery. The merchant is "long" in
his contract with the farmer (the forward
contract) in the sense that, if price rises, he’s
to the good, because the price was fixed earlier,
in the contract, and so he bought the farmer’s
grain cheap. But if the price of grain falls,
he’s hurt, because he’s stuck with a contract
price that is higher than the current price. To
offset this risk he goes "short" in the futures
contract--that is, he agrees to sell an
offsetting quantity of grain at the same price as
fixed in the forward contract. If the price of
grain falls during the interval between the
signing of and delivery under the forward
contract, though he loses on the forward
contract, as we have seen, he makes up the loss
in the futures contract, where he is the seller
and therefore benefits when the market price
falls below the contract price: The loss he would
otherwise sustain as a result of having to resell
the farmer’s grain at a lower price than the
price fixed in his contract with the farmer is
offset by his profit on the futures contract. In
sum, the price in the contract between farmer and
merchant fixed by reference to the futures
contract made by the merchant protects the farmer
against price fluctuations between the signing of
the contract and the delivery of the grain (just
because it is a fixed price and so is unaffected
by any change in market price during this
interval), while the futures contract itself
protects the merchant from the risk of loss
should the price plummet during that interval.
That’s a simple HTA contract; the "flex" feature
of the HTA contracts involved in this case comes
from the fact that they allow the farmer to defer
delivery of the grain. (On the difference between
simple and flex HTAs, see the lucid discussion in
Charles F. Reid, Note, "Risky Business: HTAs, The
Cash Forward Exclusion and Top of Iowa
Cooperative v. Schewe," 44 Vill. L. Rev. 125,
134-37 (1999).) Such a contract specifies a
delivery date but allows the farmer, upon the
payment of a fee and an appropriate adjustment in
the price to reflect changed conditions, to defer
delivery beyond that date. A farmer who exercises
this deferral option is doing what is called
"rolling the hedge." The merchant, if he wants to
hedge against price fluctuations during the
extended period of the contract, will close out
his existing futures contract by buying an
offsetting contract and will then buy a new
futures contract to expire at the new delivery
date. When the new delivery date arrives, the
farmer can again roll the hedge.
Why might a farmer want to roll the hedge? If
the market price rose between the signing of the
original contract with the merchant and the
delivery date specified in the contract, and the
farmer expected it to fall later, he could, by
rolling the hedge, sell his grain at the current
market price (since he wouldn’t have to deliver
it to the merchant), which by assumption is
higher than the price fixed in the contract; and
then, just before the new delivery date, he could
buy at the then current price, expected to be
lower, the amount of grain he was obligated to
deliver and deliver it at the price fixed in the
contract. The flex feature thus enables the
farmer to speculate on fluctuations in the market
price of his grain.
The plaintiffs did this in 1995, but
unfortunately for them prices stayed up and to
satisfy their contractual obligations they had to
buy grain at prices above the prices fixed in
their contracts with the merchants, sustaining
large losses as a consequence. They seek in these
suits to get out of the contracts by arguing that
flex HTA contracts are futures contracts. The
Commodity Exchange Act, 7 U.S.C. sec.sec. 1 et
seq., requires that futures contracts be sold
through commodity exchanges and the futures
commission merchants registered on those
exchanges, 7 U.S.C. sec. 6(a); the defendants
fall into neither category. The section just
cited declares futures contracts not sold through
commodity exchanges and registered futures
commission merchants unlawful, CFTC v. Topworth
Int’l, Ltd., 205 F.3d 1107, 1114 (9th Cir. 1999);
CFTC v. Noble Metals Int’l, Inc., 67 F.3d 766,
772 (9th Cir. 1995); CFTC v. Co Petro Marketing
Group, Inc., 680 F.2d 573, 581 (9th Cir. 1982),
and the parties assume that futures contracts
rendered unlawful by section 6(a) are indeed
unenforceable.
We cannot find any case that holds this,
although several cases require disgorgement of
profits obtained under unlawful such contracts,
see id. at 582-84; CFTC v. American Metals
Exchange Corp., 991 F.2d 71, 76 (3d Cir. 1993);
CFTC v. American Board of Trade, Inc., 803 F.2d
1242, 1251-52 (2d Cir. 1986), and many cases say
that contracts made in violation of law are
unenforceable. E.g., Shlay v. Montgomery, 802
F.2d 918, 922 (7th Cir. 1986); MCA Television
Ltd. v. Public Interest Corp., 171 F.3d 1265,
1280 n. 19 (11th Cir. 1999); Total Medical
Management, Inc. v. United States, 104 F.3d 1314,
1319 (Fed. Cir. 1997); Development Finance Corp.
v. Alpha Housing & Health Care, Inc., 54 F.3d
156, 163 (3d Cir. 1995); Paul Arpin Van Lines,
Inc. v. Universal Transportation Services, Inc.,
988 F.2d 288, 290-91 (1st Cir. 1993); Resolution
Trust Corp. v. Home Savings of America, 946 F.2d
93, 96 (8th Cir. 1991). The Supreme Court has
stated flatly that "illegal promises will not be
enforced in cases controlled by the federal law."
Kaiser Steel Corp. v. Mullins, 455 U.S. 72, 77
(1982). Yet despite this ringing declaration,
many cases continue to treat the defense of
illegality to the enforcement of a contract as
presumptive rather than absolute, forgiving minor
violations and disallowing the defense to be used
to confer windfalls. See U.S. Nursing Corp. v.
Saint Joseph Medical Center, 39 F.3d 790, 792
(7th Cir. 1994); Olson v. Paine, Webber, Jackson
& Curtis, Inc., 806 F.2d 731, 743 (7th Cir.
1986); Northern Indiana Public Service Co. v.
Carbon County Coal Co., 799 F.2d 265, 273 (7th
Cir. 1986); Lulirama Ltd. v. Axcess Broadcast
Services, Inc., 128 F.3d 872, 880 (5th Cir.
1997); E. Allan Farnsworth, Contracts sec. 5.5,
pp. 344-46 (3d ed. 1999). (U.S. Nursing Corp. and
Lulirama are cases under state law, but the
others we have cited are federal-law cases.) In
light of the defendants’ concession we need not
pursue the question how far or in what
circumstances the fact that a contract was found
to have been made in violation of the Commodity
Exchange Act would absolutely bar any relief to
the victim of the breach of such a contract.
The Act defines a futures contract as a contract
for future delivery, but defines future delivery
to exclude "any sale of any cash commodity for
deferred shipment or delivery," 7 U.S.C. sec.
1a(11), that is, any forward contract. Lachmund
v. ADM Investor Services, Inc., supra, 191 F.3d
at 787. The plaintiffs argue that since the flex
feature of their contracts permits delivery to be
deferred indefinitely, the contracts are not
forward contracts, but instead futures contracts.
The district court disagreed and dismissed the
suits, believing it plain that the language of
the contracts showed they were forward contracts.
Some of them contain arbitration clauses, so in
addition to dismissing the suits the court
confirmed arbitral awards for the defendants for
the plaintiffs’ breaches of contract in failing
to make delivery when due. 65 F. Supp. 2d 740
(N.D. Ill. 1999).
Although futures contracts specify delivery as
a possible method of satisfying the short’s
obligations, it is much more common for such
contracts to be closed out by the "buyer’s"
taking an offsetting position in a new contract
identical but for its price. Dunn v. CFTC, 519
U.S. 465, 472 (1997); Merrill Lynch, Pierce,
Fenner & Smith, Inc. v. Curran, supra, 456 U.S.
at 359 n. 18 (only 3 percent closed out by
delivery); Salomon Forex, Inc. v. Tauber, 8 F.3d
966, 971 (4th Cir. 1993); Cargill, Inc. v.
Hardin, 452 F.2d 1154, 1156 n. 2 (8th Cir. 1971)
(fewer than 1 percent closed out by delivery);
Reid, supra, 44 Vill. L. Rev. at 129 n. 27. This
option for getting out enables people who are not
agriculturalists, and wouldn’t know an ear of
corn from a soybean if it slapped them in the
face, to speculate in the prices of commodities.
In other words, these contracts are really a type
of security, like common stock, rather than a
means of fixing the terms by which farmers ship
their output to grain elevators and other
agricultural middlemen. It is because commodity-
futures contracts are a type of security that
Congress has seen fit to subject them to a
regulatory scheme, the Commodity Exchange Act,
which parallels that administered by the SEC for
trading in corporate stock. There was no
intention of regulating the commerce in
agricultural commodities itself. But because
futures contracts do contain a provision for
delivery as an optional mode of compliance with
obligations created by such contracts, rare as
the exercise of that option is, it isn’t always
easy to determine just from the language of a
contract for the sale of a commodity whether it
is a futures contract or a forward contract.
The flex feature in the HTA contracts moves
these contracts in the direction of futures
contracts by attenuating the obligation to
deliver, and there is anxiety that by loading
such features onto what would otherwise seem to
be garden-variety forward contracts the
regulatory scheme will be evaded. This led our
court in the Lachmund case to look with favor
upon a "totality of the circumstances" approach
for determining whether a contract is a futures
contract or a forward contract, 191 F.3d at 787-
88, as have other courts as well. See Grain Land
Coop v. Kar Kim Farms, Inc., 199 F.3d 983, 991
(8th Cir. 1999); Andersons, Inc. v. Horton Farms,
Inc., 166 F.3d 308, 317-21 (6th Cir. 1998); CFTC
v. Co Petro Marketing Group, Inc., supra, 680
F.2d at 579-81. But as noted by Judge
Easterbrook, also a member of this court though
sitting by designation as the trial judge in this
case, the "totality of the circumstances"
approach invites criticism as placing a cloud
over forward contracts by placing them at risk of
being reclassified as futures contracts traded
off-exchange and therefore illegal. Of course, if
the legality of a contract cannot easily be
determined in advance, that might be a factor
rebutting the presumption noted earlier that
illegal contracts are unenforceable; but this is
not a possibility that we need consider in this
case, or perhaps in any flex HTA case, since the
problem of legal uncertainty under the "totality
of circumstances" is less serious than it appears
to be.
As is often true of multifactor legal tests, the
"totality of circumstances" approach turns out in
practice to give controlling significance to a
handful of circumstances; and fortunately they
can usually be ascertained just by reading the
contract. The cases indicate that when the
following circumstances are present, the contract
will be deemed a forward contract (see Lachmund
v. ADM Investor Services, Inc., supra, 191 F.3d
at 788-90; Grain Land Coop v. Kar Kim Farms,
Inc., supra, 199 F.3d at 990-92; Andersons, Inc.
v. Horton Farms, Inc., supra, 166 F.3d at 317-22;
CFTC v. Noble Metals Int’l, Inc., supra, 67 F.3d
at 772-73; CFTC v. Co Petro Marketing Group,
Inc., supra, 680 F.2d at 579-81; Top of Iowa
Coop. v. Sime Farms, Inc., 608 N.W.2d 454, 465
(Iowa 2000)):
(1) The contract specifies idiosyncratic terms
regarding place of delivery, quantity, or other
terms, and so is not fungible with other
contracts for the sale of the commodity, as
securities are fungible. But there is an
exception for the case in which the seller of the
contract promises to sell another contract
against which the buyer can offset the first
contract, as in In re Bybee, 945 F.2d 309, 313
(9th Cir. 1991), and CFTC v. Co Petro Marketing
Group, Inc., supra, 680 F.2d at 580. That promise
could create a futures contract.
(2) The contract is between industry
participants, such as farmers and grain
merchants, rather than arbitrageurs and other
speculators who are interested in transacting in
contracts rather than in the actual commodities.
(3) Delivery cannot be deferred forever,
because the contract requires the farmer to pay
an additional charge every time he rolls the
hedge.
As long as all three features that we have
identified are present, eventual delivery is
reasonably assured, unlike the case of a futures
contract--and remember that the Commodity
Exchange Act is explicit that a contract for
delivery in the future is not a futures contract.
If one or more of the features is absent, the
contracts may or may not be futures contracts.
This refinement of the "totality of
circumstances" approach that we adopt today,
while it will not resolve every case, will
protect forward contracts from the sword of
Damocles that these plaintiffs wish to wave above
the defendants’ heads, yet at the same time will
prevent evasion of the Commodity Exchange Act by
mere clever draftsmanship.
The three features are present here, as can be
ascertained from the contracts themselves; and
while the plaintiffs allege that there are oral
as well as written terms in some of the contracts
with the defendants, they have not alleged any
oral terms that would prevent eventual delivery
or cancel the fee for rolling, which places a
practical limit on how long delivery can be
deferred. The district court was therefore
correct to dismiss the plaintiffs’ complaint, and
we proceed to the question whether the court was
also correct to confirm the arbitration awards in
favor of the grain merchants.
For the reasons stated in Harter, a materially
identical case, we think the court was correct.
But there is an issue not addressed in Harter
that may repay discussion, although it turns out
to be academic. A regulation promulgated under
the Commodity Exchange Act, 17 C.F.R. sec. 180.2;
see id. sec. 180.3(b)(7), imposes certain
procedural formalities on arbitrations under the
Act, such as a right to cross-examine witnesses,
that are not found in the Federal Arbitration
Act, under which the awards challenged by the
plaintiffs were confirmed. The defendants point
out that the regulation is limited to disputes
arising under the Commodity Exchange Act, which a
dispute concerning a forward contract does not
arise under; that Prima Paint Corp. v. Flood &
Conklin Mfg. Co., 388 U.S. 395, 402-04 (1967),
makes the validity of a contract that contains an
arbitration clause itself an arbitrable issue
(the issue here, of course, is whether these are
forward or futures contracts), see Hammes v.
AAMCO Transmissions, Inc., 33 F.3d 774, 783 (7th
Cir. 1994); Colfax Envelope Corp. v. Local No.
458-3M, 20 F.3d 750, 754-55 (7th Cir. 1994);
Europcar Italia, S.p.A. v. Maiellano Tours, Inc.,
156 F.3d 310, 315 (2d Cir. 1998); and that the
plaintiffs’ argument that the contracts in issue
are invalid by virtue of being subject to the Act
is a validity challenge that the arbitrators
resolved against them by holding that these are
forward contracts.
The plaintiffs reply that if the parties to a
contract are free to establish a bobtailed
arbitration procedure for determining the
contract’s validity, the Act will be
circumvented. But the inapplicability of the
regulation to arbitral determinations of validity
did not make the arbitration procedurally
inadequate. It just meant it was governed by the
Federal Arbitration Act, which establishes
procedural minima deemed adequate to enable
arbitrators to make responsible decisions on
issues of validity. 9 U.S.C. sec. 10; Harter v.
Iowa Grain Co., supra, 2000 WL 426366 at *8;
Flexible Mfg. Systems Pty. Ltd. v. Super Products
Corp., 86 F.3d 96, 99 (7th Cir. 1996); Dawahare
v. Spencer, No. 98-6356, 2000 WL 489712, *2 (6th
Cir. Apr. 27, 2000); Morani v. Landenberger, 196
F.3d 9, 11-12 (1st Cir. 1999); Scott v.
Prudential Securities, Inc., 141 F.3d 1007, 1015-
17 (11th Cir. 1998); Tempo Shain Corp. v. Bertek,
Inc., 120 F.3d 16, 20 (2d Cir. 1997). Anyway we
earlier in this opinion resolved the issue of
validity against the plaintiffs who did not have
arbitration clauses in their contracts, which
renders academic the question whether the
arbitrators were entitled to resolve the issue:
if they were not, we were, and we come to the
same resolution of it.
The only other issue that merits discussion is
whether the district court was premature in
denying class certification; it was not. As is
often and puzzlingly the case, see Amati v. City
of Woodstock, 176 F.3d 952, 957 (7th Cir. 1999);
Frahm v. Equitable Life Assurance Society, 137
F.3d 955, 957 (7th Cir. 1998); Bieneman v. City
of Chicago, 838 F.2d 962, 964 (7th Cir. 1988)
(per curiam), the plaintiffs, who lost in the
district court and could not, in light of
Lachmund and Harter, rationally rate their
chances of a reversal high, are arguing for class
treatment, even though that will extinguish the
claims of all members of the class who do not opt
out, Robinson v. Sheriff of Cook County, 167 F.3d
1155, 1157-58 (7th Cir. 1999); Pabst Brewing Co.
v. Corrao, 161 F.3d 434, 439 (7th Cir. 1998),
while the defendants are arguing against class
treatment, though if the argument prevails the
res judicata effect of a judgment in their favor
will be curtailed.
In any event, we do not find persuasive the
plaintiffs’ argument, perfunctorily made, that
the district court could not deny class status on
its own initiative without giving the plaintiffs
a chance to introduce evidence concerning the
suitability of the case to be a class action. The
case had been pending for several years when the
court ruled, and the plaintiffs had never during
that period moved for class certification, even
though Rule 23 of the Federal Rules of Civil
Procedure and the cases interpreting it require
that the issue of class certification be resolved
as quickly after the suit is filed as
practicable. Fed. R. Civ. P. 23(c)(1); Crawford
v. Equifax Payment Services, Inc., 201 F.3d 877,
881 (7th Cir. 2000); Bennett v. Schmidt, 153 F.3d
516, 519-20 (7th Cir. 1998); Bieneman v. City of
Chicago, supra, 838 F.2d at 963-64. Not only did
the plaintiffs’ counsel flout this precept, but
they demonstrated to the district court’s
satisfaction that they were incapable of
representing the class adequately. Fed. R. Civ.
P. 23(a)(4); Amchem Products, Inc. v. Windsor,
521 U.S. 591, 626 n. 20 (1997); General Telephone
Co. v. Falcon, 457 U.S. 147, 157 n. 13 (1982);
Secretary of Labor v. Fitzsimmons, 805 F.2d 682,
697 (7th Cir. 1986) (en banc); Greisz v.
Household Bank (Illinois), N.A., 176 F.3d 1012,
1013-14 (7th Cir. 1999); Marisol A. v. Giuliani,
126 F.3d 372, 378 (2d Cir. 1997) (per curiam).
It was apparent, moreover, both that each class
member had a sufficiently large stake to be able
to afford to litigate on his own--a consideration
that weighs against allowing a suit to proceed as
a class action, Amchem Products, Inc. v. Windsor,
supra, 521 U.S. at 617; Frahm v. Equitable Life
Assurance Society, supra, 137 F.3d at 957, in
view of the well-known drawbacks of class
litigation, In re Rhone-Poulenc Rorer Inc., 51
F.3d 1293, 1299-1300 (7th Cir. 1995)--and that,
because the complaints alleged fraud, which is
plaintiff-specific, issues common to all of the
class members were not likely to predominate over
issues peculiar to specific members, which is
still another requirement of Rule 23 for class
certification. See Fed. R. Civ. P. 23(b)(3);
Amchem Products, Inc. v. Windsor, supra, 521 U.S.
at 622-23; Frahm v. Equitable Life Assurance
Society, supra, 137 F.3d at 957; Andrews v. AT&T
Co., 95 F.3d 1014, 1023-24 (11th Cir. 1996);
Castano v. American Tobacco Co., 84 F.3d 734,
744-45 (5th Cir. 1996).
Affirmed.