London, 30 April 2010

The Commodity Futures Trading Commission (CFTC) has no statutory authority to impose position limits on energy futures contracts, according to multiple filings made by the financial services industry as part of the recent consultation exercise. The CFTC's lack of authority has been articulated most forcefully by the U.S. Futures Industry Association (FIA), the International Swaps and Derivatives Association (ISDA) and the Financial Institutions Energy Group (FIEG). The major commodity banks have been more circumspect. But most endorse the "lacks authority" approach either by footnote, cross-reference to the FIA and ISDA letters, or implicitly. Only Bank of America-Merrill Lynch restricts its objection to the practical implication of the account aggregation and crowding out provisions.

Barclays Capital is typical when it writes: "The proposal suggests that speculative position limits may be needed to address the perceived risks of 'excessive speculation' and 'excessive concentration of positions', yet to our knowledge, neither of these supposed negative externalities has been substantiated with economic analysis.

"We are not aware of any empirical evidence for the existence of 'excessive speculation' or any robust economic analysis that concludes that speculation itself is inherently problematic."

Section 4 Dispute

Section 4 (a) of the Commodity Exchange Act (7 USC Section 6(a)) says the Commission "shall" establish trading or position limits as it finds "necessary" to "diminish, eliminate or prevent" the burden on interstate commerce caused by "excessive speculation".

In its Notice of Proposed Rulemaking (NPR) the Commission focused on the words "shall" and "prevent" to argue Congress had given it a clear instruction to impose limits; all it needed to show was that excessive speculation could cause an undue burden in future, not that it had actually done so at any point in the past.

In contrast, most industry filings focus on the word "necessary" to argue Congress has established a factual condition or trigger threshold that must be met before the Commission can impose limits. In their view, the law requires the Commission to show empirical evidence that "excessive speculation" really exists, and is not merely a theoretical possibility. It must also show that position limits are an effective response.

The industry claims the Commission has shown neither. It has sidestepped the issue of whether speculation rather than supply and demand is responsible for recent movements in crude oil and other commodity prices.

Other agencies such as Britain's Financial Services Authority (FSA) and the CFTC's own economists have found no evidence of a speculative impact. Moreover, position limits imposed in agricultural markets do not appear to have resulted in any less price movement than in other markets where hard federal position limits are not currently enforced.

Existential Crisis

This has created something of an existential crisis for the CFTC. If the courts were to accept FIA's reading of the statute, with its focus on an empirical threshold, the impact would not be restricted to the proposed limits on energy contracts. The Commission could be forced to abandon current federal limits on farm contracts and stop requiring exchanges to set their own position limits and accountability levels in oil, gas and gasoline.

That result is counter-intuitive. Much of the industry accepts the current accountability levels. But opposition to the NPR would actually undermine the legal framework for them.

Barclays, for example, says "Perhaps instead of imposing additional hard limits, the Commission should consider enhanced accountability levels that could take into consideration OTC positions". It notes: "Accountability limits would also be more consistent with the position management approach by the FSA and other international regulators."

But if the CFTC must show an empirical basis to trigger powers set out in Section 4 (a) and set limits itself directly, then it would also presumably have to show an empirical basis under Section 4 (a) to make exchanges set and enforce softer accountability levels. It is not clear what legal force accountability could really have if the FIA's reading of the statute prevails.

See You in Court?

As the commissioners start to consider the responses to the consultation, the first decision they have to make is whether they have the power to impose limits. If they press ahead, despite industry opposition, there is a risk the FIA, or anyone else with standing, will ask the U.S. Court of Appeals for the District of Columbia Circuit to enjoin the Commission from enforcing the rule while its statutory authority is litigated in the federal courts.

Whether the CFTC would prevail is uncertain. Among other things, the rules of statutory construction require the courts (1) to give effect to all the words in the legislation (including "necessary"); (2) in their ordinary accepted meaning (unless Congress has given them a specific meaning); (3) to take account of the intent of Congress as shown by the legislative history; and (4) other relevant factors such as rulings in related cases and the history of how the statute has been applied in practice.

In the end, the question is about the burden of proof. Must the Commission produce empirical evidence of a real problem before it exercises its regulatory power in this area? Or should the industry be required to prove no problem exists before it can ask a court to prevent the Commission exercising powers set out in Section 4 (a).

Like most legal questions, it depends on the inclination of the judges. But the Commission might face an uphill battle through the relatively conservative DC Circuit Court of Appeals and the Supreme Court (where the current 5-4 conservative majority has been sympathetic to business efforts to push back against intrusive government regulation).

Jurisprudence in other areas, for example Environmental Protection Agency rulemaking under the Clean Air Act, or by the Federal Energy Regulatory Commission, requires strong evidential thresholds to be met before regulators can take action.

Need to be Sure

The Commission needs to be very sure of its ground here before going ahead. Defeat would call into question much more than just the proposed energy limits. It is not clear whether the CFTC has requested an outsider opinion from the Justice Department's powerful Office of Legal Counsel or the solicitor-general (who would supervise the case in the appellate courts and before the Supreme Court).

Perhaps the most powerful argument in the Commission's favour is that Congress, or least some members, clearly do intend to give the CFTC the power to set limits. Most versions of the financial reform currently being considered by Congress would actually extend the Commission's limitsetting powers into OTC and foreign markets. But none of those is law yet.

If the Commission has any doubt about the sufficiency of its statutory authority it could return to Congress and ask for language to be inserted into the pending bills amending Section 4 (a) or clarify the meaning of "necessary". Either way, the Commission needs to make a strategic choice. It could drop the position limit proposals altogether (at present only 2 of the 5 commissioners seem certain to vote in favour of adopting them). It could ask Congress to clarify its authority. Or it could take a risk in federal court. Something the commissioners will have to think hard about in coming weeks.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now. The views expressed are his own.