New York Law Journal
WEDNESDAY, DECEMBER 12, 1979

Commodities Law
By David C. Buxbaum

Cash-Settlement System Recommended

Introduction

    As a result of the infamous May, 1976 default in the New York Mercantile Maine Potato Futures contracts, the Department of Agriculture, pursuant to the Futures Trading Act of 1978, Section 27, was required to undertake a comprehensive study of the marketing and futures trading of Irish potatoes. This study, which has recently been published, contains some very unusual suggestions, among them recommendations that call for a cash settlement system rather than delivery of the commodity. A brief review of the summary and recommendations of this study are discussed in this article.

I. Nature of the Contract.

    As the study points out there are two potato futures markets, namely, the New York Mercantile Exchange and the Chicago Mercantile Exchange has had the greatest volume by far of potato futures contract. The contract on the New York Mercantile Exchange calls for delivery of Maine round white potatoes, while the contract on the Chicago Mercantile Exchange calls for russets grown in Idaho and other designated states. The Department of Agriculture found a divergence between the cash prices of these two types of potatoes, and differences in their monthly and annual movement which may be substantial, although recognizing that they both follow the same trends. Thus, these contracts are not essentially interchangeable.

    At the same time, production of Maine potatoes has been declining while production of all potatoes in the United States has been increasing. Additionally, the study found that Maine potato acreage has been planted to early maturing potatoes which have poorer storability than the later maturing varieties. Thus, the quantity of round white potatoes deliverable on April and May Futures contracts has decreased. One of the problems noted in the massive default on Maine potatoes future contracts, was the inability to make proper delivery, presumably because of failure to meet certain standards as a result of poor storability.

II．Basic Becomes More Variable.

    The Department of Agriculture found that the basis, that is the difference between the futures and spot price, has become more variable in the Maine potato contracts. In addition, contrary to what the Department of Agriculture expected in a properly functioning market, where cash and future prices normally would converge as one gets closer to the delivery period, they found this not to be true as trading comes to an end in the Maine potato market. The reason for this lack of convergence is obvious, namely, that it is increasingly difficult and costly to make an acceptable delivery. Hedging has become more difficult.
    Furthermore, in comparison with other futures markets, the study found that a large number of positions in Maine potato futures contracts were held open until the last day of trading. Most people holding positions are holding short positions. The Department of Agriculture summarized as follows:
    “The difficulty in making good delivery, the congestion on the last day of trading, the lack of convergence of cash and futures prices, and the unusual volatility of last day prices all are pat of the recent picture of difficulties in the NYME potato futures market”.

III. Alternative Developments.

    Some of the trade associations such as the National Potato Council and the Potato Growers of Idaho have called for the elimination of potato futures contracts.
    The New York Mercantile’s proposal for a new contract covering round white potatoes in fifteen states is designed to eliminate the narrow base of supply in later delivery months, as to some extent is the Chicago Board of Trades contract calling for russets. Objections to these contracts have been raised in particular, with regard to the New York Mercantile contract, since Maine will probably be the only state to have round white potatoes available in May when heavy trading takes place.

IV. Recommendations.

    One of the essential and most startling recommendations of the Report is a scheme for financial settlements formula combined with provisions for physical delivery. While ordinarily one can insist on delivery if one has purchased a futures contract, in fact, as we know in the Maine potato scandal, delivery did not take place on a large number of contracts. The Department of Agriculture has pointed out the problems in obtaining delivery. Thus, we essentially had in 1976 the development of a new status or at least a new provision within the contract called nondelivery. Now we have yet another provision suggested by the Department of Agriculture called delivery in cash instead of in kind. We shall return to this recommendation in a moment.

    The Report also recommended that the contract traded on the New York Mercantile Exchange should be broadened to permit the delivery of round white potatoes grown in locations other than Maine. Thus, the deliverable supplies would thereby presumably be increased in November and March.
    The Report also recommended certain negative remedies, if a program of financial settlement cannot be implemented. For example, recommendations on limits of the size of position held by individual traders, and a tapering down of said limits as the contracts approach maturity, increasing margin requirements as the contract approaches maturity, trading for liquidations only, and prohibition of trading in the May contract were all possible suggestions.

V. Conclusions.

    The Report of the United States Department of Agriculture seems to provide an excellent analysis of the problems with the New York Mercantile contract on Maine potatoes, as well as a good analysis of the problems with the Maine potato industry. However, the Report suggests a substitution of financial payment for actual delivery on a futures contract which this author believes essentially undermines the very nature of the futures contract. While delivery often does not take place in futures trading, since it is not called for, the fact that delivery can be expected is an essential element in a futures contract.
    The Department of Agriculture’s position while not without reason, in suggesting a system of optional financial settlements, would seem to undermine the very nature of futures trading and puts into question the portion of the Report that says that the futures contract on Maine potatoes is indeed a useful one. The tremendous divergence that occurs between the spot prices and the futures prices and which continues as one gets closer to delivery, is obviously caused by the reality that there may not be delivery. This is not the sort of reality one would wish to encourage. For if indeed the futures contracts on Maine potatoes are useful for hedging purposes then delivery should and must take place. In fact, if anything, failure to deliver should be governed by additional sanctions, because of the previous experience that had so dramatically startled people in the industry.
    While realizing that delivery of the actual underlying commodity is very desirable, there are times when the futures market apparently cannot perform the functions it was designed to perform. On these occasions, it may be best to eliminate the futures contract, and rely solely on the spot market. Obviously, however, to encourage lack of delivery, after the Maine potato scandal, will lead to a belief that persons do not have to deliver on other futures contracts. This could undermine the entire industry. While the Department of Agriculture is not concerned with the entire futures industry, it would seem to this author, that contrary to the recommendations for optional financial settlements in lieu of delivery, that delivery should not only be insisted upon, but failure to deliver on a futures contract containing the sort of risks that the Maine potatoes contract contains, should contain serious penalties.

    David C. Buxbaum, a former law professor and presently a member of the Law Offices of David C. Buxbaum, P.C., has been involved in international business transactions between the United States and the People’s Republic of China, and is also actively involved in commercial litigation.