ADM Investor Serv v. Collins, Mark W. ( 2008 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 06-4412
ADM INVESTOR SERVICES, INC.,
Plaintiff-Appellee,
v.
MARK W. COLLINS,
Defendant-Appellant.
____________
Appeal from the United States District Court for the
Northern District of Illinois, Eastern Division.
No. 05 C 1823—John F. Grady, Judge.
____________
ARGUED SEPTEMBER 25, 2007—DECIDED FEBRUARY 7, 2008
____________
Before EASTERBROOK, Chief Judge, and BAUER and
KANNE, Circuit Judges.
EASTERBROOK, Chief Judge. Mark Collins traded futures
contracts on the Chicago Board of Trade through ADM
Investor Services, a futures commission merchant (the
equivalent of a stockbroker for derivatives). Over
the course of 18 months, Collins made almost $1 million.
His last trade, on July 27, 2004, was in soybean contracts.
Collins purchased 40 contracts for delivery in August 2004
while selling 40 contracts for delivery in November.
Matched pairs of long and short contracts take a posi-
tion in the difference between the prices, which the
futures business calls the spread. On July 27 the August
contract was selling for $6.69 per bushel and the Novem-
2 No. 06-4412
ber contract for $5.89, a spread of 80¢. Collins stood
to make money if the spread increased and to lose if
it decreased.
Three days later the spread was down to 30¢. The
November price had declined to $5.69, so the short posi-
tion for that month had increased in value, but the August
price stood at $5.995, and Collins had lost $99,000 more
on his long position than he gained on his short posi-
tion. ADM made a margin call. Collins posted only
$15,000, so ADM liquidated his position by offsetting
purchases. It sent Collins a bill for $85,521.83, which he
did not pay. ADM filed this suit under the diversity
jurisdiction to collect, and the district court entered
judgment in its favor. 2006 U.S. Dist. LEXIS 3282 (N.D. Ill.
Jan. 26, 2006), 2006 U.S. Dist. LEXIS 68049 (N.D. Ill. Sept.
26, 2006).
Collins has two defenses. One is that Shell Rock Enter-
prises, an introducing broker, has paid ADM about $75,000
under its contractual guarantee of Collins’s trades. This
means, Collins insists, that ADM is not the real party
in interest. The brief reads as if counsel (Collins’s brother)
had never heard of the collateral-source doctrine. That a
third party reimburses part of a loss does not disable
the injured person from recovering under tort or contract
law. ADM did not assign its rights to Shell Rock (there
is no subrogation agreement), so ADM is the proper
plaintiff. How ADM and Shell Rock settle accounts be-
tween themselves is none of Collins’s business.
The other defense is that the soybean contracts were
“illegal” because on July 27, 2004, a margin call was
outstanding on another of Collins’s trades. He insists
that ADM should have used the money tendered as mar-
gin on the soybean spread to satisfy the margin call on the
existing trade; had ADM done this, it could not have
executed the soybean-spread trades, because the initial
No. 06-4412 3
margin would have been insufficient. Rule 431.012(11) of
the Chicago Board of Trade provides:
Members shall not accept orders for new trades
from a customer, unless the minimum initial
margin on the new trades is deposited and unless
the margin on old commitments in an account
equals or exceeds the initial requirements on
hedging and spreading trades and/or the mainte-
nance requirements specified in Regulations
431.03 and 431.05 on all other trades.
The Commodity Exchange Act requires futures commis-
sion merchants to abide by a board of trade’s rules; it
follows, Collins insists, that his trades of July 27 were
illegal and that he need not cover his losses. He invokes
the principle that courts do not enforce “illegal con-
tracts”—for example, cartel agreements or wagering
debts in states where gambling is prohibited. ADM replies
that on July 27 Collins still had time to meet the margin
call on his older trades, so “the maintenance require-
ments specified in Regulations 431.03 and 431.05 on all
other trades” did not prevent ADM from allowing its
customer to make additional trades. We need not decide
whether this is right, because Collins’s argument
founders on more fundamental grounds.
A soybean spread is not “illegal” in the sense of the rule
against enforcing “illegal contracts.” There is nothing
unlawful about buying or selling futures contracts for
soybeans. They are freely traded on public exchanges. A
contract does not become “illegal” just because a trader
fails to put down a deposit (that’s what margin is in a
futures market), any more than a buyer’s failure to
post earnest money makes a contract to sell Blackacre
“illegal.” Failure to post security as required enables
the other side to rescind but does not provide benefits
to the person who has failed to honor his own obligations.
4 No. 06-4412
Another way to see this is to ask why margin is re-
quired in futures transactions. In securities markets, the
full purchase price must be paid to the seller before a
transaction is complete; margin is a loan from the dealer
to the customer, secured by the assets acquired in the
transaction. The Federal Reserve regulates these loans,
along with many other aspects of financial intermedia-
tion, as part of its control of the aggregate money sup-
ply. Regulation of this kind could be seen as an effort to
protect the general public from the effects of investors’ and
brokers’ activities. Margin in the futures business, by
contrast, does not represent an extension of credit, and
there are no third-party effects.
A futures contract is executory; no asset changes hands
when the contract is formed. See generally CFTC v.
Zelener, 373 F.3d 861 (7th Cir. 2004). The buyer (the
holder of the long position) transacts with the seller (the
creator of the short position) through a clearing corpora-
tion. When a long and a short agree to a contract, each
makes his promise to the clearing corporation, which
then becomes the counterparty of each original party. The
risk that the clearing corporation assumes is that an
obligor won’t perform when the time comes to deliver the
soybeans (or to pay for them). Reducing this risk of
nonperformance, usually called the “counterparty risk” in
derivatives markets, is the role of margin. See Lester G.
Telser, Margins and Futures Contracts, 1 J. Futures
Markets 225 (1981); Haiwei Chen, Price Limits and
Margin Requirements in Futures Markets, 37 Financial
Rev. 105 (2002).
Exchanges and clearing corporations set margin high
enough that short-term price movement is likely to leave
a net equity balance available to the dealer. If price
movements reduce its security unduly, the dealer may
have time to demand an additional deposit—and to
liquidate the position, before the balance goes negative,
No. 06-4412 5
as a form of self-protection if the investor does not meet
the margin call. Occasionally, though, prices move so
fast that a position’s value is negative before a margin
call can be issued; what happened in July 2004 to the
August–November soybean spread shows the risk. The
futures commission merchant then is on the hook, for it
is a condition of participation in these markets that
each dealer guarantee customers’ trades. When Collins
did not post the margin, ADM had to buy offsetting
positions in the market, which enabled the clearing
corporation to close Collins’s trades without absorbing
a loss.
It should now be apparent that margin requirements
in futures markets are not designed to protect investors
such as Collins from adverse price movements. Margin
protects counterparties from investors who may be unwill-
ing or unable to keep their promises. Counterparties
are protected directly by clearing corporations (that’s
why trading can be anonymous and contracts homoge-
neous); clearing corporations are protected not only by
the balance in their portfolios (every long position exactly
offsets a short) but also by the futures commission mer-
chants, which generally are substantial businesses; the
futures commission merchants are protected, to a degree,
by the margin deposits posted by customers such as
Collins. So the person injured by a shortfall of margin
was ADM, not Collins, and ADM’s failure to take all
available steps to protect itself from defaulting cus-
tomers is hardly a reason why customers should be
allowed to renege. No surprise, then, that both circuits
that have addressed the issue have held that a customer’s
failure to post required margin for a futures contract
does not excuse him from paying. See Merrill Lynch,
Pierce, Fenner & Smith, Inc. v. Brooks, 548 F.2d 615 (5th
Cir. 1977); Thomson McKinnon Securities, Inc. v. Clark,
901 F.2d 1568 (11th Cir. 1990). We agree with these
6 No. 06-4412
decisions. As Justice Holmes once put it, there is a vital
“policy of preventing people from getting other people’s
property for nothing when they purport to be buying it.”
Continental Wall Paper Co. v. Louis Voight & Sons Co.,
212 U.S. 227, 271 (1909) (Holmes, J., dissenting).
Still another way to see this point is to observe that
balky customers are not in the zone of interests protected
by margin-posting requirements. Margin protects dealers
and counterparties from defaulting customers, who are
in no position to complain when the protection of their
trading partners turns out to be incomplete.
Collins is particularly poorly positioned. Almost $450,000
of his $1 million net profit on transactions through ADM
came from trades executed while a margin call was
pending on another open position. If, as Collins maintains,
any contract entered into while a margin call is pending
is void, then Collins is the loser: the cost to him of avoid-
ing an $85,000 debt will be the need to make restitution
of the rest, for a net judgment of $365,000 in ADM’s favor.
Collins should give thanks that he has lost this appeal.
AFFIRMED
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—2-7-08