Forward Contracts For Supply Of Grain Are Not Derivatives Or Financial Products

Keynes v Rural Directions Pty Ltd (No 2) [2009] FCA 567

In Brief

• The Federal Court of Australia has rejected an argument that "forward contracts" for purchase of grain are "derivatives" or "financial products" for the purposes of Part 7 of the Corporations Act 2001.
• Liquidated damages provisions do not mean that the contract permits the seller's obligations to be "wholly settled in cash"¹.
• A practice whereby sellers who cannot meet their obligations under forward contracts cover or cap their liability by entering into a corresponding purchase contract does not amount to the seller's obligation being "closed out by the matching up of the arrangement with another arrangement of the same kind"².

Background

The plaintiffs operated a farming business primarily concerned with production of wheat and barley. The defendants were variously a rural consultant and grain wholesalers.

The plaintiffs entered into a number of "forward contracts" with the defendant wholesalers, which required that they deliver specified quantities of grain on a specified date at a specified price.

The plaintiffs were not able to deliver the required quantities of grain as required by the forward contracts because of production failure. The contracts were "washed out", a process whereby the plaintiffs indicated to the grain wholesalers that they could not meet their obligations under the contracts, and the grain wholesalers then elected to cancel the contract and claim liquidated damages.

The plaintiffs took the first step by suing the defendants in the Federal Court of Australia seeking damages for alleged losses caused by entering into the forward contracts. Central to this claim was a contention that the plaintiffs were not liable under the forward contracts. This was put forward on a number of bases, in particular that the forward contracts were derivatives or "financial products" pursuant to Chapter 7 of the Corporations Act 2001 (Cth), and the defendants were therefore required to provide a Product Disclosure Statement containing information relating to the risks inherent in the forward contacts, such that the plaintiffs would not have entered into them if they had received a Product Dsclosure Statement.

As the Court later observed, the practical consequences of such a characterisation could be farreaching. The plaintiffs' interpretation in one respect "would catch an ordinary transaction like the sale and purchase of a motor vehicle with payment of the purchase price today and delivery in one week's time"³.

The defendants filed Notice of Motion seeking summary dismissal of the plaintiffs' claim.

Application for summary judgment

Submissions during argument before Besanko J centred on the provisions of section 761D(3) of the Corporations Act 2001 (Cth):

"... the following are not derivatives for the purposes of this Chapter...:

(a) an arrangement in relation to which subparagraphs (i), (ii) and (iii) are satisfied:

(i) a party has, or may have, an obligation to buy, and another party has, or may have, an obligation to sell, tangible property (other than Australian or foreign currency) at a price and on a date in the future; and

(ii) the arrangement does not permit the seller's obligations to be wholly settled by cash, or by set-off between the parties, rather than by delivery of the property; and

(iii) neither usual market practice, nor the rules of a licensed market or a licensed CS facility, permits the seller's obligations to be closed out by the matching up of the arrangement with another arrangement of the same kind under which the seller has offsetting obligations to buy;

but only to the extent that the arrangement deals with that purchase and sale;

First argument: "Does not permit the seller's obligations to be wholly settled by cash"

In regard to sub-section 761D(3)(a)(ii), the plaintiffs argued that the forward contracts permitted their obligations to be "wholly settled by cash", because (a) the buyer's remedy under the contract would be damages and the seller would pay such damages in cash; and (b) the washout provisions meant in effect that the seller could settle its obligations wholly by cash (as liquidated damages applied).

Besanko J rejected these arguments. He noted that the obligation to pay damages arises when the seller breaches its obligations, not when it settles them. The availability of nominal damages under the contract at other times only reinforced their point. And it seemed inherently unlikely that Parliament intended that the application of such a provision would depend upon whether damages as opposed to specific performance were likely to be awarded.

The "washout provisions", whilst they contained a liquidated damages clause, only operated if the sellers suffered production failure leading to default. Therefore they could not be said to apply to the contract in all aspects of its operation. In any case, the washout provisions operated at the option of the buyer only. The washout provisions were properly characterised as contractual provisions dealing with "the buyer's remedies in the case of breach and the measure of damages or compensation payable to the buyer in those circumstances"⁴. It followed that the forward contracts did not permit the seller's obligations to be "wholly settled by cash".

Second argument: "whether usual market practice permitted the forward contracts to be matched and offset against others"

The court accepted evidence that there was no market in which forward contracts are traded or can be traded. However, the plaintiffs argued that a seller who is facing a production failure may hedge or cap its losses by entering into contracts to buy, and this would satisfy sub-section 761D(3)(a)(iii).

Besanko J rejected this argument. He held that such a practice was properly characterised as "a means of making a profit or capping a liability in a market where goods are readily obtainable"⁵. In other words, it was the nature of the goods, rather than market practice which permits the seller to act in this way. Further, what the section requires to be matched out is the seller's obligations, not the goods as such.

Instead his Honour accepted the defendants' arguments that the words in the section "matching up ... with another arrangement" require a market practice whereby the seller's obligations are brought to an end upon the entering into of the offsetting arrangement.

Besanko J therefore held that the forward contracts were not "derivatives" and therefore not "financial products" within the meaning of the Act. This ultimately led to the making of an order for summary dismissal of the plaintiffs' claim.

Implications "

• The proliferation of financial services regulation can have unintended consequences. In this case, the argument that a forward contract was a derivative appeared deceptively attractive (and indeed was initially conceded by one of the defendants). Yet, with respect, the contrary decision of the court appears in accord with commercial practice relating to a common type of trading contract.
• Whilst on a statutory provision, the decision is also useful for consideration of the proper characterisation of off-setting contracts and liquidated damages clauses.

Footnotes

1 Section 761D(3)(a)(ii) Corporations Act 2001 (Cth)

2 Section 761D(3)(a)(iii) Corporations Act 2001 (Cth)

3 Judgment paragraph 87

4 Judgment paragraph 74

5 Judgment paragraph 80

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