Price protection seems like a good idea. So, you forward contract your corn to an ethanol plant. How did you get into a bankruptcy proceeding in Delaware? What do you mean you have to deliver at the new market price, and lose the benefit of your forward contract?
Price protection seems like a good idea. Your cattle on feed eat corn. You hedge both. But the market goes the wrong way on the grain. Live cattle prices fall dramatically. And the banker is uncomfortable. What do you do about the market calls to maintain your hedge?
Change came to American politics on January 20, 2009. Several months before then, during 2008, change was inaugurated at the marketplace in America and across the world. Looking back, did the global economy hold its breath to complete the Olympic games and then collapse at the finish line with the sprinters and the marathoners? Thousands of American producers of food and fiber face calamitous losses. Their mistakes: They hedged, forward contracted, and locked in certainty, only to find uncertainty confronting them.
What happened is less important than what can be done. The former question is for an economist’s historical study. The latter, looking to the future, is a producer’s question. And a lawyer’s.
An Example – Hedge To Arrive Contracts.
“Hedge to arrive” (“HTA”) contracts provide a
superb example about risks involved in marketing agricultural products.
HTA contracts are sold because they induce the producer to believe a crop
can be placed with a buyer, at a target price, with a reserved right to
“roll” the sale price and delivery date forward into the future.
The roll places delivery beyond the original date, at a newly established
price for a nominal fee. Often, HTAs are sold without a limitation on
the number of rolls, and without conventional margin call adjustments
for market changes or risks.
HTA contracts are dangerous. So often, they induce producers to believe there is no real risk because rolls can continue perpetually, preventing loss, and permitting enduring, unending patience with confidence the market eventually will change.
This approach essentially teaches the unwary producer to believe that his contract is perpetual. If he doesn’t like the delivery price at the scheduled time, he simply rolls it forward.
But, contracts are legal instruments, and legal instruments cannot operate to perpetuity. As a general proposition, the law abhors perpetuities and strikes them out of contracts. The law also zealously protects priority lien rights, and abandons unsecured creditors to the lowest class of claimants when financial disaster strikes.
HTA contracts are largely takeoffs on market conditions that exist, and are available, generally. A forward contract requiring performance of payment cannot be rolled so simply, but it can be replaced with a new marketing instrument offsetting the old, and advancing the interests of the investor forward. Eventually, even this strategy must end, and perpetuity cannot occur.
These steps do not protect the seller. The elevator, as purchaser, protects itself with its offsetting Board of Trade position. If cattle or swine are involved, packers do the same thing with offsetting Board positions.
But the producer misses a step. As the seller, the producer’s position is naked; performance is dependent on the general financial ability and goodwill of the elevator, grain company, packer, or other purchaser of products.
So, why not require that the purchaser in a forward contract, hedge to arrive contract, or other future pricing vehicle, pledge the purchaser’s offsetting position on the Board to the producer-vendor to assure payment? In other words, the producer would sell, and lock in a price with collateral in the form of the buyer’s offsetting sale contract as collateral for the sale position and eventual payment. This would add virtually no cost to the buyer’s circumstances, assure payment, and provide little or no adverse impact on credit circumstances.
Using the HTA example and the three factors that contracts should contain as specified above, simple safety would add a fourth component to the transactional matrix.
The purchaser in the hedge setting would be required to pledge its offsetting position to the contract seller as collateral, execute a specific collateral agreement creating a first priority lien, and the producer would perfect the security interest in the offsetting position. The purchaser would be required to make margin calls, keep the producer notified that they are met and inform, and otherwise comply, with the purchaser’s hedge or sale transaction.
As a result, the purchaser’s circumstances would remain hedged, and the producer’s transaction would be protected.