Michael Caglioti and Jeffrey A. Burt

The recent financial meltdown of Russia has certainly delayed, and ominously threatened, Russia's full integration into the global market economy. The collapse in the value of the ruble undermined a major achievement of the Russian government in introducing currency stability and low inflation since 1994. By abandoning in August 1998 the defense of the ruble, imposing a temporary moratorium on foreign debt payments, and defaulting on domestic sovereign debt, the Russian government has brought about a sharp contraction in imports and massive consolidation of a much weakened Russian financial industry. Price controls and additional current and capital account restrictions are distinct possibilities. The financial collapse, President Yeltsin's failing health and popularity, and the complexion of the new Russian government have brought into question in the minds of many the commitment and ability of Russia to persevere toward long-term market reforms.

Despite these setbacks, Russia's progress toward a market economy in the post perestroika-era remains impressive and must be viewed against its historical context. Many of the largest state enterprises have been privatized. Fledgling entrepreneurs have started new businesses and many will likely survive. Commercial and financial contacts between Western banks and businesses and their Russian counterparts, though shaken by recent events, should be viewed against the pre-Yeltsin era where Western oriented interaction was severely circumscribed.

Reflecting the early movements toward market reforms, the Russian central bank and Russia's largest private financial institutions in 1991 formed the Moscow Interbank Currency Exchange (MICEX). MICEX developed into the largest exchange market for trading Russian government securities and foreign currencies. In 1996, foreign currency futures, i.e., contracts for the future delivery of certain hard currencies (U.S. dollars and German marks) or the Russian ruble, began trading on MICEX.

In reaction to the Russian government's decisions to float the ruble and to force restructuring of ruble-denominated debt, the governing board of MICEX suspended trading in currency futures and ordered the settlement of all open positions based on the exchange rate prevailing before the government's decree. These emergency measures, taken under MICEX's rules for force majeure situations, denied hedgers and speculators who held long positions in foreign currency futures of additional profits from the sharp depreciation of the ruble. Although criticized by some as inconsistent with free market principles, the emergency measures were not only necessary but also fully consistent with the rules and practice of the world's leading futures exchanges. While Russia's financial collapse was certainly unexpected, it would be highly unfair to criticize Russian agencies or institutions for imposing reactive measures which have clear precedent in the international marketplace.

Background

After months of committing foreign currency reserves to defend the external value of the Russian ruble, the government of the Russian Federation and the Russian Central Bank, on August 17, 1998, declared a 90-day moratorium on repayment of foreign commercial loans by banks and effectively devalued the ruble by allowing its value to float in the market. Russian authorities announced that the ruble would trade in a band of 6 to 9.5 rubles per dollar, but the value of the ruble immediately depreciated far outside of this band.

Quite unexpectedly, the Russian government at the same time also essentially defaulted on its internal debt. Russian authorities suspended trading in government debt securities (GKO/OFZ) and directed the eventual conversion of those securities into new securities with deferred maturities. GKO/OFZ securities thus immediately became illiquid and highly uncertain in value. GKO/OFZ securities collateralized approximately 70 percent of the margin deposits and guarantee fund contributions of MICEX Derivatives Division members.

GKO/OFZ securities and foreign financing constituted principal sources of liquidity for the Russian commercial banking system. Russian commercial banks also held a very significant portion of their assets in these securities. As a result of the default on GKO/OFZ securities, the Russian banking system became illiquid, several large banks failed, and bank customers generally could not access their funds on deposit.

Responding to this unprecedented financial collapse, the MICEX Directorate, on August 17, 1998, suspended trading, clearing, and settlement operations for all derivative instruments, including foreign currency futures contracts. On the same day, the Directorate considered the alternatives of:

· Settling all positions in futures contracts at the prices recorded at the close of trading on August 14, 1998, or

· Resuming trading in futures contracts by members of the Derivatives Division, provided that those members posted additional margin deposits and guarantee fund deposits.

On August 21, 1998, the MICEX Board ratified these decisions of the MICEX Directorate, and on August 26, 1998, required all clearing members to increase their margin deposits before August 31, 1998. When the required deposits failed to materialize, on September 2, 1998, the MICEX Board ordered the closing out of all derivatives positions at the closing prices on August 14, 1998, the last trading day before the Russian government announced the foreign debt moratorium and restructuring of its GKO/OFZ debt.

Emergency Powers

The rules of the MICEX Derivatives Division authorize the governing board of MICEX to implement emergency measures in force majeure situations. These rules are similar to those governing other major futures exchanges, including the Chicago Mercantile Exchange, the Chicago Board of Trade, and the London International Financial Futures and Options Exchange. The emergency powers of these futures exchanges are intended to address emergencies that threaten the performance of contracts or the orderly trading of futures contracts.

In determining whether an emergency exists, the governing board of a futures exchange must exercise discretion and judgment in evaluating the prevailing circumstances and ascertaining the best interests of the exchange. The rules of the MICEX Derivatives Division, accordingly, expressly vest the MICEX Directorate with substantial discretion to declare the existence of a force majeure situation. These rules also define characteristic features of a force majeure situation, including that the exigent events are external to the futures market, were not in existence or unknown to the Directorate when it admitted the derivative instrument to trading, and are unavoidable and incapable of reversal by MICEX. Further, the MICEX rules provide that, after declaration of a force majeure situation, the governing board may order the suspension of trading and the settlement of all open positions on the basis of prices attained on the trading day immediately preceding the emergency.

Given the broad discretion that the Derivatives Division rules afford MICEX and the crisis atmosphere in the Russian financial markets last summer, MICEX, in compliance with its rules, exercised its emergency powers. The Russian government's default on GKO/OFZ debt securities destroyed the value of the collateral that MICEX members had posted for margin deposits and contributions to the guarantee fund. The Russian banking system was largely illiquid, and several banks had failed or were in the process of forced consolidation. In these dire circumstances, MICEX acted to forestall systemic collapse of the derivatives trading, clearing, and settlement mechanisms.

International Norms

In undertaking emergency measures last summer, MICEX acted consistently with the practices of major futures exchanges in dealing with extraordinary market disruptions. For example, in Thomson v. Thomson, 146 N.E. 451, 455 (Ill. 1925), the Supreme Court of Illinois upheld the actions of the governing board of the Chicago Board of Trade, taken pursuant to the rules of the Board of Trade, that compelled the settlement of grain contracts at reasonable prices after the United States had declared war on Germany. By forcing settlement of grain contracts at reasonable prices, the Board of Trade deprived traders with long positions of additional profits from escalating grain prices. Other U.S. courts have followed Thomson and endorsed the principle that a futures market may suspend trading in an emergency and liquidate open positions at a reasonable price.

Similarly, administrative precedent under the Commodities Exchange Act has deprived traders of additional profits from market disruptions. In In re Chicago Mercantile Exchange, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) 20,436 (May 20, 1977), the lifting of federal price controls threatened to disrupt a free and orderly market in pork belly futures contracts and, in these circumstances, the Chicago Mercantile Exchange exercised its emergency powers, including forcing the settlement of unliquidated contracts as of the last trading day rather than at market prices. The administrative law judge upheld this emergency action, which prevented traders holding long positions from realizing substantial additional profits.

Although most members of MICEX's governing board actively participated in the derivatives market, that fact did not invalidate MICEX's emergency measures or even present an unusual conflict of interests - it is rather an ordinary consequence of MICEX's status as a self-regulatory organization. U.S. futures markets are similarly self-regulated, and U.S. courts have "noted that the system of self-regulating exchange boards established by Congress makes it inevitable that members of exchange boards will be called upon to make decisions in their capacity as exchange officials that may have an impact on their private business interests." This "system of self-regulation inevitably will provide dissatisfied traders with some evidence consistent with self interest" on the part of the governing authorities of an exchange.

In fact, a U.S. court may overturn the emergency action of a futures exchange in exceptionally narrow circumstances. A court would invalidate emergency measures only if the governing authorities of the futures exchange acted in such a self-interested manner that those measures amounted to fraud. More specifically, the governing board of an exchange would have adopted emergency measures in bad faith only if the "dominant reason" for adopting those measures was "self-interest or other ulterior motive unrelated to proper regulatory concerns." Conversely, "if the governors sincerely and rationally believe their action is in the public interest, there should not be liability simply because the action has the incidental effect of advancing their private interests or damaging someone whom they do not like."

Under this test, MICEX's emergency actions served a proper regulatory purpose. By suspending trading in derivatives instruments and directing settlement of open positions on the basis of pre-emergency prices, the MICEX Directorate and Board, as noted, forestalled a systemic collapse of the entire Derivatives Division. This dominant regulatory purpose overrode any effect of the emergency measures in incidentally damaging traders who held long positions in foreign currency futures contracts.

Commercial Expectations

Certainly no one expected the extent of Russia's financial collapse last summer or the magnitude of trading losses occasioned by that collapse. Insofar as MICEX's emergency measures exacerbated those losses or curtailed gains, those effects, however, were not commercially unforeseeable.

The emergency measures implemented by MICEX, for instance, precluded some Derivatives Division members who held long positions in foreign currency futures contracts from realizing additional profits from the depreciation of the ruble. Although unfortunate for these traders, such potential "losses" were foreseeable because the Rules of the Derivatives Division expressly contemplate the suspension of trading of derivative instruments in a force majeure situation and the liquidation of open positions on the basis of prices attained on the last trading day preceding the emergency. Thus, by joining and trading futures contracts on the Derivatives Division, traders assumed the risk that enforcement of the Division Rules might curtail their profits.

The loss of such additional profits to long traders, significantly, did not occur merely because the ruble depreciated sharply last summer. While parties to a futures contract do explicitly allocate the risk of changes in currency values, neither MICEX nor any of its members expected the government of the Russian Federation to default on service and repayment of GKO/OFZ debt securities. This entirely unexpected event caused the liquidity crisis that required emergency action by MICEX.

In light of the unexpected default of the Russian government on domestic sovereign debt and the overall paralysis of the Russian financial system, MICEX implemented emergency measures last summer. These actions accorded with the practice of other major futures markets in addressing emergency market conditions. Western derivatives traders and businessmen therefore can not properly regard MICEX's emergency actions as contributing to the general pessimism concerning the commitment of Russian institutions to market principles. Russia's integration into the world economy, although clearly damaged by recent events, will remain dependent upon commitments to international principles and precedents, which includes proper reactivity to force majeure events.

Jeffrey A. Burt is the partner in charge of Arnold & Porter's Russian practice and specializes in international transactions and litigation. Michael Caglioti, a partner located in Arnold & Porter's Washington office, specializes in legal work for financial institutions. The firm has handled certain matters for MICEX. Jeffrey Burt is a member of the Board of Directors of the Russian-American Chamber of Commerce®.

Notes

1. See MICEX Derivatives Division Rules Art. 84(1).

2. MICEX Derivative Division Rules Arts. 80(1) and 84(2)(a).

3. The Derivatives Division rules require members to contribute funds to a guarantee fund, which MICEX may use to manage the insolvency of one or several members. See MICEX Derivatives Division Rules Arts. 64, 69 and 82.

4. Notably, the Commodities Futures Trading Commission (CFTC), the federal regulator for futures markets in the United States, has stated that it will not find the governing board of a futures exchange to have taken emergency measures improperly "merely because the [CFTC] would have selected a different approach for dealing with the market situation or would not have declared an emergency." CFTC Interp. Ltr. No. 79-2, [1979-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) Ý20,860 (July 25, 1979); see also In re Chicago Mercantile Exch., [1975-1977 Transfer Binder] Comm. Fut. L. Rep. (CCH) Ý20,023 (Feb. 20, 1975) (CFTC Chairman Peterson criticized CFTC's challenge to emergency action based on hindsight).

5. See Sam Wong & Son, Inc. v. New York Mercantile Exch., 735 F.2d 653 (2d Cir. 1984) (applying principle); Crowley v. Commodity Exch., Inc., 141 F.2d 182, 183 (2d Cir. 1944) ("[t]here is no doubt of the general power of the Board of Governors of the Exchange to compel members and their customers to cease trading and accept a reasonable settlement of their contracts"); Seligson v. New York Produce Exch., 378 F. Supp. 1076, 1104 (S.D.N.Y. 1974) (recognizing same principle); Garcia Sugars Corp. v. New York Coffee & Sugar Exch., 7 N.Y.S.2d 532, 534 (N.Y. Sup. Ct. 1938), aff'd sub nom. Rifkind v. New York Coffee & Sugars Exch., 16 N.Y.S.2d 1023 (N.Y. App. Div. 1939) (applying principle).

6. Minpeco, S.A. v. Hunt, 693 F. Supp. 58, 65-66 (S.D.N.Y. 1988); see also Bishop v. Commodity Exch., Inc., 564 F. Supp. 1557, 1562 (S.D.N.Y. 1983) (recognizing inherent conflict of interests in self-regulatory exchanges).

7. Jordan v. New York Mercantile Exch., 571 F. Supp. 1530, 1548 (S.D.N.Y. 1983), aff'd in part, rev'd in part, sub nom. Sam Wong & Son, Inc. v. New York Mercantile Exch., 735 F.2d 653 (2d Cir. 1984). In Crowley v. Commodity Exch., Inc., 141 F.2d 182, 188 (2d Cir. 1944), the court of appeals stated that a commodities hedger, "when it undertook to do business through the Exchange, would expect to deal with those favoring either short or long interests, if not both." The court of appeals declined to overturn the action of the Commodity Exchange in directing the liquidation of all outstanding raw silk contracts at fixed prices, noting that "[p]laintiff's real difficulty is that the group presumably interested his way did not have the necessary votes."

8. See Daniel v. Board of Trade, 164 F.2d 815, 819 (7th Cir. 1947).

9. Sam Wong & Son, Inc. v. New York Mercantile Exch., 735 F.2d 653, 677 (2d Cir. 1984) (emphasis added); see also Ryder Energy Distrib. v. Merrill Lynch Commodities Inc., 748 F.2d 774, 780 (2d Cir. 1984); Miller v. New York Produce Exch., 550 F.2d 762, 766 (2d Cir. 1977); Grossman v. Citrus Assocs. of the New York Cotton Exch., Inc., 742 F. Supp. 843, 853 (S.D.N.Y. 1990); Gordon v. Hunt, 558 F. Supp. 122, 124 (S.D.N.Y. 1983); P.J. Taggares Co. v. New York Mercantile Exch., 476 F. Supp. 72, 77 n.22 (S.D.N.Y. 1979); Smith v. Groover, 468 F. Supp. 105, 118 (N.D. Ill. 1979).

10. Sam Wong & Son, 735 F.2d at 677 (emphasis added).

11. See, e.g., Compania de Salvadorena v. CFTC, 467 F. Supp. 687, 691 (S.D.N.Y. 1978) (by consenting to by-law, traders agree that governing board of futures market may determine existence of emergency on basis of its opinion and without findings of fact).

12. In the parlance of contract law, the GKO/OFZ default can be viewed as constituting a supervening event that relieved parties of the obligation to perform their contracts. The liquidity and value of GKO/OFZ securities, which secured the margin deposits and guarantee fund contributions of clearing members, formed, under this construction, an implied condition of the futures contracts traded on the Derivatives Division. Thus, when the unexpected governmental action caused GKO/OFZ securities to become illiquid and highly uncertain in value, that implied condition no longer existed, and the parties to futures contracts were no longer obliged to perform those contracts. Summarizing this fundamental principle of contract law, a learned treatise on contract law states that "wherever a contract required for its performance the existence of a specific thing, the fortuitous destruction of that thing, or such impairment of it as makes it unavailable, excuses the promisor, unless he has clearly assumed the risk of its continued existence." Samuel Williston, A Treatise on the Law of Contracts ßÝ1948, at 87-88 (3d ed. 1978) (emphasis added); see generally 2 American Law Institute, Restatement (Second) of Contracts ßÝ263 (1981).

Last Updated: 14 June 1999.
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