MCX negative oil futures pricing mess: Jury out on contract law

By Shruti Rajan

The precipitous crash in crude oil prices and its consequential impact on the settlement price of crude oil futures is the latest in a volley of jolts that Covid-19 has unleashed on the financial markets this year. The dramatic dip in the settlement price of MCX crude oil futures was well reported by now and will likely beckon judicial as well as regulatory intervention. And in doing so, it will be interesting to observe whether this will put to test some well-established legal tenets that have guided financial markets so far.

The facts
The story so far is simple yet riveting, even if one accounts for the constant bustle that typifies a commodity such a crude oil, infamous for its price volatility. The MCX platform is home to more than 94 per cent of trades in crude oil futures across India, where contracts are settled, in cash on a monthly basis, on the date of the expiry of the contact. As per existing contract specifications, the final settlement price of such contracts is pegged to the settlement price of NYMEX crude oil front-month contract, as reflected in rupee value, on the expiry date of the MCX contract.

On April 8, 2020, an advisory was issued by CME Clearing, the clearing arm of NYMEX, to assure the clearing firms that testing plans were under way to support the possibility of negative prices and to enable normal functioning of the business. A week later on April 15, 2020, CME Clearing announced that its trading and clearing systems had been enabled to trade in zero or negative prices and allowed trading firms to test such negative futures in the new systems released by the clearing corporation.

Here in India, on April 20, 2020, the due date for contract settlement ended at 5 pm on account of Covid-19 modified market timings, with the last trade made at Rs 965 per barrel. Hence the Indian market woke up the next day to an overnight crash in crude oil prices at NYMEX, where prices plunged to a negative $37.

This posed a unique quandary for MCX, in terms of determining the due date rate or settlement price, and the exchange rolled out the following responses to control market sentiment :-

Due to unprecedented market fluctuation in the international markets, it initially, by a circular dated April 20, 2020, provided for a provisional settlement price of Re 1 per barrel for computation of brokers’ obligations for April futures.

Thereafter, by a circular dated April 21, 2020, MCX published the final rate for crude oil futures contract ending on April, 20 2020 at Rs (-) 2,884 per barrel, consistent with its contract specifications and in line with NYMEX WTI crude oil front-month contract’s settlement price.

It is relevant to mention here that although the rules and regulations of Sebi or MCX do not preclude a negative price settlement, they do not expressly contemplate such a possibility either. Neither do they recommend any contingency measures that can be implemented by exchanges in such circumstances. Faced with losses of more than Rs 450 crore, brokers are reported to have approached the Bombay High Court, challenging the final settlement price ascertained by MCX.

Legal Issues
A number of interesting legal issues will emanate from any judicial scrutiny of the facts as well as the legal regime applicable to such contracts.

First, the sanctity of the terms of the contract itself. Contract specifications serve as the standard terms and conditions between the buyers and sellers of futures contracts. In this case, fixation of the settlement price appears to be in accordance with the benchmark identified in contract specifications. Should an exception be made to the express terms of the contract on account on an unprecedented event, how will that balance with the principle of contractual sanctity, which recognises the primacy of a written agreement between two parties and discourages interference? Any curative measures taken to now modify the settlement price also run the risk of operating as a precedent and will, therefore, have to be approached with a degree of caution that befits the setting of such a yardstick.

Various other factors will also have an important role in determining the fate of this controversy. Central to this will be the amendments to the contract specifications that were undertaken by the exchange to accommodate the change in trading hours. This is particularly crucial since the contracts were amended by a circular dated March 26, 2020 (for the period between March 30 and April 14) directing closure of trading hours at 5 pm (as reduced from the original 11:30 p.m.), whereas trading at NYMEX was uninterrupted and continued to commence at 7 pm IST, impairing brokers from exiting positions to limit losses.

In line with applicable Sebi circulars, the change in timings was treated as a material amendment and undertaken in consultation with Sebi. However, only a five-day notice period was provided, as opposed to the 30-day notice mandated under the law. Whether this will amount to a unilateral alteration or novation to the contract terms and how substantial a modification this is proven to be will be at the heart of the party’s ability to strike at the root of the contract and repudiate its payment obligations. Brokers will also undoubtedly rely on the systemic constraints in the exchange architecture, which are not geared towards recognising negative pricing and identify this as the realistic perimeter within which the terms of the futures contract must operate.

Finally, there will be the interplay of all of the above with the principle of settlement finality, the sine qua non of any exchange. Trades executed on an exchange platform are inviolable, final and irrevocable, and this principle is unambiguously ensconced in regulatory guidance as well as exchange bye-laws.

Settlement of contracts executed on an exchange platform are also guaranteed by the clearing corporation and cannot be annulled unless on account of fraud, mistake or wilful misrepresentation – in other words, grounds based on which a contract per se can be declared void. Unconditional settlement finality is the holy grail of any exchange traded system and an important international metric to determine sophistication of financial markets. Re-interpreting or reading in exceptions, even through interim injunctive reliefs, will require careful consideration.

Although MCX has settled the contracts and reverted to its standard trading hours, the judicial reaction to the challenge posed by brokers will be interesting to observe. The court’s inclination to interfere with settlement finality and established, automated market processes will also be conditioned by the “materially adverse,” unforseeable nature of prevailing circumstances and the ability of parties to demonstrate injury that is so irreparable and compelling, that it necessitates the unscrambling of an egg.

While the jury is out on these key questions of contract law as well as established securities law principles, the regulator will undoubtedly also use this as an opportunity to commission renovations to the contract architecture itself, weed out lacunae in the current price mirroring system for internationally referenceable commodities and implement international best practices to restore market confidence.

(Shruti Rajan is a Partner at Cyril Amarchand Mangaldas. Views are her own)