(a) The Spread Trade Issue
14 The applicants' contention that the Exchange could only cancel the whole of a spread trade and not its constituent legs turns on the wording of the Operating Rules. The operating rules of a licensed market, such as the respondents' Exchange, have the effect, inter alia, of a contract under seal between the licensee of the market (here the Exchange) and each "participant" in that market: s 793B Corporations Act 2001. A participant is a person who is directly allowed to participate in the market, under that market's operating rules: s 761A. The Operating Rules contemplate that there will be both Full Participants and Local Participants. The difference between these two classes is not material to this litigation. In either case, participants are authorised to enter into business on their own behalf in the market.
15 Transmarket is a Full Participant (actually it is a Proprietary Full Participant but nothing turns on that) and Biskra and Kestrel are Local Participants. Accordingly, each is bound by the Operating Rules by force of s 793B. In addition, each has also executed a participant agreement with the Exchange agreeing independently to be bound by those rules.
16 However, none of the 27 cancelled trades in dispute was executed by the applicants in their capacity as "participants". Each of them, in fact, operated through a broker which was also a participant and which executed the trades on their behalf. In both Transmarket and Biskra's case each retained BrokerOne Pty Ltd ("BrokerOne") and the relevant agreements between them and BrokerOne were in evidence. Mr Fleming, a futures trader and director of Kestral, gave evidence on behalf of the second applicant that it had appointed BrokerOne as its executing broker and UBS AG ("UBS") as its clearing broker on 2 November 2006. I accept this evidence but the actual terms of the arrangement between Kestrel, BrokerOne and UBS were not in a satisfactory state in the evidence before me. The document which was said by Mr Fleming to constitute the relevant agreement between all three was incomplete and was missing the critical parts dealing with the status of the brokers. I was told that the missing page was to be found as the first page to another document exhibited by Mr Fleming in his affidavit entitled "CJF 3" but that document was plainly a different one between different parties. I propose, nevertheless, to proceed on the basis that:
(a) there is an agreement between Kestrel and BrokerOne appointing the latter as the former's executing broker and between Kestral and UBS appointing the latter as its clearing broker; and
(b) that the agreement complies with the Operating Rules.
No attempt was made by either party to explain what the difference between these two brokers was and since the relevant page of the agreement is missing from the evidence it is difficult to know clearly. Both parties assumed, however, that the relevant broker for the purposes of the issues in these proceedings was UBS not BrokerOne and in that circumstance, I propose to assume that the agreement complies with cl 2.2.25 of the Operating Rules which provides relevantly:
A Full Participant, other than a Proprietary Full Participant, shall have in force a duly signed agreement with each of its Clients, (except where the Client is another Full Participant, as the agreement is deemed and does not require to be signed), containing the following minimum terms:
…
(c) Benefit to Participant of Contract Registration with SFE Clearing
Any benefit or right obtained by any Participant upon registration of a contract with SFE Clearing by way of assumption of liability of SFE Clearing under any contract or any other legal result of such registration is personal to the Participant and the benefit of such benefit or right does not pass to the Client.
(d) Client only has Rights Against Participant
In relation to all trades conducted on the Exchange by the Participant and all Contracts registered by the Participant with SFE Clearing the Client has no rights whether by way of subrogation or otherwise, against any person or corporation other than the Participant.
17 I proceed on this basis because (a) the agreements between BrokerOne and Transmarket and Biskra are in evidence and do contain such a term; (b) it was not submitted that there was no such a term in the case of Kestrel; and (c) it is appropriate to assume, in the absence of evidence to the contrary, that BrokerOne and UBS complied with their obligations under cl 2.2.25.
18 Later in these reasons I deal with the Exchange's argument that the applicants have no entitlement to sue. This is said to be the case because the principals on those trades were necessarily BrokerOne or in Kestral's case UBS. The present point to be made is that one of the applicants' answers to that argument is that they are entitled to sue as undisclosed principals. This is important because it identifies the contract to be interpreted on the applicants' case as the one between the Exchange and BrokerOne or UBS as undisclosed agents.
19 It is true that the Operating Rules apply by force of s 793B of the Act to each of the applicants as "participants". However, that conclusion has no immediate impact on the issues in this case. None of the applicants, in fact, executed the trades on their own behalf or in their capacity as participants. In my opinion, the binding effect of the Operating Rules arising from s 793B applies only to persons operating as participants. I do not, in that circumstance, read the Operating Rules as directly binding a client operating through a broker when, coincidentally, the client happens also to be a participant.
20 The question then to be determined is whether the contract between BrokerOne and UBS, on the one hand, and the Exchange, on the other, entitled the former to cancel a single leg of a spread.
21 The terms of that contract consist of the Operating Rules. It is necessary to start with the Exchange's cancellation powers and obligations. Clause 1.11.1 of the Operating Rules provides:
Cancellation of Trades
The Trading Manager may, in his sole discretion, cancel an order, direct a Participant to withdraw an order, or cancel a trade where:
(a) an order has been entered or a trade has been executed otherwise than in accordance with the Custom Market Strategy Rules at Rule 3.2.3;
(b) an order has been entered or a trade has been executed which is not, in the Trading Manager's opinion, in the best interests of a fair, orderly and transparent market; or
(c) the matter cannot be adequately or appropriately dealt with pursuant to Section 5.
22 The critical word here is "trade". Clause 7.1 defines the expression "to trade" and Similar Expressions" to mean:
To enter, acquire or dispose of Contracts on a Market operated by the Exchange.
23 This links the concept of a trade to that of a "contract" which, in turn, is defined to mean:
A contract entered, acquired or disposed of on the Exchange or capable of being entered, acquired, or disposed of on the Exchange.
24 Consequently, the kinds of trades which can be cancelled under this power of cancellation are those involving contracts "entered, acquired or disposed of on the Exchange" or capable of being so dealt with.
25 Another cancellation power is conferred by cl 1.13.2. It provides:
Notification of Error Trades
(a) The Exchange may create a No Cancellation Range, a Qualifying Error Range and a Market Integrity Range that, when applied by the Trading Manager in exercise of powers conferred by this Rule 1.13 and Rule 1.11 result in the Exchange taking different actions in response to Error Trades, depending on how far away the trade is effected from a fair price valuation as determined by the Exchange.
(b) The Exchange will take the following actions:
(i) If the Error Trade is within the No Cancellation Range, the Error Trade will not be available for cancellation;
(ii) If the Error Trade is within he [sic] Qualifying Error Range, the Error Trade will not be available for cancellation unless the Error Trade is reported to the Exchange within such time as determined by the Exchange and then the Error Trade will only be cancelled if the counterparty to the Error Trade approves the proposed cancellation of the Error Trade within such time as determined by the Exchange;
(iii) If the Error Trade is within the Market Integrity Range, the Error Trade will be cancelled as soon as possible.
26 The definition of "error trade" has been set out above, but for the sake of clarity in the argument I will set it out again:
A Trade transacted in error or deemed by the Exchange to be transacted in error because it is not in the best interests of a fair, orderly and transparent market.
27 Critically, this too is connected to the concept of a "trade" and hence also to the idea of a contract "entered into, acquired, or disposed of on the Exchange".
28 The Exchange's powers and obligations of cancellation apply, therefore, to contracts of that kind. The applicants did not deny this but sought to characterise entry into a spread position as being such a contract.
29 In order for the applicants to succeed it would be necessary then for them to establish that each of their spread trades was a contract "entered, acquired or disposed of" on the respondents' Exchange or capable so of being dealt with. It is an unavoidable consequence of that argument - and one from which the applicants do not shrink - that each spread trade must result in a multi-partite single contract. In its simplest form, that contract had to consist of the three cornered contract between the person "acquiring" the spread position and the two other parties at the other end of each leg. However, because spreads may have legs consisting of more than one contract, the argument must necessarily embrace the possibility that a spread contract has as many parties as there are contracts making up its legs plus the spread trader itself.
30 I reject this argument. No such contract either came into existence on the completion of the spread orders nor, even if it did, would it be a contract within the meaning of the Operating Rules.
31 To see why this must be so it is first necessary to say something of the manner in which spread trades occur. It would, of course, be possible to acquire a spread position simply by executing two different contracts. However, if that were to be done there could be no guarantee that the particular differential in price sought by the spread trader could be achieved for the market might well have moved on after the execution of the first contract and before execution of the second contract could be satisfactorily completed. That timing risk is called "legging risk". The Exchange's platform SYCOM offers a facility which, in an automated fashion, executes spread trades with a fixed differential and by doing so removes legging risk, for the spread will not be executed unless SYCOM identifies and simultaneously enters into both of the constituent legs. The person seeking to place such a spread order inputs into the SYCOM terminal the defined spread market, the price differential and the volume sought. Since the price is not important that information is not entered into SYCOM. SYCOM then identifies matching contracts and upon such identification automatically executes both contracts (or more when a leg consists of more than one contract). That operation of the SYCOM system reflects the Operating Rules.
32 Rule 3.2.1 provides:
Exchange to Prescribe Contracts and Procedures
The Exchange may prescribe Contracts and procedures for Strategy Trading and Participants must execute such Strategy Trades in accordance with this Rule 3.2.
33 A spread trade is a "strategy trade". As rule 3.2.1 contemplates, the Exchange has prescribed the procedures for spread trading. These are as follows (as contained in an explanatory rule to the Operating Rules):
2. - Spread Trading
(a) Procedures for Intra-Commodity Spreads
1 A Participant specifies the quantity of Futures Contracts bid or offered and the price differential when entering an Intra-commodity Spread order.
2 A bid will be buying the near month and selling the far month, an offer will be selling the near month and buying the far month.
3 An Intra-commodity Spread order when executed will be filled for both legs by the Trading Platform simultaneously with equal volume.
4 The Intra-commodity Spread market is fully interactive with the underlying market.
5 An Intra-commodity Spread order, if and when matched by the Trading Platform, may trade with other spread orders or orders from the underlying market.
6 When an Intra-commodity Spread order is matched with another Intra-commodity Spread order the Trading Platform will use the spread trade price algorithm to determine the proceeds of the individual legs, as detailed below.
7 As per Rule 3.2.2(b) each individual leg of an Intra-Commodity Spread is allocated to the same account.
(b) Procedures For Inter-commodity Spreads and Inter-Regional Spreads
1 A Participant specifies the quantity of the spread bid or offered and the price differential when entering an Inter-commodity Spread or Inter-regional Spread order.
2 Inter-commodity Spread or Inter-regional Spread markets pre-defined by the Exchange shall be at a ratio of one to one unless otherwise defined by the Exchange from time to time.
3 If an Inter-commodity Spread or Inter-regional Spread order is traded at a volume ratio then one lot of an Inter-commodity Spread or Inter-regional Spread order shall be, if and when matched, matched at the pre-defined volume ratio for the individual legs.
4 An Inter-commodity Spread or Inter-regional Spread order will be filled for both legs automatically by the Trading Platform simultaneously with the pre-defined volume ratio when matched.
5 The Inter-commodity Spread or Inter-regional Spread is partially interactive with the underlying market.
6 An Inter-commodity Spread or Inter-regional Spread order, if and when matched by the Trading Platform, may trade with other Inter-commodity Spread or Inter-regional Spread orders or orders from the underlying market.
7 When an Inter-commodity Spread or Inter-regional Spread order is matched with another Inter-commodity Spread or Inter-regional Spread order, the Trading Platform will use the spread trade price algorithm as detailed below to determine the prices of the individual legs.
8 As per Rule 3.2.2(b) each individual leg of an Inter-commodity Spread or Inter-regional Spread is allocated to the same account.
9 An Inter-Commodity Spread order can be traded so that the spot expiry month of one commodity can be spread against an expiry month of another commodity other than the spot expiry month.
(c) Spread Trade Price Algorithm
The Trading Platform uses the following algorithm to determine the individual leg prices for Spread-to-Spread trades:
1 If there is a bid and offer in the near month, then the algorithm uses the mid point of this bid and offer to establish the near month price, the spread differential traded at will be used to establish the far month's price.
2 In the absence of a bid and offer in the near month, the algorithm uses the mid point of the bid and offer in the far month to establish the far month price. The spread differential traded at will be used to establish the near month's price.
3 In the absence of a bid and offer in the near and far month, the algorithm uses any bid or offer existent in the near month to establish the near month price. The spread differential traded at will be used to establish the far month's price.
4 In the absence of a bid or offer in the near month, the algorithm uses any bid or offer existing in the far month to establish the far month price. The spread differential traded at will be used to establish the near month's price.
5 In the absence of any of the above, the algorithm uses the closing price (assume this is the settlement price) in the near month to establish the near month price. The spread differential traded at will be used to establish the far month's price.
(d) Specified Tick Ranges
For table containing Specified tick Ranges please click onto this link: Specified_Tick_Range_Rule_3_2
34 An inter-commodity spread is, by way of explanation, one transacted in contracts involving different commodities whereas an intra-commodity spread is one involving positions in the same commodity.
35 I turn then to the argument that upon execution of a spread order a single spread contract comes into existence. There are insuperable difficulties standing in the way of accepting this argument. First, one of the essential terms of the spread order necessarily must be the price differential. Further, because it is only that differential which is of any interest to a spread trader the terms of the spread order need not include any terms as to the price of the underlying legs and, as already noted, the SYCOM system is not configured to require the input of that (irrelevant) information. However, the other parties to this alleged single spread contract will often be persons seeking entry into a futures contract at a nominated price. Price, therefore, will be, one of the essential terms of those contracts yet it will form no part of the contract sought by the person placing the spread order. Correspondingly, it is impossible to locate from the counterparties' perspective any term concerned with price differential.
36 Secondly, allied to the first problem is the fact that the counterparties on each leg need not know that they are party to a futures contract which is part of a spread. On the applicants' case such a party has not entered into a futures contract with one other party but, in fact, into a multi-partite contractual arrangement potentially with an unknown number of unknown parties.
37 Thirdly, the inevitable consequence of the applicants' argument is that if the counterparty is itself a party to another spread then both spreads become a single conglomerated contract. That process of agglomeration need know no bounds. If five or six spread trades are connected by having multiple matched legs this leads to the conclusion that what is in play is a single contract with numerous parties all understanding themselves to have entered into one kind of arrangement but, in fact, entering into a very different one.
38 Fourthly, those observations highlight that no such single contract can come into existence because there is no correspondence between the terms of the contract that the counterparty understands itself to be entering into - a futures contract with one other party - and the contract contemplated by the party placing the spread order - a multi-partite arrangement concerned with differences in price and not price itself. For those reasons the existence of a single contract constituted by both (or all) of the legs to a spread must be rejected. Its existence would be antithetical to the basic principle of contract law that there can be no formation of a contract without agreement. Without entering into the debate as to whether contractual formation is always to be approached on the basis of the offer-acceptance model, it is apparent nevertheless that two parties understanding themselves to be agreeing to completely different things cannot be held to have formed a contract. Thus a person who volunteers information to the police about a crime in ignorance of the existence of a standing offer to pay a reward for such information cannot be held to have formed a contract thereby. In R v Clarke (1927) 40 CLR 227 Higgins J said (at 241):
The reasoning of Woodruff J. in Fitch v. Snedaker seems to me to be faultless ; and the decision is spoken of in Anson (p. 24) as being undoubtedly correct in principle : - "The motive inducing consent may be immaterial, but the consent is vital. Without that there is no contract. How then can there be consent or assent to that of which the party has never heard ? " Clarke had seen the offer, indeed ; but it was not present to his mind - he had forgotten it, and gave no consideration to it, in his intense excitement as to his own danger. There cannot be assent without knowledge of the offer ; and ignorance of the offer is the same thing whether it is due to never hearing of it or forgetting it after hearing. But for this candid confession of Clarke's it might fairly be presumed that Clarke, having once seen the offer, acted on the faith of it, in reliance on it ; but he has himself rebutted that presumption.
39 It is inconceivable that a person who understood himself to be entering into a contract to buy 100 90 Day September 07 contracts from one person could, by so acting, be entering into a spread contract consisting of a contract to sell 1000 90 Day September 07 contracts and to buy 1000 90 Day March 08 contracts at a price differential of 0.3 without any terms as to price with 20 other parties of whose existence he was completely ignorant.
40 The contract potentially brought to life by this argument owes more to Mary Shelley's Frankenstein than it does to Corbin on Contracts. However, whatever else one might say about this contract one can certainly say that it would not be a "Contract" within the meaning of the Operating Rules and hence entry into it could not be a "Trade" either. I have already sketched the connection between those concepts which the definition provisions of the Operating Rules contemplate, in particular, the necessity for there to be a contract "entered, acquired or disposed of on the Exchange" or so capable before there can be a "Trade". Those words alone are sufficient to exclude the possibility of a spread contract being a single contract and hence a contract of that kind. The evidence did not suggest that the applicants were trading spread to spread or that there was a market in which the only participants were spread traders and the only thing traded spread positions. I was taken to no part of the Operating Rules which suggested the existence of such a market.
41 The only contracts so traded are those that are "listed" by the Exchange. Once they are listed the rules provide detail as to the terms and to the method of their trading. Those rules are set out in Part 6 of the Operating Rules. That part deals specifically with interest rate contracts, equity contracts, currency contracts and commodity contracts. There is no hint in those Rules that the Exchange conducts a market in "spread contracts". No attempt was made before me to establish the existence of such a market.
42 I reject therefore the applicants' contention that the powers of cancellation possessed by the Exchange could only be used to cancel the whole of a spread position. The spread positions were not "contracts" at all and they could not be "contracts" which were traded on the Exchange. I should add for completeness that I do not accept that the interpretation of these terms in the Rules is a matter upon which expert evidence as to their meaning in the industry is of any assistance. The task at hand is the construction of a document formulated by the Exchange in the discharge of quasi-regulatory functions. It is given legal force by s 793B of the Corporations Act. The understanding of persons in the market about the Operating Rules is not the object which is given force by s 793B. This is not a case where the Court is seeking to construe the meaning the parties to a contract intended by the use of a particular specialised trade term. Rather, what is involved is a deemed contract written by the Exchange alone and given force by statute. The interpretation of such a statutory contract does not turn on the intentions or understandings of the persons upon whom it was imposed.
(b) The error trade issue
43 The Exchange's powers of cancellation and the facts surrounding the actual cancellation of the 27 trades the subject of these proceedings are best explained together.
44 I have already set out the events, in broad compass, which occurred between 11.30am and 11.33am. At the risk of repetition they were, in summary, the 90 Day and 3 Year September 07 contracts decreased 12 and 31 points respectively whilst the 90 Day December 07, March 08, June 08 and September 08 contracts increased by between 12 and 17 points, before retracing their steps by 11.33am. It will be recalled that the CPI announcement raised the spectre of future interest rises. Generally speaking, the price of debt instruments such as bonds and bank bills, go down as interest rates go up, so that the 90 Day September 07 and 3 Year September 07 contracts moved as might have been expected (that is, down) whereas the price of other 90 Day contracts moved contrary to expectation (that is, up).
45 Mr Raper was watching his SYCOM screen immediately after the CPI announcement and observed an unrelated anomaly in the 3 Year September 07 contract, in that the gap between the bid and offer prices was larger than was usual, however, apart from this minor matter it was behaving otherwise normally, that is, I interpolate, decreasing in price. He thought that the anomaly was likely to be the result of thin liquidity. More significantly, to his surprise, he observed that the 90 Day December 07 contract was rising rapidly. He had never seen the prices of such correlated contracts move in opposite directions by such a significant degree following a major announcement. He then turned his attention to the 10 Year September 07 contracts and saw that they were decreasing in price (as expected) and was less concerned.
46 His initial impression was that the unexpected upward price movement in the 90 Day December 07 contract must have been caused either by a technical failure in the SYCOM system itself or by reason of some participant having made a large error in the entry of an order.
47 After about 20 or 30 seconds he left his office to go to the Exchange's operations room which was located just outside. He expected to find his staff receiving phone calls about the unusual price movements and for one or more participants to be reporting that an error had taken place in their trading. However, the phones were not ringing. This was such an unexpected outcome for Mr Raper that his first thought was that the phone system was down. The phones were then checked and found to be in working order.
48 The phones then began to ring. He stood in the Operations Room and watched the SYCOM screen which, apparently, displays the most recent 1,000 trades. The extent of the trading was such that the trades which had occurred at 11.30am were about to disappear from the screen. At 11.32am Mr Raper observed that the post September 07 90 Day contracts were retracing their previous upward movement. By the end of the three minute period Mr Raper observed that they were now trading below the price they had been trading at immediately prior to the CPI announcement. By 11.33am Mr Raper thought that trading had stabilised. He thought that the trading he had witnessed was both "extraordinary and disorderly".
49 Consequently he thought that a disorderly and unfair market had come into existence affecting a range of interest rate futures. He decided that he needed to investigate what had occurred, particularly because he knew the issue had not been caused by a technical problem with SYCOM.
50 In order to understand what had happened next it is necessary to say something about error trades. A practical problem which arises from time to time is the erroneous placing by participants of orders. This may come about by incorrect data entry - for example, a trader enters a price 93.4 rather than 94.3 into SYCOM - or by any other number of ways in which human fallibility may manifest itself. Such errors are, of course, a concern to the person placing them but they can also be of concern to the efficient operation of a market. The Operating Rules of the Exchange contain elaborate, although poorly drafted provisions, regulating how such trades are to be treated and the circumstances in which they may be cancelled. As might be expected they involve a balancing between the rights of the persons placing the orders, their counterparties and the Exchange itself.
51 Mr Raper, it will be recalled, was expecting the phones to ring and for someone to report the occurrence of an error trade but that call never came. The difficulties in this case arise because it is possible - without such a report - for the Exchange to activate the error process itself. The definition of "error trade" in cl 7.1, which I have set out above, has two limbs which reflect the assumption underpinning the Operating Rules that there will be both error trades reported by participants and error trades flagged by the Exchange itself. This case concerns the second limb of the definition of error trade, that is, the limb applying in the case of trades deemed by the Exchange to be in error, which I shall refer to as "Exchange generated errors".
52 The language of that second limb is ambiguous in a number of ways. One reading is that it is activated by the Exchange's decision to treat a particular trade as an error trade because of the Exchange's own view that the trade was not in the best interests of a fair, orderly and transparent market. Another is that it may mean that if a particular trade is not, as a matter of objective fact, in the interests of such a market then the Exchange may deem the trade to be an error. A third reading - propounded by the Exchange- is that the clause is a definition provision which does not enable the Exchange to deem anything about a trade but instead is to be read as referring to situations where such a deeming has already occurred under some other provision of the Operating Rules.
53 I have already set out above cl. 1.13.2 which deals with error trades. There are several features of it requiring explanation. The power contained in (a) is a power to fix specified ranges but the power is discretionary and need not be exercised; so much flows from the word "may". What are the ranges? There are three: the qualifying error range, the no cancellation range and the market integrity range. The no cancellation range and the qualifying error range are defined in clause 7.1 in these terms:
Qualifying Error Range The range, as determined by the Exchange, above or below a fair price valuation, as determined by the Exchange, within which trades will not be cancelled unless the Error Trade is reported to the Exchange in accordance with procedures determined by the Exchange and counterparty approval is obtained.
No Cancellation Range The range, as determined by the Exchange, above or below a fair price valuation, as determined by the Exchange, within which Error Trades will not be cancelled.