London Metal Exchange (LME) sued by Elliott Management - A Commentary – PART III

By Rodrigo Zepeda, CEO, Storm-7 Consulting Limited

[Part III of a four part blog series]

Fund manager ‘Elliott Management’ has commenced a judicial review claim against London Metal Exchange (LME) in the English High Court via its affiliates, Elliott Associates LP (EALP) and Elliott International LP (EILP). The LME has publicly asserted that this claim is ‘without merit’ (Makortoff 2022). This is a stupid thing to say. First, whoever advised the LME to issue this comment has clearly not analysed the English law jurisprudence on ‘A1P1’ cases (Article 1 (A1) of the First Protocol (P1) of the European Convention on Human Rights) extensively in depth.

If they had, they would see that the English courts have often taken a highly restrictive approach to administrative powers being exercised in ways that implement widescale retroactive and retrospective changes in the law and rights. The present case is even worse, as LME did not have express legislative power to implement such massive widescale retroactive changes in the first place. Consequently, applied to the facts, the EALP/EILP judicial review case is far from one that would be analysed as being without merit. Second, I believe the LME thinks this statement shows strength, when in fact it demonstrates weakness.

By asserting this claim and noting that it will be contesting the claim ‘vigorously’ (Makortoff 2022), the LME demonstrates that it has not truly understood the ramifications of this High Court litigation. This clearly shows a weakness in strategic law analysis. This is a Johnny Depp v. Amber Heard litigation-type situation that has arisen, namely one that should never have been entered into in the first place – strategically it is a lose-lose situation. If the LME cannot see that, this shows clear weakness on its part.

One the ond hand, if the LME loses, it will not simply be the $456 million damages that Elliott Management is seeking. It will also be the $15.3 million damages sought by Jane Street Global Trading, and the millions of dollars more sought by other market participants, together with the spiralling legal and litigation costs, and the mounting losses in dwindling trading revenues. On the other hand, if the LME ultimately wins, I would logically recommend that every LME member resigns their membership. Which firm wants to trade on an exchange where every single trade that has been legally executed and agreed between trading parties can be cancelled at the end of a day’s trading?

Ostensibly, this would occur when markets have been subjectively held to have been operating in a disorderly manner. This could be held to have been 8 hours ago, 12 hours ago, or 16 hours ago, no one knows, it is not at all made clear to any market participants, they simply have to grin and bear any losses – well, some of them anyway. This approach undermines British constitutional democratic principles and the Rule of Law (Bingham 2011), it undermines the sanctity of contracts, and it most certainly undermines the principle of Legal Certainty (Raitio 2003; Fenwick and Wrbka 2016).

This reflects a situation where trades are potentially torn up based on arbitrary and non-transparent policies that were never disclosed beforehand to market participants, to allow them to give their prior informed consent to participate in such markets. By analogy, imagine if you were an LME employee, and at the end of the day LME informed you that you would not be paid for that day’s work, as you had not performed according to standards that had never been disclosed to you previously? Does that seem fair to you?

From a strategic law perspective, the end result is that even if LME wins, it will be a pyrrhic victory – the costs in terms of lost market trust and confidence, lost market participants, and lost revenues, may turn out to be too great in the long-term. In United Company Rusal Plc, R (On the Application Of) v The London Metal Exchange [2014] EWHC 890), Phillips J noted that the LME provides three main functions, namely: (1) a price-discovery mechanism for traded metals; (2) a price-hedging mechanism for metal consumers and producers; and (3) a source of last resort for the physical delivery of these metals (para. 9). As a result of the LME’s decision and this judicial review case, the commercial viability of these last two functions have been called heavily into question.

AN OVERIVEW OF LME MONITORING REQUIREMENTS AND CAPABILITIES

I have provided in-house central counterparty training for some of the world’s top exchanges and clearing houses, such as Eurex Exchange (Eschborn), EEX AG (Leipzig), and KPEI (Jakarta), and I have spoken in depth with their management and senior personnel. So, I know what type of advanced technology and monitoring systems they have implemented and run. These types of exchanges and clearing houses are also subject to highly extensive market abuse regulatory frameworks, which I also have expert knowledge of. So I have highly extensive expert professional experience of the monitoring systems and capabilities that these types of exchanges have.

In practice, this means that all of these institutions have to have legally implemented advanced real-time monitoring technologies for trade monitoring, market abuse, and systemic risk purposes. These real-time monitoring capabilities need to be capable of immediately responding to, or intervening in, any sudden spikes in volatility, or turbulence in market conditions. Paragraph 5 of the LME ‘Policy on Order Cancellation and Controls’ (Version 1.0) sets out LME Controls, and states that “The LME has arrangements to prevent disorderly trading and breaches of capacity limits”, these include a throttle limit, mechanisms to manage volatility, and pre-trade controls. Paragraph 5.1 (Throttle Limit) states:

“The LME operates mechanisms to halt or constrain order entry/updates and trading at all times during trading hours. The LME will ensure that… mechanisms to manage market volatility are continuously monitored…

The LME will maintain records of the rules and parameters of the mechanisms to manage volatility and any changes thereof, as well as records of the operation, management and upgrading of those mechanisms…

The LME may, at its absolute discretion, acting reasonably, suspend trading on LME Select for such periods it considers necessary in the interests of maintain [sic] a fair and orderly market.”

Paragraph 5.2 (Pre-trade and post-trade controls) states:

“The LME’s pre-trade controls are designed to readjust limits during the trading session and in all its phases, with a delay of no more than five seconds…

Post-trade controls include a continuous assessment and monitoring of market and credit risk of the Member and controls regarding the maximum long and short and overall strategy positions”.

Paragraph 6 (Monitoring) states:

“The LME will perform ongoing monitoring of the LME Select, including, without limitation, performance and capacity, orders sent by Members on an individual and aggregated basis, message flow, and the concentration of flow orders, to detect potential threats to the orderly functioning of the market.”  

The LME notified all nickel market participants that nickel contracts would be cancelled from 00.00 am London time (8 March 2022), which LME asserted was the last point in time at which LME could be absolutely confident that the market had been operating in an orderly manner (Makortoff 2022).

So, bearing in mind all of LME’s advanced technological monitoring capabilities, specifications, and requirements, the 456-million dollar question is: 

“If LME was absolutely certain that from this point in time onwards, the market was disorderly, why did it not actually intervene at such time?”

Its mechanisms to manage market trading volatility are continuously monitored, and LME is able to respond in real-time to intervene and suspend trading within minutes if necessary. In fact, it is legally required to do so for market abuse purposes.

Russia invaded Ukraine on 24 February 2022 and so the LME had actively known about potential risks and volatility to nickel trading from that time onwards. It also knew of the build-up of short positions by Tsingshan Holding Group Co. Ltd’ (Tsingshan) since 2021, and of the increasing volatility of trades that had occurred by Friday 4 March 2022. Clearly, there is no way that it can argue that it was somehow caught off-guard. So, the real question is why did the LME not intervene and suspend trading at 01.05 am London time, or 02.00 am, or 03.00 am, or even 04.00 am? Why did the LME have to wait 8 hours to suspend trading on 8 March 2022?

LME’S POLICY APROACH TO CANCELLATION OF TRADES

The underlying duty of LME as a Recognised Investment Exchange (RIE) in the United Kingdom (UK) is to MAINTAIN a fair and orderly market. This means it has to conduct real time monitoring of trading activities and market participants on a forward-looking basis. It has to be ready at all times to rapidly intervene and suspend or halt trading activities, if necessary, because of, for example, high market volatility and disorderly market conditions. It is submitted that this is its primary function, to maintain fair and orderly markets, not to RE-ADJUST historic markets and re-write history.   

Clear or Serious Errors

LME’s power to cancel error trades set out in its ‘Error Trades and Erroneous Order Submissions Policy’ (Version 2.1) (LME Error Policy) clearly demonstrates the exceptional and minor nature of error trade cancellation procedures. Paragraph 3 (Permission to cancel error trades) states:

“The LME recognises that cancellation of LMEselect trades can be disruptive to the market as a whole. The LME will not permit the cancellation of an LMEselect trade by agreement between the parties unless the LME determines, in its absolute discretion, that the trade was a clear or serious error. In making the determination as to whether or not a trade was a clear or serious error the LME will take into account, without limitation, the factors outlined below:

a) Market conditions and volatility for all contracts in that product prior to, and immediately after, the disputed trade including reviewing bids, offers and trades in LMEselect and Ring or kerb trading.

b) Any relevant economic data or news stories displayed by market vendors.

c) The possible market disruption that could be caused by cancelling or not cancelling the trade.

d) Any other information that the LME considers in the circumstances to be relevant, including in particular the relevant no-cancellation range as published on www.lme.com in accordance with paragraph 4 above.”

(the LME Cancellation Factors).

Even then, LME is required to act within an extremely fast timeframe, according to the LME Error Policy, the LME is required to look to reach a decision to invalidate a transaction within 15 minutes (p. 5). Overall, the power to cancel legally executed nickel contracts under this framework is limited to undeniable cases of clear or serious errors. For example, if after the 08.15 am (8 March 2022) nickel trade suspension notice, a number of trades were executed in ignorance of this trade suspension. Overall, this exceptional and minor approach to cancellation of trades, combined with the massive 8-hour delay in suspending trading in, and then cancelling, nickel contracts, would tend to support the view that LME acted unlawfully and exceeded its powers.

ANALYSIS OF JUDICIAL REVIEW CLAIM

In legal practice, researching and analysing the different grounds for judicial review to be presented by the claimants could take weeks, and could stretch across a wide range of different legal arguments. There is insufficient space to cover all of these in depth here. Instead, I will provide brief analysis and examples that may be relevant to each of the grounds for judicial review sought by the claimants.

Judicial Review Ground 1: Reasonableness

To prove this ground, the claimants would be required to prove that LME’s decision was not one that was rationally open to a reasonable decision maker possessed of all the facts; in particular, that LME’s decision was beyond a range of responses open to a reasonable decision maker (Associated Provincial Picture Houses Ltd v Wednesbury Corporation [1948] 1 KB 223). The claimants might seek to prove this by showing historical examples of trade records of when LME has cancelled error trades (e.g., for the nickel market and for metals in general).

These records might go back between 1 to 3 years. They would demonstrate LME behavioural patterns, and the types of narrow range of responses to error trade cancellation historically invoked by LME. For instance, what size and volumes of nickel and metal trades were cancelled; the underlying reasons why these trades were cancelled; the speed of response and cancellation by LME; and how far back in time (i.e., hours back) they were cancelled (i.e., proof of historic time cancellation periods).

The claimants might also seek this data from other similar exchanges (if possible), to prove that market practices demonstrate that cancellation of trades is historically very limited and exceptional in nature. In effect, the rationale would be to show that LME’s trade cancellation decision was clearly beyond a range of responses open to any reasonable exchange decision maker. The claimants might also seek to prove that cancellation of contracts was not actually required, as suspension of trading alone (without cancellation) would have been sufficient to maintain orderly markets going forwards.

The claimants might seek to show that heightened volatility in nickel markets may lead to significant gains and losses for all market participants, and sometimes even to large margin calls that may negatively impact market participants. By showing responses of other exchanges to past periods of heightened volatility in such commodity markets, the claimants might seek to show that the objective is to maintain future orderly markets, not to re-write historic markets (i.e., beyond a range of industry market responses).

Judicial Review Ground 2: Irrationality

To prove irrationality, the claimants would be required to show that LME’s decision was unsustainable; it amounted to an abuse of power; it was one where LME acted in bad faith; it was one where LME attached wholly disproportionate weight to a particular factor; or one where LME made a logical blunder which rendered LME’s whole reasoning process unlawful (Government Legal Department (GLD) 2018, p.36). The claimants would need to build up an extremely in-depth and granular picture and understanding of all events at LME that led up to the decision to cancel the nickel contracts.

This means the claimants would need to obtain copies of all documentary evidence pertaining to decision-making that occurred at LME prior to the decision to cancel the nickel contracts. For example, this would cover emails; phone calls; phone messages; text messages; meetings; minutes of meetings; the chronology of communications and meetings; the chronology of decision-making; which people were involved and from which firms; details of everyone who was consulted with respect to these events. It would also include market trade decision-making. It might include whistleblower information.

For example, what internal LME (technology, trade, and risk management and personnel) analysis was made of the nickel markets at 00.00, 01.00, 02.00, 03.00, 04.00, 05.00, 06.00, 07.00, 08.00). Also, which people from which firms were consulted and/or involved in the decision-making procedure? Would these people normally be consulted for this kind of decision-making, or were they consulted on an exceptional basis? Are there any potential conflicts of interest in roles and/or firms consulted that can be identified? Are there any potential conflicts of interest that can be identified but which LME failed to address, thereby potentially showing abuse of power?

Were any existing nickel market participants consulted, and if so, who, when, and to what extent? Was this consultation of nickel market participants warranted, could it be said to be biased in any way? Is there any evidence that can be identified by the claimants that LME vitiated the exercise of its discretion in any way? Did LME attach wholly disproportionate weight to a particular factor (e.g., the market position and/or accrued financial losses of Tsingshan, any advice or recommendations provided by Hong Kong Exchanges and Clearing Ltd. (HKEX), or by a government?)? What evidence can the claimants identify and submit that demonstrates that LME made logical mistakes which undermine its whole reasoning process (e.g., failure to identify market disorder earlier, failure to intervene earlier)?

Judicial Review Ground 3: Illegality

To prove the illegality ground, the claimants would need to show that either there were significant errors of law or errors of fact (R v Lord President of the Privy Council, ex parte Page [1993] AC 682); or LME decision makers acted beyond their powers; or decision makers fettered their discretion (e.g., adopting an over-rigid policy, not carrying out a true and proper exercise of LME’s discretion) (British Oxygen Co Ltd v Minister of Technology [1971] AC 610; R (Rogers) v Swindon NHS Primary Care Trust [2006] EWCA Civ 392).

In addition, the claimants might seek to prove illegality by showing that there was an abuse of discretion either because LME used a power for an improper purpose, or LME took into account irrelevant considerations or failed to take into account relevant considerations (Wheeler v Leicester City Council [1985] AC 1054). The claimants should seek to identify and differentiate these into factors which:

(1) must be taken into consideration;

(2) may be taken into consideration; and

(3) must not be taken into consideration (Richards Harwood & Wald 2010, p. 37).

Practically, the claimants would need to “flesh out” the substantive content of the LME Cancellation Factors noted above further. This could be done by analysing and interpreting how the Cancellation Factors were used, interpreted, and applied in previous cancellation events carried out by LME. The claimants might potentially also seek such information from other "friendly" exchanges using confidential channels.

This would allow the claimants to understand in detail the breadth and relevance of factors that have historically been taken into account by LME. By doing this, the claimants would then be able to interpret and better understand how the range of factors identified in relation to the cancellation of nickel contracts actually reflected, or differed from, the standard historic LME approach. By identifying these factors, and by then mapping out these factors and applying them to specific periods prior to 08.15 am 8 March 2022 (e.g., 01.00, 02.00, 03.00, 04.00, 05.00, 06.00, 07.00), the claimants would be able to identify if any errors in decision-making or exercise of discretion were made on the part of LME.

TO BE CONTINUED

The final fourth part of the blog will strategically analyse the final ground for judicial review (human rights), and will provide commentary and analysis on the potential long-term impact on trust and confidence of participants and investors in the LME nickel market.