Monday, September 3, 2012
Commodity prices fluctuate. That's why parties lock in prices well in advance -- the protect themselves against unpredictable variations in the prices of raw materials. But as reported in the Wall Street Journal (sorry-subscription required), since 2010, up to 205 of cotton contracts have been either breached or renegotiated.
As the WSJ puts it, cotton may change hands as many as seven times on its route from "seed to sweater." Parties at various places along that transactional chain assume various positions to hedge against the risks of fluctuation. But if contracts are broken, they may be left without product with which to cover their positions.
The WSJ tells of a typical case in which a farmer pledged cotton at 75 cents/lb. but then claimed to have lost the contract (or not signed it) after the price climbed to $1.30/lb. According to the economic assumptions that inform contracts damages, the farmer should have had no incentive to breach his original contract. He may get $1.30 up front, but the other party would have to cover at the same price. It will sue him for the difference, leaving both parties in as good a position as they would have been in had the promise been kept. But both parties are actually worse off because of the litigation costs, and if the buyer had unavoidable transactions costs related to cover, those get added on to the damages the farmer had to pay. Moreover, as these are repeat players in an economic community, there are reputational harms for such sharp dealing, as indicated in the WSJ article through a quotation from a farmer who won a suit against a trading house. "I'll never sell to [them] again."
When prices dropped this year, buyers started walking away from their deals. The middlemen are getting squeezed at both ends.
So why are parties breaching their contracts? In part, it may be because the contracts are enforceable only through an international arbitral body whose awards are not always enforced.
Here are some interesting tidbits gleaned from the WSJ article:
- 242 arbitration cases were filed with the International Cotton Association in 2011, up from 73 in 2010
- So far this year, 175 new arbitrations have been filed
- The Association has awarded $317 million this year, up from $76.7 million in 2011
- Enforcement of such arbitral awards in problematic, with $251 million outstanding from 520 companies that owe on judgments going back to 1998
If I were an international cotton dealer who wanted to hedge against the possibility of a suit, I would just arrange to have all of my cotton shipped via the Peerless (right).