London, 1 April 2014
The LME’s moves to regain credibility in the aluminium market have seen a plot twist at the last minute, write Maquarie Bank. Following a UK High Court ruling on Thursday supporting a claimant case brought by RUSAL around the rule change consultation, the LME will now not implement the previously proposed warehouse changes on April 1. This defeat, which comes as a surprise to the metals market, potentially has significant implications for LME metals participants. In our view, there will be plenty more twists and turns in the coming months
Here, Reed Smith review the judicial review action brought by the Russian aluminium producer. As a result, the LME will not be permitted to introduce the rule and will have to rethink its strategy for dealing with the issue of long queues at LME warehouses.
On 7 November 2013, following a three month market consultation (the “Consultation”), amongst other measures, the LME announced its proposal (the “Proposal”) to implement a linked Load-In Load-Out Rule (the “Rule”), the aim of which was to reduce the further build up of stocks that are disproportionate to the rate of load out from certain affected warehouses and therefore, combat the existence of queues. In summary, the Rule required that warehouses with queues longer than 50 days would be required to load more metal out than was loaded into the warehouse.
On 5 February 2014, the LME provided an assessment of market responses to the Consultation and announced the enactment of the Rule. At that stage the LME believed that the Rule was already having an effect, due to the commencement of the Preliminary Calculation Period (the initial period during which the LME monitored metal loaded in and out) from 1 July 2013. Between 2 July 2013 and 29 January 2014, three of the five warehouses affected by queuing of more than 50 days had loaded out more stock than loaded in, thus contributing to a reduction in stock at those warehouses, and queues had fallen at four of the five affected warehouses.
Against this background, Rusal, which is the world’s largest aluminium producer, brought judicial review proceedings in the English Court before Phillips J. Rusal claimed that implementation of the Rule would result in a short-term fall in the global market price of aluminium potentially causing hardship, including long-term damage through the closures of smelters. Rusal argued that the Consultation was procedurally unfair, that the decision to implement the Rule was made without adequate consideration or inquiry into relevant matters and that the decision breached Rusal’s human rights.
The court agreed with Rusal, holding that the Consultation was procedurally unfair and that there was a failure to conduct sufficient inquiry and a failure to consider relevant matters by the LME. Following these conclusions it was not necessary for the court to make a determination regarding the breach of human rights issues raised by Rusal. Rusal’s Arguments The grounds upon which Rusal succeeded were, primarily, that the LME failed to identify and provide information in relation to certain key alternative options, in particular, the option of banning / capping the charging of rents by warehouses for metal in long queues.
Furthermore, the LME had failed to give sufficient reasons why this option had been discounted. Philips J was also critical of the LME for, in relation to the option of banning / capping warehouse rents, only seeking consultation of the LME Warehouse Committee. In Philips J’s view, this was “an aspect of the unfairness of excluding that option from consideration in the consultation”. In reaching this conclusion, Phillips J determined that fairness demanded that the Consultation should include what the LME subsequently recognised as "the most practical suggested alternative", having been suggested by at least 10 of the 33 written responses to the Consultation.
Although 10 out of 33 may not seem substantial, it must be considered alongside the LME's consideration of the various differing and in some cases diametrically opposed views of the participants ranging from warehouse owners to producers to end-users. The option of rent capping / banning was an alternative which the Judge stated might have caused metal producers less damage and this option should therefore have been considered in the Consultation. The LME had argued during the hearing that this option was rejected by the LME on the basis of competition law concerns. The fact that the LME had commenced a fresh competition law review during the Consultation, was in the Judge’s view, “tantamount to an admission that it had failed to make sufficient inquiry and had failed to consider relevant matters prior to commencing the consultation”.
While the above arguments succeeded, other grounds put forward by Rusal were rejected. For example, the Judge did not agree that the LME’s failure to disclose certain documents, carry out a detailed risk or costs-benefit analysis, or consult on the reduction in the queue length threshold from 100 to 50 days constituted procedural unfairness. Nor was there a conflict of interest and inherent bias in the structure of the LME which constituted procedural unfairness. Similarly, the failure to: (i) consider the effect of the new rule on the ‘all-in’ price (i.e. global market price, including premium); (ii) consider profits made by warehouse owners; or (iii) analyse the effect of reducing the threshold, did not “constitute a failure to make sufficient enquiry or consider relevant matters” as Rusal had argued.
Indeed, the Judge stated that it was essential for the LME to approach the issue uninfluenced by the competing interests of buyers and sellers in the effect on price, unless this would result in damage to the market. Impact of the decision? The LME has now issued a LME Notice confirming that it will not now be introducing the Rule on 1 April 2014 and that it is currently taking legal advice with regard to its available options, including appeal or re-consultation.
The LME’s Notice following the decision also emphasises that the Court made no adverse comments on the substantive merits of the proposed changes to LME’s warehousing policy, and in particular the Rule itself. This would tend to suggest that the LME believes that once the procedural irregularities that led to the Judge finding the Consultation was procedurally unfair are overcome, the implementation of the Rule will nonetheless remain the LME's preferred solution. As such, the LME’s Notice appears to indicate that it is more likely to be a matter of when, not if, the Rule will be implemented. That said, if the result of the competition law review is that the LME is allowed to cap / ban rent in queues, the LME will likely have to consider the benefits and unintended consequences that arise from such a decision. On the one hand, capping / banning rent in queues should reduce the gap between the LME price and all-in price thereby increasing its accuracy as a reference point for metal prices.
However, potential unintended consequences could include reduced investment in warehouse capacity, increase of rents by warehouses etc. It will also be interesting to see whether the delay caused by the judgment gives the LME the time needed to fully investigate the development of premium hedging products, which may provide an additional tool to the market that helps address the pricing transparency challenges caused by the length of warehouse queues. This further delay in finding a solution to the long queues at certain warehouses will likely not be well received by the consumer sector. One factor that led the LME to seek to implement the Rule, despite its ongoing consideration of the competition law concerns with the rent capping / banning option, was the concern of increased regulatory scrutiny and oversight.
Arguably, now with more delays in finding a solution, other regulators and legislators, such as the CFTC, the US Department of Justice, the FCA or the US Senate, may feel obliged to take action to address the complaints of market participants. Ultimately it may be that Rusal’s actions are merely delaying what is an inevitable reform to the warehousing infrastructure that supports the LME market. Apart from the increased risk of regulatory intervention, the more immediate effect of a delay in implementing the Rule remains to be seen. Even before the Rule was implemented, the LME believed that the lengths of queues in some affected warehouses had (slowly) begun to reduce.
It will be interesting to see if the delay in providing a solution to the warehouse queue issue leads to another increase in queues?