The collared futures contract and binary option contract that have been approved are based on the opening weekend revenue for the forthcoming film Takers, due to be released on 20 August.

The creation of film futures exchanges has been highly controversial, with strong opposition from the Motion Picture Association of America and equally vehement support from the two companies that have set up exchanges: Media Derivatives (MDEX) and Cantor Exchange.

While the exchanges claim the instruments would be a useful hedging product for participants in the multi-billion dollar US movie industry, opponents believe they are an unprecedented kind of instrument that is open to manipulation.

Changes required

The CFTC explained in its statement that the Commodity Exchange Act requires the Commission to “approve any such new contract or instrument... unless... would violate the Act”. On the advice of its staff, three of the commissioners believed the Media Derivatives products did not violate the Act or the CFTC’s regulations. However, the CFTC did require certain modifications “to guard against manipulation or any other abusive conduct in the trading of any contract by knowledgeable and informed sources within the studio or distribution company”.

The CFTC decided that the contracts were based on commodities, were not readily susceptible to manipulation and served an economic hedging purpose – though the last of these three is not legally required for approval.

A new kind of commodity

Both Chilton and Sommers expressed scepticism that film box office revenues could really be characterised as commodities.

The CFTC’s majority view was that Section 1a(4) of the Commodity Exchange Act (CEA) provides that “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in” are statutory commodities.

The Commission believes that Congress intends it to regulate futures and options on “all commodities, goods, articles, services, rights, and interests which are or may be the subject of futures contracts”.

It pointed to more than 500 existing contracts at US exchanges that are based on intangible rights or interests, or on non-price-based measures of economic, commercial or environmental activity. In many cases there is no cash market underlying these derivatives.

In an appendix, the CFTC listed 14 pages of such existing contracts, ranging from options on the earnings per share of specific companies to futures and options on economic indicators like inflation and employment numbers, to specific merger and acquisition scenarios and weather derivatives.

The CFTC concluded that movie revenues were “little different” from these other events.

The second major issue considered by the CFTC, which it said was “of paramount concern”, was the contracts’ potential susceptibility to manipulation “either (1) through trading behavior or (2) by using or manipulating privileged or insider information by certain studio or distribution company officials”.

Manipulation fears dismissed

US exchanges are obliged under Core Principle 3 of the CEA to list “only contracts that are not readily susceptible to manipulation”.

The CFTC staff insisted on specific modifications to the original contract proposal to “ensure that knowledgeable parties cannot intentionally release or misreport data that would have an impact on the trading or settlement of this contract”.

In its statement, the CFTC paid particular attention to Rentrak, the company that collects the data on box office revenues that will be used as the underlying indicator for the contracts.

The regulator said it was “satisfied that the revenue numbers used by these contracts to determine settlement should minimize the potential for manipulation”.

In particular, it said Rentrak was a third party data aggregator with no direct monetary interest in any film, and a strong incentive to produce accurate figures. Its collection of data is mainly automated but also involves emails and faxes – the CFTC said this was analogous to the processes used to compile pricing data for agricultural and commodity futures.

“Fair and equitable”

Another point addressed by the CFTC was that MDEX’s rules “properly address fair and equitable trading and false reporting concerns”.

The CFTC has insisted that MDEX adopt a rule that requires entities and individuals who control a film’s marketing budget, release date or opening screen number to provide the exchange with information regarding such decisions whenever that entity or individual holds a position of 1,000 or more contracts.

“The Commission has responded,” it said, “to the concerns that have been raised by various individuals and parties that a distributor could influence, to some degree, the level of box office revenues for a film by changing a movie’s marketing budget, release date or number of screens on which it opens. Concerns were raised whether parties could ‘intentionally or accidentally’ misreport data relevant to the revenue contracts or change the number of theaters that would show the film during the opening weekend. This rule change will permit those entities to utilize this hedge instrument, if they desire, but provide essential transparency to the exchange, the National Futures Association and the Commission, which all have oversight responsibilities ensuring fair and equitable trading.”

The Commission went on to say that while it did not believe the revenue numbers were readily susceptible to manipulation, “‘false rumors’ or misreporting of data may exist in the motion picture industry, just as it does with many other industries”.

Although such false reporting might be a violation, the CFTC argued, the possibility of that happening did not mean the contracts violated the CEA.

One of MDEX’s rules will require studios or film distributors that trade contracts on films they have released to adopt firewall procedures to separate employees.

Another MDEX rule forbids any employee of a distributor who is responsible for compiling film revenue numbers to trade any contracts on films released by that distributor; nor may any Rentrak employee use them, or disclose information about the revenues.

The Commission said it “believes these additional protections agreed to by MDEX satisfy the requirement to ensure that trading in this contract is fair and equitable”.

A way to manage risk

Finally, the CFTC addressed the question of whether the contracts would “provide reasonable means for managing risks”.

The agency explained that since the Commodity Futures Modernization Act of 2000, it has no longer been required to apply an economic purpose test to evaluate whether proposed new contracts fulfilled a useful hedging purpose.

Nevertheless, “in light of the comments raised by the studios” which attacked the futures, the Commission did evaluate the contracts’ utility as a hedging tool.

“The Commission found that the contracts can perform hedging and price discovery purposes,” it said. “Industry profit and losses have a clear and direct relationship to box office revenues. A contract based on those revenues could be used to hedge related risks.”

Its analysis found that “there are significant risks faced by many firms in the movie industry”, including “third party” financing, estimated to amount to $14bn since 2004.

“Studios have increasingly relied on third party financial arrangements through Special Purpose Vehicles and/or securitization to reduce their own commercial exposure,” it found. “The Commission understands from numerous written comments... that these third party investors may utilize futures contracts to mitigate their commercial exposure, even if the studios do not.”

Second, the CFTC found that “box office revenue numbers are viewed by the industry as meaningful indicators of the success of a particular film”, and that these numbers are used in contracts such as for TV licence fees and payments to stars.

Third, the CFTC relied on nine comment letters or statements at its public hearing, which either said the contracts would provide a risk management tool or expressed interest in using them for hedging.

“Those commenters stated that direct participants in the motion picture industry, such as studios and producers, may benefit from having motion picture revenue futures contracts,” it said. “They also stated that parties not directly involved in the motion picture business, such as third party financiers, licensers and merchandisers, might hedge risks associated with motion pictures”.

“A line that should not be crossed”

Sommers and Chilton both disagreed with the CFTC’s analysis on fundamental points. Sommers concluded her statement: “There are a number of questions which I believe have never been answered and although staff has recommended approval of these particular , it is unclear to me how they fit into our current regulatory structure.”

In particular, Sommers said the first step in analysing any contract submitted for approval was to determine whether the contract actually was a sale of a commodity, as defined by the CEA.

“While the definition of ‘commodity’ is rather broad, it is not without limits,” Sommers contended. “The Statement of the Commission does not appear to recognize a limit to that definition.”

She explained that the Commission had analysed whether box office revenues were a “right or interest” and therefore a commodity. The analysis found that they were not rights and “did not fit within the common definition of an interest” but that it was nevertheless “not problematic” to consider them an interest because the CFTC had previously approved other futures that did not fit within the definition.

But Sommers argued: “In applying the Act and Regulations, where that which underlies a contract does not neatly or cleanly fit within the definition of a ‘commodity’, the Commission should carefully exercise its judgment in determining whether or not the underlying is, in fact, a commodity. Carefully exercising that judgment involves drawing lines. Invariably, when drawing lines some things will end up on one side of the line, and some will end up on the other. I believe that including motion picture box office revenues as ‘rights or interests’ that fall within the definition of ‘commodity’ contained in Section 1a(4) of the Act crosses a line that should not be crossed.”

Sommers regretted the fact that the CFTC had not completed a process, begun in 2008, of devising a policy on how to regulate event contracts, and said she would prefer that the Commission solve the broad policy issues first.

Not commodities for Chilton

Chilton’s dissent was longer, more detailed and more trenchant. He said he believed that the proposed contracts violated the CEA.

His analysis came in two sections. The first examined the question of whether movie box office revenues were a commodity. In Chilton’s view, the CFTC’s ruling on this point was “fundamentally flawed”. Although Congress meant to define “commodity” broadly, he said, “There is a limit to the elasticity of the definition.”

Chilton argued: “In interpreting the CEA, we are to exercise some modicum of common sense in determining whether or not there is a public interest in deeming some ‘thing’ a commodity... Otherwise, the statute is meaningless; unless some sensible judgment is exercised, we could approve terrorism contracts, or contracts on whether a certain movie star will die or become disabled, or contracts on the likelihood of UFOs hitting the White House... To say that, simply because one can develop a futures contract, the underlying is a ‘commodity’ is circular reasoning, at best. Using this analysis, anything under the sun could be a commodity if you could, at some time in the future, have a futures contract on it. We know that is not how Congress intended for us to interpret the Act.”

Chilton said the CFTC’s reasoning that movie futures were like other contracts it had previously approved was not supported by sufficient legal analysis, “particularly when we have so much evidence that movie box office revenues are not ‘what we’ve seen before’.”

He also attacked the idea that movie futures could qualify as “excluded commodities” under section 1a(13) of the Commodity Futures Modernization Act. Chilton argued that these contracts were not “occurrences” as contemplated in part (iv) of that section, because the transactions are not “beyond the control of the parties to the relevant contract”.

Chilton said it was mystifying why the Commission had focused on the question of whether there was a requirement for a futures market to be based on a cash market, as that was not the point at issue. Rather, it was the lack of clear policy on event contracts that mattered. Instead of having “more fully developed these legal issues” the Commission had “simply made the virtually unadorned assertion that ‘these are commodities’.”

Chilton concluded that “if there is no clear applicable definition of ‘commodity’ into which we can fit movie box office returns, there is a fundamental jurisdictional obstacle to approving the requested contracts”.

“Inherent conflicts”

The second part of Chilton’s statement analysed whether the contracts involved managing and assuming price risks.

He criticised the CFTC’s focus on whether the contracts will be “susceptible to manipulation” and on the Rentrak numbers. He said the key point, “whether there is evidence that the contract can actually be used to manage those risks” had “regrettably been avoided”.

Chilton argued: “Given the conflicting information received on this point, and the inherent conflicts that a single producer/single ‘commodity’ contract presents, the Commission has not provided sufficient basis to approve this contract as a viable hedging tool.”

He went on: “This is an action of first impression at the Commission – the first time that it has approved a contract where there is a single producer, a single entity controlling the entirety of the ‘market’. The fact that conflict of interest rules were necessary points out the fundamental flaw in reasoning of the approval: if it is necessary to ‘wall off’ the primary (or at least, one of the primary) users of the contract, how can it be deemed a viable transaction used to ‘manage’ risk?”

He said the testimony that movie investors “may” be able to use such contracts was rebutted by other testimony “that the contract design was fundamentally flawed, both in timing and in scope”.

Concluding that MDEX had not fulfilled its obligation to show that the transactions did not violate the requirements of the CEA, Chilton said “Moving forward on such slim evidence is not, in my opinion, either warranted or wise. It is my hope and expectation,” he ended, “that, in the future, the Commission will perform a more fulsome and careful review of such submissions.”

The CFTC must now decide by June 28 whether to approve the application of the Cantor Futures Exchange to offer contracts linked to the soon-to-be launched film Expendables.

However, while Media Derivatives seems to have won the battle to list film futures, it may yet lose the war. The Motion Picture Association has lobbied the Senate to include a section in its financial market reform bill which would ban movie derivatives, though this still needs to be approved by Congress.

Jon Hay +44 207 779 8372 jhay@fow.com

Colin Packham, Sydney cpackham@fow.com