FCStone LLC, a New York City-based futures commission merchant (FCM), has been slapped with a $1.5 million civil penalty by the Commodity Futures Trading Commission (CFTC) for “failing to diligently supervise its officers and employees” relating to its business as an FCM during 2008 and part of 2009.

The Commission charges that FCStone failed to implement adequate customer credit and concentration risk policies and controls with its customers’ accounts, and with a specific account, which was primarily controlled by two individuals who traded natural gas futures, swaps and option contracts from Jan. 1, 2008 through March 1, 2009. The one natural gas account acquired a massive gas options position that it could not afford to maintain, according to the CFTC.

Ultimately, the CFTC noted that FCStone was forced to take over the gas account, which lost close to $127 million. In addition to the $1.5 million penalty, the FCM has been ordered to retain an independent consultant to review internal controls and procedures, as well as cease and desist from violating its supervisory obligations.

Parent FCStone Group reported in late February 2009 that it was caught on the wrong side of a natural gas deal and was expected to incur an additional $60-80 million in a pre-tax bad debt provision for 2Q2009 in connection with previously reported losses by “a significant energy trading account,” for which FCStone served as the clearing firm (see NGI, March 2, 2009). Through organic growth, acquisitions and a 2009 merger between International Assets Holding Corp. (INTL) and FCStone Group, the company became the Fortune 500 financial services organization called INTL FCStone Inc.

Numerous traders and firms also were caught on the wrong side of the trade during the mercurial rise and fall of natural gas futures values in 2008 and 2009. By the time of FCStone’s announcement in late February 2009, natural gas futures values had fallen 70% since the front-month contract reached a high of $13.694 on July 2, 2008. On Feb. 26, 2009, the front month contract closed at $4.077, a $9.617 discount to summer 2008’s high.

The CFTC Wednesday said that because FCStone did not have adequate credit and concentration risk policies and controls, the two account owners accumulated a massive position — more than 2.5 million relatively illiquid commodity option contracts, which the account owners could not afford to maintain.

“After the value of the positions deteriorated over the course of 2008, the account owners were unable to meet their financial obligations with respect to the account,” the Commission said. “As FCMs are required to do in that situation, FCStone assumed the financial obligations to the clearing house that carried the positions. Unable to successfully manage the positions, FCStone ended up suffering $127 million in losses.”

The Commission found that FCStone violated regulation 166.3 by failing to supervise in a manner designed to mitigate risks associated with customer accounts, such as the risks arising from unsatisfied margin obligations, negative account balances and handling large, relatively illiquid positions.

“The Commission’s supervision regulation helps ensure the financial integrity of the markets and safeguard customer funds,” said CFTC Director of Enforcement David Meister. “When an FCM’s financial risk controls are so lacking that they do virtually nothing to prevent an unchecked customer from taking grossly excessive trading risks as happened here, a harmful domino effect of financially dangerous consequences can follow, affecting not only the FCM but also potentially other customers and the market at large. This case should serve to remind FCMs to make sure that their risk controls are in order.”

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