LONDON (Reuters) - Lawsuits alleging aluminum price fixing by big banks will shine an uncomfortable light on the role played by the London Metal Exchange, suggesting that the murky world of metal trading is likely to attract more attention from the authorities.
Even if it successfully defends itself from class action lawsuits by aluminum manufacturers, the LME may have to accept greater external oversight into a trade that until now flourished with little external supervision.
The LME, which was sold last year by its member bank owners to the operator of the Hong Kong Stock Exchange, is a defendant in lawsuits which accuse Goldman Sachs (GS.N), JP Morgan (JPM.N) and Glencore-Xstrata of rigging the aluminum market.
The lawsuits, brought by small aluminum manufacturers in the United States, accuse the banks and traders of hoarding metal in warehouses, driving up the prices of industrial products from soft-drink cans to aeroplanes.
Plaintiffs argue that the LME abetted the scam by writing rules that made it possible and ignoring calls to change.
Although the LME insists its rules were made independently, at the time the actions took place Goldman and JP Morgan were its two biggest shareholders, with JP Morgan owning 10.8 percent and Goldman owning 9.5 percent.
Goldman and JP Morgan have dismissed the lawsuits against them as without merit. Glencore declined to comment.
Hong Kong Exchanges and Clearing Ltd (0388.HK), the LME's new owners, also said the lawsuits were without merit and the LME would contest them vigorously.
The lawsuits coincide with a preliminary probe by the U.S. Department of Justice into the metals warehousing industry.
Those who watch the trade say it is no surprise that lawyers have finally been summoned. Reuters first revealed in a special report in 2011 that Goldman and others were earning large profits from LME-registered aluminum warehouses that take in far more metal than they release. reut.rs/qHBlry
"The suits have been a long time coming," Societe Generale analyst Robin Bhar said.
Since 2010, companies including Goldman, JPMorgan, Glencore-Xstrata and trade house Trafigura have run a lucrative business building up big aluminum stocks, charging rent to store the metal and delivering it only at a limited rate.
The LME's industrial clients have long blamed the exchange for letting long queues build up for material. The delays mean extra costs added on to the price of the metal.
The LME was set up 135 years ago to provide a venue for trade conducted for centuries among metal merchants in the British capital. Before it was set up, traders met in London coffee houses with a circle drawn on the floor in chalk.
It is still one of the last "open outcry" trading exchanges in the world. Sessions take place in a trading ring with red padded seats. Only 12 firms have access to the ring, arranged in fixed positions in a circle. Traders juggle telephones and communicate in archaic hand signals.
Those quaint proceedings belie a vast mechanism for allocating the supply of industrial raw materials.
To even out fluctuations in the price with rising and ebbing demand, the LME certifies a network of storage warehouses from Baltimore to Johor, and sets rules for their operation.
Until last year, its rules required warehouse operators to ship out 1,500 tonnes of aluminum per day from any city where they hold the metal.
By owning many large warehouses in the same city, operators could easily meet that target while allowing only a fraction of the aluminum they take in to ever reach consumers.
Goldman's vast warehousing subsidiary in Detroit now holds more than a quarter of the total global LME stocks of around 5.5 million tonnes.
Last year the LME increased the shipping requirement to 3,000 tonnes per day, but buyers say that is still a fraction of the amount needed to bring stocks to market. The LME last month announced sweeping proposals to change its warehousing policy aimed at easing wait times and placating irate industrial users.
Opinions vary on how viable the lawsuits are, and pinning blame on the LME will be difficult.
But win or lose, analysts and metals industry participants say the reputation of the LME has been seriously undermined, and the murky, self-regulated world of commodities trading is likely to face heavier scrutiny from the authorities in the future.
Defending itself will be a big financial burden just nine months after Hong Kong Exchanges and Clearing bought the LME for $2.2 billion.
"Legally, the LME might be doing nothing wrong, but ethically and morally you could lay a lot of charges against the LME," Societe Generale's Bhar said. "Arguably you could say this is the biggest crisis since Sumitomo."
In 1995, Japanese trade house Sumitomo Corp's head trader Yasuo Hamanaka racked up $2.6 billion in unauthorized losses after he allegedly tried to corner the entire world's copper market.
The incident plunged the copper market and the LME into crisis, triggering a massive overhaul of the LME's rule book, which introduced limits on traders' positions. It still ranks among the highest trading losses in financial history.
But even in that case, the LME was never itself accused of wrongdoing on its own behalf. The new lawsuits allege the exchange conspired with Goldman to inflate prices, restrict supply and violate anti-trust laws.
Because Goldman and JP Morgan were both big shareholders in the exchange, and because the LME itself earns revenue on the warehousing industry, it is harder to make the case that it was nothing but a neutral market maker for independent traders.
"Hamanaka was operating secretly, but he didn't own 10 percent of the LME," said Christopher Lovell, the lawyer who brought a case last week against Goldman and the LME on behalf of aluminum user Superior Extrusion Inc.
A Goldman representative was a member of the LME's board before the Hong Kond takeover. The warehousing units of Goldman, JP Morgan, Glencore and Trafigura all remain members of the LME's warehousing committee.
"The LME had, at that time, an incentive to accommodate Goldman and other large shareholders of the LME, and also brought customers to the LME," Lovell's suit states.
It alleges that the LME-approved rules empowered Goldman to push prices up and restrain aluminum supplies.
Michigan-based Superior Extrusion, which makes aluminum tubes, bars and shapes for cars, pipelines, railings and furniture, says it was damaged by being forced to buy aluminum at an inflated premium despite global oversupply of the metal.
"Far from dissociating itself from Goldman's anti-competitive conduct, the LME has, notwithstanding repeated public complaints that the Goldman/LME conduct was inflating aluminum prices, continued to make and perform agreements with Goldman," the lawsuit says.
Before Goldman bought its Metro warehousing subsidiary in Detroit in 2010, it took six weeks to get metal from it. The current wait time is around 18 months. While the metal is kept in the warehouse, Goldman earns rent.
The brought revenue directly to the LME, which collects a levy of 1.1 percent of the daily rent.
Rents for LME aluminum have risen almost 50 percent to a median 47 cents per tonne since 2007/2008, according to Reuters calculations. Meanwhile, premiums that buyers in the spot market have to pay to get their hands on metal now have risen from $115 per tonne to as high as $250 per tonne.
"Goldman has said it was operating according to the LME rules. Until it was sold, the LME wasn't doing anything about it," Lovell told Reuters.
It is still early days for the litigation.
Moves to bring class action suits so soon after the revelation of a government inquiry could be an effort by lawyers to jockey for lead position among the many who may bring cases. It is likely that the lawsuits, and others that could follow, will be rolled into one multi-district litigation.
"Defendants have known since 2010 of the conspiracy and collusion to create a cartel to control the storage and delivery of aluminum," lawyer Tim Howard, of Florida-based Howard & Associates, said in a lawsuit on behalf of Master Screens Inc.
While the problem started in Detroit with aluminum, it has since spread to other locations, other companies and other metals like zinc, copper and lead.
The legal proceedings will likely take years, but like the Sumitomo crisis almost 20 years ago, the fall-out from the regulatory and political scrutiny will be felt sooner on the LME's trading floor, in its board room and in its vast warehousing network.
"This has now moved beyond the idiosyncrasies of the LME system to something with a broader dynamic," said Macquarie analyst Duncan Hobbs. "Now it's political."
Additional reporting by Harpreet Bhal in London and Melanie Burton in Singapore; Editing by Veronica Brown and Peter Graff