A recent court case offers insight for how organisations may be able to assess the hedging and/or speculative nature of their derivatives transactions and their capacity to trade. Michael Beaton managing director, Derivatives Risk Solutions LLP explores this court case.
Introduction
On 27 July 2012, the Court of Appeal passed down judgment in the case of Standard Chartered Bank (“SCB”) and Ceylon Petroleum Corporation (“CPC”). The case is primarily concerned with the question of capacity to enter into derivative transactions, but is notable for the obiter comments of the court regarding the difference between a ‘speculative’ transaction and a ‘hedging’ transaction.
Background
CPC is a corporate body established under the Ceylon Petroleum Corporation Act 1961. Its primary business purpose is the importation of crude oil and refined petroleum products to the internal Sri Lankan market. As an importer, CPC is exposed to the risk of increasing oil prices.
The case related to two ‘zero-cost collar’ derivative transactions on Singapore Gasoil, entered into under a 2002 ISDA Master Agreement in May and July 2008 by CPC and SCB. Pursuant to the transactions, CPC purchased a call option from SCB and sold a put option to SCB. As a result, broadly speaking, SCB was required to make periodic, albeit quite small, payments to CPC whilst oil prices remained high. Conversely, CPC would be required to make payments to SCB if the price of oil fell below an agreed floor.
In the second half of 2008, oil prices fell rapidly. Whilst the price at which CPC was able to purchase oil in the market also fell, CPC moved ‘out-of-the-money’ under the derivative transactions with SCB, with the result that it was obliged to make payment to SCB. From December 2008, CPC defaulted on its payment obligations. SCB began proceedings against CPC seeking to recover USD 166,476,281. CPC claimed that the contracts were not binding on CPC because it did not have capacity to enter into them insofar as they were speculative in nature.
Capacity
In the court’s view, the central question was whether CPC had capacity to enter into the relevant transactions, not whether those transactions were speculative in nature or for hedging purposes. This question was to be answered by analysing whether the transactions fell within the scope of the business that CPC was formed to undertake, rather than looking at the nature of the transactions themselves.
The Court of Appeal found that CPC had been established to act as a commercial entity. As such, in the absence of any indication to the contrary, the intention must have been that CPC should have the capacity to enter into any transaction that could fairly be said to be incidental to its statutory objects. On the facts, the court held that the transactions were incidental and conducive to CPC’s business objects, and therefore enforceable, because they “were intended to help CPC manage the twin risks of running out of cash in general and foreign exchange in particular”. Specifically, the transactions:
• provided a modest degree of upside protection against rising prices;
• provided a modest degree of assistance in relation to CPC’s requirement for foreign exchange; and
• resulted in a positive cash-flow, which was urgently needed by CPC.
The court noted that CPC had always accepted that it had capacity to enter into oil-based derivative contracts and that such transactions were rightly to be regarded as incidental or conducive to its objects. That being the case, the fact that they could be characterised as hedges or speculative transactions was immaterial.
Hedging versus Speculation
Although it was unnecessary for the purposes of the appeal to decide whether CPC had the capacity to enter into speculative transactions, the court did make a number of obiter comments in this area which may be of interest to practitioners.
The Court of Appeal concluded that “there is no hard and fast line between what traders regard as hedging and what they regard as speculation”. The concepts of ‘hedging’ and ‘speculation’ begin to blur at their edges as any given transaction can have aspects that are both speculative and yet also address risk management issues. A subjective assessment of intentions and aims is required, however difficult an exercise this might be in practice. In addition, the view as to whether a transaction could be regarded as prudent could be very different depending on whether the matter is considered before, or after, the event. Nonetheless, broadly speaking, in the context of commodity trading, the term ‘hedging’ is generally used to describe steps taken to reduce existing exposure to risks and increase certainty of outcome, whereas ‘speculation’ is used to describe the act of entering into a new obligation in the hope of making a profit as a result of favourable movements in the market. By implication, therefore, ‘speculation’ involves the acceptance of the risk resulting from adverse market movements.
On the facts, the Court of Appeal expressed the opinion, again obiter, that the transactions were either highly speculative hedges or speculations with elements of hedging about them. Although at pains to emphasise the fact that it was not necessary to categorise the transactions into one camp or the other, if it had, the court marginally favoured regarding the transactions as speculative in nature.
Conclusion
The Court of Appeal has made clear that, in determining whether a derivative transaction is enforceable against a counterparty, the fundamental question is whether in anticipation, and not in retrospect, derivative transactions can rightly be seen as ordinarily part of, ancillary or conducive to, the business of the counterparty. If so, they are binding, and the question as to whether they are speculative or hedging in nature becomes very much secondary. Nonetheless, the court did highlight a number of factors with respect to the particular derivatives transactions between CPC and SCB which may help practitioners to assess their own transactions:
Factors suggestive of hedging
• the existence of a board decision to use derivatives to implement a hedging strategy “without delay”;
• the fact that the strategy entered into by CPC and SCB was designed to avoid both up-front payments to the bank and the risk of losses (by ensuring a low floor price);
• the fact that, at least initially, CPC’s strategy had been generally successful and profitable;
• the fact that CPC was a physical importer of oil which meant that any losses on the derivative transactions would be offset by gains generated by the falling cost of oil; and
• that the relevant transactions gave some, albeit limited, protection against high prices, and alleviated CPC’s most pressing need, which was the shortage of hard currency.
Factors suggestive of speculation
• over time, CPC’s strategy changed to one of making short-term profits, rather than to hedge risk;
• in reality, CPC’s strategy generated fixed and limited upside profit at the expense of accepting uncertain and potentially large downside risk, which the Court of Appeal regarded as akin to taking a premium to insure SCB against falling prices;
• the strategy could be regarded as becoming more risky over time due to the fact that a fall in the price of oil was becoming more likely;
• despite the existence of a physical underlying which offset losses on the derivatives contracts, as a matter of fact, CPC was unwilling to accept losses on its derivatives portfolio in a falling market; and
• ultimately, the risk to CPC’s foreign currency obligations was even greater by reason of the absence of the money which would have been received by sale of a naked put option.
