High Court of England & Wales Upholds ISDA Oil Derivatives Transactions
Richard Powell | Bloomberg Law
Standard Chartered Bank (SCB) is the latest bank to see off an attempt by a commercial counterparty to escape from an unfavourable derivatives contract.1Hamblen J, in a judgment of the High Court in London of 11 July 2011, dismissed a claim by the Ceylon Petroleum Corporation (CPC) to release it from two oil derivatives transactions, and/or alternatively, that SCB was in breach of its duty to advise and should be liable for consequential losses. In doing so, amongst other matters, the Court followed the decision of the Court of Appeal in Springwell Navigation v JP Morgan Chase Bank  EWCA Civ 1221 (CA) on the circumstances in which an advisory duty of care may arise.
Ceylon Petroleum Corporation
CPC is Sri Lanka’s state-owned importer, refiner and retailer of oil, a significant commercial entity. It regularly purchases physical oil on the international markets which are priced in U.S. dollars. The period 2003 until mid 2008 saw a very significant increase in the oil price and from 2007, in an attempt to protect itself from rising oil prices, it entered into a series of oil derivative contracts with SCB and other banks with a presence in Sri Lanka.
The two specific transactions in dispute were made under the International Swaps and Derivatives Association (ISDA) Master Agreement (2002) subject to confirmations containing details of the specific transactions dated June and July 2008. Under these when oil prices rose SCB made payments to CPC and when they declined CPC was obliged to make payments. Initially, this meant that while CPC had to pay more in U.S. dollars for its oil imports it received payments from SCB. However, from July and August 2008, unexpectedly, oil prices were subject to very substantial falls in price as the financial crisis heightened and world economies went into recession. This meant that while physical oil was cheaper to buy it became “out-of-the-money” under the derivatives transactions and indeed on similar agreements with other banks. In December 2008 CPC defaulted on these and other transactions. This failure took place against a background of political controversy in Sri Lanka which saw the intervention of government and judicial authorities.
In the High Court, SCB claimed the balance of payments due, U.S. $161,733,500, on the basis that the two transactions were made at arm’s length between two commercial counterparties. In answer, CPC disputed the validity of the specific agreements, although not the ISDA Master Agreement in general. The state-owned entity argued that:
- It lacked the legal capacity to enter into the derivatives contracts as they fell outside the scope of its general objects;
- The signatories lacked actual authority from the CPC board; and
- It would be unlawful to comply because of a direction from the Sri Lankan authorities.
In addition, CPC counterclaimed for the amount outstanding to SCB. It argued that the bank had acted as an adviser encouraging it to enter into transactions which instead of hedging the risk of adverse price movements had exposed CPC to making significant payments when prices fell. As one of a number of alternatives to these transactions, CPC might have bought a call option giving it the right to purchase oil at the “strike price” on a future date. The down side would have been the cost of paying a significant premium.
Material Issues of Fact
In reaching his judgment Hamblen J had to consider a number of key factual issues. The Judge looked at what was said at a presentation meeting between both sides on 24 October 2007 where CPC’s strategy, expectations and risk appetite were discussed. While the Judge accepted that the Sri Lankan entity wanted daily contact with SCB on such matters as market updates, he held there was no “discussion or agreement as to SCB undertaking a general advisory role” on the entering into of transactions.2 The judgment also referred to the knowledge of two key CPC directors about the terms of the transaction. This was important as it was said to condition the nature of the parties’ relationship. Despite, the directors giving evidence to the effect they had read little of the documentation, the Court did not accept that they were “entirely ignorant” of the term sheet and confirmations, rather they had understood the “broad thrust of the provisions.”3
A third and fundamental issue was whether the transactions amounted to speculation in, rather than a hedge to price movement in the oil market. The Court recognised the difficulty of distinguishing between these concepts and, having considered expert evidence, it was not persuaded that the transactions were speculative. In part, this was because they were carried out in the context of an underlying physical position in oil and, at the time, neither party had considered them to be speculative. This was despite the price protection element in the various transactions having reduced over time, and CPC coming to use them primarily for cashflow purposes and as a means to acquire foreign exchange.4
Capacity, Authority & Illegality
The Judge first addressed the question of whether CPC and its directors had the ability and authority to enter into the two transactions. On the facts, and applying Sri Lankan law (which shares a common origin with the English law doctrine of capacity), and on the basis that the transactions had not been speculative, CPC was found to have had capacity. Consideration was then given to whether the directors had actual authority to enter into the two transactions. It was concluded that whether or not the directors had actual authority, as against SCB, they held ostensible authority because the bank had been induced by representations over the directors’ authority. According to Hamblen J, it would have been “inconceivable that SCB would have entered into the Transactions (and the corresponding back-to-back obligations) if SCB had not held such a belief.”5
As to illegality and the proper place for performance, the Court examined the facts as against English law and the circumstances when performance may be excused. SCB successfully argued that performance can only be excused where a party is obliged under a contract to perform (e.g., pay) in a country where that would be illegal.6 The authorities in Sri Lanka had purported to prohibit payments although the direction appeared to be directed at SCB and not CPC. In the event, Hamblen J did not accept that the terms of the ISDA Master Agreement required payment to be made from Sri Lanka. In fact, it was required to be made in New York and how that was done was for CPC to decide.7
Under its counterclaim, CPC argued that SCB owed a duty of care in contract or tort to advise on hedging and derivatives. If the bank had not breached this duty the Sri Lankan entity would have pursued, it said, a “proper” hedging strategy and would not have entered into the two transactions. SCB not only denied the existence of any such duty and its breach, but argued that CPC was estopped from contending there was one.
The Judge examined the legal authorities on implied terms of contract to the effect that these will only be implied where it is necessary to do so. In this respect a term will not be implied if the parties would or might have acted exactly as they did in the absence of a contract.8 As for a duty of care in tort, there were various tests, such as whether there had been an assumption of responsibility together with reliance. Recent case law, however, had taken a pragmatic approach looking at the conduct and relationship of the parties rather than relying on high level principles or a single test. Hamblen J cited Springwell Navigation as containing a good summary of the law in this area, a matter which concerned a similar allegation of an advisory relationship.9 According to the Court:
in determining whether the circumstances are such as to impose a duty of care, an important factor is the way in which the parties have sought to regulate their relationships, and to allocate risk, by contract. Where the parties have entered into agreements containing representations or acknowledgments as to sophistication and non-reliance the court is not required to undertake a detailed textual analysis of the precise ambit, extent and legal effect of each relevant clause.10
The Court further opined that it was unreasonable for CPC to ignore the clear and repeated disclaimers in the contract documentation, finding that that these negated the assumption of an alleged advisory role. Similarly, it held that CPC would be contractually estopped as a result of contractual non-reliance statements, citing Cassa di Risparmio della Repubblica di San Marino SpA as authority for the proposition that parties to a contract may agree that a particular state of affairs is to be the basis on which they contract whether it is true or not.11
In the circumstances, the Court was ready to reject the existence of a duty of care whether in contract or tort. With similar ease it dismissed allegations that SCB had made misrepresentations or negligent misstatements, or that CPC had relied on these, when entering into the transactions. In any event, Hamblen J said he would have held that CPC was contractually estopped from doing so pursuant to section 9(2) of the Master Agreement, necessarily ruling in the process, that it satisfied the test of reasonableness under section 3 Misrepresentation Act 1967.12
This judgement takes the opportunity to remind commercial litigants of the courts’ reluctance to intervene in commercial transactions.13 Where commercial parties have entered into an agreement, especially with the benefit of legal advice, it is left to them to decide how to allocate the risks and responsibilities between them.14
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