Commodities Contracts: should the paper transaction be left out of account?
This article was first published in the June 2011 edition of Butterworths Journal of International Banking and Financial Law.
Difficult questions can arise when considering the interrelation between a derivative position used as a means of hedging (the paper transaction) and the physical transaction if the physical transaction runs into difficulties.
Can expenses incurred in prospectively protecting the physical position be recovered?
Are the damages to which the innocent party is entitled increased or reduced as result of any hedging position that party has adopted?
The court has shown itself willing to consider hedging contracts as an integral part of the physical market.
It is commonplace that the commodities and shipping markets have experienced very considerable increase in the use of derivatives to guard against volatility, in other words hedging. Trading companies hedge ‘in order not to be caught with open positions in a volatile market’ (Choil Trading SA v Sahara Energy Resources  EWHC 374 (Comm)). They are often required to do so by their financing institutions. (There has been a similar growth in the speculative trading of futures themselves. Ironically, the market’s volatility, against which hedges are intended to protect traders in the physical market, has itself claimed as victims many, particularly in the freight futures or forward freight market, who had sought to trade speculatively.)
Where, in contrast to the trading of futures, they are used as a means of hedging, difficult questions can arise about the relationship between the paper and the physical transaction if the physical transaction runs into difficulties. The usual intention is to match an exposure in the physical transaction by use of a suitable derivative, a future, option or swap intended to act as protection against market movement.
Where the physical transaction does run into difficulties and claims for damages are contemplated as result of an alleged breach, two questions commonly arise when considering the interrelation between the derivative position and the physical transaction; firstly, can expenses incurred in prospectively protecting the physical position be recovered; secondly are the damages to which the innocent party is entitled increased or reduced as result of any hedging position that party has adopted? In each case, the threshold question is whether the paper transaction is left out of account.
The starting point for any consideration of damages is that they should be ‘that sum of money which will put the party who has been injured, or who has suffered, in the same position as he would have been in if he had not sustained the wrong for which he is now getting his compensation or reparation’ (Livingstone v Rawyards Coal Co (1880) 5 App Cas 25, 39).
As early as Addax v Arcadia Petroleum  1 Lloyd’s Rep 496, the court (Mr Justice Morrison) took into account the contracts for differences that the claimants (sellers) had entered into, as part of their decision to elect for a ‘deferred price option’ for the Brent crude which was the subject of the sale contract. He also said, as regards the costs of the hedging instruments, that they were:
‘an integral part of the calculation of the net position, and if the net position is a directly relevant loss, so must the hedging costs be so regarded. To extract the costs of the hedging devices is wrong in principle and has no commercial merit ... It was I think wholly foreseeable that if the claimants took a position which was otherwise than back-to-back with their contract with the defendants, they could cover their position with one of a multitude of hedging transactions available. While the contract instrument used may well vary from trade to trade (or possibly trader to trader), the defendants must have foreseen the need for the claimants to get cover.’
In Glencore Energy UK Ltd v Transworld Oil Ltd  EWHC 141 (Comm), the defendant sellers of a cargo of Nigerian oil were found in breach, having agreed once the due date of the delivery had passed, to keep the contracts alive. They then argued that the claimant buyers’ damage should be reduced to give credit for the loss that the claimants would have suffered on their hedging contracts if those contracts had been closed out against the physical delivery of the cargo. The claimants’ position, by contrast, was that the closing out of their futures positions was not by way of hedge but independent transactions. This raised precisely the question of the connection between the physical and paper contracts. The judge did not require documentary evidence of the connection or paper trail to link the two: hedging had been presented as ‘an essential part’ of the claimants’ business (whereas speculating in the movement of oil prices was not part of their business at all) and the decision to close out the futures positions only when it became clear that delivery would not be made and after the contractual date for delivery had passed had been relied on as evidence that the contract had been kept alive. The judge found that closing out the positions was something that the claimant had done, and (importantly) had been required to do, as part of its duty to mitigate its loss once the sellers’ breach became clear.
In Choil Trading, the judge made reference to both the Glencore case and the Addax case, in deciding that the claimant buyers of a naphtha cargo were entitled to take into account the cost of the hedges against their open position that they had entered into when their own onward buyer rejected the cargo for a defect in quality. Those hedges realised a loss. Choil Trading was entitled to recover that loss as representing a reasonable attempt at mitigation (just as, in Glencore, the claimant buyers had to give credit for the loss they had avoided by closing out their positions). The judge found that the defendant sellers were well aware that the claimants would be likely to enter into hedging contracts in the circumstances and considered it reasonable.
In short, the court has shown itself willing to consider hedging contracts as an integral part of the physical market. Traders must be aware of this and ensure that their paper positions are demonstrably closely connected with, or not, as the case may be, the physical transaction.
Dominic Happe’s practice focuses on all aspects of international trade, particularly shipping (both dry and wet) and commodities, as well as ship sale and purchase and shipbuilding.
He acts in arbitration, in the Commercial Court and in the Court of Appeal. He has wide experience in interlocutory applications, particularly anti-suit injunctions.