Clearing brokers' duties when exercising close out powers

In the current economic climate, brokers will find the decision of the High Court (UK) in Euroption of considerable interest, since it considers the duties of a broker which is conducting a close-out and liquidating the position of a client who is in a state of default.

Euroption Strategic Fund Limited v Skandinaviska Enskilda Banken AB [2012] EWHC 584 (Comm).

The facts

The claimant (Euroption) was a BVI-domiciled investment fund which primarily conducted options trading on the London International Financial Futures Exchange (LIFFE). As a non-member of LIFFE, it could only do so through engaging one of the clearing members of the exchange and accordingly entered into a contract with Skandinaviska Enskilda Banken (SEB).

Pursuant to that contract, Euroption was obliged to meet margin calls when requested by SEB in order to provide SEB with protection against adverse market movements on the fund's positions, failing which SEB was entitled to close out Euroption's open contracts "at any time without reference to" the fund and to do so having made reasonable efforts to contact Euroption if "at any time SEB deems it necessary for its own protection."

Basis of Euroption's claim

It was common ground that SEB had a contractual right to close out Euroption's open positions and could choose the moment in which it did so. However, the claim involved allegations regarding SEB's conduct of the forced close out of the portfolio in the extraordinary market conditions which prevailed in early October 2008. Euroption claimed for loss that was suffered as a result of the use of a trading strategy which involved the purchase of additional option positions together with their sale (so-called combination trades), as well as the delay in the close out of certain positions (during which the extent of losses increased). Euroption said that SEB's conduct was in breach of:

• a duty not to conduct the close out in an capricious, arbitrary or irrational manner;
• an implied contractual duty of care to perform the close out with reasonable care and skill; and/or
• a tortious duty of care brought about by an assumption of responsibility to act with reasonable, care and skill.

Basis of SEB's defence

SEB countered that the mandate between SEB and Euroption provided a broad and unfettered discretion in relation to the conduct of any close out process and that, having taken the decision to liquidate the portfolio, SEB could effect that liquidation in a number of ways which were not limited by the express terms of the contract. Accordingly, the only limitation on what it could do to bring about the liquidation of the portfolio was that it must not act capriciously, arbitrarily or irrationally.

Regarding the specific trading strategies adopted during the close-out, SEB pointed to the fact that Euroption's own expert had accepted that the 'combination' trades which were entered into by SEB were a legitimate means of closing out an options portfolio (and were in any event authorised by Euroption's primary trader responsible for management of the portfolio) and that the delay in the sale of the short call positions was reasonable in the circumstances (even if not, with hindsight, the optimal strategy).

The Court's findings

In relation to the argument that a contractual duty to take reasonable care was owed by SEB in exercising its close out rights, the Court held that no such duty could be implied into the broking agreement, either by the terms of section 13 of the Supply of Goods and Services Act 1982 or otherwise. The Court held that the implied term imposed by section 13 (requiring services to be carried out with reasonable care and skill) applies only to services which it is agreed will be provided under a contract; it does not extend the obligations under the contract. Certain advisory services and the settlement and exchange services were the services which the Broker had contracted to provide, not the close out of the portfolio which was a consequence of the client's breach. Accordingly, absent express provisions in the contract, there was no basis on which to imply a requirement of reasonable care and skill into how the close-out was conducted.

Equally, there was no assumption of responsibility by the broker to the client to take reasonable care in exercising its right of close-out, in view of the nature of the role which a clearing broker undertakes and the modest commission which it receives for that role.

Moreover, the Court determined that, following a default, the broker was entitled to put its own interests first in order to protect itself against the exposure which had been brought about by its client's breach (the failure to post margin). It was therefore the broker's decision, which can be made in its own interests, how the close out should be conducted, subject only to the requirement that it did not step outside the bounds of a duty to act in good faith, honestly and not arbitrarily or irrationally.

On the experts' evidence, SEB's method of closing out the options positions was found to have been reasonable, both in entering new 'combination' trades as part of the close out and the delay in closing out some of the short call positions. In those circumstances, SEB was found not to have acted arbitrarily or irrationally.

Furthermore, the judge found that, even if she was wrong in rejecting the existence of a duty to take reasonable care in conducting the close out, SEB did not breach any such a duty. It was emphasised that looking back critically at each trading decision with the benefit of hindsight, as Euroption (and its expert) had sought to do, was not a permissible way to assess the trading strategy adopted by SEB:

"The issue for the court is not the relative strengths and weaknesses of another strategy compared with the strategy in fact adopted but whether the decisions actually taken were within the bounds of reasonableness."

Accordingly, Euroption's claim was rejected in full.