State entities' contractual capacity in derivatives transactions

A recent Court of Appeal (UK) decision contains an interesting and timely consideration of the capacity of a state-owned entity to enter into derivative contracts, including the relevance of the distinction between speculative and hedging transactions.

Standard Chartered Bank v Ceylon Petroleum Corporation [2012] EWCA Civ 1049.

Ceylon Petroleum Corporation (CPC) is a state owned entity established under Sri Lankan statute, with responsibility for the domestic supply of petroleum and crude oil in Sri Lanka. It was therefore a very significant importer of oil and exposed both to the price of oil and currency movements as part of the ordinary course of its business. By early 2007, the price of oil was on an unprecedented upward curve and CPC accordingly took steps to mitigate the continuing risk it faced from high prices by entering into a number of oil derivative transactions with Standard Chartered (and a number of other banks). The transactions were subject to an ISDA Master Agreement (2002 version).

The terms of the two transactions that were the subject of the appeal had the effect of the bank making modest dollar-denominated payments to CPC whilst the oil price remained high, but required CPC to make increasingly large payments if the price of oil subsequently fell below a contractually agreed floor during the contractual term.

Much of the debate between the parties concerning the capacity of CPC to enter into the derivative contracts centred on whether, properly characterised, the transactions were for hedging purposes or amounted to speculation. On the one hand, CPC was clearly exposed to movements in the price of oil and anything which sought to mitigate that risk and to provide greater certainty around the price it would pay for oil would hedge its exposures. On the other hand, the terms of the transactions in question did not necessarily achieve greater certainty, in that they exposed CPC to sizeable payments if the oil price fell below the floor. In that sense, its position could be said to have been speculative in that it was akin to taking a small premium to insure the counterparty (Standard Chartered) against the risk of falling prices.

The Court of Appeal took the view that, in practice, it was often extremely difficult to draw bright lines between speculative and hedging trades and that hedging trades typically involved an element of speculation, whilst speculative trades involved an element of hedging. The Court was therefore not particularly assisted by the parties' submissions on this distinction.

Instead, it focused on the creation of CPC by the relevant Sri Lankan statute as an entity which was intended to be run as a commercial entity and construed its objects clause, which allowed it to do anything "incidental or conducive" to the importation, sale, supply and distribution of petroleum, in that context. The transactions in question performed two commercial functions for CPC:

(i) receipt of the payment from Standard Chartered whilst the oil price remained high in effect reduced the price it was paying for the oil it was importing; and

(ii) by receiving that payment in dollars, CPC was reducing (to some degree at least) its exchange rate exposure.

The fact that, with hindsight, the transactions turned out to be imprudent given the collapse in the price of oil which occurred from July 2008 does not alter the fact that, at the time, there was commercial benefit to CPC.

Accordingly the Court of Appeal found that the transactions were "incidental or conducive" to CPC's objects and that they were therefore within its capacity.