Background
Speculation versus hedging
Capacity under legislation
Comment
In Standard Chartered Bank v Ceylon Petroleum Corporation ([2012] EWCA Civ 1049) the Court of Appeal considered the capacity of a statutory corporation to enter into derivative contracts linked to the market price of oil, and whether the distinction between 'speculative' and 'hedging' or 'risk management' transactions was relevant in this context.
The appellant, Ceylon Petroleum Corporation (CPC), was a corporate body established under statute in Sri Lanka for the purpose of supplying crude oil and petroleum products to the internal market. One of its major functions was to buy oil in US dollars in the international markets, import it into Sri Lanka and refine and sell it. In order to mitigate its exposure to the price of oil (in particular, the cash-flow difficulties caused by very high oil prices), in 2007 it began to enter into oil derivative contracts with the respondent, Standard Chartered Bank (SCB), and a number of other banks, including Citibank NA (Citi). In total, CPC entered into 30 such derivative contracts, including 10 with SCB – two of which, known as 'T8' and 'T9', were the subject of this appeal.
The basic effect of T8 and T9 was to require SCB to make payments to CPC when oil prices rose above an agreed ceiling and for CPC to make payments to SCB when oil prices fell below an agreed floor. Where prices remained between the two levels (ie, within the collar), no liability arose. This meant that CPC obtained a discount on the market price of oil while prices remained high, but would have to pay a premium when oil prices were low. T8 and T9 also included additional features that amplified the downside risk while capping the potential upside.
In July and August 2008, contrary to many industry forecasts, oil prices began to fall rapidly, with the result that monthly payments became due from CPC to its counterparties under the oil derivative contracts, including to SCB under T8 and T9. In December 2008 CPC stopped making the payments due to SCB under T8 and T9 and SCB commenced recovery proceedings. CPC defended the claim on a number of grounds, all of which were rejected by the trial judge. CPC appealed on a single ground – namely, that T8 and T9 were not binding because CPC did not have the capacity to enter into the transactions.
The same capacity issue, in the context of very similar oil derivative contracts, had already been decided in an arbitration between CPC and Citi which, unusually, had been made public. In that arbitration, it had been common ground between the parties that if entering into the transactions amounted to pure 'speculation' by CPC, rather than 'hedging' or 'risk management', then they were outside its capacity. This followed the reasoning in Hazell v Hammersmith and Fulham London Borough Council ([1992] 2 AC 1), in which the House of Lords held that Fulham Borough Council did not have the capacity to enter into an interest rate swap on the basis that it was purely speculative, even in circumstances where the swap was underpinned by an existing loan with an obligation to pay interest.
The effect of oil derivative contracts entered into between CPC and Citi was to give CPC a $5-per-barrel discount on the price of oil – provided that the market price remained high – in exchange for the risk of loss if the market price collapsed. The arbitral tribunal held that:
"It is impossible to categorise as examples of risk management transactions which do not protect the company against either adverse movements or volatility in the market price, but yield a fixed return unless the market price should collapse."
Accordingly, the transactions were deemed speculative; CPC thus did not have the capacity to enter into them and was not bound by them.
Like the arbitral tribunal in the Citi case, the trial judge in the present case focused on the question of whether the transactions with SCB (ie, T8 and T9) amounted to speculation or were better categorised as hedging. Unlike the Citi tribunal, the trial judge was not satisfied that T8 and T9 were speculative and found that the transactions were within CPC's capacity.
CPC appealed the judge's finding. Its submission to the Court of Appeal was again that T8 and T9 were speculative and that, as a result, it did not have the capacity to enter into them. The Court of Appeal, rather than engaging with this question, rejected the distinction between speculation and hedging as unhelpful. While the lord justices agreed that the terms 'hedging' and 'speculation' had generally accepted meanings – the former relating to the reduction of existing risk exposure and the latter to entering into new obligations in the hope of making a profit – they doubted that there was sufficient clarity for the distinction to form the basis of a sensible legal test, noting that "hedging may come in more or less speculative forms, and that speculation may come in more or less hedged forms".
Moreover, the Court of Appeal questioned the relevance of Hazell to the present case. Although there were similarities between the interest rate swap in Hazell and T8 and T9 in the present case, there was no clear parallel between an English local authority and a Sri Lankan statutory corporation. Accordingly, the Court of Appeal disregarded the distinction between hedging and speculation, and approached the issue of whether the transactions were within CPC's capacity from first principles.
Although the issue of whether CPC had capacity to enter into the contracts was to be determined by reference to Sri Lankan law, the parties agreed that there was no relevant material difference between this and English common law. As a statutory corporation, CPC's capacity was therefore determined by the legislation under which it was established – in this case, the Ceylon Petroleum Corporation Act 1961. Section 5 of the act provides that:
"The general objects of the Corporation shall be –
(a) to carry on the business as importer, exporter, seller, supplier or distributor of petroleum;
(b) to carry on the business of exploring for, and exploiting, producing, and refining of petroleum; and
(c) to carry on such other business as may be incidental or conducive to the attainment of the objects referred to in paragraphs (a) and (b)."
The Court of Appeal considered that the objects set out in the act fulfilled the function of the objects clause in the memorandum of association of a company incorporated under the Companies Acts. The lord justices cited the decision of the House of Lords in Attorney-General v Great Eastern Railway Co ([1880] LR 5 App Cas 473) as authority for the proposition that, notwithstanding the specific provision in Section 5(c) of the act, whatever is fairly incidental or conducive to carrying out a company's objects should be regarded as falling within them. This applied equally to statutory corporations.
The Court of Appeal held that it was clear from CPC's objects that the legislature intended CPC to act as a "commercial entity for the purposes of engaging in international and domestic trade", and that "the legislature must have intended that CPC should have capacity to enter into the whole range of transactions that a commercial organisation acting in that field of business would ordinarily undertake". As a commercial entity, CPC had an obligation to manage its finances, and it accordingly had a "responsibility, and certainly a capacity, to use the increasingly sophisticated tools available to and ordinarily used by a commercial oil trading company". The Court of Appeal held that oil derivative contracts such as T8 and T9 were such tools, and that CPC thus had the capacity to enter into them; with the benefit of hindsight, it may have been imprudent for CPC to enter into T8 and T9, but this did not bear on the question of whether it had the capacity to do so.
This decision reaffirms the proposition that in determining the powers of a statutory body, the starting point is the legislation under which it was established and the intention of the legislature in doing so. Moreover, given that the outcome turned on the wording of an obscure (at least to the English courts) Sri Lankan statute, the point on which the decision turned is unlikely to arise again.
However, the Court of Appeal's refusal to place any weight on the distinction between hedging and speculation, and its comments on the scope of Hazell, are of broader interest and application. More specifically, they suggest that the fact that a transaction may be speculative in nature is insufficient to conclude that a public body does not have the capacity to enter into it. Rather, careful analysis and construction of the underlying objects of the body are required.
For further information on this topic please contact Daniel Hemming at RPC by telephone (+44 20 3060 6000), fax (+44 20 3060 7000) or email ([email protected]).
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