Hedging in damages: A trader's playing field or minefield?

What exactly are we talking about?

Hedging operations and derivative products are double the size of physical markets, and it is not surprising that traders are using these tools to recover hedging losses as damages for late delivery and non-performance under sale/purchase agreements. The key point to be drawn from this newsletter is whether a party should be increasing or decreasing its claim depending on whether it has hedged. Conversely, the opposing party could seek to reduce the claim, if a profit was made on a hedge; if the claimant failed to mitigate its losses by not hedging, alternatively, that an unhedged loss is too remote to form part of damages.

Are traders expected to hedge?

Deriving my appreciation of hedging(1) losses by means of alternative damages, I rely on Karina Albers’ notable expertise in this field as an expert and LMAA arbitrator who says: "freight derivatives are an integral part of freight trading nowadays. … Unpredictable market conditions…challenge any trader to protect their exposure and forward physical positions. […] one could say that hedging and the use of derivates is an integral part of chartering business nowadays…."

Why are lawyers considering hedging losses/gains?

Some degree of caution must be applied when a party’s decision to mitigate forms part of their assessment of damages.

For the purpose of claiming losses, that is almost always going to be the differential between the contract price and market price at the time of the breach, the so called “market measure”.

However, what is a claimant to do, if there is no available market, i.e. it is impossible to achieve an available market at the time of the breach? To calculate that loss, we need to look at another market measure where the recoverable loss can be determined.

Where have the authorities taken us so far?

Hedging an integral part of business. InTrafigura v MSC [2007], the evidence was that Trafigura did not try to match particular purchases with particular forward contracts. Instead it maintained a book of business whereby compatible hedging requests were netted off. Trafigura had to roll over its hedges as a result of the breach and it incurred a loss on those. It claimed for the value of the cargo plus the losses made on the hedges.

Trafigura was awarded damages based on the value of the cargo, but not the consequential losses as the court found that hedging had not been properly executed. Had Trafigura hedged correctly, they most likely would have been awarded consequential damages on the hedges.

Avoid hedging apples with pears. In Vitol v Beta [2017], Vitol based its hedging calculation on future contracts but were unable to support their claim, since they hedged key market indicators rather than swaps. The court held that the comparability test could not be satisfied.

Here, I should note that this dispute was heard under the short trial scheme, which in my view was unsuitable bearing in mind the complexity of the derivatives platforms, evidence and expert input that needed to be presented in this detailed type of claim.

Not too remote. In Addax v Arcadia [2000], Addax hedged its exposure to price fluctuations. Morison J held in favour of Addax commentingobiter that “The costs of the hedging devices are 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. ”See also Choil v Sahara [2010].

Positive position and reducing the claimed losses. In Glencore v Transworld [2010], a non-delivery claim, Glencore hedged against market fluctuations and made a positive position reducing its overall losses from USD 11 million to USD 8.6 million. It sought damages for the full USD 11million, the difference between the contract price and the value on the date the cargo ought to have been delivered, the so-called market differential.

Blair J found that closing out the hedges constituted a reasonable mitigation of losses and should reduce damages to the lesser amount.

Failure to mitigate. In Mena v Hascol[2017], Hascol’s defence was largely reliant on Mena’s failure to mitigate through hedging. The key question was: should a claimant be deprived of damages for choosing not to hedge? Ultimately, it is the claimant's decision to bear a large fixed price risk, which should with all reasonableness affect their right to claim additional damages.

Post New Flamenco [2017], how are losses assessed where a hedge gain is made?

Reflecting on the above decisions, it is highly probable that English courts would be hesitant to award damages at large where a clear profit has been made.

Is hedging a game changer in calculating damages?

To answer briefly, it is. The parties need to appreciate that claiming hedging losses swings both ways, because a defaulting party will argue that a claimant’s failure to mitigate through hedging increased the amount of damages. Conversely, if the claimant's hedging achieved a positive position, the damages may have to be reduced.

The upshot of the above decisions is that courts appear to be increasingly willing to consider the effect of hedging on the assessment of damages.

How hedging for damages develops remains to be seen, but as fewer disputes settle, so will the volume of disputes litigated increase, and we may shortly see a number of authorities on this topic.

How can Skuld assist?

The Skuld claims and underwriting team works closely with our charterers and traders members and delivers hands-on and proactive assistance when assessing the risk and relevant covers prior to the entry. Apart from traditional charterers P&I and FD&D cover, we can provide cover for certain FD&D disputes under sales contracts and P&I liabilities where the cargo is owned and shipped on non-chartered vessels. We can also provide general loss prevention advise within our P&I and FD&D covers. The claims and underwriting team is made up of professional lawyers representing over 17 different jurisdictions with extensive experience in handling exposures and disputes worldwide. The Skuld team can assist with advice on the effect of hedging on assessment of damages.

Written by Sarah Brooke, Skuld Oslo 1.

Cited authorities and publications:
Trafigura Beheer BV v Mediterranean Shipping Company Co SA (The “MSC Amsterdam”) [2007] EWHC 944;
Vitol v Beta Renewable[2017] EWHC 1734 (Comm);
Addax v Arcadia Petroleum Ltd [2000] 1 Lloyd’s Rep 493;
Choil Trading SA v Sahara Energy Resources Ltd [2010] EWHC 374 (Comm);
Glencore v Transworld "The Narmada Spirit" [2010] 1 CLC 284;
Mena Energy DMCC v Hascol Petroleum [2017] EWHC 262 (Comm);
Globalia Business Travel S.A.U. of Spain v Fulton Shipping Inc of Panama (The “New Flamenco”) [2017] UKSC 43;
“Moneyball for Mitigating Losses with Derivatives” by Karina Albers.