Case Law Update On Claiming Hedging Profit And Loss - Interplay Between Physical And Paper Contracts

The courts have recently shown willingness to consider hedging contracts as an integral part of the physical market. Where 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 be 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.

Choil Trading SA v Sahara Energy Resource SA [2010]

Sahara contracted to buy a quantity of naphtha FOB from Choil. In breach Sahara rejected the goods. Choil resold the goods for a higher price. Choil made no physical loss. However under its hedging arrangements Choil made a loss.

The contract stipulated that:

"Neither party shall be liable for any consequential, indirect or special losses or special damages of any kind arising out of or in any way connected with the performance of or failure to perform the agreement"

Choil recovered its hedging losses. The Hon Mr Justice Christopher Clarke ruled:

"I do not regard the damages so far discussed as consequential, indirect or special....It did not require any special knowledge to realise that hedging was what Choil was likely to do. It was regarded as a normal and necessary part of the trade."

Glencore Energy v Transworld Oil [2010]

Glencore bought a quantity of crude oil FOB from Transworld. In breach, Transworld failed to make shipment. Glencore made a loss. Glencore closed out their hedging contracts. Glencore made a gain. Transworld argued that the close out of Glencore's hedging position was in mitigation of its losses, and damages payable by Transworld should be net of that gain.

Glencore argued that the hedging position was an independent transaction, not linked, and therefore not appropriate to set off. Damages were...