Derivatives Alerter: English Court of Appeal decision on capacity of statutory corporation to enter into derivatives
The English Court of Appeal last week handed down judgment on a case that clarifies the capacity of statutory corporations to enter into derivative transactions and that is likely to be useful in determining the capacity of other types of entity.
The appeal was brought by Ceylon Petroleum Corporation ("CPC") against a judgment of the High Court in July 2011 in favour of Standard Chartered Bank (the "Bank"). See: Standard Chartered Bank v Ceylon Petroleum Corporation EWHC 1785 (Comm) for the decision of the High Court and Standard Chartered Bank v Ceylon Petroleum Corporation EWCA Civ 1049 for the decision of the Court of Appeal. The Court of Appeal dismissed CPC's appeal and upheld the judgment of the High Court that the derivative transactions entered into by CPC were not ultra vires. It is understood that CPC may appeal further to the Supreme Court.
The principles that were decided were that:
1. Whether a statutory corporation has the capacity to enter into derivative transactions is a matter that has to be determined by reference to the terms of the legislation under which it was incorporated. The decision in the House of Lords in Hazell v Hammersmith and Fulham London Borough Council that Hammersmith and Fulham London Borough Council (also a statutory corporation) did not have the capacity to enter into derivatives is not authority for the proposition that no statutory corporation has such capacity. It is necessary to look at the specific statutory framework to determine the types of activity into which the legislature would have expected the statutory corporation to enter. In the case of CPC, it was clear that the legislature intended CPC to act as a commercial entity for the purposes of engaging in international and domestic trade. CPC is a commercial, albeit public, corporation and, as such, the Court of Appeal considered that the legislature must have intended CPC to have the capacity to enter into the whole range of transactions that a commercial organisation acting in that field of business would ordinarily undertake. CPC had not only the power but also the responsibility to use the "increasingly sophisticated tools available to and ordinarily used by a commercial oil trading company... to provide for attempts to mitigate the risks to which it was otherwise exposed".
2. Derivative transactions of the type entered into by CPC may properly be regarded as incidental or conducive to its objects (in the context of an objects clause which refers to carrying on such business as may be "incidental or conducive to the attainment of" CPC's other objects). Whether derivative transactions are incidental or conducive to a company's objects, and whether a company has the capacity to enter into them, is to be determined by reference to the nature of the transactions, rather than whether they were prudent or imprudent or in the nature of hedging or speculation. In the context of CPC, the derivative transactions in question (which were zero cost collars) were incidental and conducive to CPC's objects, because they could be expected to produce a modest degree of protection for CPC in relation to its FX exposures as well as a positive cashflow which the business needed. This was despite the fact that, with the benefit of hindsight, the transactions proved to be unprofitable.
3. A distinction between hedging and speculation for the purpose of determining capacity (in the absence of such a distinction being drawn in the relevant legislation) is "unsatisfactory". The Court of Appeal referred to an arbitration award published on 31 July 2011 in relation to a dispute between Citibank N.A. and CPC (in which CPC successfully argued that it did not have capacity to enter into similar derivative transactions with Citibank) but noted that the arbitration was decided on the basis that both parties in that instance had accepted that speculative transactions entered into by CPC were ultra vires. The arbitration therefore focused on the distinction, if any, between speculative and hedging transactions. The Court of Appeal noted the difficulty in identifying a clean line between the two types of transaction and the potential difficulty for a counterparty such as the Bank in knowing whether a particular transaction is a hedge or a speculative transaction (since the surrounding factual circumstances and motivations of the person hedging/speculating would be unknown to it). The Court of Appeal held that it would be difficult for CPC to argue that an individual derivative transaction was ultra vires simply on the grounds that it was speculative.
4. In those circumstances where a distinction between hedging and speculation is to be drawn (for example, a power to enter into hedging transactions), and in the absence of a definition excluding subjective determinations, it is not possible to exclude all subjective elements to determine whether a transaction is speculative or a hedging activity.
The Court of Appeal did not consider it necessary to reach a conclusion on the related question of whether a broadly drafted power (in this context, to do all other things which CPC considers necessary to facility the proper carrying on of its business) is capable of giving a company capacity to enter into a derivative transaction in circumstances where that transaction does not fall within one of its objects. The Court of Appeal did, however, note that the jurisprudence on the question is complex.
While CPC is incorporated under the laws of Sri Lanka (and therefore questions of capacity are governed by the laws of Sri Lanka), there are no material differences between those laws and English law. While the decision is limited to determining questions of capacity of statutory corporations (in particular, that of CPC), it is likely to be of wider interest. Various entities, not just statutory corporations, have objects that do not expressly refer to entry into derivative transactions but which permit (either expressly or by operation of law) activities that are incidental or conducive to the entity's wider activities. Banks are also likely to have previously faced the difficult task of entering into derivative transactions with an entity on the basis that such transactions are hedging, rather than speculative, without having the ability to take full comfort as to the surrounding circumstances. In these and other contexts the Court of Appeal's decision is likely to be helpful in giving banks more comfort as to whether derivative transactions fall within their counterparty's capacity.