Traders who buy and sell goods with volatile prices are likely to be exposed to price movements during the course of the transaction, and that risk is often managed by hedging. As well as minimising losses from fluctuating market prices, a hedge might also have the effect of reducing or avoiding a loss following a breach by another party, such as the owner of the vessel chartered to carry the goods. Where the hedge has effectively netted off the loss in the trader’s book, they might understandably take the view that they have not suffered any loss, but is it right that the hedge has as a matter of law reduced the amount of damages that can be recovered?
According to a recent decision by the High Court - Rhine Shipping v Vitol SA [2023] EWHC 1265 (Comm)., the answer may depend on whether the hedge is “external”, a transaction with an external counterparty; or “internal”, as a result of offsetting against other trades within the trading house’s portfolio.
Background
The claim involved a charterparty for the carriage of a cargo of crude oil from West Africa to the Far East in connection with sale contracts that the charterers, Vitol, had agreed for the purchase of oil and for its on-sale to another buyer. Under the sale contracts the price payable depended on when the bill of lading was issued, whereas the price at which Vitol sold the oil was fixed. As a result of this difference in pricing terms, Vitol was exposed to any increase in the price of crude before the bills of lading were issued.
As part of its risk management procedure, details of the financial exposure arising from this position were entered into Vitol’s internal trading information system, “Vista”. The system grouped together the various pricing risks in trades across Vitol’s entire portfolio, which allowed them to identify the net exposure faced by the business and, if appropriate, take steps to manage the overall risk. This might involve taking external swaps with third parties, but for this particular trade there was no external hedging arrangement. There was only an internal record of the risk being offset by an opposing trade from another area of the business. This was referred to as the Vista hedge.
The vessel was delayed in arriving at the load port which resulted in the bill of lading being issued several days later than expected and, because of price movements, the amount payable to the seller had increased by around USD 3.7m. When it became clear that the vessel was going to be delayed the Vista hedge was updated (or “rolled over”) to ensure that the relevant dates for the internal hedge continued to coincide with the loading date. This generated a “gain” which was recorded against this transaction and offset against the price increase so that, according to the Vista system, the loss on this trade had been reduced to around US$800,000.
Causation and remoteness
The delay to the vessel had been caused by a detention at a previous port in support of claims against the bareboat charterers, and it was found that the owners were responsible for this detention under the terms of the charterparty. The judge accepted Vitol’s arguments that if the delay had not occurred, they would have been able to load the cargo and the bills would have been issued on the expected date, and the loss from the price increase would have been avoided. He went on to consider the effect of the Vista hedge, and owners’ argument that the “gain” recorded in the system had reduced Vitol’s loss.
In considering this argument the judge reviewed the existing authorities in relation to hedging, clarifying that hedging gains can in the right circumstances reduce the amount of damages payable, provided that the hedging transaction was sufficiently closely linked to the breach (e.g. a swap taken in order to mitigate losses) or where the closing out or rolling over of the hedge was done in consequence of the breach. The question of whether the existence of the hedge itself was too remote did not appear to be in issue in this case, perhaps because the experts were agreed that the pricing and hedging arrangements were entirely usual for an entity of Vitol’s size. However this is likely to be a central question in any case where a hedge is involved, particularly where hedging losses are claimed, as discussed in a previous Steamship article.
Since in this case the Vista hedge had been rolled over in anticipation of the delay, the gain could be said to have been caused by the breach. On this basis, if the hedge had been an external one, the losses would have been reduced accordingly. The question then was whether internal hedges should be treated differently.
Should the “gains” be taken into account?
The judge carried out a detailed analysis of the Vista system and its use by Vitol’s traders, drawing upon guidance from an analyst at Vitol and expert evidence from oil traders. His findings were clear in that he did not consider the Vista hedge to have reduced Vitol’s loss in any meaningful way. He accepted that the risk relating to this transaction had been offset within the system by opposing risks arising from other transactions but found that the Vista hedge merely transferred the risk between different portfolios within Vitol. It was an internal arrangement only which did not affect Vitol’s overall profit or loss.
He then considered a further question in relation to remoteness: if there was no hedge, then any loss caused by not hedging the pricing risk from this trade was outside the contemplation of the parties, and therefore too remote to be recovered.
Owners were effectively arguing that if the loss had not been offset by the Vista hedge, then it should have been offset by other hedging arrangements, and they should only be responsible for the loss that would still have been suffered. The problem here was that, as both experts agreed, the pricing for the sale contracts and the short position taken by Vitol was not unusual, and the risk management arrangements in place for this trade (the internal Vista hedge only) were normal for a large trading house such as Vitol with a sufficiently diverse portfolio of transactions. In other words, the parties would have contemplated that external hedging arrangements might not have been in place and that unhedged losses might be incurred. The loss was therefore not too remote and was recoverable in full.
Conclusion
Traders may wish to take note of this decision because it illustrates the legal principles determining when a hedge or swap or other similar transaction might be taken into account in assessing losses, drawing a clear distinction between internal and external hedges. It confirms that internal risk management procedures will not ordinarily be taken as having mitigated a party’s loss, provided that the risk is not then placed outside of the company by way of an external swap or similar transaction. This may provide a useful reference when putting in place similar arrangements to manage their own risk portfolios.
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