The practice of arbitrating derivatives disputes

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The practice of arbitrating derivatives disputes

A wholly foreign-owned bank in China established by a leading global commodity derivatives trading bank group (the claimant), and a large Sino-foreign joint venture non-ferrous metal smelting and processing enterprise (the respondent) entered into a copper forward transaction (the original transaction) under which the respondent would purchase copper from the claimant. Afterwards, due to the respondent’s poor management, the claimant terminated the original transaction by closing out the position (the closing-out transaction), and requiring the respondent to pay the settlement amount by the settlement date in January 2015.

However, the respondent failed to pay and did not respond to a subsequent delivery confirmation letter. Consequently, the claimant applied for arbitration at the Shanghai International Arbitration Centre, based on the arbitration clause, claiming for the respondent to pay the settlement amount and interest on the late payment.

TRIBUNAL’S FINDINGS

After hearing the case, the arbitral tribunal considered there were four aspects in dispute. First, regarding the application of the law, the tribunal held that the transaction between the parties was an over-the-counter forward transaction of copper commodities in financial derivatives trading. According to the agreement on “applicable law” in the schedule, the master agreement and the schedule are governed by the laws of the People’s Republic of China. The tribunal referred to the Interim Measures for the Administration of Derivative Product Trading Business of Banking Financial Institutions, amended by the China Banking Regulatory Commission (CBRC) on 5 January 2011, and other general civil and commercial laws and regulations, such as the Contract Law.

Second, on the issue of whether the parties are qualified to engage in derivatives trading, the tribunal ascertained that the claimant, as a wholly foreign-owned bank, was qualified to engage in derivatives trading related to foreign exchange, commodities, energy and equity, as well as over-the-counter derivatives trading business as approved by the CBRC, in compliance with articles 5 and 6 of the above-mentioned interim measures.

Additionally, the tribunal concluded that the respondent had the underlying assets linked to the derivative products to be traded when it conducted OTC copper forward transactions with the claimant, and had a genuine need to hedge the risk of fluctuations in the market value of the underlying assets, in compliance with the interim measures.

Third, with regard to the validity and performance of the agreements, the tribunal found the claimant and the respondent had corresponding civil capacities at the time of signing, the contents of the contract were the consensual expressions of the parties, and their contents were not contrary to the mandatory provisions of Chinese laws and administrative regulations regarding the validity of contracts. Accordingly, the master agreement and the schedule were established and effective according to the applicable law.

The tribunal also noted that under the master agreement and its annexes, the single derivative transaction was made in such a way that the dealer of the counterparty completed the transaction with the bank by telephone and confirmed the transaction details in writing through a confirmation letter afterwards. The tribunal agreed with the claimant that, in terms of operational timeliness of the transaction, since the market value of the underlying assets linked to the derivatives changed rapidly, the counterparties needed to conclude the transaction according to the real-time market situation.

Because it took some time to sign the written confirmation, it was reasonable that the counterparties sent instructions by phone or email, and the transaction could be considered concluded after the bank explicitly accepted it. As for the original transaction, the two parties reached an agreement by telephone and the respondent confirmed it by signing the confirmation letter afterwards.

For the closing-out transaction, the respondent’s trader reached an agreement with the claimant on the closing of the position by telephone and replied to the claimant’s email about the closing transaction and settlement payment by email to confirm it. Therefore, even if the respondent did not sign the confirmation letter of the closing-out transaction, it did not affect the fact that the transaction was concluded.

Finally, with regard to the settlement payment and interest claimed by the claimant, the tribunal noted that, according to the parties’ transaction arrangements, if the original transaction was performed normally, the settlement payment shall be the difference between the forward price and the floating price, multiplied by the notional quantity. If the floating price is higher than the forward price, the settlement amount shall be paid by the claimant to the respondent; otherwise, the respondent shall pay the claimant.

If the respondent wishes to terminate the original transaction, the parties need to enter into a transaction opposite to the original trading position. Accordingly, the claimant referred to the LME Standard March copper futures contract price on the termination date, combined with the market’s expectation of the copper price at that time, and subtracted the commission to determine the final reference price at the settlement date under the reversal of the original transaction. After rolling back that price with the agreed forward price of the original transaction and multiplying it by the notional quantity, the final settlement amount was obtained. The tribunal considered that calculation method was in line with the trading practice, and confirmed by the respondent’s trader’s email, so it held that the respondent should perform the contract and pay the settlement amount.

If the respondent failed to pay the settlement amount in time, the tribunal held that the claimant had the right to demand the respondent pay the overdue interest in accordance with the contract and legal provisions.

SOME CONTEXT

Given the complexity and timeliness of derivatives transactions, a common way of concluding a transaction is for the counterparty to conclude by verbally confirming that with the bank dealer through their pre-reserved confirmed authorised dealer. Once the transaction is concluded, the bank generates a written (trade) confirmation reflecting the transaction details.

Generally speaking, the counter-party is required to sign the confirmation letter via a pre-determined signature to fix the transaction details in writing, but the confirmation letter should be understood as evidence to assist in proving the parties have entered into a derivatives transaction, rather than its precondition.

The tribunal fully respected the usual practice of derivatives transactions and found the transaction and calculation of the settlement amount was concluded. The decision demonstrated that commercial arbitration can give full play to the advantages of respecting contracts and commercial practices and quick determination of cases by experts when resolving disputes over complex financial transactions.

On 20 April 2022, the 34th session of the Standing Committee of the Thirteenth National People’s Congress voted to adopt the Law on Futures and Derivatives. It is foreseeable that more domestic and foreign enterprises will participate in derivatives trading in the future, and it is worthwhile for commercial entities to pay full attention to how to use the arbitration system to resolve disputes efficiently and quickly.


Xu Zhihe is deputy director of the department of research and information at SHIAC