The Central Bank of Russia fears the local derivatives market could be seriously damaged by a shock court judgement ordering Sberbank to pay 67 billion rubles ($1.12 billion) compensation to state-owned transport company Transneft for losses incurred on trades during the 2014 ruble devaluation.
“The emerging judicial practice creates unacceptable legal risks for over-the-counter transactions concluded between Russian banks and Russian non-financial organisations,” a spokesperson for the central bank says in an email to Risk.net. 50% plus one share of Sberbank are state-owned, with 45% of the remainder held by foreign investors; Transneft is entirely state-owned.
“This will result not just in higher hedging costs but also in the curtailment of these transactions in the Russian jurisdiction. In these conditions we believe a serious decline in the Russian OTC market is all but inevitable.”
The central bank led a chorus of industry criticism over the Arbitration Court of Moscow ruling on June 21 that invalidated two expired vanilla options contracts. According to the court, Russia’s largest oil pipeline company lacked the financial expertise and experience to understand the transactions and was misled about the risks. The US dollar/ruble-linked options resulted in huge losses for Transneft after the ruble plunged against the dollar in 2014.
Russia’s central bank told Risk.net that, contrary to the opinion of the court, companies such as Transneft had the expertise and experience to assess the risks of the trades.
In these conditions we believe a serious decline in the Russian OTC market is all but inevitableCentral Bank of Russia
“The largest Russian companies, due to their position in the industry, have not only the financial capacity to attract external independent expertise in the use of complex financial instruments, but also their own extensive experience in the financial market, as well as highly qualified personnel. These companies use internal risk management policies, including currency and interest rate policies,” says the central bank.
“The management bodies of the largest Russian companies include individuals with significant experience in the financial market, and the structural divisions of such companies, responsible for managing risks and conducting transactions in the financial market, are headed by professionally trained specialists. Thus, the activities of large companies in the financial market are systemic in nature and they are certainly qualified investors who have the ability to make independent decisions on the use of derivatives for risk management, and to assess the consequences of concluding such transactions,” the bank adds.
The court case revolved around two vanilla options contracts signed under Russian documentation that Transneft entered to lower the cost of its ruble-denominated debt.
The first was a one-touch put option Sberbank sold to Transneft where, for a premium of 169 million rubles, Transneft had the right to sell around $2 billion for receipt of 65 billion rubles if the ruble/dollar spot rate exceeded 45. At the same time, Transneft sold Sberbank a call option where, for a premium of 1.3 billion rubles, Sberbank would have the right to sell to Transneft 65 billion rubles for receipt of $2 billion – set to the same spot-rate barrier.
At the time the trades were struck in late 2013, the ruble was trading at 32.67 to the dollar. However, over the course of the following year, falling oil prices and geopolitical tensions precipitated a crisis in the Russian currency. The trade was restructured in 2014 and the spot threshold was increased to 50.35, but by December 1 that year the rate hit 52.62. Sberbank exercised its call option at that point, creating a 67 billion ruble liability for Transneft – one of the largest derivatives trading losses ever recorded by a non-financial company. The company settled in September 2015.
That was thought to be the end of the story, until Transneft filed a lawsuit against Sberbank in January 2017. The company argued the contracts should be invalidated for a breach of Articles 1 and 10 of the Civil Code of the Russian Federation, which require parties to a contract to act in good faith. In particular, the company told the court it did not have experience of trading complex derivative instruments, and lacked the expertise to properly assess the risks in the contracts that Sberbank had not adequately disclosed.
The court ruled in favour of Transneft. Sberbank is understood to be planning to appeal the verdict. The Russian bank was unable to comment by the time of publication.
The ruling is not the first controversial derivatives judgement made by the court – in 2013, it allowed a UniCredit client to walk away from an interest rate swap without paying termination costs. But this case has much wider scope, as it impacts any derivatives contract under Russian law.
The Central Bank of Russia’s fears for the local market in the wake of the ruling are shared by derivatives lawyers in Moscow. They warn that if the first-instance judgement is upheld, other corporates will seek to invalidate a derivatives contract using such arguments.
Although legal precedent is not an official source of law in Russia, they say the court’s acceptance of the case made by Transneft could encourage other companies that lose money on derivatives.
Banks are being portrayed as over-professional and corporates – even the ones that are very large and clearly proficient in financial and hedging matters – portrayed as unsuspecting victims of the banks’ mastermindsAndrei Murygin, Linklaters
“Whenever the trade becomes out-of-the-money for a corporate counterparty they could try to use similar formalistic arguments to challenge the trade,” says Andrei Murygin, a partner at Linklaters in Moscow. “It potentially jeopardises the trading of OTC derivatives in the local market. Banks are being portrayed as over-professional and corporates – even the ones that are very large and clearly proficient in financial and hedging matters – portrayed as unsuspecting victims of the banks’ masterminds.”
If a flood of similar litigation materialises then the legal risk could push trading offshore. This was what happened when the Supreme Arbitration Court ruled in 1998 that non-deliverable forwards (NDFs) breached Article 1062 of the Russian civil code covering gaming and betting.
“This opens Pandora’s box because it means any contract on similar terms can be disputed,” says Konstantin Kroll, a partner at law firm Orrick in Moscow. “There are lots of corporates that lost significant sums of money after the ruble devalued in 2014. We are talking huge amounts – potentially hundreds of contracts.”
“Unless the first-instance verdict is overturned, foreign banks will have a huge advantage,” he adds. “They will target Russian counterparties and do deals with them offshore under International Swaps and Derivatives Association English law documentation – just as they did back in 1998.”
Pushing for reform
A large part of the problem is the absence of market standards on risk disclosure in Russia. An industry initiative is already underway to develop standards for disclosure of information for derivatives trades, led by the Association of Russian Banks (ARB). According to Russian media reports, the standards were to be discussed at the ARB’s Board on Derivatives and Financial Instruments meeting on June 27, and again at a more broadly focused meeting of the ARB on June 29.
But trades such as the ones involving Transneft were not covered by risk disclosures, which leaves the interpretation of a client’s suitability up to the court.
“The court is free to interpret the conditions of each particular transaction at its own discretion,” says Natalia Okuneva, head of the legal department at UniCredit Bank in Moscow. “As a result, it may put the blame on a credit institution for not depending on the extent of risk disclosure done by the client. The classification of investors also needs to be developed.”
Banks may do their utmost to disclose all the risks on a trade but nobody can be sure the courts will respect thatKonstantin Kroll, Orrick
The Central Bank of Russia is preparing amendments to legislation on the legal categorisation of investors. The aim is to provide more clarity around which types of investor should be classified as professional and which types should be regarded as unqualified and in need of additional protections.
In the meantime, Linklaters’ Murygin advises banks to take extra care when entering into derivatives transactions in the Russian market.
“One should work on the risk declaration and make it as fulsome as possible,” he says. “Secondly, get a consistent and comprehensive set of representations from the counterparty which would acknowledge the counterparty’s understanding of the risk involved and its professionalism, and acknowledging that the bank is not the adviser to the counterparty.”
UniCredit’s Okuneva says the bank has recently updated its risk disclosure forms, which must be signed by prospective clients to acknowledge the risks of a derivatives trade before execution.
However, according to Orrick’s Kroll even that level of due diligence might not be sufficient to protect against the fate suffered by Sberbank at the court.
“There was in my view a broad disclosure made by Sberbank but it was not taken into account by the court. They tried to adhere to very high standards of disclosure but, in the absence of any policy, ruling or guidance, the court ignored that. So banks may do their utmost to disclose all the risks on a trade but nobody can be sure the courts will respect that,” says Kroll.
Additional reporting by Olesya Dmitracova
Update, July 5, 2017: The ruble conversion has been changed from euros to dollars for consistency with house style.
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