This brief summary of the decision that was published on 21 June 2017 will be of interest to anyone entering into derivative transactions that involve Russian counterparties.
Open Joint-Stock Company Transneft (“Transneft”) and Open Joint-Stock Company Sberbank of Russia (“Sberbank”) entered into two foreign exchange options on 27 December 2013. Under the FX put option (the “Put”) Sberbank granted an option to Transneft to sell to Sberbank USD 2 bn at the strike price of RUB 32.5 per 1 USD (the “Strike Price”). Under the FX call option (the “Call”) Transneft granted a call option to Sberbank to buy from Transneft USD 2 bn at the Strike Price. Both options were executed under the same standard single master agreement dated 8 November 2011.
One of the most contentious provisions in both transactions was that to be able exercise the Put or the Call, the exchange rate of RUB/USD prior to the expiry date of the options on 18 September 2015 (the “Expiry Date”) had to be at some point equal to or higher than 45 (the “Barrier”). On 26 September 2014 the parties agreed to amend the terms of the transactions by increasing the Barrier level from 45 to 50.35.
On 1 December 2014 the RUB/USD exchange rate was 52.62, which was higher than the amended Barrier. As a result, the Put and the Call became exercisable on the Expiry Date. On the Expiry Date the RUB/USD exchange rate (the “Closing Price”) was 66.01. As under the Call Sberbank had the right to buy USD 2 bn at the Strike Price, which was much lower than the Closing Price, Transneft was out of the money under the Call, owing to Sberbank around RUB 66.95 bn as a result of the fairly significant difference between the Strike Price and the Closing Price (the settlement amount was calculated as the difference (calculated in RUB) between RUB 65 bn and USD 2 bn as at the Expiry Date).
It is worth noting that for Transneft to exercise its rights under the Put, both conditions would have to be satisfied: (i) the Barrier would have to be triggered prior to the Expiry Date, and, following that, (ii) the exchange rate would have to move in the opposite direction so that the Closing Price would become lower than the Strike Price. In other words, the exchange rate of RUB/USD would have to reach more than 50.35 on any day during the life of the trade, and, following that, the exchange rate would have to drop below 32.51 towards the Expiry Date.
Whilst Transneft made the necessary payment to Sberbank under the Call in full as requested by Sberbank to settle the option transaction, it filed a lawsuit against Sberbank in January 2017 to declare both options as null and void and to seek restitution. The main argument put forward by Transneft was that Sberbank did not act in good faith (and as a result was in breach of a mandatory rule under Russian civil law) when entering into the options. The restitution requested by Transneft in particular required returning the premium to Sberbank under the Call and returning the settlement amount under the Call to Transneft. The court in its judgment handed down on 8 June 2017 has agreed with Transneft’s arguments, rendered the option transactions null and void ab initio, and ordered restitution of any payments made between the parties.
Arguments of the court:
To arrive at its decision the court noted the following arguments:
The court decided that despite the size of Transneft’s business and its relatively frequent involvement in FX derivative markets, Transneft was not a sophisticated counterparty and therefore when entering into any complex FX derivative transaction required more transparency and guidance from Sberbank. The court further concluded that the options with Sberbank were particularly complex, and Sberbank, having a duty to act in good faith, failed to disclose all material risks to Transneft prior to offering such product to Transneft. The court has put a significant emphasis on the conduct of business rules applicable to Sberbank by concluding that a substantial breach of conduct of business rules can render the entire transaction null and void.
Financial institutions offering derivative products to Russian counterparties may find the decision unhelpful as from their perspective derivative transactions being offered to Russian clients may not be viewed as overly complex, and large corporate clients they deal with might be expected to understand such structures. The court decision may prompt some counterparties who made a “wrong bet” in the past when they entered into a derivative transaction and lost money to try their luck in court by raising the argument of lack of good faith and failure to disclose all material risks by their counterparties.
It remains to be seen how this decision will impact the derivatives market in Russia, but there will certainly be even more focus on any communications with counterparties prior to entering into any derivative contracts and on thorough risk disclosure and disclaimer statements coupled with robust representations and acknowledgements from the counterparties.