Everything about the hedge implemented by the Ceylon Petroleum Corp (CPC) and local banks and the following arbitration was wrong. The hedging programme and the subsequent arbitration appeal process was a constant game of trial and error where a few individuals were well rewarded while the economy was sliding down due to high energy bills. [...]

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The Sundaytimes Sri Lanka

Hedging gone astray

By Upul Arunajith
SCB’s ‘leveraged swap’ was a banned instrument
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Everything about the hedge implemented by the Ceylon Petroleum Corp (CPC) and local banks and the following arbitration was wrong. The hedging programme and the subsequent arbitration appeal process was a constant game of trial and error where a few individuals were well rewarded while the economy was sliding down due to high energy bills. It’s a collection of crises driven by personal agendas of a select few blatantly in violation with the economic interest of an entire nation striving to make a come-back and put the house in order. Since the introduction of this so called “Hedge” the writer has closely monitored the sequence of events as they unfolded. Sri Lanka lost a golden opportunity to take advantage of a globally successfully and time tested concept of hedging.

In an egalitarian society, each member has a clearly defined role to contribute to the greater good of the majority: Contribute to the welfare of others, highlight systemic flaws and offer constructive criticism in the hope they are well received. At a policy formation level, the floor is set to encourage criteria to offer critical reviews of issues of national interest. Within that realm, this is a critical review of this giant national tragedy which has a rippling effect that extends far beyond mere payments as ordered by a foreign judiciary. I have assumed the right to be blunt, given that I also provide a possible solution to the problem.

This is a departure from a culture that frowns at the messenger and the whistle blower. My comments/reviews are not politically driven as Sri Lankan politics is too much for my comprehension and I have no affiliation to any political outfit. As an apolitical, what drives me to get involved in matters Sri Lankan from distant shores is the insatiable love I have for my birth country, a country with infinite potential provided things are done the proper manner.

Solutions are as many as much as those with a vested interest in this “Hedging scheme”.
London Ruling:
CPC need not pay a dime to the Bank.

Why? Because, the Standard Chartered Bank (SCB) had a fiduciary responsibility by a non-financial client the CPC to provide a thorough and a full disclosure of these complex Derivatives instruments. The bank must assess the “Suitability” of the product.
The “Leveraged Swap” the bank used is not only a wrong instrument but its industry-wide knowledge that its use is banned in many countries. In a long list of instruments available for commodity hedging, how and why would a commercial bank used a banned instrument to provide a hedge to a crown corporation whose operations impact every sector of the economy? In the past those who used the Leveraged Swap went bankrupt or was on the verge of bankruptcy and was salvaged. Though a valid concept, now in Sri Lanka hedging is taboo as a consequence of this concocted hedge. The only effective solution to volatile spot market price is the introduction of a proper hedging programme with a dedicated energy trading firm. These were the directives given by the Treasury Secretary but were ignored.

The bank took the CPC on a scenic route and left the entire country on the lurch.
Did the bank misuse soft dollars? Soft dollars were misused to the core. Giving furniture to a head of a department of the energy agency; sponsoring family holidays….the list is long. Not stopping at that, the CPC was further led on a wrong path that these payments were due to the bank as a sovereign commitment and to defend the government wasted money to retain the services of Patrick Crowley. They don’t come cheap.

Having got caught, the bank claimed that it is willing to resolve this crisis in a mutually amicable manner, but they rush to their home base in London to commence arbitration proceedings. SCB is a British icon in the financial sector. Given their position, any arbitration proceeding in London (or home territory) cannot be deemed as impartial.

Given the bank mislead the CPC, used a banned instrument, failed in its fiduciary duties and misused soft dollars, to seek legal remedy against a host country and then be successful in such an endeavour, is not only amusing but has defied all odds. More importantly, it needs to be ascertained as to why the Attorney General (AG) agreed to the proceedings be held in London and not in an independent country i.e Singapore. London, being the home base of SCB they have a giant clout. Besides, from a cost stand-point, Singapore would have been a cost-effective alternative.

It now appears that, the hedging was totally messed up whilst the arbitration process was tainted with the connivance of those who were associated with the proceedings is a safe assumption until proven otherwise. Beyond doubt the bench was misled, as even the top brains in Wall Street get it wrong at times when it comes to derivatives trades. With due respect to the bench, misleading the bench is no difficult task. I am reminded of the old Sinhala folk saying “bari they nokaran abaroo”!

Flawed optimism:
Now the most crucial and pertinent question; Will our envisaged appeal to the House of Lords succeed? Absolutely not! Appealing to the House of Lords in London at this stage is a futile endeavour no worse than trying to defuse a bomb after it has gone off. It’s another waste of tax-payers money. However, we have at our disposal many solutions and strategies provided there is a sincere interest to resolve the problem.

In spite of the AG’s optimism and assured victory in a foreign turf, from the very outset the AG should not have agreed to the proceedings being conducted in London. We need to find out as to how many trips were made to London by those in the AG’s department over the period and the cost.

The key to success is clarity of purpose. Nothing achieved in the absence of clarity and strong purpose. The game changer is to approach the problem with clarity and purpose. Blindly running to the House of Lords is a repeat performance of our costly trial and error approach thus expecting a different outcome hopefully with some divine intervention. This is indicative of lack of strategy, clarity of purpose and above all total absence of fundamental knowledge that is needed to counter this crisis.

In this connection, on August 6th 2011, I wrote that we will not be successful in our appeal. I have been proven right. CPC and the AG appealed the ruling and they lost. Waste of money. Prior to that, with surgical precision I predicted and wrote that the hedge provided by the three banks will go against the CPC given that they were all wrong. They did go wrong.

I have been correct on two counts and confident that I will be correct the third time as well should the AG appeal to the House of Lords, in London.

Contrived Concoction:
The banks did an outstanding job in misleading the CPC. At the initial stages when the bank had to make payments to the CPC, those events were given wide media coverage and there were photo opportunities and interviews with the media. This was unprecedented as in most derivative-related transaction settlements are made on a daily basis, based on mark to market valuation. If there is media coverage for all these daily derivative trade settlements, it will become a symphony of comedy! There was no need for such media hype. The banks knew it but they were all done with ulterior objectives to coax the policy makers and the expert at CPC who got himself trained on the subject on the Internet who then misled the CPC Chairman. If one were to objectively review the interviews given by the banks at the very initial stages they only inferred that they give a cheque to the CPC every time the world spot market price increased beyond a certain point.

In terms of the payments made by the banks and getting wide media publicity, I wish I could have written that the banks make a full payment at least to justify media coverage! Regrettably, they did not make the proper payment based on the variance betwee the CAP and the SPOT price in the Zero Cost Collar strategy. The total amount should have been US$5 million but the bank made a mere US$1.5 million. I informed the CPC of this situation where the deal was skewed in favour of the bank, but was totally ignored.

The use of a Leveraged Swap, a banned derivative instrument is unpardonable. This is corporate crime of the highest order. The bank failed in its duty to assess the suitability of the derivatives that were sold to the CPC and also see the ability and the willingness of the CPC to assume risk associated with the product. The CPC wanted to hedge its exposure but ended up as a speculator with wrong banks and wrong instruments. The bank failed in its due diligence.

Perils of Arrogance:
The CPC hedge failed in particular due to arrogance and concealed agendas of a select few. Having monitored the hedging programme, I informed the stakeholders of the impending disasters. I wrote to the CPC, Central Bank (CB), the Minister and the Treasury.
The CB was swift to confirm they were experts in the subject and no external advice was required. Assuming they were the “experts” they claimed to be, the experts in the CB should have then stopped the use of a banned instrument (leveraged swap) and then get the bank to make the proper payment to the CPC based on the Zero Cost Collar structure the CB wanted implemented. They failed to do so in the interest of the economy. As always, the CB will defend its stand.

Only the Treasury Secretary took the time to follow-up on the advice. CPC ignored all advice that was given and carried on with an agenda of its own enjoying bank – sponsored family vacations at the cost of the national economy until it was way too late.
A winning game plan:

“None is so blind than those who refuse  to see”!
Blindly running to London to appeal is futile. London being the home turf of the SCB our chances of an impartial hearing are zero. So long as we are trying to legally prove our stand, we will never win, no matter where the proceedings take place. Our continued failure to see this basic truth will not get us our desired result.

On a more serious note what potentially will happen is, when we fail in the House of Lords appeal by trying to bring about legality of non-payment, this will set a precedence for the other two banks to appeal and at that point in time we will end up losing all arbitration hearings.

Taking a contrarian stand and being receptive to new thinking, we can get traction and we can successfully counter this on technical flaws that were deliberate. We will never be successful if the hearing is in London. This has to be moved to an independent state. As well, any endeavour to fight this on legal grounds will be unproductive and a waste of time and money. It is imperative that we retain a savvy technical team (let’s spare those experts at the CB for this time around!) who will lead the team of lawyers. The “knock-out” blow has to come from the technical team.

The same way how the trailblazer concept of hedging was introduced against all odds and many an opposition, once again, I am writing this with utmost confidence, that the CPC can win this arbitration and need not pay a dime to any of these banks. For that to happen, we need a meaningful change in the approach and in the thinking. When the bank zigs we must zag!

At a policy making level, will there be new thinking?
(The writer is a Sri Lankan-born derivatives specialist based in Canada who has repeatedly written on the hedging issues)




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