The StandardChartered Bank (SCB)/Ceylon Petroleum Corporation (CPC) hedging programme and the recently concluded arbitration hearing, is like a tragi-comedy!
Following the much awaited ruling on the infamous SBC/CPC hedging arbitration, this is written in the interest of the compatriots, as it will be their tax money that will be paid to these banks. Errors made were not honest errors but were meticulously engineered to mislead a non-sophisticate client. A review of the term sheet amply demonstrates their intent.
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| November 16, 2008 File pic: Officials briefing the media denying the CPC's hedging agreements were wrong. L to R: Clive Haswell – CEO Standard Chartered Bank, Dennis Hussey – CEO Citibank, Amitha Gooneratne – Managing Director Commercial Bank, Asantha De Mel – Chairman CPC. Pic by J. Weerasekera |
The time tested concept of hedging failed in Sri Lanka because the CPC officials failed/refused to be guided by professional advice, ignored all warning signals, got involved with the wrong counter parties, unilaterally disregarded directives of the Treasury Secretary and most importantly had concealed agendas that put self interest ahead of that of the country.
Arbitration hearing was lost because a “learn as you go” approach was adopted. If we fail to change, our failures will be perpetual. I state, as I see it.
The court ruling converged with my expectation as my position was that any endeavour to fight this matter on legal terms is an outright futile endeavour. Validity of the structure/instruments and the court ruling must be contested. For that to happen, change is required. Success of the appeal is contingent upon technical expertise, and the legal team be guided accordingly. Any endeavour to pursue the appeal process in isolation without technical expertise would result in a repeat performance of what we just saw.
London High Court ruling
A critical component of this ruling is to ascertain the validity of the financial claim made by the SCB amounting to $162 million and what the basis for this amount is. The judiciary did not validate the amount but awarded as claimed by the bank. This warrants a forensic audit and a detailed investigation.
The CPC clearly demonstrated inability to frame clear and compelling narratives to effectively counter all arguments made by the SCB. Material information was withheld and there was a serious omission of factual information. Accent has been on peripheral information that had less of an impact on the broader scheme of affairs.
Excerpts from the arbitration hearing - (Term sheet) :
4) At the bottom of each page of the Term Sheet, the document also stated that:
"SCB has no fiduciary duty towards you, and assumes no responsibility to advise on, and makes no representations as to the appropriateness or possible consequences of, the prospective transaction."
The above clause on the term-sheet should have been challenged, questioned and dismissed by the CPC legal department forthwith prior to the commencement of hedging. Why did the CPC agree to this clause when the officials lack the knowledge on the subject? Were these officials placed under undue pressure or were the officials oblivious to the obvious?
It is double trouble when they further include a clause that unwinding these trades is costly. I see something inherently wrong in these clauses. This is a toxic agreement. While the above clauses indemnify SCB of its obligations to the CPC, SCB still had an ethical and corporate responsibility to the CPC and the host country. This is so, whether it is explicitly stated or not. At all times, the hedge provider is deemed to have assumed the role of a specialist and expected to act in a manner that will not compromise the integrity of the trade and act within the bounds of good governance.
The team of experts retained by the CPC failed to educate the judge on the idiosyncrasies of the structure/Derivative instruments of the Hedge model. The brief is full of misleading technical jargon that is indicative of a lack of comprehension of the subject. In the absence of specialized knowledge to objectively review and analysis the facts, the judge was placed in a position that compelled him to entertain a screened and a distorted version of information which led to a ruling in favour of SCB.
White Crime
The global economy has created a beast, “The Corporation”: Inanimate by nature, driven by insatiable greed and the only objective being “Profit”. In the pursuit of increasing the bottom line, the corporation is mandated to go to any extent breaking all barriers and compromising all ethics that is expected of a corporation.
The Enron scandal gives us what this white crime is all about. The CEO cooked up the books to conceal the losses and in the process drove the company to bankruptcy and wiped out millions of savings in the employee pension funds.
A Detriot-based auto manufacturer in the 80’s concealed faulty signal circuits. Having evaluated the costs and benefits of a total recall of vehicles against the class action law suits, it decided to stand trial. Finally, victims were compensated but in the process the auto plant was able to save billions of dollars not having to recall the millions of faulty cars. In the decision-making process, immediate profits remain the constant. Ethics don’t seem to be a part in this model. This is amply demonstrated when the former chief of the SCB, referred to a breakfast meeting he had with His Excellency the President Mahinda Rajapaksa. I dispute the validity of this statement as the President, would never have given such a payment guarantee that would seriously dent our foreign exchange reserves.
To delve into the recent turn of events in Sri Lanka where some international banks in Colombo got into a scheme with the CPC to provide a hedge is a classic case of white crime. The banks sold wrong instruments, mislead the officials, and misused soft dollars to the very extremes of it. These banks are no paragons of virtue by any stretch of imagination for they went over the tipping point of established corporate ethics in order to grab the CPC hedge.
When the host country is incurring, unprecedented economic and non-economic losses directly due to banks slip-shot hedge models structured without proper understanding and after having conceded they are at fault, the banks are swift to run to the international court seeking compensation. This is ludicrous. Derivatives, while being a zero-sum game, hedging, must not be construed as a mechanism that facilitates windfall gains for one party. Unfortunately though, the banks failed to do the pre-requisite work. They structured a skewed deal, and drafted a unilateral agreement and levied outrageous commission that is unheard of elsewhere. That year the SCB profit grew many folds. The crucial and the most pertinent question is if we see the SCB and these foreign banks associated with the CPC hedge, acting in the best interest of the host country? If they did, the least they can do is avoid pursuing arbitration. Do we need banks of this nature operating in Sri Lanka?
Do we see it to be fitting that these banks who were swift to run to international arbitration demanding compensation from Sri Lanka, to stand trial in Sri Lanka? Should Sri Lanka have a counter claim on them for the economic and non-economic for losses these banks have brought on our national economy still fledgling to raise the head after three decades of a meaningless and a ruthless war in the recent times? We should actively pursue the proposition of counter litigation for that will send a strong message.
Pre – hedge era
There are multiple theories that these transactions were in violation of the CPC Act of 1971. In 1971 there was no need for hedging as the prices were stable. Accordingly, there was no provision to accommodate such a mechanism in the CPC act of 1971. Oil price spikes started in 1973 and Sri Lanka failed to move and keep up with the changing times. Crude oil hedging is a valid concept widely used in the industry. The concept of hedging was initially proposed in 2002 during a time when our annual oil imports were just under $ 600 million. Today, the compensation to these banks and legal expenses exceeds $ 600 million! It is nonsensical to assume that hedging is invalid because the CPC Act precludes such mechanisms or for that matter discard the concept of hedging, due to our losses from hedging. Hedging is a valid mechanism so long as it is done the proper way and is an integral component of the energy industry.
Former CPC Chairman Asantha De Mel did right when he implemented commodity hedging as an effective counter measure for volatile commodity prices. He did have what it takes to go against the political obstacles. But then he erred when he got lined up with the wrong counter party and got into a wrong structure.
SCB is not a dedicated energy trading firm. Dedicated energy trading firms to name a few would be - BNP Paribas, Total, Cargill USA, Shell, Koch oil, and Society General. Shell had one of best hedging programs. When the CPC first decided to go for hedging, Shell (Singapore) indicated their desire to be a hedge provider but resigned due to various policy constraints. SCB should not have got into an area that they lacked the skills and outside of their core business activities. Besides, the CPC officials should not have retained SCB as a hedge provider. The Treasury Secretary gave directives at the discussions in February 2007 that CPC retain dedicated energy trading firms.
Basket Hedge Model
The judge commented that a Call Option would have required the upfront payment of a large Option premium but in the case of a Zero Cost Collar, there is no such premium payment involved and of the two structures the Zero Cost Collar is the better Option. This is what the SCB led the judiciary to believe the best was the Zero Cost Collar Option strategy. The Put Call ratio analysis in relation to volatile market conditions, extreme leverage or the implied volatility of the put against the call position or the validity of funding in the money Call Option with the proceeds of deep out of the money Put Option is beyond the judge.
At the very start, the foundation was laid for a dynamic hedge model on a trial basis with a Geneva -based well capitalized Energy major (cannot be divulged at their request). If this was adhered to then our oil bill would have been much lower than what it is today. This was not only rejected but the arrogance of the official refused to acknowledge receipt of the submissions made by the Geneva based energy major.
The basket Hedge Model (covering the freight + commodity exposure) developed by the Geneva -based Energy major, a $90 million Option premium payment made upfront would have most certainly averted a $162 million and accrued fines to the bank and payment to a battery of legal experts.
More importantly, it would have locked in the price of a barrel of oil at $61 for 18 months with the flexibility of downside participation. A relatively small upfront payment of $90 million would have given the country a return of 500% on the investment. The statement made by the judge in this regard is wrong. The option premium is not an expense but an investment. In the complex world of Derivatives, SCB was very successful in convincing the judge that a free lunch is after all possible when they actively promoted the concocted Zero Cost Collar.
The fabricated story put forward that the cabinet approved only a Zero Cost Collar fails to hold water. With due respect, the very people at the SCB who sold the Zero Cost Collar to the CPC wasn’t savvy about the transaction, as revealed in the final report. Against this background, can one reasonably expect a group of policy makers to comprehend the distinctions between an Asian Option and a Zero Cost Collar? It will not be a reasonable expectation from the policy makers to evaluate the merits and de-merits of the available options and then recommend the Zero Cost Collar strategy over Asian Option. If they made an educated decision having evaluated the instruments, then most certainly, the Asian Option would have been the preferred Option. Zero Cost Collar, was the wrong strategy. Even the judge would have agreed.
German court ruling against Deutsch Bank
Recently, the German courts made a ruling against one of its leading banks, the Deutsch Bank.
In the case of a paper products manufacturer and the Deutsch Bank, Deutsch Bank was the hedge provider in the Interest Rate Hedging program. The bank misled the manufacturer and sold a structure that was heavily in favour of the bank. That was the position from the very start and the bank on two counts successfully led the judiciary on a wrong path concealing the salient facts pertaining to the structure of the Interest Rate Hedging program.
Notwithstanding the two failed attempts, the paper company fought tooth and nail and finally won the case having made a convincing case against the German finance major. This was no slam-dunk case but the manufacturer did present its perspective in a lucid and convincing manner at the third attempt and they were successful as the judge concluded the bank failed to adequately inform the true nature of the Derivatives that they were selling a client who is non-sophisticated.
Running as a parallel, the SCB too failed to explain to the CPC as a non financial entity, the risk associated with this structure while selling an asymmetrical Option based structure skewed towards the bank and failed to act in the best interest of the client and the host country.
CPC appeal of arbitration ruling
“Insanity, is repeating the same thing expecting different outcomes” – Albert Einstein.
Appealing the arbitration ruling is quite a commendable decision provided we shift gears and change our approach. Prior to the commencement of the proceedings, our victory was assured on many fronts. However, legal arguments provided no proper basis for this much assured success. As per agreement, CPC agreed to pay the hedge provider if and when the spot market price drops. CPC is in violation, in the event of non-compliant with the terms.
Just like winning the war against terrorism, we could also win this arbitration appeal. We need clarity of purpose. We showed resilience when we maintained 5% GDP growth in the heights of war, while dodging bullets and bombs. Victory against this type of economic terrorism where a few corporations try to siphon off public money must be fought with all our might sending a strong message that Sri Lanka is a country to reckon with. There are misgivings that this will have an adverse impact on our foreign direct investments. But then do we need such investors who swindle us? If we stand up to them, only then we send the right message. We need investors who will be partners in our nation’s forward march and not investors who will part with our public money. Not the investor who would send public money to a black hole.
Flaws are a many in this hedging and the arbitration drama. Slicing and dicing of the technical details necessitates specialized technical knowledge. Flaws must be analysed at length and articulated in laymen language so that it is within the comprehension of the judiciary. For this to happen, a change is a pre-requisite, if not an imperative. We need a new team. The old team will give us the same old result and a new team will give us the desired results. There are a multiple approaches to circumvent this crisis while we maintain goodwill with all concerned parties.
I am optimistic of a victory but we must have a shift in our total approach. We cannot expect a different outcome if we continue to operate within the same frame that got us in to this crisis. The same approach that got us in to the crisis will not get us out if the crisis.
Every dark cloud, they say has a silver lining. From failure to success transition is a real possibility.
That said, I conclude on a lighter note, in order to bring this success we need a team that in legal parlance is often referred to as “bull dogs” who are legal and technical experts who will slice dice and pulverize the bank’s arguments based on logical technical analysis. A team that will go to great lengths beyond Calls and Puts and read between lines interpreting the abstracts.
(The writer is a hedge specialist based in Canada who has been following the hedging deals closely and was among the first to propose to the Government, many years ago, the need to hedge against rising oil prices). |
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