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.

Background:

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:

1. The claimant is not a professional participant in the derivatives market. Whilst the defendant argued that the claimant entered into similar derivative transactions with other banks, the court decided that this transaction was radically different and was much more complicated due to the use of the knock-in Barrier to determine whether the option transaction was exercisable. The court concluded that the defendant did not properly explain the main risks of entering into the option transactions to the claimant. There were four presentations delivered to the claimant where the defendant tried to explain the risk profile of the options, but the court held that they contained misleading information about the nature of the transactions and none of the presentations were detailed enough given the lack of sophistication of the claimant.
    
2. The claimant did not enter into the product it thought it was buying. In particular, the claimant was under the impression that it was entering into some sort of arrangement whereby the interest rate payable under the bonds issued by the claimant was reduced (essentially, the defendant was subsiding the interest payable by the claimant by paying an option premium to the claimant under the Call which was substantially higher than the premium under the Put), and the risk of depreciation of USD in the FX market was capped. What the claimant did not fully appreciate was that by reducing the risk of depreciation of USD currency under the Put it concurrently incurred a contingent liability under the Call in case of appreciation of USD. The court accepted evidence that the probability of the claimant exercising the option was mere 0.5% due to the existence of the Barrier. The court noted that that the contingent liability of the claimant under the Call was unlimited, whilst the liability of the defendant under the Put was not.
    
3. The claimant successfully argued that in light of previous longstanding relationship of the parties involved the defendant should be treated as its advisor rather than an independent counterparty. The claimant trusted the defendant when it received proposals from the defendant to enter into the option transactions as the claimant believed that the defendant knew what the claimant wanted to achieve from entering into such options. The defendant was in breach of claimant’s trust because it sold a product to the defendant that it did not need, as the product sold was a “highly speculative instrument”.
    
4. The court agreed that the defendant received “ultra profits” from this transaction because the settlement amount under the Call was 138 times higher than the premium paid by the defendant to the claimant under the Call. The defendant argued that it did not receive any “ultra profits” because it hedged its risk with a third party, so the majority of the amount payable by the claimant (except for some usual price differential) was paid to the defendant’s hedging counterparty. The court did not agree with that argument, noting that the mere fact that the defendant incurred certain “expenses” in connection with the hedging transactions does not undermine the argument that the defendant received “ultra profits”
    
5. Apart from the general breach of good faith, the court confirmed that the defendant did not act in the spirit of guidance of the self-regulatory organisations of the financial market participants acting in Russia and their standards requiring the professional participant to disclose all relevant information when entering into investment contracts and to take care of the client’s interests. The court argued that the defendant did not take the claimant’s real interests into account when proposing to the claimant to enter into the transactions.
    
6. The court observed that the transaction was negotiated for almost a year, whilst the defendant only provided the declaration of risks to the claimant eight calendar days before the deal was entered into and such risks disclosure did not properly highlight forecasts of RUB depreciation at such time. When the deal was restructured (by way of increasing the Barrier levels), the defendant decided that there was no need to refresh the risk disclosure to the claimant, and the court held that such approach was not justified in this context.

Summary:

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.