Redelivery requirements in repo transactions

Redelivery requirements in repo transactions

What constitutes delivery of goods in a commodities repo transaction? Ruhi Sethi, commercial barrister at 4–5 Gray’s Inn Square, examines the recent Mercuria judgment that provides an endorsement for the structure of repo transactions as well as a reminder of the importance of cogent drafting of the agreements governing repo transactions

Original news

Mercuria Energy Trading Pte Ltd and another v Citibank NA and another [2015] EWHC 1481 (Comm), [2015] All ER (D) 221 (May)

The parties entered repo transactions concerning metal. The first claimant commenced proceedings, seeking declarations that bring forward notices served by the defendants were invalid or superseded by its notice declaring a termination event. The Commercial Court held that the defendants had not effected delivery for the purpose of the parties’ agreements and it was liable for damages for failure to deliver with respect to one transaction. Further, the bring forward notices were valid and the first claimant was in breach of those obligations. Furthermore, the defendants were entitled to terminate the agreements as a matter of contract and common law.

What was the nature of the dispute in this case?

This case concerned a series of repo transactions which were governed by the terms of two Master Agreements between Mercuria Energy Trading Pte Ltd (Mercuria) and each of the defendants (collectively referred to as ‘Citi’). The transactions related to cargoes of metal stored in the Chinese ports of Qingdao, Penglai and Shanghai.

The dispute arose when it came to light that significant quantities of metal might be missing from the warehouses in Qingdao and Penglai where the metal was thought to have been safely stored. In response to this, on 9 June 2014, Citi served what are known as ‘Bring Forward Event’ (BFE) notices on Mercuria which sought to bring forward the sale date of all of the forward transactions. On 11 July 2014, Mercuria served a notice declaring a termination event which required Citi to deliver equivalent metal under the Master Agreements before Mercuria was obliged to pay the price.

Following this, Citi purported to deliver the metal to Mercuria by way of tendering endorsed warehouse receipts issued to Citi. Citi did not issue a release instruction to the warehouse operators who had not attorned to Mecuria—ie they had not acknowledged that they held the goods on behalf of Mercuria.

What were the key issues to be decided in this case?

The central issue for the court to determine was whether Citi had complied with its redelivery requirements under the repo transactions by delivering endorsed warehouse receipts to Mercuria in circumstances where there was uncertainty as to:

  • the existence of the metal
  • the title to that metal if it existed, and
  • whether the warehouse operators had not attorned to Mercuria as required by the Sale of Goods Act 1979, s 29(4) (SGA 1979)

The court also had to consider whether the BFE notices were valid, the effect of the termination event notice and whether Citi was entitled to terminate the Master Agreements for repudiatory breach of the agreements.

What were the judge’s findings in relation to the key issues?

Mr Justice Phillips rejected Citi’s argument that tendering endorsed warehouse receipts to Mercuria amounted to a ‘deemed’ delivery which was sufficient to effect the forward sales under the Master Agreements. He found that the wording of the forward sale confirmation to be inconsistent with the intended meaning and effect of Citi’s delivery obligation pursuant to the Master Agreements and the overall commercial scheme of the repo transactions.

Mr Justice Phillips examined the law relating to delivery of goods in the possession of a warehouseman, including SGA 1979, s 29(4). At para [59], the judge found that:

‘[…] an attornment by the warehouse operator is a necessary element in the transfer of constructive possession from the seller to the buyer and, as delivery is by definition the transfer of possession, it is also a condition of delivery.’

Given the above, it could not be said that the parties had excluded the requirement of SGA 1979, s 29(4), and given that Citi had failed to provide an attornment from the warehouse operator, it had not effected delivery within the meaning of SGA 1979, s 29(4). It followed that Citi was not entitled to judgment for the unpaid price of that metal as Mercuria had a defence by way of circuity of action. Furthermore, Citi was not entitled to make delivery by assigning its rights to the metal to Mercuria.

Mercuria attempted to argue that SGA 1979, s 29(4) was mandatory, but Mr Justice Phillips did not see that it was relevant to resolving the issues in dispute in this case. Accordingly, it is unclear whether contractual terms which purport to exclude the need for attornment by the third party would be enforceable.

Mr Justice Phillips found that Citi not only held the opinion that the storage facility was no longer able to store the metal safely and satisfactorily, but that this belief was rational and objectively reasonable in compliance with the requirement set out in the Master Agreements. Therefore, the notices were valid and effective. In para [70] of his judgment, Mr Justice Phillips found that ‘the risk in the metal passes to Citi under the Sales Transactions and Citi is free to deal with the metal as it wishes thereafter’.

In relation to termination, it was held that Citi had a right to terminate the Master Agreements on the basis of its terms and at common law on account of Mercuria’s actual breach in failing to pay. In para [155] of his judgment, Mr Justice Phillips found:

‘There was no reason to depart from the logical principle […] that a party’s accrued right to terminate is not affected by whether or not he could himself perform subsequent obligations. That factor is relevant only to the question of compensation.’

Citi did not lose this this right on the basis that it could not deliver the metal to Mercuria. Mercuria’s termination notice did not affect Mercuria’s accrued obligations of payment brought forward by the valid BFE notices served by Citi.

What significance will this case have for lawyers? What should they take note of and what should they advise their clients?

In spite of this decision being somewhat split, it does provide judicial authority on the question of what constitutes delivery of goods in a commodities repo transaction. The decision does not go as far as saying that the requirement of attornment as set out in SGA 1979, s 29(4) is a mandatory one, but clients should adopt a cautious approach to agreeing to exclude the need to provide an attornment as the enforceability of such an agreement remains a grey area.

The decision also confirms that in repo transactions, title is transferred to the buyer (in this case Citi) who carries the risk that the commodity or asset in question may be stolen or lost after the sale and before the repurchase. This is extremely important for would-be buyers to bear in mind when entering into repo transactions.

In light of the judgment, clients should thoroughly check the wording of their agreements to ensure they are consistent with the intentions of all parties and the structure of repo transactions.

Once more details emerge regarding the fraud in the Qingdao and Penglai warehouses, there may be further litigation to ascertain whether either party breached warranties as to title in relation to the repos. Citi could also have a claim against Mercuria for breach of its obligations to properly store the metal under services agreements entered into. Therefore, it is advisable for clients to check that adequate safeguards by way of warranties and service agreements are put in place to protect them on forward sales in repo transactions.

Clients should also ensure that appropriate insurance is in place as insurance claims may well be made following the judgment in this case.

Clients must also be aware of the risk of such frauds, especially when commodities are located in different jurisdictions and should be advised of the importance of localised and ongoing due diligence and monitoring procedures to manage its risk. Clients should also ensure that they act swiftly upon reports of potential frauds as Citi did in this case.

Do you have any predictions for the future?

While this case has been ongoing, banks have to some extent scaled back their lending in relation to repo transactions given the uncertainty of the outcome of both the investigation in the Chinese warehouses and this case.

The decision demonstrates that the structure of a repo transaction is robust and will be upheld by the UK courts. Following the decision, I think that banks can take some comfort from the judgment as even though Mercuria was not ordered to pay, it does highlight that the repo transaction structure provides sufficient sureties and safeguards for the banks in the event that a fraud on the financed commodity or asset is uncovered.

I think the judgment may encourage banks to increase their lending in relation to repo transactions leading to more widespread use of the repo structure.

Interviewed by Susan Ghaiwal.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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About the author:
Tony has in-depth experience of many areas of financial legal practice, including debt capital markets, derivatives, bank finance, development finance, synthetic securitisations and other structured products. The highlight of his career before joining LexisNexis was twenty years as a partner in Simmons and Simmons (1992–2012). During this time he advised a number of global investment banks on debt capital markets transactions, synthetic securitisations and bespoke structured transactions. He also opened the firm’s office in Madrid and opened and managed the firm’s office in Moscow. Tony now divides his time between the Banking & Finance and Financial Services Practice Areas at Lexis®PSL.