The judgment on the claim brought by Mercuria Energy Trading Pte Ltd and Mercuria Energy Group Ltd (Mercuria) against Citibank NA and Citigroup Capital Markets Ltd (Citi), has now been published by the English Commercial Court and its impact on the financing of metals and other commodities in China and elsewhere is already being weighed carefully by market participants.

The dispute centres around Mercuria’s sale to and repurchase (repo) from Citi of quantities of aluminium and copper stored in warehouses in the ports of Qingdao and Penglai in China. This took place in the context of the discovery of a substantial fraud involving the alleged disappearance or multiple financing of metal and affecting a number of traders and banks involved in the financing of metals in both locations.

The issues The key questions raised by the case and which are of concern to market participants are:

  • How do the courts construe the commonly used provisions of commodity repo agreements designed to accelerate the repurchase date?
  • What performance was required by a buyer to redeliver warehoused goods under a commodity repo transaction without physical delivery of the goods themselves? Does the seller (trader) still have to pay if the buyer (bank) fails to deliver?
  • Where does risk of loss lie as between the seller (trader) and buyer (bank) in a commodity repo transaction, when the goods are alleged to have been lost (or never to have been in existence)?
  • What are the financial implications for seller and buyer of failing to repurchase/redeliver in such circumstances
  • Where will this dispute go next?

Background facts

  • Citi and Mercuria entered into two Master Agreements in May 2013 under which a number of “obligated” repo transactions were executed. Mercuria was bound to repurchase the metal from Citi at the end of the contract term. Citi and Mercuria also entered into a parallel services agreement whereby Mercuria undertook certain obligations in relation to the storage and care of the metal.
  • The contract entitled Citi to serve a "Bring Forward Event notice (BFE notice) in certain circumstances where its metal was seen to be at risk.
  • The effect of a BFE notice was to accelerate the repurchase (and payment date) of a transaction to one banking day after the notice is served, rather than await the later contractual resale date. In circumstances where the underlying goods may be in danger, it allows the buyer (bank) an opportunity to exit the transaction (and therefore its risk position) earlier.
  • Discovery of fraud at warehouses in Chinese ports in June 2014 led Citi to serve BFE notices on all the transactions.
  • Mercuria in turn notified Citi of a termination event on all the transactions on the basis that Citi were not in a position to perform redelivery.
  • Citi tendered redelivery of the warehouse receipts of the affected warehouses in China.
  • Mercuria disputed delivery through tender of warehouse receipts and refused to pay the approximately US$270 million repurchase price.
  • Mercuria sought a declaration that the BFE notices were not properly served and that Citi had failed in any event to properly deliver the metal.

The BFE notices – were they valid? The court held that the BFE notices were validly served – these notices are common contractual devices in commodity repo transactions. Subject to the redelivery issue below, Mercuria was bound to pay the price on the new date. The BFE notice enables the purchaser (usually a bank) to react to events affecting the goods and manage their risk. The fraud in Qingdao and the uncertainty surrounding the goods was an event which warranted the serving of a BFE notice, according to the court.

Was redelivery by tender of warehouse receipts good delivery? Was Mercuria bound to pay? The court held that Citi could only have contractually tendered “metal of the same brand and quality and stored in the same location” through either (a) delivery of LME warrants, (b) an acceptable release confirmation (a document issued by the storage operator ‘attorning’ in favour of the owner of the metal) or (c) another “document of title” acceptable to both parties.

The warehouse receipts did not qualify under any of those three headings. Citi therefore failed, in the judge’s view, to redeliver in accordance with the contract. Since there would then be a complete failure of consideration by Citi (entitling Mercuria to the return of any sums paid by way of repurchase), the court would not force Mercuria to pay the repurchase price in the first place. In relation to the one transaction that had come up for completion on 3 June (and completed with payment by Mecuria under reservation of rights), Mercuria was entitled to damages resulting from the failure of Citi to deliver.

Where does risk lie in a repo transaction? The court said that it was common ground that the transactions were all ‘true sales’, the consequence of which was that the buyer (Citi) took constructive possession of the goods on the initial purchase. One of the distinguishing features of a true sale is that title and risk passes to the buyer, even where the underlying intention may be to provide finance to the seller. Citi could not perform a “deemed” delivery in order to transfer that risk back to Mercuria. The court did not, however, rule on any claims Citi might have under parallel services agreements pursuant to which Mercuria agreed to look after the goods physically. The judgment has changed nothing in this regard.

Financial implications for buyer (Bank) and seller The court’s judgment does not change the balance in commodity repo transaction in terms of financial risk. English courts have always adopted a holistic approach to assessing whether a repo transaction is truly a sale arrangement, rather than a loan looking at the net effect of the contractual provisions when seen together. In a loan transaction, the bank retains full recourse (normally) against the borrower, who is at risk for any loss of the goods. In a repo transaction, that risk profile is reversed. The in-principle acceptance of risk for any loss during the period of ownership by the buyer (bank) must therefore follow (subject to any extra-contractual arrangements reversing that presumption). The court was not swayed by suggestions made in argument that the repo was essentially a financing arrangement and that risk should be allocated accordingly.

What happens next? The court has ruled that Mercuria does not have to pay Citi the repurchase price on the accelerated repurchase date, even though the BFE notices were properly served. However, these proceedings dealt only with that narrow issue.

Importantly, the argument on this focused issue proceeded on the assumption that (i) Mercuria gave Citi good title when it sold the goods to them and (ii) the goods had been stolen or had otherwise disappeared after Citi acquired title. Citi argued that even with no metal to redeliver, it could tender warehouse receipts to Mercuria by way of ‘deemed delivery’.

The next stage in proceedings looks likely to focus on whether some or all of those assumptions are, in fact, correct, and on claims related to representations given by Mercuria as to the existence/quantity of metal in the warehouses, as well as claims under the services agreement by which Mercuria warranted the safekeeping of the metal.

Properly drafted, the service agreements are designed to reverse the effects of the risk transfer that goes with the repo and gives an independent claim for damages. What the issues and outcomes in this case show is that the drafting of repo agreements and the associated documentation is key to either party preserving its position in a situation such as the parties faced here.

What will be of much greater interest going forward is how the court construes the parties' wider rights and obligations under the master agreements and the parallel services agreement in the next stage of the litigation. Commodity repo agreements, as a method of providing inventory finance, appear to emerge unscathed following this initial skirmish.

Nothing in the judgement warns market participants off commodity repo transactions as a structure, and while the judge was clear that the concept of ‘deemed delivery’ of metal was at odds with the commercial and legal nature of a commodity repo, the judgment expressly acknowledges that there may be further litigation either on the basis of breach of warranty as to the title, or under the parallel services agreement relating to care and custody of the metal by Mecuria. There may also be insurance claims and claims against third parties, none of which are precluded by this judgment.