United States: Recovery of Hedging Losses as Consequential Damages in New York Arbitration

The scenario is common enough: an owner voyage-charters its bulk cargo vessel to a charterer to load a cargo of, say, wheat, for carriage from Point A to Point B. En route, the vessel suffers serious mechanical problems resulting in a long delay in the delivery of the cargo. The cargo is undamaged, but indexed market values for wheat drop substantially between the time the cargo was expected to be delivered and the date it was actually delivered. To complicate matters, the charterer, a sophisticated international grain trading company, claims that it entered certain futures contracts at the time it purchased the cargo in order to fully hedge against the risk of such market fluctuation; however, as a result of the delay, it suffered a further loss on the hedge positions because they matured before the cargo arrived. The charterer also claims to have suffered losses on certain currency futures positions it had taken to hedge against fluctuating exchange rates between the time of purchase of the cargo and the time of anticipated sale. Can the charterer recover these losses against the owner?

All of these losses fall under the category of consequential damages. Apart from where the contract may provide other wise, the rule in New York of when consequential damages may be recoverable derives from the well-known and oft-quoted decision in Hadley v. Baxendale, 9 Exch. 341 (Ct. of Exchequer 1854). Simply stated, only those damages that are reasonably foreseeable—at the time the contract is entered—as being a likely and probable consequence of a party's breach may be recovered. Importantly, the inquiry is not whether the breaching party should have foreseen the exact manner in which the loss came about; but rather, the loss must only be shown to have been foreseeable as a natural and probable consequence of the breach. Numerous New York arbitration awards and court decisions have reaffirmed these basic principles.

So where do hedging losses fall in this analysis? Perhaps surprisingly, this question has received very little treatment by New York arbitrators. Indeed, it appears that the only reported New York award to address this issue in any great depth is The M/T BONI, SMA No. 3053 (1994). That case involved claims under a chain of ASBATANKVOY charters and bills of lading for various losses resulting from a fire on board the vessel that caused the voyage to be terminated. The vessel was towed back to Singapore, where part of the cargo was sold and part of the cargo was transshipped to Puerto Rico. The subcharterer/cargo owner asserted various claims up the charter chain, including a claim for approximately $2.3 million in losses based on a comparison of the hedge positions it placed for the date the vessel was scheduled to arrive and the date that the cargo actually did arrive.

In analyzing this element of the claim, the panel first considered whether hedging losses could be said to be foreseeable in the context of this charter relationship. Answering this question in the affirmative, the panel observed as follows:

Having concluded that it was reasonably foreseeable that this charterer would suffer hedging losses caused by a substantial delay in delivery of the cargo, the panel then turned to analyze the actual hedging losses that were claimed. Ultimately, the panel denied the claim on the basis that the actual transactions were not truly "hedges" within the chart - erer's own stated hedging procedures and were not placed in accordance with accepted industry standards. As the panel noted, "[h]edges are never an absolute protection against the risks of market fluctuations, but if placed properly...they offer a large measure of price protection. They were not so placed here."

One can extrapolate some basic principles from this award. First, in considering whether hedging losses are reasonably foreseeable, a panel must look at the trade involved and at the parties' knowledge and experience in that trade. In the M/T BONI, the panel found significant not only the fact that the owner and disponent owner were generally aware that the charterer operated a refinery and traded petroleum in the spot market, but also the fact that they were themselves in the petroleum business—one in lighterage and the other in tanker operations—and surely had derived some understanding of the petroleum markets from that business. Indeed, to the extent it was true in 1994 that "most companies are aware of the need and advantage of hedging products to assure price stability," it can only be more so in 2011. The same is probably true about other kinds of hedges, such as currency contracts, forward freight agreements, and other similar kinds of derivatives.

But the second part of the analysis is as important as the first, and in any given case it will probably be the more difficult part of the proof: is the hedge actually a hedge or is it a market play? It is easy to see why this distinction is critical, for no contracting party should be liable for the other's own poor decisions in trying to speculate on the futures markets. At bottom it is a question of causation, i.e., did the breach cause the loss or was the loss caused by trading strategies that were not properly designed to hedge a specific price risk?

For a party seeking to avoid this kind of liability, the solution is simple: make it explicit in the contract that consequential damages (or, more specifically, losses resulting from hedging or derivative positions) will in no event be recoverable under the contract. For a party wishing to be able to recover these kinds of losses, on the other hand, a specific clause in the contract allowing such recovery would at least answer the question of whether this kind of loss was foreseeable. At a minimum, however, such a party should communicate to its counterparty in the pre-contract communications some details about its hedging program and intentions in order to support an argument down the road that the hedging losses were a foreseeable consequence of the counterparty's breach.

But in addition, the party seeking recovery for hedging losses probably will need to be able to show that its hedging practices were in fact hedges relating to the specific cargo at issue and not merely part of a larger market position strategy. This will often be difficult to do because hedging positions are not usually so directly linked to specific cargos. It is difficult to speculate based on the M/T BONI award exactly how close a link must be proven, but at the least it seems clear that some causal connection must be demonstrated between the breach and the hedging loss in order to meet the foreseeability test for recovery of consequential damages.

A further issue, not reached by the M/T BONI award, is whether the party seeking recovery for hedging losses acted reasonably in trying to mitigate its damages by, for instance, covering open positions or, perhaps, even taking new positions. Another issue is how these kinds of liabilities might travel up or down a charter chain, where different parties may have different degrees of understanding or knowledge about the business of the party ultimately claiming the loss.

It is perhaps somewhat surprising that there have not been more cases seeking recovery for hedging losses resulting from breach of a charter, particularly given the increased prevalence of the various kinds of hedging instruments that are now commonly used in connection with the transportation of cargo by sea. The table is set for such claims, however, and owners, charterers, and cargo interests alike should be aware of this issue so they can protect their interests accordingly.

This article first appeared in Lloyd's List, "Beware Rise in Claims for Cargo Hedging Losses," on February 15, 2011.

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