Financial Derivatives Arbitration
1. Nature of Financial Derivatives Contracts
Financial derivatives are contracts whose value depends on an underlying asset (e.g., interest rates, currencies, commodities, or indices).
Common derivatives:
Interest Rate Swaps (IRS)
Credit Default Swaps (CDS)
Currency swaps
Options and futures
Most transactions are governed by:
ISDA Master Agreement
Schedule and Credit Support Annex (CSA)
2. Common Types of Disputes
(a) Mis-selling and Suitability Claims
Investors allege they were not properly informed of risks.
(b) Valuation Disputes
Disagreement over mark-to-market valuation or close-out amounts.
(c) Termination and Close-Out Netting
Disputes after early termination events.
(d) Market Disruption Events
Whether extraordinary events justify suspension or adjustment.
(e) Collateral and Margin Calls
Failure to meet margin requirements under CSA.
(f) Illegality and Regulatory Violations
Contracts challenged due to regulatory breaches.
3. Legal Issues in Derivatives Arbitration
(i) Enforceability of ISDA Close-Out Netting
Close-out netting allows aggregation of obligations upon default.
Key issue:
Whether netting is enforceable across jurisdictions.
(ii) Misrepresentation and Risk Disclosure
Tribunals examine:
Whether banks adequately disclosed risks
Sophistication of the counterparty
(iii) Interpretation of Standard Form Contracts
ISDA agreements are highly standardized; disputes focus on:
Definitions (e.g., “Market Quotation”)
Event of Default clauses
(iv) Illegality and Ultra Vires Transactions
Some entities (e.g., municipalities) may lack authority to enter derivatives.
(v) Calculation of Damages
Includes:
Replacement costs
Lost profits
Hedging losses
4. Important Case Laws
1. Hazell v Hammersmith and Fulham LBC
Principle: Ultra vires and illegality
Local authority entered into interest rate swaps
Court held contracts void due to lack of authority
Significance:
Landmark case on legality of derivatives transactions.
2. Credit Suisse International v Stichting Vestia Groep
Principle: Misrepresentation and capacity
Dutch housing association entered complex derivatives
Alleged mis-selling and lack of capacity
Significance:
Clarified duties of banks in complex financial products.
3. BNP Paribas v Yukos Oil Company
Principle: Enforcement and arbitration
Dispute over financial obligations linked to derivatives
Court upheld arbitration and enforcement mechanisms
Significance:
Supports arbitration in high-value financial disputes.
4. Lomas v JFB Firth Rixson Inc
Principle: ISDA payment obligations
Issue: whether non-defaulting party must continue payments
Court interpreted ISDA provisions strictly
Significance:
Key precedent on ISDA contract interpretation.
5. Dexia Crediop SpA v Comune di Prato
Principle: Mis-selling and municipal derivatives
Municipality challenged swaps as unsuitable
Focus on disclosure and advisory duties
Significance:
Highlights regulatory scrutiny in derivatives markets.
6. Lehman Brothers Special Financing Inc v National Power Corporation
Principle: Flip clauses and priority
Dispute over payment priority after default
Court upheld contractual provisions
Significance:
Reinforces enforceability of complex ISDA clauses.
5. Role of Arbitration in Derivatives Disputes
(a) Technical Expertise
Arbitrators often have financial expertise, crucial for:
Valuation models
Risk assessment
(b) Confidentiality
Important for:
Protecting trading strategies
Avoiding market panic
(c) Cross-Border Enforcement
Derivatives are global; arbitration ensures enforceability under:
New York Convention
(d) Flexibility
Tribunals can:
Appoint financial experts
Adapt procedures to complex evidence
6. Key Contractual Provisions in Derivatives Arbitration
(i) Arbitration Clause
Increasingly included in ISDA agreements
Specifies seat and rules
(ii) Close-Out Netting Clause
Determines calculation of termination amount
(iii) Collateral and Margin Provisions
Govern credit risk mitigation
(iv) Events of Default
Bankruptcy
Failure to pay
Breach of agreement
(v) Governing Law Clause
Common choices:
English law
New York law
7. Drafting Lessons
Ensure clear valuation methodologies
Include robust risk disclosures
Define termination events precisely
Provide dispute resolution clarity
Address regulatory compliance explicitly
8. Conclusion
Financial derivatives arbitration represents one of the most complex areas of commercial dispute resolution. Tribunals emphasize:
Strict interpretation of standardized contracts
Enforcement of close-out netting mechanisms
Accountability in risk disclosure
As financial markets evolve, arbitration remains a preferred mechanism due to its expertise, neutrality, and enforceability, making it indispensable in resolving high-stakes derivatives disputes.
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