UK: Forward Freight Agreements - Financial Weapons Of Mass Destruction?

Last Updated: 25 February 2009
Article by Jeb Clulow and Eurof Lloyd-Lewis

Forward Freight Agreements ("FFAs") are often in the news, at present with Armada of Singapore being the latest major operator to blame them for its financial woes.

FFAs are derivatives contracts. In essence, a FFA is an agreement between two parties whereby one party will be required to pay the other party depending on whether the market freight rate for a type of voyage or period of time turns out to be higher or lower than the figure specified in the contract.

Risks

Where used as a "hedge" against a physical charterparty trade, a FFA should, in theory, reduce a party's risk. However, FFAs are often stand-alone transactions, unrelated to any physical charterparty trade, and are purely for the purpose of speculating on the market. In the current market, such trades can be, as Warren Buffet described them, "financial weapons of mass destruction". In addition to Armada, there have been a number of insolvencies which have been attributed to FFAs.

This highlights another problem with FFAs: counterparty risk. Most FFAs are traded "over the counter" ("OTC") and not through an exchange. Accordingly, as with a physical charterparty trade, a party to a FFA is at risk in the event that the counterparty becomes insolvent.

Form

The Forward Freight Agreement Brokers Association has issued three editions of FFA terms: 2000; 2005; and 2007. The majority of transactions are on the most recent 2007 terms, but there are still many transactions on the earlier 2005 terms.

At first blush, a FFA, whether on 2005 or 2007 terms, can appear simple. However, lurking behind the main FFA terms is a more complex document, known as the ISDA Master Agreement, which runs to 18 pages of dense type. It is this document which sets out in detail the parties' rights and obligations with regard to payment, interest, events of default, early termination and so on.

We discuss below the main obligations under the FFA and then contrast the position between the 2005 and 2007 terms in cases of counterparty bankruptcy.

Payment

At the end of each delivery month, the parties will calculate, by reference to the relevant Baltic Index, who is "in the money". The party who is "in the money" will send to its counterparty an invoice with bank details to allow payment of the "Settlement Sum". Payment is due on the later of two London business days after presentation of the invoice, or five London business days after the Settlement Date, which is the last Baltic Exchange Index publication day of each contract month.

If payment is not made by the stipulated time, the non-defaulting party has to decide whether to terminate the transaction early, thereby accelerating or crystallising the value of the transaction. If the non-defaulting party chooses to terminate the transaction early, it must first give notice requiring payment within three local business days. It is worth mentioning that the notice provisions of the ISDA are particular and antiquated (for instance, notice by email is not valid).

Alternatively, the non-defaulting party may choose not to terminate and withhold payment in respect of any future transactions where the defaulting party may be "in the money".

Bankruptcy

The most significant difference between the 2005 and 2007 terms is that the later edition provides for automatic early termination while the earlier edition does not. In cases of counterparty bankruptcy, this can result in radically different outcomes.

Under the 2007 terms, bankruptcy has the effect of automatically terminating or "closing out" all transactions between the parties. The transaction is accelerated which, as you will see below, can have unpleasant consequences for the non-defaulting party who is "out of the money".

The non-defaulting party is obliged to make a calculation applying the contractual formula of Second Method and Loss. The party who is "out of the money" is obliged to pay their counterparty.

If it is the bankrupt party who is "out of the money", the non-defaulting party may have a very long wait for their money, if they get any at all. In those circumstances, the non-defaulting party will feel pretty hard done by.

If it is the non-defaulting party who is "out of the money" it may be required to pay a large lump sum because the market is currently unfavourable in the sense that it can buy or sell the same trade on more favourable terms and ISDA requires it to account for this benefit to its counterparty. This can have serious cash flow implications for the non defaulting party.

The significant difference under the 2005 terms is that bankruptcy does not result in automatic early termination. This can have very significant advantages for the non-defaulting party who is "out of the money".

Under the 2005 terms, the solvent party has the right but, importantly, not the obligation to terminate the contract. If the non-defaulting party does not exercise its right to early termination, the transaction is not accelerated. However, its primary obligation to make payment in relation to each delivery month, and to pay interest on any sums which would otherwise be payable, are suspended, at least until the default has been cured. An insolvent party will not usually emerge from bankruptcy as a going concern and the practical effect of the suspension is therefore to allow the solvent party to "walk away" from any unprofitable trades. With regard to any profitable trades, the solvent party may still claim payment, subject to the insolvency rules governing the bankruptcy.

There have been instances where the liquidator of the insolvent company has sought to utilise his power to disclaim unprofitable contracts in order to try and "unsuspend" the solvent party's obligations. These attempts have generally been unsuccessful. See, for instance, Enron Australia v TXU Electricity in which the court held that it would "...deprive [the solvent party] of [its] contractual rights, under contracts which expressly contemplate and deal with the consequences of liquidation, to decline to trigger early termination, and of the benefits they would derive from that course". The 2005 terms, therefore, confer a significant advantage to the solvent party in the event of counterparty bankruptcy. There is a debate as to whether it is unfair that the solvent party may "walk away" from unprofitable trades. However, we expect that few FFA users would dispute that the automatic termination regime of the 2007 terms can have harsh consequences for the non-defaulting party as it can affect cash flow significantly. In these difficult economic times, when the ability to maintain one's cash flow may be crucial to one's own survival, it is debateable whether the 2007 terms achieve an equitable result.

Parties involved in the FFA market may, therefore, want to pay particular attention to the difference between the two forms and, indeed, may wish to negotiate their own terms so as to take advantage of the different options available under the ISDA Master Agreement to address specifically the issue of termination in the event of insolvency.

Commodity and Interest Rate Futures/Swap Agreements

Commodity and interest rate futures/swaps are often also on ISDA form and many of the issues discussed in this article are equally relevant to them.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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