Trading in Futures – Financial Instruments of Mass Destruction?

The exposure of Indian corporates and banks to derivatives has been receiving a lot of attention lately. For example, see LiveMint (here and here), Financial Express and Economic Times. But, what are some of the key legal considerations that arise in the case of derivative transactions? To examine those, we have a guest contribution.

Image: Wikimedia Commons


The following post has been contributed by H. Karthik Seshadri, Advocate and Partner, Iyer & Thomas, Chennai

Introduction

The name Jerome Kerviel would almost go unnoticed, but he has the credit of having been involved in probably the biggest fraud ever in the history of banking. On January 25, 2008, it was revealed that Jerome Kerviel, a futures trader of the Societe Generale had entered into unauthorized transactions that cost France’s second largest bank Euro 4.9 billion (US$ 7.8 billion), approximately Rs. 32,000 crores. However, primary investigations revealed that Jerome Kerviel did not personally profit out of any of these transactions.

On March 4, 2008, the Economic Times in India carried an article wherein it was mentioned:

“In the past few weeks, more than 100 companies have cancelled their derivative contracts with banks to cut their losses. The fear of large derivative hits has suddenly deepened following the abnormal surge in currencies like the Swiss franc and yen against the dollar. Amid a relentless dollar hammering in the international markets, these currencies have appreciated 3-4% against the greenback in the past one week — a swing big enough to wipe out much of what companies had earned from these deals. Between June and September 2007, there were a flurry of deals as corporates entered into swap contracts to convert their liability into Swiss francs and yen. It looked irresistible: since interest rates on these currencies were significantly lower, converting local loans into these currencies was a quick way to cut cost, and improve profits. The bet turned sour when the currencies began to rise. Today, many banks are advising their clients to exit these deals.”

What are these instruments? What is the legal backing for these financial instruments?

A “derivative” has been defined in the Securities Contracts (Regulation) Act, 1956 (SCRA)[1]. It is clear that this security therefore has no independent value but derives its value from the underlying asset. The underlying asset can be any form of securities, bullion, stock, currency, livestock, etc. A futures contract is one where parties to the contract agree to buy or sell a security or a commodity at an explicit price on a future date.

The Reserve Bank of India (RBI) has also issued circulars pursuant to the Foreign Exchange Management Act (FEMA) laying down guidelines for regulating residents and the banks while dealing with forward contracts or other forms of derivatives.[2] The essence of the circular is that the transactions would be permitted provided that these transactions are entered into through an Authorised Dealer and in respect of transactions where sale and purchase of foreign exchange is otherwise permitted under the provisions of the Foreign Exchange Management Act and the various rules & regulations of the RBI. The onus also appears to have been cast on the authorised dealer to verify certain documents which disclose the nature of the transactions and the genuineness of the underlying exposure. The authorised dealer is also required to ensure that the board of directors of the corporate that is engaging in the transactions draws up a risk management policy with clear guidelines for concluding transactions and an annual audit for verifying the compliance with the regulations provided by the RBI Circular.

Obviously, these guidelines have been provided with a view to ensuring that the corporate as well as the bank / authorised dealer are not exposed unduly to the vagaries of the market conditions and to minimise the risks involved in entering into forward contracts.

Are these Wagering Contracts?

Even though meticulous care has been taken by the SCRA, the FEMA and the RBI while defining and providing for the guidelines while dealing with the derivatives, we are lately witnessing a spate of litigations that have been commenced wherein parties to various derivative contracts have now approached the courts with a plea that the contract is vitiated as it amounts to a “wager”.

Section 30[3] of the Indian Contract Act, 1872 declares that a contract that is in the nature of a wager would be void ab initio, and no action can lie to either recover anything that is due under a wager or for performance of a contract that is in the nature of a wager. The expression “wager” has not been defined in the Indian Contract Act. A classic definition is however available in the case of Carlill v Carbolic Smoke Ball Co., 1891-94 All ER Rep 127. A wagering contract is one by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that, dependant on the determination of that event, one shall win from the other, and that other shall pay or hand over to him, a sum of money or other stake; neither of the parties having any other interest in that contract than the sum or stake he will so win or lose, there being no other consideration for making of such contract by either of the parties. If either of the parties may win but cannot lose, or may lose but cannot win, it is not a wagering contract.

The Master Circular issued by the RBI provides that the banks and authorised dealers are to cover their exposure by back-to-back contracts. Therefore, any money given to the counterparty or received from the counterparty is passed on to the other parties with which banks/authorised dealers have taken their back-to-back positions. In a situation where a bank would have paid a certain amount from the derivative transactions to the counterparty, the bank would not lose the equivalent amount. Similarly, where a payment is received from a counterparty, such money would not be there on the books of the bank as profit. Taking this logic further in case a counterparty which had become obliged to pay a certain money under the derivative transaction does not pay such money, the position of the bank does not remain neutral as bank has to honour the payment of similar obligations in respect of back-to-back contracts and thus bank loses even by winning in such contract from its counterparty.

On the face of it, an argument by certain parties that these derivative transactions are wagering contract is clearly on account of legal ingenuity and only to be rejected. However, there is one aspect that requires serious introspection. Were the banks / authorised dealers’ diligent while advising the counter parties at the time of entering into these derivative transactions? Did they not have a duty of care thrust on them, by the RBI Circular? Were these risks properly analysed, examined and the consequences thereof understood by the boards of directors of the counter parties? Was it prudent on the part of the board to first of all enter into transactions without properly appreciating the risks involved and the dangers that it exposed the company to? These are interesting and important questions that will have to be answered by the courts.

Conclusion

It is most likely to be presumed that persons of commerce are likely to know what transactions they are entering into and what would be the risks they are likely to be exposed to. If that be the case, is it a mere coincidence that more than a 100 corporates get involved in these financial transactions and are having to cancel the derivative contracts? The answer lies somewhere in between. Only the future will reveal what the truth is.

One cannot forget what Warren Buffet, had to comment on financial derivatives to the shareholders of his company way back in 2002:

“We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

——————–

[1] Section 2(ac) “derivative” includes – (A) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; (B) a contract which derives its value from the prices, or index of prices, of underlying securities;
Section 2(h) Securities include (ia) derivatives…

[2] RBI Master Circular No./6/2007-2008.

[3] Section 30 – “Agreements by way of wager void: Agreements by way of wager are void; and no suit shall be brought for recovering anything alleged to be won on any wager, or entrusted to any person to abide the result of any game or other uncertain event on which any wager is made.”

Update (March 17, 2008): Further references – Banks` derivatives exposure may be capped in Business Standard, The time bomb in our financial system in Rediff Money & Stung firms want banks to pay in Livemint.