Legality of ‘Exotic’ Derivatives – Part I

A previous post had noted that the Madras High Court has recently upheld the legality of the so-called exotic derivatives, holding that they qualify for recovery through the Debt Recovery Tribunal. The following is an analysis of that judgment – Rajshree Sugars & Chemicals v. Axis Bank Ltd. (MANU/TN/0893/2008, C.S. No. 240 of 2008, decided on 14 October 2008).

The well-reasoned and comprehensive decision of the Court covers many aspects important to corporate law – primarily the legality of derivatives, but also the jurisdiction of the civil court in such a transaction vis a vis the Debt Recovery Tribunal, the permissibility of granting injunctions against proceeding in the DRT etc. The plaintiff (“RSC”) was an exporter of sugar, and consequently had several External Commercial Borrowings (ECB’s) from foreign banks. Correspondingly, many of its receivables were also in foreign currency. RSC had entered into an “ISDA Master Agreement” with Axis Bank (“the Bank”), an internationally standardised format under the aegis of ISDA – the International Swaps and Derivatives Association. As the Court noted, the normal practice is for specific deals to ‘flow out’ of this Master Agreement. There were 10 deals of this sort between RSC and the Bank, and the dispute arose out of the tenth, OPT Contract No. 727.

The structure of OPT 727 is becoming increasingly commonplace. It is described in detail in the judgment, but its essence was that RSC would receive $100,000 if 1 USD never touched 1.2385 Swiss Franc within a fixed period, between what is known as the “trade date” and the “fixing date”. Correspondingly, RSC was obliged to buy $20 million USD from the Bank if the exchange rate touched 1.3300 at that rate. On the happening of certain other contingencies, there was to be no exchange of principal. The Court found that the object of the transaction was for the plaintiff to hedge its receivables against foreign exchange fluctuations. As it happened, the plaintiff received a sum of $ 100,000 from the Bank and later claimed that the contract was “knocked out”, with no liability for either party. The Bank challenged this claim, and the plaintiff approached the Madras High Court seeking a declaration that the contract it had entered into was void.

Several important questions are answered in the course of the judgment. These are summarised at the end of this post. To briefly discuss the contentions, the fulcrum of RSC’s case was two-fold – first, the transaction is a “wagering contract” and is void as it contravenes Section 30 of the Contract Act, and secondly, that it is not supported by “an underlying transaction” and is therefore opposed to RBI Circulars and is void as per Section 23 of the Contract Act. RSC also made arguments specific to the circumstances of its case – that the Bank failed to study the “risk management policy” and that its own CFO exceeded his authority in entering into the transaction. I will discuss these contentions (particularly wagering and public policy) in detail in a subsequent post.

Here I examine two preliminary contentions the Bank raised, as these are also likely to be of commercial importance – first, that such a suit is not maintainable as the proper forum is the Debt Recovery Tribunal, and secondly, that no injunction can be given in such cases against the Bank proceeding in the DRT, since the DRT is not “subordinate” to the High Court.

On the first preliminary point, the Court noted that although ‘debt’ is defined widely in the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (Section 2(g)), this does not automatically bar a civil suit, which is permissible on narrow grounds set out by the Supreme Court in earlier judgments. However, in what is likely to be of significance in other cases, the Court held that such a suit will be transferred to the Tribunal if the borrower’s pleas are “inextricably connected” with the Bank’s claim – the reason it was not transferred in this case was that the Bank had not made a request seeking transfer.

The second preliminary point draws from Section 41(b) of the Specific Relief Act, which provides that an injunction cannot be granted to stay proceedings in a court “not subordinate” to the one granting injunction. The Court noted that the Supreme Court has granted anti-suit injunctions in respect of foreign arbitrations, although technically foreign courts are not “subordinate” to the Supreme Court. However, Sections 23 and 24 of the CPC consider a court as “subordinate” only if it falls in the same “line of hierarchy” as the other court. The DRT does not. Therefore, the High Court held that the Bank could not be injuncted from instituting proceedings in the DRT. It was still necessary to examine the substantive contentions, since other remedies open to the Bank were outside the purview of Section 41(b) of the Specific Relief Act.

The following is a summary of the principles that emerge from the judgment, on both the preliminary and the substantive points.

(1) A claim arising out a derivative transaction constitutes a ‘debt’ as per s. 2(g) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993.

(2) Such a claim arises in the “course of banking business” as per s. 6(1) of the Banking Regulation Act, 1949

(3) (1) and (2) above do not automatically bar the borrower from instituting a civil suit. However, if the claim of the borrower is “inextricably connected” with that of the Bank, the suit is liable to be transferred to the DRT. This does not affect the maintainability of the suit.

(4) The bar imposed by Section 41(b) of the Specific Relief Act applies in a case of this sort, since the DRT cannot be said to be “subordinate” to the High Court. Thus, a High Court is not competent to restrain a person from instituting proceedings in the DRT. This, however, does not deprive the Court of jurisdiction to hear the case, because the Bank typically has other remedies to pursue, in respect of which also the injunction is sought, and to which Section 41(b) does not apply.

(5) A wagering agreement must exhibit four ingredients – (a) two sets of persons holding “opposite views” touching a future uncertain event; (b) one party necessarily winning and the other losing on the happening of that event; (c) the parties have no interest in the occurrence of the event, but only in its outcome; (d) Neither party must intend the contract to have legal operation, and the commercial portion of the contract must intended to be a ‘cloak’ to cover a bet

(6) Common intention and interest as per 5(d) and 5(c) above must be demonstrated from the records, and parties are bound by those representations

(7) The transaction between RSC and the Bank is of a type that is not a wager, because the purpose it serves is akin to insurance – it hedges the plaintiff’s risk

(8) Such a transaction is not opposed to public policy either, because it is expressly permitted by several Acts and Rules, and what is expressly permitted by law cannot be opposed to public policy

This judgment is a particularly valuable contribution on the subject of derivatives since it is one of the first instances where legality has been challenged. I will examine the substantive part of the judgment (Points 5-8 above) in greater detail in a subsequent post.

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V. Niranjan

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