Wednesday, October 15, 2008

Legality of Derivatives: Emerging Signs

Readers will recall that over the last few months several companies had entered into derivative transactions with banks wherein they were required to pay significant amounts of money to banks. When faced with claims from the banks, these companies challenged the validity of these derivative transactions in various courts in India, including on the ground that derivatives constituted wagering contracts that were void under the Contract Act.

Recent newspaper reports seem to indicate that courts are willing to uphold the claims in favour of the banks. LiveMint reports that in a September 15 judgment, the Bombay High Court ordered Sundaram Multi Pap Ltd to pay ICICI Bank Ltd the dues arising out of contracts for structured derivatives. The order is available here. However, this order was passed in a winding up petition, and the court has not analysed the legality of derivative transactions.

In a further development, LiveMint reports that the Madras High Court has indeed ruled on the substance of the transactions, again in favour of the banks. This was a case involving Axis Bank and Rajshree Sugars and Chemicals Ltd. It appears that the court has ruled that derivative contracts are not wagering contracts and further that the debt under such contracts qualify for recovery by the banks through the Debt Recovery Act. A further detailed analysis will have to await a review of the judgment once it is available.

For previous discussions on this topic, see: Trading in Futures – Financial Instruments of Mass Destruction?, Derivatives - a constructive critique and More on the Indian Derivatives Saga

1 comment:

Karthik Seshadri said...

It may be of interest that the first case in India challenging the Derivative Contracts was filed in the Madras High Court in a case concerning Sundaram Brake Linings and Kotak Bank. The company challenged that the derivative contracts were opposed to public policy, wagering contracts and that they were therefore liable to be struck down as being illegal. We had appeared for the Bank and argued that since there was an arbitration clause in the ISDA master agreement (International Swap Dealers Association), the Court will have no jurisdiction to even entertain the suit. An interesting issue was raised on the applicability of Section 8 of the Arbitration & Conciliation Act, 1996 in a situation where the very contract is challenged on the ground of being opposed to public policy or that it was a wagering contract. The court in a detailed judgment which now a reported case, held that the law in India was made to promote arbitration and hence it had no jurisdiction to entertain the dispute and made a distinction between Section 45 and Section 8 of the Arbitration & Conciliation Act, 1996 and relegated parties to arbitration.