Thursday, November 6, 2008

Misrepresentation by a Bank – Consequences – Rajshree Sugars v. Axis Bank

(In the following post, our guest contributor Karthik Seshadri examines the issue of misrepresentation arising out of the judgment of the Madras High Court in Rajshree Sugars v. Axis Bank. For a background of the case and issues involved, please see Niranjan’s earlier post)

In what can be termed as a locus classicus on the subject pertaining to Derivative transactions and their validity, Mr. Justice V.Ramasubramanian of the Madras High Court[1] has gone on to hold that “prima facie” the derivative transactions – option contracts – swap contracts etc., that were entered into by an exporter with a bank in order to hedge its risk against foreign exchange fluctuation were valid. The exporter in the instant case had taken a stand that the contracts were void ab initio as being hit by Section 23 (opposed to public policy), Section 30 (Wagering contract) of the Indian Contract Act, 1872 as also being opposed to provisions of the FEMA, 1999.

The Learned Judge in an exhaustive judgment and in a very characteristic manner dealt with all these objections and negatived the claim of the exporter. While dealing with the case on hand, the Learned Judge was confronted with a situation wherein the exporter was able to produce material to show that the Bank (counter party) had in fact represented to the exporter that US Dollar would never reach the stipulated level vis a vis the Swiss Franc to be faced with a situation where the exporter actually found itself in, prompting it to file the suit. The Learned Judge brushed aside the contention that there was no misrepresentation since both parties had no control over or knowledge as to how the currency would fluctuate. Is that the test? Was it correct on the part of the Bank to have made such a statement? What is level of diligence required of a Bank to make such a statement? This paper seeks to examine those aspects.[2]

Bank & Customer - Misrepresentation:

There was an economic slowdown happening in the United States of America with the “Sub Prime” crisis, ever since July-August 2007. This snowballed into a major crisis leading to credit squeeze, fall of major banks like Lehman Brothers, Bear Stearns collapsed and several others were either on the verge of a collapse or were putting up a “brave face”. Between January 2008 & March 2008 this started having an impact on Foreign Institutional Investors (FIIs’) and they started pulling out of the stock market in India as well. The Bombay Stock Exchange & National Stock Exchange started witnessing a slide as these institutions started pulling out of the market.

My wife & I, as any prudent middle class family would do, have invested our hard earned money into various security instruments, viz., shares, mutual funds, debt bonds, fixed deposits etc. Our investments are “advised” by a “new age bank”[3]. During one of our visit to the bank, the bank manager subtly told us that if we had some “spare cash” that we were looking to invest in, the ideal situation would be to invest into structured products that have been launched by certain mutual funds. That the returns on these structured products were linked to the NIFTY or the stock index; and that the structured products were capital guaranteed products. Since the NIFTY had come down to around 4000 levels, it would be very lucrative to invest in these structured products. The returns if calculated based on data on the movement of NIFTY over the years would show that the investor can get a return of about 15-18% annualised. Sounds very attractive and interesting for any investor in a sliding market!

Now, technically what was the manager doing? Was he providing an advise? Was it an advise that a normal, average man likely to rely upon and take a decision? Was the manager duty bound to explain any risk attached to the investment decision? What would happen to these structured instruments if the markets collapsed further and takes a very long time to recover?

In common law there are three kinds of misrepresentation and they are:

- Fraudulent misrepresentation occurs when one makes representation with intent to deceive and with the knowledge that it is false. An action for fraudulent misrepresentation allows for a remedy of damages and rescission. One can also sue for fraudulent misrepresentation in a tort action. Fraudulent misrepresentation is capable of being made recklessly.[4]

- Negligent misrepresentation occurs when the defendant carelessly makes a representation while having no reasonable basis to believe it to be true.[5] Lord Denning has stated this rule as:

“if a man, who has or professes to have special knowledge or skill, makes a representation by virtue thereof to another…with the intention of inducing him to enter into a contract with him, he is under a duty to use reasonable care to see that the representation is correct, and that the advice, information or opinion is reliable”[6]

- Innocent misrepresentation occurs when the representor had reasonable grounds for believing that his or her false statement was true. Prior to Hedley Byrne, all misrepresentations that were not fraudulent were considered to be innocent. This type of representation primarily allows for a remedy of rescission, the purpose of which is put the parties back into a position as if the contract had never taken place.[7]

In the Indian scenario, the law is governed by Section 18 of the Indian Contract Act, 1872.[8] The question therefore is, whether the bank manager or the agent dealing with the exporter in the ordinary course of business and selling the derivative product to the exporter is making any positive assertion to the exporter. Was not the bank under a duty to inform the exporter of the pit falls of the transaction? When the bank made a statement that the dollar would never reach the stipulated level vis a vis the Swiss Franc, was that statement that can be called a positive assertion, made out of experience, statistical data and a statement that the exporter relied upon, since it came from a person whom the exporter had no reason to doubt?

Role of Reserve Bank of India – Is there any duties cast on the Bank?

The Reserve Bank of India in exercise of its powers issued a Master Circular governing Foreign Exchange Derivative Contracts[9]. The RBI has mandated that in respect of foreign exchange derivative contracts both involving the rupee and not involving the rupee, banks should ensure that in the case of:

i. Swap structures where premium is inbuilt into the cost;
ii. Option contracts involving cost reduction structures;

• such structures do not result in increase in risk in any manner; and
• do not result in net receipt of premium by the customer

RBI has also prohibited the banks from offering leveraged swap structures or a swap route to become a surrogate for forward contracts for those who do not qualify for forward cover.

A reading of the Circular would suggest that the Reserve Bank of India as the primary regulator has imposed certain restrictions in the manner in which a Foreign Derivative Contract is entered into. A duty has been cast on the banks to ensure that certain foreign derivative contracts do not result in increase of risk in any manner nor result in net receipt of premium by the customer. The duty imposed on the banks automatically call for the banks to exercise due skill & care while providing advise to its customers and requires them to protect the client/customer from any “increase in risk”.

If that is the mandate, was such skill and care exercised by the banks? Did the banks protect its customers from any increase in risk? Even a prima facie look into the various derivative contracts would show that such application of skill and care was lacking. Further, when the bank asserts to its customer that the US Dollar would never reach the levels vis a vis the Swiss Franc, such a statement, it is submitted, apparently shows that the bank did not exercise due skill and care required of it. When the bank manager informed me that it would be attractive to invest in a structured product, certainly there was no disclosure of risks or application of skill and care expected of a bank.

Exporter getting a benefit on part of the contract – Does it make a difference?

A reading of the judgment of Mr. Justice V. Ramasubramanian would indicate that the Learned Judge was convinced that the exporter could not claim that the contract was illegal as they had derived a benefit from the same in part. It is respectfully submitted that such a view is contrary to law. Merely because a person derives a benefit from an illegality, it would not make an illegal transaction valid. The person who derived the benefit from such illegality ought to return the same. If after adopting an objective test, the court comes to a conclusion that a particular transaction is illegal, then all parts of the transaction are liable to be set aside.

Conclusion:

Though the judgment of the Learned Single Judge is not the end of the road for the exporters and they have many more battles to fight. The current trends in foreign exchange situation could be a better solution for the exporters and the bank alike. Many transactions are getting knocked off and in some cases we have started witnessing negotiated settlements. After all, a commercial solution is better than a legal one. Or is it?
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[1] Order dated 14.10.2008 by Hon’ble Mr. Justice V.Ramasubramanian, in CS No. 240 of 2008, High Court, Madras

[2] To understand a little more on Derivative transactions in India and more particularly how they were entered into in Tirupur, readers are urged to read S.Gurumurthy, …”Amstrong Palanisamy”, The Hindu, 04th & 05th July 2008.

[3] New age bank – is meant to denote a bank that markets various security products aggressively including helping customers decide in their investments in mutual funds, also through their business arms act as share brokers, provide what is termed as retail banking aggressively.

[4] Derry vs. Peek; (1889) 14 App. Cas. 337.

[5] It was first seen in the case of Hedley Byrne v. Heller; [1964] A.C. 465 where the court found that a statement made negligently that was relied upon can be actionable in tort.

[6] Esso Petroleum Co Ltd v. Mardon; [1976] 2 Lloyd's Rep 305.

[7] Section 2(2) Misrepresentation Act 1967 in England, however, allows for damages to be awarded in lieu of rescission if the court deems it equitable to do so. This is judged on both the nature of the innocent misrepresentation and the losses suffered by the claimant from it.

[8] 18. "Misrepresentation" means and includes­ -

(1) the positive assertion, in a manner not warranted by the information of the person making it, of that which is not true, though he believes it to be true ;
(2) any breach of duty which, without an intent to deceive, gains an advantage to the person committing it, or any one claiming under him, by misleading another to his prejudice or to the prejudice of anyone claiming under him ;
(3) causing, however innocently, a party to an agreement to make a mistake as to the substance of the thing which is the subject of the agreement.

[9] RBI Master Circular No./6/2007-2008 dated July 02, 2007

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