Monday, November 10, 2008

Legality of 'Exotic' Derivatives - Part II

In a previous post, I had discussed the preliminary and procedural aspects of the decision of the Madras High Court on legality of derivative transactions. This post considers the substantive aspects of the decision.

A description of the nature of the transaction is available in the previous post. The challenge to its validity rested on two grounds – wagering and public policy. The effect in both cases is to make the transaction void and ineffective in law, under Sections 23 and 30 of the Contract Act, respectively. It was argued that the transaction is one of wager because unlike with normal derivative deals, there was no ‘underlying transaction’. In other words, the suggestion was that the transaction is of the kind classically banned in law as a wager – one where the parties do not control and are not interested in the contingency on which the transaction is based. The Contract Act does not define ‘wager’, and the Court followed common law principles. The Court found that the three classic ingredients of a wagering agreement are : (a) 2 persons holding opposite views touching a future uncertain event; (b) Each party must stand do either win or lose on the happening of this event and (c) The interest of the parties is not in the occurrence of the event, but in its stake. The restrictive nature of this test invalidated commodity market transactions in the 1850’s, and Courts created a fourth ingredient – common intention to wager. In other words, the commercial transaction must be shown to be a ‘cloak’ which neither party intended would have any legal operation. Further, the Court observed that Courts in England and India had taken a liberal view with respect to wagering agreements – collateral contracts were enforced in England until statutory intervention, and are still enforced in India. Analysing the agreement itself, the Court came to the conclusion that there are ‘some contingencies’ where the Bank pays RSC, and others where RSC pays the Bank. “Thus the plaintiff stands to gain at times, while the Bank stands to gain at other times. The gain for the plaintiff is intended to off-set the loss that they may incur in their foreign currency receivables or payables.” The Court found that the transaction in question passed all these tests, especially since documents revealed that RSC had intended the arrangement to be a sort of overall exposure hedge – in the words of the Court, an agreement akin to an insurance arrangement. The contention that the CFO acted beyond the scope of his authority was rejected on the basis of the doctrine of indoor management. An earlier post has discussed the issues arising out of the claim of misrepresentation.

The other ground of challenge was public policy. In a clear analysis of the law, the Court held that what is expressly permitted by law cannot be said to be opposed to public policy. To show that derivatives are indeed expressly permitted, the Court cites pre-independence legislation from pre-independence Bombay to the Forward Contracts (Regulation) Act, 1952, Securities Contract (Regulation) Act, 1956 and several other legislations. The Court noted that the RBI has even notified Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000. A challenge to the validity of the transaction on the basis of RBI Master Circulars was also rejected.

In other words, both contentions failed because the Court found on fact that the object of the arrangement was consistent with the nature of a derivatives contract, based as it was on an underlying transaction. Thus, while this judgment will be of substantial importance to the law on this area, future decisions will need to first establish that there is an underlying transaction before applying this reasoning.

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