Willful Defaulters and Derivatives Transactions

The Supreme Court was recently confronted with a question as to whether a company that had entered into a derivatives transaction with a bank could be categorized as a “willful defaulter” under the Reserve Bank of India’s Master Circular on Willful Defaulters on account of non-performance of payment obligations. More specifically, the question was whether a bank could be treated as a “lender” in respect of such derivatives transactions. The derivatives were foreign exchange derivatives in which either party could be obligated to make payment to the other depending upon the relative movements of specified currencies over a period of time.

While there were differences of opinion between two High Courts, the Supreme Court in Kotak Mahindra Bank v. Hindustan National Glass & Industries Limited (and related matters) ruled last week that banks could invoke the willful defaulter provision even in case of unfunded transactions such as derivatives and guarantees, and that the said scheme was not confined to funded transactions such as customary lending and borrowing of sums of money.

The appeals arose out of three different cases. In one case, the Calcutta High Court held that the Master Circular applied only to borrowing and lending transactions. Since the transactions in questions were foreign exchange derivatives, it held that there was no borrower and lender and hence the derivatives counterparty (client) could not be treated as a willful defaulter. In the other two cases, the Bombay High Court came to the opposite conclusion. After considering the Master Circular and various other circulars relating to the banking industry, the Court held that counterparties of banks in derivatives transactions will fall within the purview of the Master Circular, and that banks could name them as willful defaulters (so long as they followed principles of natural justice).

On appeal, the Supreme Court was required to interpret the Master Circular. The term “willful default” is defined in the Master Circular with reference to a unit that has “defaulted in meeting its payment/repayment obligations to the lender”. The difficulty arose due to the use of the expressions “payment/repayment obligations” and more specifically the expression “lender”. A literal interpretation would mean that only customary lending and borrowing transactions would be covered. However, the Supreme Court instead adopted a purposive interpretation, keeping in mind the objective of the Master Circular. The Supreme Court’s decision was influenced by the broader objectives of the Master Circular. This is evident from the following extracts from the Supreme Court’s judgment:

34. When we look at the Master Circular, we find that the purpose of the Master Circular is "to put in place a system to disseminate credit information pertaining to willful defaulters for cautioning banks and financial institutions so as to ensure that further bank finance is not made available to them". Hence, the purpose of the Master Circular is to have a system to disseminate credit information pertaining to willful defaulters amongst banks and financial institutions so that no further bank finance is made available to such willful defaulters from such banks and financial institutions. …

35. Keeping in mind the mischief that the Master Circular seeks to remedy and the purpose of the Master Circular, we interpret the words used in the definition of 'willful default' in clause 2.1 of the Master Circular to mean not only a willful default by a unit which has defaulted in meeting its repayment obligations to the lender, but also to mean a unit which has defaulted in meeting its payment obligations to the bank under facilities such as a bank guarantee. …

36. The scheme of Collection and Dissemination of information on cases of willful default of Rs.25 lakhs and above was framed by the RBI in the year1999 when the derivative transactions were not part of the country's economy. … Such derivative transactions may not involve a lender-borrower relationship between the bank and its constituent, but dues by a constituent remaining unpaid to a bank may affect the credit policy and the credit system of the country. Information relating to defaulters of dues under derivative transactions who intend to take additional finance from the bank obviously will come within the meaning of credit information under Section 45A(c)(v) of the 1934 Act. …

Although the companies challenging the banks’ decision to treat them as willful defaulters raised several other issues, the Supreme Court did not set out its views on those. These include issues pertaining to the constitutionality of the Master Circular, which was not directly challenged in these appeals.

Given this interpretation of the Supreme Court, the Master Circular on willful defaults will have wider applicability beyond customary borrowing and lending transactions, and would extend to unfunded transactions as well where the obligor has any kind of payment obligation towards the banks. Among these, the Supreme Court has specifically listed out derivatives transactions as well as guarantees.

At a broader level, this decision is one among the line of cases where courts are keen to adopt more purposive reasoning to give effect to traditional legislative provisions as they apply in the context of more modern financial transactions such as derivatives and securitization. In this type of an approach, the courts seem keen to uphold the sanctity of contracts in such type of banking transactions in the interest of the overall banking and credit environment in the country. Other examples of this pro-bank approach that we have previously discussed on this Blog include the Supreme Court’s decision in ICICI Bank Limited v. Official Liquidator of APS Star Industries Ltd. and Rajshree Sugars & Chemical Ltd. v. Axis Bank Ltd.

Australian Court on Rating Complex Financial Instruments

The Federal Court of Australia has delivered an important ruling that pertains to the liability of credit rating agencies. In Bathurst Regional Council v. Local Government Financial Services Pty Ltd, the court found that Standard & Poors (S&P) was liable to several local councils in Australia for a AAA rating provided in connection with their investment in complex financial instruments known as constant proportion debt obligations (CPDOs). Along with S&P, ABN Amro which structured these instruments was also held liable.

The court found that S&P’s AAA rating was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia ...” Furthermore, it was found that S&P, in arriving at its conclusions, heavily relied upon inputs provided by ABN Amro without independently verifying them. In effect, this ruling no longer allows rating agencies to disown responsibility to investors who relied on their opinions to make investment decisions.

This judgment is interesting for several reasons. It involves a rare instance where rating agencies have been found to be liable. As the Economist notes, it is unlikely that other courts would adopt a similar stance. S&P is in any event said to be appealing this decision.

It is an unusual instance where the court has not shown any hesitation in delving into the technical aspects of complex financial instruments in minute detail. Jagot, J’s decision is 1,500 pages and 3,723 paragraphs long. The summary itself is 9 pages and 56 paragraphs long! Although the court was aided by expert evidence, the fact that these complex instruments have been stripped down to their essentials in determining the outcome of the liability of S&P and ABN Amro is remarkable.

This judgment would certainly call attention to the risk profile of rating agencies in terms of legal liability.

A further discussion of this judgment is contained in Reuters(which links to other coverage as well) and Prof. Jayanth R. Varma’s Financial Markets Blog (arguing from a financial modelling perspective that these instruments should not have been rated at all).

Black Money: Corporate Entities and Securities Markets

The Government yesterday tabled its White Paper on Black Money in Parliament. Billed as the first document to comprehensively tackle the issue, it cites various studies and is replete with data. However, it has already been subjected to criticism from various quarters owing to the lack of details and clarity in solutions to deal with the issue. This post, however, briefly touches upon the role of corporate entities and the securities markets in perpetuating the flow of black money as contained in the White Paper.

The White Paper finds that financial market transactions are used as conduits to route black money using the modus operandi of “round tripping”. For instance, it notes:

2.4.9 The illicit money transferred outside India may come back to India through various methods such as hawala, mispricing, foreign direct investment (FDI) through beneficial tax jurisdictions, raising of capital by Indian companies through global depository receipts (GDRs), and investment in Indian stock markets through participatory notes. It is possible that a large amount of money transferred outside India might actually have returned through these means.

The use of participatory notes (P-Notes) for investments back into India appears quite stark. Since P-Notes are issued by entities outside India, often through multiple-layered holding structures, Indian regulators are faced with difficulties in ensuring transparency and in identifying the ultimate beneficial owners. Despite progressively stronger KYC norms imposed by SEBI to track beneficial ownership of P-Notes, it has had mixed success, primarily owing to the difficulties associated with extraterritoriality of the investment activities in P-Notes. For previous discussions on regulating P-Notes, please see here, hereand here.

The White Paper also comments upon the use of complex corporate structures through tax havens to mask financial transactions.

2.9.1 Corporate structuring is a legitimate means of bringing together factors of production in a way that will facilitate business and enterprise and help the economy. However, an artificial personality can also be created of a corporate entity to conceal the real beneficiaries. Opaque structuring through creation of multiple entities that own each other and the secrecy granted by certain jurisdictions facilitate such misuse.

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2.9.4 With increasing realisation about the harmful effect of ownership being concealed behind complicated corporate ownership structure, such structure is coming under scrutiny. In the Indian context, it is one of the reasons for the fact that tax authorities are not able to take action in cases where money is prima facie brought back to India through round tripping and other legitimate means and it is expected that efforts taken by India in this regard as also global pressure will provide a check on these tendencies.

The White Paper further fuels the ongoing debate on issues of taxation by referring to the Vodafone case. Again, given that corporate holding structures are established on a cross-jurisdictional basis, regulating the entire chain is an onerous task.

It is quite clear from the report that the issue of black money is quite complex and requires a multi-pronged strategy to deal with. While the White Paper is a first step in documenting the various aspects of the issue, it might required a more concerted action as it involves multiple laws and regulations enforced by multiple regulators.

Enforceability of Put and Call Options in India

I have posted a working paper tentatively titled Investment Agreements in India: Is There an 'Option'?, the abstract of which is as follows:

Put and call options are ubiquitous in modern investment agreements, such as those involving joint ventures as well as private equity and venture capital investments. The enforceability of put and call options in Indian companies has been the subject matter of debate due to the existence of stringent securities legislation that has been supported by strict judicial interpretation. Moreover, recent pronouncements by India’s securities regulator, the Securities and Exchange Board of India, have expressly disallowed options in securities of Indian companies (except private companies).

This article embarks on the modest task of mapping out the legal landscape that presently shapes the enforceability of put and call options in Indian companies. It seeks to review applicable legislation and analyze key judicial pronouncements that hold sway over the field. It finds that the current legal regime governing put and call options in investment agreements is fragmented and hazy and unnecessarily restricts the ability of investors in Indian companies to enter into such arrangements to protect their own interests. It calls for a reconsideration of the legal regime so that physically settled options that are customary in investment agreements may be treated as valid and legally enforceable.

The paper essentially deals with issues arising under the Securities Contracts (Regulation) Act, 1956, the notifications issued under that legislation and various court decisions interpreting those. Comments are welcome.

Regulating Offshore Derivative Instruments

Over the last few years, SEBI has been adopting various strategies to regulate the use of offshore derivative instruments (ODIs) such as participatory notes that enable foreign investors to participate in the Indian markets without actually owning the underlying securities. The strategies include restricting the use of ODIs, and also requiring the application of know-your-client norms (KYC) by foreign institutional investors (FIIs) who issue the ODIs against underlying Indian securities they hold.

In this background, Tejesh Chitlangi and Sandeep Parekh have an interesting column in the Financial Express that examines some of the key issues involved in regulating ODIs. Although SEBI’s approach has intensified over the years, there are a number of issues in concept and practice that still need to be addressed, as they note. Matters get complicated further because ODIs are issued outside India thereby testing the extraterritorial reach of SEBI’s powers of regulation and enforcement.

RBI’s Draft Guidelines on CDS

Following its draft report released in August 2010, the Reserve Bank of India (RBI) has issued draft guidelines on credit default swaps (CDSs) for corporate bonds.

One of the principal objectives of this effort is to boost the corporate bond market. As RBI notes:

The objective of introducing Credit Default Swaps (CDS) on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS as a risk management product offers the participants the ability to hive off credit risk and also to assume credit risk which otherwise may not be possible. Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors’ interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

However, CDSs are susceptible to great risk, as the experience from the global financial crisis bears. Cautious of this factor, the RBI has imposed a number of checks and balances on the CDS market. For example, entities that are permitted to buy CDS protection may do so only to hedge against their underlying exposure to corporate bonds. They are not permitted to hold CDSs without appropriate underlying securities. The idea is to curb speculation.

There seem to be opposing concerns regarding the introduction of CDSs as well as the regime governing them. On the one hand, it is felt that the instrument is too risky to be introduced in the markets given the current environment. India’s own experience in dealing OTC derivatives has not been satisfactory, as several transactions had been mired in litigation over the last few years. On the other hand, proponents of CDS as a risk protection mechanism feel that the introduction of such an instrument with numerous restrictions will make it non-palatable to the investing community, thereby rendering it a non-starter. RBI has adopted the path involving some tight-rope walking.

The draft guidelines include some language on risk management and mis-selling:

3.1.6 Risk Management – Role of Board and Senior Management

3.1.6.1 Participants should consider carefully all related risks and rewards before entering into CDS transactions. They should not enter into such transactions unless their management has the ability to understand and manage properly the credit and other risks associated with CDS. They should establish sound risk management policies and procedures integrated into their overall risk management.

3.1.6.2 Participants which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty limits.

3.1.6.3 Participants should be aware of the potential legal risk arising from an unenforceable contract, e.g., due to inadequate documentation, lack of authority for a counterparty to enter into the contract (or to transfer the asset upon occurrence of a credit event), uncertain payment procedure or inability to determine market value when required. They should consult their legal experts on these and other related legal aspects before engaging in CDS transactions.

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3.1.10 Prevention of mis-selling and market abuse

Market-makers may ensure adherence to suitability and appropriateness criteria (as stipulated in the circular RBI / 2006 – 2007 / 333 DBOD.No.BP.BC.86 / 21.04.157 / 2006-07, dated April 20, 2007) while dealing with users. From the protection buyer’s side, it would be appropriate that the senior management is involved in transactions to ensure checks and balances. In this connection, following may be ensured by the protection sellers:

a. CDS transactions shall be undertaken only on obtaining from the counterparty, a copy of a resolution passed by their Board of Directors, authorising the counterparty to transact in CDS.

b. The product terms are transparent and clearly explained to the counterparties along with risks involved. 

The above protective mechanisms seem to be a direct fall-out of the OTC derivatives litigation in India involving banks and corporates. Please see here and here for a flavor of the issues that arose in the litigation.

Barclays Order: ODI Restrictions Lifted by SEBI

In December 2009, we had discussed SEBI’s order whereby Barclays was found to have failed in complying with certain disclosure norms while issuing offshore derivative instruments (ODIs) under the SEBI (Foreign Institutional Investors) Regulations, 1995. For this, SEBI had prohibited Barclays from issuing, subscribing or otherwise transacting in any ODIs until reporting systems are put in place to the satisfaction of SEBI.

After further hearing the parties and considering the steps adopted by Barclays to put in place adequate reporting systems, SEBI passed an order last week withdrawing the directions imposed on Barclays by its December 2009 order. In arriving at its conclusion, SEBI does not condone the previous non-compliance with disclosure obligations on the part of Barclays, but it is persuaded by the subsequent steps adopted by Barclays to establish robust reporting systems that would prevent a recurrence of non-compliance.

SEBI utilizes the opportunity to reiterate the policy on ODIs and emphasizes the importance of transparency in transactions by FIIs. Here are some extracts (references to the “Order” relate to SEBI’s December 2009 order):

As observed in the Order, SEBI places almost absolute faith and unqualified reliance on the ability of an FII to carry out the basic regulatory and prudential oversight. The oversight includes reporting all trades including ODIs as periodical returns as well as specific requests for information relating to its trading activity in India. … As per the scheme of the FII regulations, FII is required to provide all requisite information as sought by SEBI about its trading activity in India in terms of Regulation 20 of the FII Regulations. …

… The obligations that have been placed on an ODI issuer are two fold – issue ODIs and [ensure] further issue or transfer in strict compliance with the FII Regulations, and report as per the formats provided for by SEBI. The obligation to provide information about onward issuances is an inalienable part of the provisions under the FII Regulations that relate to issue of ODIs. This is very clear given the scheme of the FII Regulations and the duties expected of a FII as explained above.
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The underlying principle of Regulation 15A(1) of the FII Regulations is that ODIs could only be issued directly or indirectly to persons who are regulated by an appropriate foreign regulatory authority and after complying with the “know your client” norms. It is reiterated that full and fair disclosure forms the foundation of the FII Regulations. The very objective of imposing such obligations on FIIs is because SEBI has no direct access to verify the entities who deal in the Indian Securities Market and the nature of funds that are being invested. The said concern compelled SEBI to issue necessary amendments in Regulations 15A and 20A of the FII Regulations. SEBI, as a regulator of the securities market, places absolute reliance on the ability of an FII to carry out the functions as an FII and to comply with the basic regulatory norms put in place. When an FII fails to discharge its duties and does not exercise proper diligence, inflows through such FIIs could endanger the integrity of the securities market which may further lead to manipulation and fraud. This is the reason why SEBI has mandated FIIs to provide fair, true and correct information regarding their activity. The said information would be used by SEBI for the purposes of assessing, supervising and regulating their activity in the securities market. As already mentioned in the Order, when SEBI grants registration to an FII, it is presupposed that the said FII has the required systems and processes to ensure the integrity and accuracy of the data provided by it to SEBI under the applicable regulations and its capacity to exercise the necessary oversight. A duty is cast on the FII to ensure that no further issue or transfer of any ODI is made to any person other than a person regulated by an appropriate foreign regulatory authority. …

Although SEBI laid down exacting standards on FIIs regarding their issuances of ODIs, it was satisfied with the steps taken by Barclays in establishing appropriate reporting systems to ensure compliance with such standards. In that regard, SEBI was persuaded by the report of an independent auditor, KPMG, which evaluated Barclays’ systems and practices for ODI reporting. SEBI was persuaded only after the independent auditor’s report was expanded to include within its scope of reference certain additional matters stipulated by SEBI. The order concludes by observing:

SEBI derives regulatory comfort from the work conducted by the auditor in general and the submission of auditor’s certificate in compliance with the Order, certifying that reasonable remedial measures have been taken. The deficiencies in the systems and processes of Barclays have now been remedied and a certificate to that effect has also been furnished to SEBI, in compliance with the Order. As the situation has been remedied and the aforesaid directions in the Order have been complied with by Barclays, I am of the considered view that the ex-parte directions issued against it vide the Order need not continue and can be withdrawn.

Further Measures to Boost Infrastructure Financing

In continuation of previous measures, the Reserve Bank of India (RBI) has taken additional steps to enable financing in the infrastructure sector.

First, the proposed introduction of credit default swaps on corporate bonds (discussed here) covers corporate bonds issued by Special Purpose Vehicles (SPV) of rated infrastructure companies “keeping in view the need for development of the infrastructure sector”.

Second, the RBI has earlier announced definitive measures to permit take-out financing through external commercial borrowings (ECBs) in the infrastructure sector. As RBI observes in its notification of July 22, 2010:

As per the extant norms, refinancing of domestic Rupee loans with ECB is not permitted. However, keeping in view the special funding needs of the infrastructure sector, it has been decided to review the ECB policy and put in place a scheme of take-out finance. Accordingly, it has been decided to permit take-out financing arrangement through ECB, under the approval route, for refinancing of Rupee loans availed of from the domestic banks by eligible borrowers in the sea port and airport, roads including bridges and power sectors for the development of new projects …

The take-out financing is subject, however, to several conditions including a minimum average maturity period of 7 years, fees to overseas lenders not to exceed 100 bps per annum and that the borrowing will not be under the automatic route (thereby requiring prior approval of the RBI).

Although this is a welcome development, it remains to be seen whether the imposition of stringent conditions will thwart the growth of financing in this sector. For a further analysis of these measures, please see this article on Mondaq and this discussion on CNBC.

RBI Proposes Credit Default Swaps on Corporate Bonds

The Reserve Bank of India (RBI) has issued a draft report that proposes the introduction of credit default swaps (CDS) for corporate bonds. Comments are due on the proposal by October 4, 2010.

The move to create a market for CDS in India has been delayed for the last few years due to a lack of adequate risk management systems and lessons learned from the financial crisis (where CDS is alleged to have contributed to the downfall of large U.S. financial corporations). Added to this is India’s specific experience, with several OTC derivatives transactions having been mired in litigation throughout the country.

Due to this background, RBI has adopted a cautious approach to introduce CDS. Several checks and balances have been embedded in the instrument. For example:

- The bonds which constitute reference obligations are required to be issued by corporate entities that are rated (although no minimum rating has been stipulated);

- Market makers (or those who write CDS) must be regulated entities, while users (counterparties) are permitted to hedge only their underlying exposures, or bonds held by them;

- Users without underlying exposure cannot purchase CDS, and any purchases must correspond to the extent (both in terms of quantum and tenor) of such underlying risk. In other words, there is no room for naked CDS.

Such an approach would provide a useful tool for bondholders to hedge their underlying risk, while at the same time controlling speculation. In his column in the Financial Express, K. Vaidya Nathan highlights the risk of improper regulation of such instruments, but commends RBI’s measures:

It is not difficult to appreciate that CDS is a useful hedging tool. However, if not properly regulated, it can become an instrument for unbridled speculation. According to the International Swaps and Derivatives Association, the amount of CDS outstanding as of the beginning of this year was $30.4 trillion. Compared to this, the US Treasuries market is $4.4 trillion and its corporate bond market is $3.6 trillion. The world’s richest person has a personal net worth of $53 billion and one of the most cash rich corporations in the world, Apple Inc, has a cash pile of $46 billion. For sure, there isn’t $30,400 billion of money out there that needs to be hedged, which is what the current size of CDS market is. Quite evidently, a loosely regulated credit derivatives market has allowed market participants to indulge in rampant speculation.
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RBI needs to be commended for taking this bold step to introduce the product, because post-crisis the popular sentiment is that all derivatives are weapons of mass destruction. An easy approach would have been to defer the introduction of credit derivatives indefinitely. RBI is steering a difficult course in that it cannot afford to run the risk of being too lenient, which could result in a purely speculative market, while ensuring that it is not too strict either. If RBI is able to regulate in such as way so as to facilitate a deep and liquid credit market, it would set a good example for other central banks in the region. Regulators indeed walk a fine line and this is a confident step in the right direction.

Returning to the RBI draft report, it contains a fairly detailed analysis of regulating CDS, both from an Indian perspective and also more generally.

Miscellaneous: Commodities futures, FDI, Exchange-traded funds

The following are some key developments in the corporate sector over the last couple of days that are worth noting:

1. Commodities Futures

We had earlier discussed on this blog the preliminary findings of the Expert Committee under the chairmanship of Dr. Abhijit Sen, which failed to find a clear causation between commodity futures and the price rise in agricultural commodities. However, the Government seems to have overruled the findings in a sense when it banned futures trading in 4 commodities, being chana, soya complex, rubber and potato. This decision is not altogether uncontroversial, considering that there have been calls for a consistent futures policy. Further, the Dr. Sen committee has itself expressed its concern over the decision. The move is also likely to largely affect the trading on the commodities exchanges.

On a separate note, S. Gurumurthy presents a critical view about commodities futures and the Sen Committee findings.

2. FDI in Retail

The Hindu Business Line reports that there is unlikely to be a Government decision on the permissibility of foreign direct investment in retail trade in the near future.

3. Exchange Traded Funds

The Hindu Business Line has a column that explains this concept, which is slowly gaining popularity.

4. US-India Investment Norms

The Economic Times reports:

The US is putting pressure on India for a level-playing field for American companies investing in the country. Washington is pressing for a national treatment to US companies in the bilateral investment treaty (BIT) currently being negotiated.

A national treatment would place US investors on par with Indian investors and they may not have to adhere to the stringent guidelines laid down by the Foreign Investment Promotion Board (FIPB).

The US also wants India to agree to subjecting investment disputes between the two countries to international arbitration. While India has been resisting the proposals, the US is keen that the two become an integral part of the treaty.

Disclosures in Complex Transactions

With increasing complexity in transactions entered into by companies, especially in the financial sector, there is the lingering question of how these transactions are to be meaningfully disclosed to shareholders of the companies so as to enable them to take an investment decision (such as to buy, sell, hold, etc.). The trouble here is that institutional investors themselves are unable to appreciate the real nature of these transactions. We have seen some of this in the sub-prime crisis when several such investors bought collateralized debt obligations (CDOs). How then does one expect lay investors to grasp the intricacies involved in these transactions when they happen to be shareholders or other security holders in any of the companies that are parties to such deals?

In Going beyond Greek letters in Livemint, Amol Agrawal flags the issue by giving the example of the UBS annual report that was sent to its shareholders:

“Swiss bank UBS AG has recently released a report where it has tried to explain to shareholders what went wrong in the subprime crisis. UBS is one of the worst affected firms and the decisions of its managers needed explanation. The report is an honest admission of various judgemental errors by the management.

One wonders how many of UBS’ shareholders understood what was written. It sounds Greek all the way. There is a surfeit of jargon and acronyms. One has to continuously flip back the pages to understand the chain of events.”

He then goes on to deal with some of the policy implications that lay behind disclosures and complex financial transactions:

“All this poses numerous problems for the policymakers. They have to not only develop their financial systems, but also make them more crisis-resistant. Take the India example. There have been numerous reports on India’s financial sector. All these committees/reports suggest the same —an efficient financial system with more participation of public and encouraging financial innovation. But then, we can’t really ignore the risks from these fancy financial products. The UBS-type shareholder reports might soon be written by Indian firms (I hope not in times of crisis) and the recent derivatives crisis suggests the time will come sooner than later. How many shareholders will actually understand these derivative positions? If they don’t, then the purpose of bringing more public savings into capital markets needs to be questioned.

The subprime crisis has pointed to the need for financial literacy, but understanding what happens in financial markets requires much more than basic financial literacy. Even the best financial brains can’t figure out the developments. Hedge fund Long Term Capital Management (LTCM) failed miserably despite having Nobel-winning economists on board. The subprime crisis is a collective failure of many such minds.

There is an urgent need to tackle the perverse incentives and complexity in the financial system. The regulators alone can’t do the job and the participants will have to become responsible themselves. But then, we are all interested in our yachts, who cares for the customers/shareholders? Financial deepening without creating financial excesses (as said by Hervé Hannoun of the Bank of International Settlements) is the need of the hour. The focus so far has been on the first part. The sooner we move to second, the better it will be.”

The observations in the article are interesting. Disclosures relating to complex transactions will always result in information asymmetry. However, that just seems to be a fact that one cannot wish away. It is almost impossible to provide these disclosures in simple terms that are comprehensible to a lay investor. If at all that is attempted, there is a sure risk of oversimplification that may alter the meaning, relevance and importance of that information. Therefore, the option of providing simple disclosure that lay investors understand may not be a viable option.

As Steven Schwarcz notes in his article Rethinking the Disclosure Paradigm in a World of Complexity, what we have is a “dilemma that some structured transactions are so complex that disclosure to investors of the company originating the transaction is necessarily imperfect – either oversimplifying the transaction, or providing detail and sophistication beyond the level of even most institutional investors and securities analysts.”

This then means that disclosure is not the proper means to regulate complex financial transactions. Such transactions must either be restricted by law and regulation, or alternatively such complex investment opportunities must be made available only to sophisticated investors (e.g. qualified institutional buyers) and not to those who cannot understand and appreciate the full extent of the risks they may be taking with these investments. This must, of course, be weighed against the need for vibrant financial markets that encourage financial innovation - always a tough balance.

Draft Report on Commodity Futures

One of the reasons ascribed to the recent price rise in India is the introduction and expansion of the commodities futures markets. This has, however, been partly put to rest if one were to go by the observations contained in the draft report of the Expert Committee on Commodity Futures Trading headed by Prof. Abhijit Sen. The Committee, which issued its draft report recently, failed to find a clear causation between commodity futures and the price rise in agricultural commodities. The report states:

“The fact that agricultural price inflation accelerated during the post futures period does not, however, necessarily mean that this was caused by futures trading. One reason for the acceleration of price increase in the post futures period was that the immediate pre-futures period had been one of relatively low agricultural prices, reflecting an international downturn in commodity prices. A part of the acceleration in the post futures period may be due to rebound/recovery of the past trend.

A study of supply fundamentals (production, changes in inventory and international trade) show that changes in these also contributed to higher inflation during the period under consideration. Nonetheless, recent behaviour of food grains prices does not appear to be explained completely by supply shortfalls, and, in particular, contribution of international price movements to domestic price outcomes appears to have increased substantially. Claims that futures trading were a cause of the inflation in sensitive commodities needs to be viewed in this context.”

On the other hand, the Committee is not entirely pleased with the present functioning of the futures markets. For instance, it found that futures and hedging have failed to result in proper price discovery or an effective mechanism of risk management, which have in fact become poorer. The report makes a call to upgrade the quality of regulation both by the Forward Markets Commission and the commodity exchanges in order to prevent manipulation and abuse by speculators and arbitrageurs.

Spot markets have also been found to require large-scale reforms. Here are some excerpts:

“Reforming spot markets should be given top priority. There is a need to give thrust to encourage all state governments to pass Model APMC Act. In fact, the model APMC Act is going to revolutionize agriculture marketing in the country. Further, in order to promote integrated national markets, the Central Government should take active steps to bring inter-state spot trade under the regulation of a central authority rather than leave it to highly scattered APMCs. Entry 33 in concurrent list of 7th Schedule of the Constitution seems to provide such a jurisdiction. The setting up of National Spot Electronic Exchanges by the National Commodity Exchanges is an attempt to create a national integrated market.”

From this, it is possible to glean mixed conclusions. On the one hand, there is no evidence of the commodity futures markets exacerbating the inflation of essential commodity prices. On the other hand, there is still a lot of work to be done in improving the regulations relating to commodity futures and the exchanges on which these futures are traded. Spot markets also require a complete overhaul.

Directors’ Duties During Times of Crises

The unexpected market conditions in recent times have rocked corporate boards world over. Healthy companies have begun to declare less satisfactory results, while the unlucky one’s face extinction. Companies are increasingly being exposed to liabilities towards shareholders, creditors and other counterparties, and consequently, directors of such companies are having to face difficult conditions in which to exercise their judgments on such boards.

In this context, the Harvard Law School Corporate Governance Blog carries a memo titled Corporate Governance Update: Advice for Directors in Complicated Times: The Fundamentals Still Apply prepared by Wachtell Lipton, that contains some practical advice and a set of dos and don’ts to directors on corporate boards. While the memo has been prepared in the context of US law (specifically Delaware), it is set in quite general and user-friendly terms and its principles would apply across jurisdictions, including in relation to directors on Indian companies.

Corporate Governance and the Indian Derivatives Saga

While on the issue of corporate governance and the role of boards in financial crises, an article by Govindraj Ethiraj in the Business Standard makes for interesting reading. Specifically, it laments the inadequacy of controls and the failure of corporate governance in companies that entered into complicated derivatives transactions without adequately appreciating the risks involved in those. It further adds:

“How did it happen? I am not sure but a good question to ask is when. My understanding is that companies have been steadily stepping up their exposure to currency swaps and the like for at least four years now. Over time, as the stockmarkets (which bolster sentiment) have held their own and the prospect of any downside risk appeared more and more distant with every passing day, chief financial officers (CFOs) of companies have got braver.

One key driver appears to be the desire to cut down on interest costs. Not surprisingly, banks have played a role here, structuring products that got more exotic by the day. One consultant I spoke to said he challenged most CFOs to make “head or tail” of the complex derivative contracts that they had signed, on behalf of their companies. Maybe shareholders are also at fault for not asking but the fact is that no one paid attention or more likely didn’t care as long as the bottom line was fine.
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It’s possible many companies did keep their boards informed and made the appropriate references in their balance sheets. Though this does seem unlikely, even if they did, then as I mentioned earlier, no one was watching. It’s also possible that some companies are in violation of law. Either way, shareholders must perhaps shoulder some part of the blame.

To conclude, is this another Enron waiting in the wings? Not quite but it does raise some fundamental questions on what companies do with their shareholders’ funds. It’s also about how when the good times roll, everyone forgets to look at the figures closely. There is something in the original Cadbury committee definition of corporate governance. If I remember correctly it said, “Corporate governance is the system by which companies are directed and controlled.”

More on the Indian Derivatives Saga

While the legalities of several derivative transactions entered into between banks and corporates are pending consideration of courts, it appears that these matters have ended up in court in the first place because of unexpected market movements over the last few months which defied all prior indications and past market history. Livemint has a detailed analysis by Niranjan Rajadhyaksha who examines the transactions which resulted in disputes between the banks and corporates, and the reasons for such disputes.

He also identifies the principal problem with such derivative transactions, which is the inability to assess any losses. He says:

“Counting the damage

It is now time to count the damages.

How the losses will be totted up will depend on the precise nature of the derivatives that companies and banks have entered into. The easiest ones to deal with are what are called exchange-traded derivatives. These derivatives have a daily market quote, similar to the daily price of a listed share in the stock exchange, so marking them to market is not much of a problem.

The OTC derivatives that have been privately negotiated and are not traded will present more difficulties to accountants. The most popular way to put a value on them is to use the Black Scholes option-pricing model that is used the world over. “Unless options are listed and traded in the market, the Black Scholes model will be used to value what companies and banks hold,” says Gautam Nayak, partner in audit firm Contractor, Nayak and Kishnadwala.

This iconic valuation model was unveiled in 1973 by financial economists Fisher Black and Myron Scholes. Their widely used formula—which Indian accountants are likely to use—takes many factors into account: the price of the underlying asset, the strike price of the option, the risk-free rate of interest, the time in years for the expiration of the option contract and the implied volatility.

Rising interest rates and higher volatility in the financial markets could lead to steeper falls in the notional price of options in the months ahead. The global derivatives market continues to gasp for air—and banks with credit derivatives will have to keep more money aside as provisions.

We have not yet seen the end of the great Indian derivatives mess.”

Of course, some of the damage may come to light sooner as companies begin to declare their March 31 results, since the ICAI has issued guidance on the earlier implementation of AS30 beginning March 31 (see earlier post on this blog).

The article contains some oblique references to the failure of regulation that resulted in the crisis with respect to derivatives. It states:

“The financial sector as a whole has evolved a lot and the banking industry is coming up with newer and newer instruments which are complex. Unfortunately, regulators have not kept pace with the developments happening. The gulf between players introducing ever newer and more complex instruments and the regulators is widening to the disadvantage of the public,” says Rajeev Chandrasekhar, the member of Parliament who asked the parliamentary question that Chidambaram replied to.”

The issue of regulating complex instruments such as derivatives is quite a challenging one, with no clear-cut solutions. It perhaps commands an entire blog post by itself. But it may be worth stating a few salient points (at a high level) here for the moment.

Globally, countries follow two broad patterns of regulation of complex financial instruments. At one end of the spectrum is public regulation, which necessitates the government or regulatory authorities to step in and lay down rules and standards for operation of market players, the failure to comply with which will result in adverse consequences. At the other end of the spectrum lies private market regulation, whereby the players in the market who deal in complex financial instruments, exercise diligent market discipline through self-determined systems of checks and balances so as to avert financial crises, without involving any form of government intervention. The optimal approach to regulation should ensure that markets will function in a systematic manner without suffering from financial crises, systemic losses and other impacts that adversely affect the players and stakeholders, but at the same time the regulation should not be so onerous as to stymie financial innovation and sophistication, which form the lifeblood of financial market activity.

In an economy like India that still lacks a high level of financial sophistication (just to give an instance, several corporates that entered into these derivative transactions claim that they did not know the nature of the obligations they were incurring when they signed on the dotted line), pure market regulation may not be the answer. Some level of public regulation seems inevitable. The policy makers in the Government, however, carry the onerous task of injecting the right of level of public regulation that protects the interests of market players without dampening financial growth and market sentiments.

(Update – April 17, 2008: Today’s Hindu Business Line carries two articles on accounting for derivatives exposure. They are Accounting of Derivative Losses and Shocker of a Standard.)

Derivatives in Commodities: Some Issues

This is a cross-post from the Law and Other Things Blog.

The issue over commodities exchanges and trading of futures and options in respect commodities has been brought to the fore with the Left parties deciding not to support the Forward Contracts (Regulation) Amendment Bill.

By way of background, commodities trading can occur in two ways. One is spot trading, where a buyer and seller of commodities enter into a contract, and settle the same by delivery of the commodities and the corresponding payment within a predefined time period (usually up to 11 days). The second is forward trading, where the delivery and/or payment occurs beyond such pre-defined period. Under the Constitution, spot trading is left to States to legislate, while forward trading is within the domain of the Parliament. It is under the latter powers that the Parliament enacted the Forward Contracts (Regulation) Act, 1952 (FCRA) that governs forward trading in commodities. Under the FCRA, while forward trading was permitted in some commodities and restricted in others, options were prohibited. To explain an option, it is a contract under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. The administrative authority under the FCRA was the Forward Markets Commission (FMC), which was a government body.

With the development of the commodities futures markets over the last few years, the Government proposed an overhaul of the FCRA to take these recent developments into account. The principal changes relate to the allowance of options in commodities (that were earlier prohibited), the reestablishment of the FMC as an independent regulator (on similar lines as SEBI) rather than as an arm of the Government itself, and the organisation of commodities exchanges (to enable commodities futures trading) on corporate lines similar to stock exchanges. While these issues were part of the Forward Contracts (Regulation) Bill, 2006 that was pending in Parliament, the Government accelerated the reform process by ensuring the promulgation of the Forward Contracts (Regulation) Ordinance, 2008. The key features of the Ordinance are set out in a press release issued by the Government.

While there could be some questions as to the way in which the Government secured the changes through an Ordinance just two weeks before the Parliament commenced its session, there is little doubt that these changes were long overdue. Like the stock markets in India, the commodities markets too have been developing in a structured fashion over the last few years. Two large electronic exchanges in the form of the Multi Commodity Exchange of India Limited (MCX) and the National Commodities and Derivatives Exchange Limited (NCDEX) have been established and they now handle a significant portion of futures trading that occurs in commodities in India.

Economically, futures trading provides several benefits; it creates liquidity in the markets, enables price discovery by signaling the best price to the rest of the market participants, and most importantly, it provides traders with an avenue to hedge their risks. But, we must bear in mind that derivatives (such as futures and options) are complex instruments and hence are inherently risky. They are largely based on movements in commodity prices, and wrong bets on market movement can prove to be very costly, sometimes even to sophisticated players.

The Left has largely attacked the Ordinance by attributing the recent surge in commodity prices to extensive futures trading. However, that seems somewhat misdirected, as there is no correlation established between futures trading and increase in prices. Price increases could possibly arise due to myriad other factors.

I find that an important aspect that the Ordinance has failed to tackle is the issue of complexity of derivatives. It is not sufficient if the law merely provides a platform for derivatives trading in commodities. There needs to be a proper mechanism for disclosure, which requires persons that are selling futures and options in commodities to disclose all details (the risks in particular) relating to these products in a manner that the buyers of such products are able to appreciate the risks involved before they decide whether to participate in that market or not. In relation to derivatives in the stock market, the detailed rules issued by SEBI largely serve that purpose. It is also to be noted that the commodities futures market is likely to be patronised primarily by traders (some of them who may be of medium to small-scale) who may not possess sufficient sophistication to comprehend the risks involved in such complex instruments. The experience with derivatives in the financial markets (where the level of sophistication is somewhat higher) has not been good either, what with several companies now filing suits against banks (with whom they entered into derivative transactions) to renege on their commitments, including on the grounds that they did not fully understand what they were entering into. For details, see here and here on the Indian Corporate Law Blog). Therefore, a proper disclosure regime is called for in commodities trading so as to ensure informed trading in commodities derivatives, and thereby a transparent market.

The Left has also opposed foreign direct investment (FDI) in commodities exchanges. Although the press reports (referring to the Left objections) indicate that the FDI has been permitted under the Ordinance, it is not the accurate position. FDI is governed by various policies issued by the Department of Industrial Policy and Promotion (and not the Ordinance). The Press Note 2 of 2008 allows foreign investment of 49% in commodities exchanges (with 26% FDI and 23% FII investment) with the prior approval of the Government. Further, no foreign investor/entity, including persons acting in concert, will hold more than 5% equity in such companies. This appears to me to be a balanced approach towards foreign investment. While it allows major world players in this industry to participate in the Indian market and thereby introduce their expertise and business practices, it guards domestic interests as well. It is fairly restrictive as (i) investment is possible only with prior Government approval, (ii) majority shareholding still remains with domestic owners; and (iii) there is no risk of dominance by a single foreign player (or group) on an exchange as individual investments are capped at 5%.

It is likely that these issues will be the subject of heated debate in the near future, especially as the Bill comes up for discussion in Parliament.

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."

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[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.