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.

…

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.

JP Morgan’s Trading Losses: Regulation and Governance

There has been a great deal of debate surrounding JP Morgan’s hedging losses announced last week. There is some mystery surrounding the nature of the transactions involved, without full clarity yet on the amount of losses. Andrew Ross Sorkin has a brief explanation of the episode in the New York Times:

... Here’s an overly simplistic primer, but you’ll probably get the idea: The company’s chief investment office originally made a series of trades intended to protect the firm from a possible global slowdown. JPMorgan owns billions of dollars in corporate bonds, so if a slowdown were to occur and corporations couldn’t pay back their debt, those bonds would have lost value.

To mitigate that possibility, JPMorgan bought insurance — credit-default swaps — that would go up in value if the bonds fell in value.

But sometime last year, with the economy doing better than expected, the bank decided it had bought too much insurance. Rather than simply selling the insurance, the bank set up a second “hedge” to bet that the economy would continue to improve — and this time, traders overshot, by a lot.

This episode has given rise to renewed debate on matters of regulation of the financial services sector as well as corporate governance.

On the regulatory side, the key question relates to whether it will strengthen the hands of regulators around the world to more closely scrutinize the financial services sector. The US has already taken giant steps through enactment of the Dodd Frank Act, but the current development would have an impact on the scope, nature and implementation of the Volcker rule which curbs proprietary trading by banking institutions.

There are a number of issues on the governance side as well. For example, it raises questions regarding oversight of the company’s board and whether they ought to have exercised greater vigilance regarding activities undertaken by the chief investment office. Arguably, more effective risk management systems might have mitigated the effects of such transactions. Lastly, this has also triggered the debate regarding executive compensation, on this occasion pertaining to the specific issue of claw back of excessive compensation to affected officers of the company.

While the enormity of JP Morgan’s balance sheet size appears to have dwarfed the losses from the hedging transactions, their impact on the mode of regulating Wall Street and on governance concerns rings loud and clear.

Diaspora Bonds

The Economist has a piece that discusses the advantages of diaspora bonds to poor countries. It notes:

The idea is simple. Poor-country governments can issue bonds and market them to emigrants in rich countries. There are several advantages to milking members of a diaspora. They are often patriotic: they like the idea that their savings will pay for bridges and clinics at home. They are patient, since they have a long-term tie to the issuer. They are less jittery than other investors, too, since they have friends who can tell them whether political unrest is really as bloody as it looks on television. And they are sanguine about currency risk. …

The idea of diaspora bonds is not new to India. The State Bank of India made a high profile issuance of the Resurgent India Bonds over a decade ago to non-resident Indians (NRIs). These have also been the subject matter of analysis (e.g., a law review article, and an economic study).

However, as the Economist article notes, there are obstacles to the utilization of these instruments by sovereigns, and not all diaspora bond offerings have been successful. See also a World Bank Blog on Diaspora Bonds.

Rating Agencies Back in the Spotlight

S&P has indeed made a bold move by downgrading United States’ sovereign rating. While there may by political opposition, quibbles with the arithmetic, and the like, there is a strong view that those amount to “shooting the messenger”. The downgrading by S&P assumes greater importance because it comes in the wake of determined efforts by governments to tighten their control over credit rating agencies. These agencies had dented their credibility during the financial crisis on account of their stamp of star ratings to securities that were found to be toxic in nature.

By increasing the friction between credit rating agencies and governments, the US downgrade highlights power games that each can potentially play against the other by flexing their muscles. An op-ed in the New York Times by Professor Jeffrey Manns points to the fact that S&P’s downgrade of the US could be a deliberate strategy to achieve a push back against increasing regulation of rating agencies sought by the US Government. But he warns against any such pushback and advises that “the government should not give in to such extortion.” While that is certainly understandable, the principal issues that continue to affect the regulation of credit rating agencies are the oligopolistic nature of the industry with a handful of players wielding significant influence, and the conflict of interest generated by the financial model where issuers of securities remunerate the rating agencies for their services.

Episodes such as the US downgrade have also expanded the scope of alternative thinking. For example, the idea of doing away with credit rating altogether is also being bandied about. However, as this piece in the Economist notes, that is likely to be a tall order. The requirement of credit rating is now well-entrenched in the financial community as it is both prescribed as a requirement for regulatory purposes (e.g. for listing corporate bonds, for investment by regulated institutions) and also generally followed as a matter of practice in certain types of private contracting (such as in the case of derivative transactions or securities). In other words, credit rating agencies are here to stay because there is no suitable alternative.

As far as India is concerned, the rating agencies have not witnessed the kind of turmoil they experience in other countries. Even on the regulatory front, SEBI seems to have a significant amount of oversight on the Indian agencies compared to its counterparts elsewhere. Nevertheless, recent events have caused SEBI to step up its ante too, as it is keeping a close watch on the developments, and it is reportedly open to making changes to regulations affecting these agencies.

The regulatory debate surrounding credit rating agencies has resurfaced barely as it was dying down following the subprime crisis. On that occasion, the allegations against them were on account of their inability to spot weaknesses in the quality of the securities being issued to investors, but this time their role has come into the limelight for taking on the might of a sovereign.

The New Microfinance Institutions Bill

Over the last year or so, there has been a serious debate about the nature of regulation governing the microfinance sector. In view of the debacle in Andhra Pradesh, the Reserve Bank of India (RBI) had appointed a committee under the chairmanship of Mr. Malegam to review issues pertaining to the sector. The committee submitted its report in January this year.

In view of these events, the Government decided to relook at the Microfinance Bill previously presented in Parliament in 2007. Consequently, the Ministry of Finance has drafted the Micro Finance Institutions (Development and Regulation) Bill, 2011, which is published on its website for comments which are due August 7, 2011.

Under the new Bill, the RBI is designated as the umbrella authority that will regulate microfinance institutions. The Bill details the powers exercisable by RBI over the various types of institutions currently carrying on microfinance activity (which include non-banking finance companies and cooperatives). More importantly, the draft legislation seeks to do away with the fragmentation that currently exists in regulating the sector. For example, RBI’s role is expected to supersede regulatory powers exercised by various state governments, such as Andhra Pradesh that swiftly promulgated an ordinance last year that significant curtailed the ability of microfinance institutions to carry out their activities in that state. However, states can be expected to challenge the possible usurpation of powers by Parliament (and there are already signs of that occurring), which in turn lead to interesting constitutional questions involving the division of legislative powers between the centre and the states.

As for regulation of the sector itself, the scope of the Bill largely covers the role of RBI in overseeing the sector in terms of its supervisory powers over various institutions carrying on microfinance activity. All institutions will be required to register with the RBI. In that sense, it does not cover the whole gamut of issues considered by the Malegam committee. Moreover, as noted in this critique, the Bill’s predominant focus on organizational aspects of microfinance institutions overshadows the required regulation on the relationship between the institutions and their customers, who are represented by the needy sections of society. The Bill perhaps lacks in its silence on the latter aspect.

Although the Bill is an important step in generating greater discourse on the topic, it is bound to generate issues or objections from various interest groups, with the likelihood that its passage in any form or its implementation could be met with delays.

Infrastructure Development Fund

The Ministry of Finance has issued a press release that paves the way for setting up  “Infrastructure Debt Funds (IDFs) in order to accelerate and enhance the flow of long term debt in infrastructure projects for funding the government’s ambitious programme of infrastructure development.” IDFs are envisaged to be suitable vehicles that enable raising debt to finance infrastructure projects.

The Ministry’s proposal contemplates two organizational structures for IDFs. The first is a vehicle in the form of a mutual fund using the traditional trust structure. The second is a company structure that is established in the form of a non-banking finance company (NBFC). Due to the nature of regulation governing the two types of entities, an IDF set up as a mutual fund (trust) will be regulated by Securities and Exchange Board of India (SEBI), while an IDF set up as an NBFC will be regulated by the Reserve Bank of India (RBI).

Although the proposal to set up IDFs is laudable and could result in obtaining the require finance to develop infrastructure, the nature of dual regulation could result in problems in implementation and also regulatory arbitrage. Past track record also indicates that overlapping jurisdiction of multiple regulators could cause confusion, as we have witnessed last year in the ULIP saga. Unless any other alternative is pursued, the Financial Stability and Development Council (FSDC) established a few months ago would have to bear the burden of coordinating policy-making among the different financial sectors regulators.

Islamic Finance and the Indian Constitution

The concepts of Islamic banking and Islamic finance are yet to gain significant ground in India and attain the popularity they have witnessed in other countries. While there has been a debate about the need for a separate legal framework in India to promote the form of finance recognized under principles of Sharia law, the judiciary recently had the opportunity to test the validity of Islamic finance against the touchstone of the Constitution.

The case of Dr. Subramaniam Swamy v. State of Kerala involved a constitutional challenge mounted against the participation of the Kerala Government and the KSIDC in the formation of an Islamic investment company for attracting investment to finance projects in Kerala. The principal ground for challenge was that the state’s participation violates the principles of secularism enshrined in the Constitution. The rationale of the Government for using the Islamic investment vehicle was to tap the vast flow of funds generated by non-resident Indians in the Gulf countries. After considering the arguments of parties (almost entirely on issues of constitutional law), the Kerala High Court upheld the state’s action in establishing the Islamic financial institution. Please see this post on the Law-in-Perspective Blog for extracts and a link to the court’s decision.

Although the Kerala High Court’s decision may not directly propel Islamic finance activity in India, it goes to remove at least one obstacle in popularizing the concept.

RBI Sub-Committee on Microfinance

With several legal and regulatory issues affecting the microfinance sector lately, more so in the state of Andhra Pradesh, the Reserve Bank of India (RBI) had appointed a sub-committee under the chairmanship of Mr. Y.H. Malegam to “study issues and concerns in the microfinance sector in so far as they related to the entities regulated by the [RBI]”. The keenly awaited report, which was expected to resolve a number of the issues, was published by the RBI a few days ago (and is summarised by Ramesh S. Arunachalam).

While the report clarifies several regulatory matters pertaining to the microfinance sector, it has also invited a number of comments on the specific recommendations (e.g. this critique in the Mint). The purpose of this post, however, is to highlight the recommendations of the committee on corporate governance and financing in microfinance institutions.

By way of background, the idea of microfinance was initially spearheaded by self-help groups and other non-profit institutions. However, with the need to create a scalable model, the sector began attracting private capital through market-based mechanisms that required the creation of for-profit enterprises. This witnessed the emergence of the traditional corporate set up where companies were incorporated to carry on microfinance business. This business is financed through traditional means of corporate finance: bank loans, investments from private equity or venture capital investors, and increasingly through securities offerings to the public.

The prevalence of for-profit companies raising finance from the markets gives rise to a peculiar corporate governance issue: a dichotomy of objectives in the microfinance sector. On the one hand, microfinance institutions are established with social goals, i.e. the reduction of poverty, and in that sense need to cater to the interests of their stakeholders, who are the poorer and less-privileged sections of society that avail of their services as customers. On the other hand, raising finances from the financial markets imposes pressures to constantly deliver returns to the markets, thereby incentivizing managements to earn profits. A delicate balancing exercise is involved in this addressing this dichotomy. Apart from mandatory norms imposed by regulators as to the manner in which microfinance companies carry on business, the nature of management and governance of these companies does have a significant role to play. Unfortunately, the governance issues are difficult to grapple with, and there is no direction is sight yet.

In this context, the Malegam committee recognises the importance of corporate governance in the microfinance sector, and makes recommendations. The relevant portion of the report is extracted below:

16. Corporate Governance

16.1 MFIs have twin objectives, namely to act as the vehicle through which the poor can work their way out of poverty and to provide reasonable profits to their investors. These twin objectives can conflict unless a fair balance is maintained between both objectives. This makes it essential that MFIs have good systems of Corporate Governance.

16.2 Some of the areas in which good corporate governance can be mandated would be:-

a) the composition of the board with provision for independent directors

b) the responsibility of the board to put in place and monitor organisation level policies for:-

(i) the growth of the loan portfolio including its dispersal in different regions
(ii) the identification and formation of joint liability groups
(iii) borrower training and education programmes
(iv) credit and assessment procedures
(v) recovery methods
(vi) employee code of conduct
(vii) employee quality enhancement programmes
(viii) compensation system for employees including limits on variable pay and the limit therein on weightage for business development and collection efficiency
(ix) customer grievance procedures
(x) internal audit and inspection
(xi) whistle blowing
(xii) sharing of information with industry bodies

c) disclosures to be made in the financial statements including:

(i) the geographic distribution of the loan portfolio, both in terms of number of borrowers and outstanding loans
(ii) analysis of overdues
(iii) the average effective rate of interest, the average cost of funds and the average margin earned
(iv) analysis of the outstanding loans by nature of purpose for which loans were granted
(v) composition of shareholding including percentage shareholding held by private equity

16.3 We would, therefore, recommend that every MFI be required to have a system of Corporate Governance in accordance with rules to be specified by the Regulator.

While the recommendations do well in identifying the dichotomy between social and financial objectives of microfinance companies, they are somewhat cursory in nature in the absence of a detailed conceptual discussion and analysis of the issues involved. That is perhaps understandable because the committee was operating within the aegis of the RBI as a financial regulator. Since corporate affairs fall within the purview of the Ministry of Corporate Affairs (for unlisted companies) and SEBI (for listed companies), a more detailed consideration may have to await their intervention. Since microfinance activity has witnessed exponential growth in India in the last few years, this is an opportune time to consider corporate governance of microfinance through a different paradigm (especially for companies that are accessing the public markets), and it is not sufficient to rely on conventional models of corporate governance.

Apart from microfinance companies, the investors and financiers of such companies also have a significant role to play in this debate. If finance is provided on conventional terms, it is not too much for the investors and financiers to expect market-based returns, which skew the social objectives. Hence, there is need for socially responsible investments in this sector. The Malegam committee does take note of this issue and suggests measures as follows:

21 Funding of MFIs

21.1 It has been suggested that the entry of private equity in the microfinance sector has resulted in a demand for higher profits by MFIs with consequent high interest rates and the emergence of some of the areas of concern which have been discussed earlier.

21.2 Without expressing any opinion on the matter, it is necessary to understand the circumstances in which private equity has entered the sector. On the one hand, there was a huge unsatisfied demand for microfinance credit and on the other, there was a limitation on the capacity of not-for-profit entities to meet this demand. When for-profit entities emerged, microfinance was seen as a high-risk entity but venture capital funds are not allowed to invest in MFIs and private equity rushed in to fill this vacuum.

21.3 We believe it is necessary to widen the base from which MFIs are funded in respect of the Net Owned Funds needed for Capital Adequacy and for that purpose the following need to be examined.

a) It has been suggested that a "Domestic Social Capital Fund" may be permitted to be established. This fund will be targeted towards "Social Investors" who are willing to accept "muted" returns, say, 10% to 12%. This fund could then invest in MFIs which satisfy social performance norms laid down by the Fund and measured in accordance with internationally recognized measurement tools.

b) MFIs should be encouraged to issue preference capital which carries a coupon rate not exceeding 10% to 12% and this can be considered as Tier II capital in accordance with norms applicable to banks.

21.4 We would, therefore, recommend that:

a) The creation of one or more "Domestic Social Capital Funds" may be examined in consultation with SEBI.

b) MFIs should be encouraged to issue preference capital with a ceiling on the coupon rate and this can be treated as part of Tier II capital subject to capital adequacy norms.

Although there has been some momentum in the past with socially responsible investment methods, it is not clear whether it has attained sufficient size and robustness so as to make a difference in the Indian context, particularly with reference to the microfinance sector.

Participatory Notes Fall in Popularity

After initially cracking down in 2007 on indirect investment routes such as those using participatory notes (P-notes), SEBI a year later reversed its decision and allowed foreign investors to participate in the Indian markets through P-notes. SEBI’s decision to allow P-notes was the subject-matter of critique on this Blog as it raises questions regarding transparency.

As observed in that post: “In a nutshell, P-notes are instruments that derive their value from an underlying financial instrument such as a share traded on an Indian stock exchange. They are issued by foreign institutional investors (FIIs) to various offshore investors on the strength of underlying equity, derivatives or other securities that are held by the FIIs.” In other words, P-note holders are able to indirectly participate in the Indian markets without being subject to registration and other requirements under Indian regulations.

Critics of P-notes may now rest easy as its market seems to have corrected itself, at least quantitatively. The Economic Times reports that the flow of funds into India through P-notes has substantially reduced. It states:

The value of participatory notes as a percentage of FIIs’ stock investments, which was as high as 50% in a couple of months during the peak of the previous bull run in 2007, has been in the range of 13-15% in the past six months. This is despite the value of FII assets under management rising to `9.7-lakh crore in July 2010, the highest since December 2007, when that bull run peaked.

It is believed that a more streamlined process for registration of FIIs allowed investors that hitherto used derivative instruments such as P-notes to access Indian markets through the front door.

Added to this is another plausible factor. P-notes were largely used by investors such as hedge funds that prefer to offer fewer disclosures to regulators in markets where they invest. However, the recent financial crisis and the resultant tightening of regulation governing such investors have made them somewhat cautious and sluggish as this Economist report observes:

The creep of regulation is one reason why hedge funds increasingly resemble more traditional investment managers. America’s financial-reform bill, passed in July, will require hedge funds with assets over $150m—a low threshold—to register with the Securities and Exchange Commission, to hire or designate a compliance officer and to maintain records on trading positions and leverage. Proposals for new EU regulations would, if adopted, lead to increased oversight of hedge funds by regulators and put limits on funds’ leverage.

The introduction of greater transparency in the affairs of hedge funds and other similar investors will encourage them to invest directly in markets (such as India), which may also partly explain the decline in P-note activity.

DEMAT Account for Religious Deities

An interesting issue recently fell for the consideration of the Bombay High Court- whether DEMAT accounts could be held in the name of deities. The Court answered this question in the negative, relying on largely practical and partially moralistic reasons in coming to its conclusions.

The decision was pronounced by a Division Bench of the Bombay High Court in Ganpati Panchayatan Sansthan Trust v. Union of India, on a writ petition filed against an order of the National Securities Depository Ltd. [“NSDL”], refusing to grant permission for the opening of a DEMAT account in the name of some deities. The petitioner was a private unregistered trust, of which the deities were shareholders. The primary contention of the petitioner was that the deities were artificial legal persons, and were recognised as such under Indian law and the Income tax Act. The Senior Counsel appearing for NSDL, Mr. Dwarkadas, contended that only natural persons could hold a DEMAT account, and that there was no provision which allowed an account to be opened in the name of a deity.

However, disappointingly for those interested in the legal rationale adopted by the Court, the contentions of the respondent, and the decision of the Court accepting these contentions make little mention of any legal provision disallowing accounts in the name of artificial persons. Neither do they point out that a natural reading of the provision allowing for DEMAT accounts can extend it only to natural persons.^* The rationale adopted by the Court for holding the refusal by NSDL to be valid, and dismissing the writ petition rested primarily on three bases- (a) a DEMAT account requires regular monitoring, and “personal skill, judgment and supervision”, which cannot be done by an artificial entity; (b) since the petitioner is an unregistered private trust, in the case of an irregularity, neither the deity nor the trust will be held accountable; and (c) that the petition essentially amounted to “bringing the Gods/Goddesses into share transaction business”, which the Court frowned upon. Of these, the first two are clearly pragmatic considerations, while the third is one which reflects the Court’s reluctance to allow the entry of religious deities into commercial transactions. However, by basing its decisions on these grounds, the Court leaves open the larger question of DEMAT accounts for non-religious entities, for which there may be better accountability mechanisms. Thus, while arguably reaching the appropriate conclusion on the facts of the case before it, the judgment does fall short in providing a legal framework for subsequent issues which may arise in similar fact scenarios.

^*(The only mention made is that of a SEBI Circular (¶ 8), the relevant provisions of which have not been reproduced in the decision. Any comments from readers as to which circular is being referred to, or its relevant provisions, are most welcome).

Bulk Deals and Order Matching

The availability of income tax exemptions (on long term capital gains) for share transactions that are executed through stock exchanges have caused otherwise negotiated share sale and purchase deals to be implemented through the stock exchange mechanism. This would require parties to bear only the securities transaction tax (STT) at rates which are negligible compared to the erstwhile capital gains tax that would have applied to such deals.

In his blog, Professor J R Varma has an interesting post that deals with some practical issues that arise while putting a negotiated bulk deal through the stock exchange mechanism. Specifically, there is the likelihood of a leakage of some shares owing to orders that are placed at the same time by other purchasers in the market. Professor Varma notes:

“It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.”

The other problem identified relates to fraudulent and unfair trade practices under the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003. This would arise if the market places sell orders at high prices in anticipation of acquirers executing bulk deals on stock exchanges. Professor Varma notes here:

“The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens.
…

I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative.”

While there may be a possible exposure to the regulations that prohibit fraudulent and unfair trade practices, it is often extremely difficult for regulators to succeed in an action under these regulations, for the element of ‘mens rea’ is a necessary ingredient of an offence under those regulations, and proving ‘means rea’ especially in secondary market transactions is an onerous task.

Some Lessons from Bear Stearns

The New York Times DealProfessor has a column Burying Bear Stearns that highlights the takeaways from the Bear Stearns saga, which incidentally are matters we often endeavour to stress on this blog. They are:

- Moral hazard
- Systemic risk
- Corporate governance

Regulating Hedge Funds

I have uploaded an abstract of a working paper titled Analysing India's Approach to Hedge Fund Regulation on SSRN, which is reproduced below:

“Hedge funds tend to employ aggressive investment strategies, and they highly leverage their funds. While hedge funds infuse liquidity into the financial markets and enhance market efficiency, they also engage in complex financial transactions that leave open the possibility of systemic losses that are often borne by the financial markets they invest in.

In this context, the role of regulation of hedge funds in host-countries that receive their investment assumes importance. Regulation needs to balance healthy development of financial markets and the prevention of 'systemic loss' due to risky investment strategies. While a worldwide debate lingers on the need for governmental regulation to rein in hedge funds (as opposed to leaving it to market forces to determine their own regulation through market discipline), the Indian securities regulator, the Securities and Exchange Board of India (SEBI) has experienced a checkered history of regulating hedge funds while always adopting a somewhat cautious approach. It has employed different regulatory strategies to deal with hedge fund investments. These include the prohibition strategy, disclosure strategy, restriction strategy and the registration strategy.

This paper analyses SEBI's strategies for regulating offshore hedge funds investing into India. It finds that each time a regulatory strategy has been employed by SEBI, the hedge fund industry has reacted by displaying considerable malleability in being able to dilute the force of regulation. One such instance relates to the manner in which hedge funds reacted to the prohibition strategy by investing through offshore derivative instruments such as participatory notes so as to stay outside the purview of the Indian regulatory regime (although this route too has been significantly curtailed more recently). Using the example of SEBI's measures in the Indian context, the paper examines the dynamics involved in regulating the offshore hedge fund industry. Although this study is primarily focused on India, the results would apply at a conceptual level to other emerging economies that receive investments from offshore hedge funds.”

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.

Role of Law and Politics in India’s Economic Growth

There is a recent paper titled “Law, Finance, and Politics: The Case of India” by John Armour and Priya Lele that has been posted on SSRN. The authors join the debate as to whether a country’s legal origins (e.g. common law or civil law) necessarily have an impact on the extent of its financial development, and in doing so, they examine India as a case study. The authors find that in India’s case, political explanations have a greater bearing in explaining India’s growth, and that its legal heritage as a common law country has not played a significant role towards that end.

Here is the abstract:

“The process of liberalization of India's economy since 1991 has brought with it considerable development both of its financial markets and the legal institutions which support these. An influential body of recent economic work asserts that a country's 'legal origin' - as a civilian or common law jurisdiction - plays an important part in determining the development of its investor protection regulations, and consequently its financial development. An alternative theory claims that the determinants of investor protection are political, rather than legal. We use the case of India to test these theories. We find little support for the idea that India's legal heritage as a common law country has been influential in speeding the path of regulatory reforms and financial development. There is a complementarity between (i) India's relative success in services and software, (ii) the relative strength of its financial markets for outside equity, as opposed to outside debt, and (iii) the relative success of stock market regulation, as opposed to reforms of creditor rights. We conclude that political explanations have more traction in explaining the case of India than do theories based on 'legal origins'.”

The paper also contains a useful background discussion about the development of various institutions in India’s business and financial sectors. These include the evolution and the roles of bodies like the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (BSE) as well as other self-regulatory bodies like the stock exchanges. The paper also offers some reasons why the capital markets in India have been growing at a fast pace and acquiring greater depth, while the debt markets (including for bank lending) have not been keeping the same pace.

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.)

Accounting for Derivatives Exposure

A recent announcement by the Institute of Chartered Accounts of India (ICAI) has added to the imbroglio over derivatives. Accounting Standard 30 (AS30) that deals with accounting for derivatives was to become mandatory with effect from April 1, 2011. However, the ICAI in an emergent decision has called for an early adoption of AS30 for financial statements as on March 31, 2008. Corporates not following AS30 are required to measure unrealised losses on financial instruments using principles of prudence explained in AS1. The Business Line has a report on the implications.

This appears to be a knee-jerk reaction to recent events and is likely to cause a stir among corporates in their year-end reporting. Business Standard has an editorial today that touches upon some of the issues:

“… The problem of course is that the directive has come on a week-end, with one working day left for the financial year to close for most companies. Saddling companies with a serious accounting change at the very end of the year has given them an unpleasant shock, and many of them will be scrambling to deal with this last-minute situation. This is not the way in which matters should be dealt with.

The new accounting directive should mean that all the facts will be known when the March accounts are reported, but shareholders may remain in the dark about the true dimensions of the potential problem. If some companies are tempted to take the view that many foreign exchange derivative contracts have maturity dates that are still in the future, and therefore they can legitimately take the view that until the stipulated date comes round, there are no losses to report. Since some of the affected companies have gone to court against the banks that sold them the derivative contracts, they will be taking legal advice on whether they have a strong case, and whether that gives them protection from “marking-to-market”.

Companies will be eager to look for such escape routes as the immediate disclosure of large exposures could endanger their relationships with other bankers and suppliers, with the attendant risk of credit drying up and affecting the running of the business. However, the accounting norms that have been introduced do not leave any room for such creative thinking. There is also the possibility that banks and companies will work out arrangements whereby existing derivative contracts are unwound, and replaced by new contracts that have an even longer maturity period. But even this will not prevent full disclosure to shareholders. In any case, such “ever-greening” of loans also runs the risk of increased exposure, and a bigger problem being bought for the future.”

Improving Stock Sales Practices of Intermediaries

Stock intermediaries around the world, such as brokers and sub-brokers, who recommend and sell securities to clients, are regulated by the securities regulatory agencies of the countries where they operate as well as the stock exchanges of which they are members. However, the stock intermediation industry has been facing several problems over the years on account of inappropriate business practices. These include acquisition of clients without following proper know-your-client (KYC) norms and peddling complex financial products (such as derivatives) to clients, particularly individuals, who do not possess sufficient sophistication to bear the high risk involved in such products.

Further, the stock analysts within these broking entities have been found to have conflicts of interest that impinge on their independence of analysis while providing recommendations to “buy” or “sell” a particular stock. In fact, a few years ago, the (now infamous) Eliot Spitzer, then Attorney General of New York State, prosecuted analysts for issuing rosy recommendations on Internet stocks that they themselves knew were not valuable, and forced settlements that ran into hundreds of millions of dollars. The problems associated with the action arose from the fact that many of these analysts that issued recommendations on companies were affiliated to investment banking arms that were taking those very companies to the public markets through IPO during the Internet boom, and that clearly constituted a conflict of interest.

Regulations regarding sales practices by brokers and analyst conflicts of interest have not been very stringent in India, as compared to more developed markets. However, that is likely to change with SEBI’s Proposed Policy for Improvement in Sales Practice by the Members of the Stock Exchanges that was issued yesterday. The policy document is available here.

Key measures proposed include strengthening KYC norms, sales practices, fair dealing with customers regarding derivatives or new financial products, tackling conflicts of interest and improving recordkeeping.

Comments are due on the proposal before April 15, 2008.

Inadequacies of the FII Regime

One of our guest contributors, Somasekhar Sundaresan, has a well-argued column in the Business Standard in which he calls for an overhaul of the regulations that govern foreign institutional investors (FIIs) in India. Here it is:

The regulatory regime for foreign institutional investors (FIIs) is the Indian capital market’s window to the outside world which often gives the first impression of how ugly or beautiful the house to which it belongs is.

This regulatory regime is in a shambles. Too much is cloaked in undeclared policy, and the administration of law can be unpredictable. Efforts to codify and streamline it have been initiated a few times, but the lack of attention to detail and general apathy to the needs of the market hurts this segment of capital market regulation.

The Indian rupee is not convertible on the capital account and India is still subject to exchange controls which are administered by the Government and the Reserve Bank of India. Not all persons resident outside India are freely permitted to trade in shares on the Indian stock market.

FIIs, as a class, are specially permitted to purchase and sell shares in India and move funds into and outside India at will. They are subjected to individual caps of 10 per cent ownership in any Indian company, and the aggregate FII holding in a company too is capped — in most sectors, it is linked to the level of the overall foreign holding permitted in the respective sectors.

The Securities and Exchange Board of India (SEBI) has been designated as the authority to register and regulate FIIs. The SEBI (Foreign Institutional Investors) Regulations, 1995 (FII Regulations), came to be notified by SEBI only in 1995, years after FIIs had set up shop.

The FII Regulations have hardly undergone any significant amendment to keep pace with developments. Amendments, too, have tended to merely take on board market realities and developments in the system — for example, several years after offshore derivatives instruments and participatory notes (ODIs) became well known, the FII Regulations provided a framework to regulate issuance of such instruments.

Over time, a range of internal policy developed within SEBI, often sporadically. For instance, SEBI took a position that stock broking firms would not be registered as FIIs. Also, it long held a view that any investor describing itself as a “hedge fund” would not be granted FII registration. However, the regulations did not provide for such preferences or ineligibilities. Therefore, the world does not entirely know what the position was. More recently, an unstated aversion to letting foreign companies register as FIIs has gained ground, but has not been codified into law. The FII Regulations even allow foreign individuals to get registered as FIIs. But SEBI does not even register individuals!

Last year, the policy around ODIs was revised and the board of directors of SEBI resolved to make several amendments to the law. This included imposing supply-side constraints on the ability of FIIs to issue such instruments by linking the aggregate size of such instruments to the size of investments of the respective FIIs in India.

The backlash to a consultative paper circulated by SEBI resulted in it taking notice of the slackness in the policy and announcing several measures to ease the registration process. However, nearly 6 months later, the FII Regulations remain untouched.

For instance, the policy decision taken last year was to state that an applicant for FII registration could have any individual investor to beneficially own up to 49 per cent of the fund. The FII Regulations continue to cap at 10 per cent, the maximum ownership that any individual investor could have in a fund, in order to qualify as a broad-based fund.

SEBI had wanted an FII to readily have information about the ultimate beneficial ownership of counterparties to its ODIs. Till date, this area has not been clarified.

Last month, this column spoke about the unsustainable ambiguity against non-resident Indians (NRIs) being occasioned by bad administration of FII Regulations. A provision that makes NRIs ineligible to be registered as FIIs is being cited internally to deny FII registration to funds managed by NRIs.

An amendment to the regulations to remove this prohibition is under consideration. Such an amendment is unnecessary — one does not need to amend the law to correct wrong administration of the law. SEBI has historically never asked FIIs to declare that its funds managers are not NRIs, and indeed, there are many registered FIIs that have NRI fund managers.

Another ambiguity is about whether a fund which is registered as an FII may raise funds from NRI investors. So long as the fund is broad-based, it should matter little who the money is raised from, with the exception of resident Indians. However, SEBI has singularly refrained from putting pen to paper and confirming this position.

The FII Regulations are the broken window of the Indian capital markets that projects a bad image of India to the international community. It is time to fix it.”

The list of problems with the FII regime goes on, and I suppose it is only the word-limit of the column that imposed constraints on Somasekhar.

The most important takeaway from this discussion is the need for precision in regulatory thinking and blemishless communication of the same through drafting. In the context of the FII regulations, their state of apathy due to flawed drafting was best described by Prof. J. R. Varma who commented: “The FII regulations are quite ambiguous. You could read it one way and think hedge funds are allowed, and read it another way and think they are not.” Financial market regulation cannot afford to carry such ambiguity.

At an overall level, it seems that with economic liberalisation in the early 1990s, two broad routes of foreign investment were envisaged, one being foreign direct investment (FDI) and the other foreign institutional investment (FII). The FDI route was tightly regulated and subject to stringent approval requirements, while FII investment under the portfolio route was allowed more freely. FIIs were also eligible to favourable tax treatment on capital gains compared to FDI investment. However, over the years, FDI has undergone sea change. FDI investment is now permissible in most sectors without prior approvals, and such investors can also exit through the stock market at prevailing prices. FDI taxation on taxation has also progressive reduced now making it on par with FII taxation. While the FDI route has been streamlined over time, the FII regulations have been left untouched, thereby largely obliterating the several advantages that were earlier available to FIIs. As Somasekhar has rightly argued, it is time that the FII regulations are also overhauled so as to deal with the dynamic financial environment affecting capital markets.

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.