Post by Sapphire Capital on Jul 24, 2008 3:22:05 GMT 4
Derivatives Loss: Litigation is not the best solution
23 Jul, 2008
Abraham Lincoln once said: “Discourage litigation. Persuade your neighbours to compromise whenever you can.” Ambrose Bierce, the American satirist, more colourfully described litigation as “a machine, which you go into as a pig and come out of as a sausage”. If some companies had read what these two had to say, they may not have taken their banks to court on the derivatives issue.
One is at loss to understand why so many people have decided to look for solutions in the courtrooms. There are no precedents to fall back on and some structures are so complex that it would be difficult for a court to immediately spare enough time to get into the nitty-gritty. The whole process can drag on and it may be months or years before matters are resolved.
Obviously, in some cases, filing a case is just a strategy to buy time to postpone paying up what is due to banks, which have no choice but to cough up the money on due dates to their overseas counterparts. Companies, which had earlier collected the profits when the structures were in the money, have a very weak case now. How can a transaction, which was perfectly legal for a part of its life, suddenly become illegal?
Most customers have signed all the documents placed before them by the banks, presumably with their eyes wide open. How can a party to deal, who declared that he understood all aspects of the transaction and the risks attached, drag the counterparty to court when the documented evidence points to them being willing parties to the transaction?
Then, there is the argument that the transactions are not valid because they violate the Exchange Control Law, the basic requirement of which is that a company can enter into a forex derivative contract only to hedge an underlying risk. It means that if you are not exposed to risk due to a normal business transaction, you can’t buy a derivative.
Customers are required to prove to banks that they do indeed have an underlying risk and banks have to ensure that the risk exists. There is a view that, if there is no underlying risk, the derivative becomes a wager, and the derivative contract is, therefore, illegal and void. However, in such cases, while the bank has slipped in not verifying the facts, the customer is guilty of false representation, which is certainly the graver offence.
Non-compliance with prudential guidelines of the Reserve Bank is also cited as a reason for questioning the validity of the transactions. The comprehensive guidelines on derivatives issued by the department of banking operations and development on April 20, 2007, define what a ‘derivative’ is and explain what a ‘hedge’ is. (Incidentally, none of the enactments relating to banking define ‘hedge’). These guidelines also leave no doubt with regard to ‘suitability and appropriateness’.
However, there are two views on ‘guidelines’. One is that, unlike ‘directives’, ‘regulations’, and ‘rules’, which have the force of a law behind them, guidelines are more advisory than mandatory. A wise banker will not differentiate and would take even a suggestion or a hint from the central bank as mandatory; but it is possible that others may go by the letter of the law.
Some people point out that the covering letter to the above-mentioned guidelines ends with the sentence “Guidelines, in respect of foreign exchange derivatives, will be issued separately” and therefore, these guidelines, even if they are mandatory, do not apply to forex derivatives. While prudence tells us that these guidelines are valid for all kinds of derivatives, a few could believe that there is no legal compulsion in respect of foreign exchange derivatives. (An existing master circular issued earlier by the foreign exchange department covers exchange control aspects relating to forex derivatives).
The real aggrieved parties, in this mess, are the shareholders of the companies, which have indulged in currency trading and the more dangerous game of trading in derivatives and lost large amount of money. They may feel justified in taking the managements to court. Some banks may feel, with some justification, that some of these companies have sullied their reputations by taking them to court and generating bad press. The wise thing to do now, for all concerned, is to take Abraham Lincoln’s words seriously.
(Former Dy Controller, RBI, and Chennai-based forex consultant)
23 Jul, 2008
Abraham Lincoln once said: “Discourage litigation. Persuade your neighbours to compromise whenever you can.” Ambrose Bierce, the American satirist, more colourfully described litigation as “a machine, which you go into as a pig and come out of as a sausage”. If some companies had read what these two had to say, they may not have taken their banks to court on the derivatives issue.
One is at loss to understand why so many people have decided to look for solutions in the courtrooms. There are no precedents to fall back on and some structures are so complex that it would be difficult for a court to immediately spare enough time to get into the nitty-gritty. The whole process can drag on and it may be months or years before matters are resolved.
Obviously, in some cases, filing a case is just a strategy to buy time to postpone paying up what is due to banks, which have no choice but to cough up the money on due dates to their overseas counterparts. Companies, which had earlier collected the profits when the structures were in the money, have a very weak case now. How can a transaction, which was perfectly legal for a part of its life, suddenly become illegal?
Most customers have signed all the documents placed before them by the banks, presumably with their eyes wide open. How can a party to deal, who declared that he understood all aspects of the transaction and the risks attached, drag the counterparty to court when the documented evidence points to them being willing parties to the transaction?
Then, there is the argument that the transactions are not valid because they violate the Exchange Control Law, the basic requirement of which is that a company can enter into a forex derivative contract only to hedge an underlying risk. It means that if you are not exposed to risk due to a normal business transaction, you can’t buy a derivative.
Customers are required to prove to banks that they do indeed have an underlying risk and banks have to ensure that the risk exists. There is a view that, if there is no underlying risk, the derivative becomes a wager, and the derivative contract is, therefore, illegal and void. However, in such cases, while the bank has slipped in not verifying the facts, the customer is guilty of false representation, which is certainly the graver offence.
Non-compliance with prudential guidelines of the Reserve Bank is also cited as a reason for questioning the validity of the transactions. The comprehensive guidelines on derivatives issued by the department of banking operations and development on April 20, 2007, define what a ‘derivative’ is and explain what a ‘hedge’ is. (Incidentally, none of the enactments relating to banking define ‘hedge’). These guidelines also leave no doubt with regard to ‘suitability and appropriateness’.
However, there are two views on ‘guidelines’. One is that, unlike ‘directives’, ‘regulations’, and ‘rules’, which have the force of a law behind them, guidelines are more advisory than mandatory. A wise banker will not differentiate and would take even a suggestion or a hint from the central bank as mandatory; but it is possible that others may go by the letter of the law.
Some people point out that the covering letter to the above-mentioned guidelines ends with the sentence “Guidelines, in respect of foreign exchange derivatives, will be issued separately” and therefore, these guidelines, even if they are mandatory, do not apply to forex derivatives. While prudence tells us that these guidelines are valid for all kinds of derivatives, a few could believe that there is no legal compulsion in respect of foreign exchange derivatives. (An existing master circular issued earlier by the foreign exchange department covers exchange control aspects relating to forex derivatives).
The real aggrieved parties, in this mess, are the shareholders of the companies, which have indulged in currency trading and the more dangerous game of trading in derivatives and lost large amount of money. They may feel justified in taking the managements to court. Some banks may feel, with some justification, that some of these companies have sullied their reputations by taking them to court and generating bad press. The wise thing to do now, for all concerned, is to take Abraham Lincoln’s words seriously.
(Former Dy Controller, RBI, and Chennai-based forex consultant)