The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.
With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-
A Derivative includes: -
- 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;
- a contract which derives its value from the prices, or index of prices, of underlying securities;
The earliest derivative transactions started off as producers of commodities protecting themselves against future price fluctuations of the commodity they produce. This was a derivative contract in its most rudimentary form. Since then derivatives have become the rage in Western Financial Markets. However, instead of controlling risks derivatives have been the cause of many disasters and bankruptcy including the centuries old Barings Bank of England, Enron, Societe General of France. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's annual report calling them financial weapons of mass destruction.
In India, this kind of trading was regulated through an RBI notification in 2007. It allows trading in derivatives only when there is a genuine underlying exposure to risk. One can enter into derivative contracts only with Authorised Dealers (AD) under the FEMA, 1999 and only in transactions that it permits.
No Risk or More Risk
It has been mentioned before derivatives are meant to be an insurance against possible losses in the future, so why is it that something that is meant to hedge risks creates more risks. Derivatives (especially swaps) expose investors to counter-party risk. This is due to the fact that the nature of the transaction is such that one party takes on another’s exposure to risk.
Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments.
The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. The SEBI had set up the Varma Committee with a view to examine the reduction of risks in such derivative transactions. It has been said under the heading "legal issues" in the same report that
"Some members expressed the concern that certain legal opinions seem to be suggesting that mere declaration of cash settled futures as securities under SC(R)A would not put them on a sound legal footing unless the provisions of the Contract Act were either amended or explicitly overridden. Some court judgements in foreign countries were said to be extremely worrying in this regard"
The main problem with derivatives in India right now is that due to lack of information about them, banks often enter into contracts with companies which are not usually in consonance with RBI and SEBI guidelines, which seem to advocate more or less the position in the Indian Contract Act being referred to in the above quote which is that all contracts based upon an uncertainty are unenforceable in law.
Though there is not much case law in this regard, the researcher believes that the RBI and SEBI guidelines are such that they incorporate derivative transactions into the Indian capital markets without any contradiction with the Indian Contract Act. However, the same cannot be said of the actual transactions being entered into by banks and companies. The following is an examination of whether companies which innocently enter into illegal and risky contracts have a remedy in criminal law and whether as per Indian law such conduct of banks could be considered an economic offence.
Indian Law – The Response to Derivatives
The former Revenue Secretary, Government of India, Mr D. Bandopadhyay, at a recent workshop in Kolkata on `Formulation of new Economic Offences Code for India' at the West Bengal National University of Juridical Sciences campus, said, "the intertwining of corporations, accounting & law firms, and banking institutions on the stock exchanges would constitute a vast and complex subset of the universe of economic offences, and this would be a very difficult area to legislate upon and implement."
The Malimath Committee has proposed a definition for economic offences. The salient features of this definition are that it should be an illegal act, committed through misrepresentation or outright deception, by an individual or group, with specialized skills whether professional or technical, with a view to achieve illegal financial gain, individually or collectively.
In India, this kind of trading was regulated through an RBI notification in 2007. It allows trading in derivatives only when there is a genuine underlying exposure to risk. One can enter into derivative contracts only with Authorised Dealers (AD) under the FEMA, 1999 and only in transactions that it permits. This is subject to further conditions some are:
- The AD Category I bank through verification of documentary evidence is satisfied about
the genuineness of the underlying exposure (that is one must be exposed to some risk which one
wishes to avoid), irrespective of the transaction being a current or a capital account transaction.
Full particulars of the contract should be marked on such documents under proper authentication and
copies thereof retained for verification.
- The maturity of the hedge does not exceed the maturity of the underlying transaction
The contravention of this RBI notification is an offence as per Section 58B of the RBI
Act 1934 punishable with fine of Rs. 1000 for each day that the offence continues.
It may lead to liability under the FEMA,1999 as section 10 (4) and (5) make it necessary
that all RBI notifications issued from time to time must be complied with by authorised Dealers.
The nature of derivatives is such that it is in the form of insurance, and as long as there is an underlying exposure, the risk can be validly insured against. When the underlying exposure is minuscule or absent as compared to the gains to be made, the contract in Indian law is hit by Section 30 of the Indian Contract Act, which prevents wagering agreements.
A SEBI circular SEBI/ IMD/CIR No. 4/2627/ 2004 with regard to stocks lays down "The guiding principle while initiating any derivatives position shall clearly be ‘hedging’ or ‘portfolio balancing’. At no point in time the derivative position shall result, even for a few moments on an intra-day basis, in actual or potential leverage or short sale / short position on any underlying security." It also makes it an obligation on the Bank to disclose the position to the investors.
The violation of this will lead to criminal charges as per the recently amended Securities Contract Regulation Act, 1956 which under Section 18A says that only those derivative contracts are valid which are traded in accordance with the rules of the stock exchange. Section 23 provides that any contravention of this section is an offence punishable with upto 1 year imprisonment, or fine or both. These offences are cognizable under the Criminal Procedure Code per Section 25 of the SCRA, 1956.
In India, speculative practices have always been viewed with skepticism. Section 30 of the Indian Contract Act makes all agreements which are in the form of a wager illegal. Derivatives transactions, though they are meant to be contracts of insurance, often assume a purely speculative nature. An example would be traders who engage in short selling activities. Short selling activities means the transferring of certain property (usually securities) which do not belong to ones self to another person at current market prices, in the hope that market prices for that commodity will fall in the future, when the transferor may exercise his call option and buy back those securities, and make the difference between market price at time of sale and buy back as profit.
SEBI regulations strictly prohibit these activities as the transferor here is engaging in a purely speculative transaction. He does not own the shares himself and therefore is exposed to no risk of falling market prices for those shares. He only bets that the market price will fall in the future. He has no insurable interest in the whole deal and therefore his activities constitute an offence under the SEBI regulations.
All regulations from the SEBI and the RBI are majorly centered on ensuring that derivatives contracts remain insurance contracts and do not become merely speculative transactions. Most of the regulations place a high importance on ensuring that there be an underlying exposure to risk or insurable interest, which the derivatives contract will hedge against. If no underlying exposure to risk can be shown, then the promisor (which is an authorised dealer under the meaning of the FEMA) will be faced with criminal penalties.
Without an insurable interest or in the case of derivatives contracts, an underlying exposure to risk, contracts will be hit by section 30 of the Indian Contract Act and will become unenforceable, causing parties involved in the transaction great losses. To ensure that parties do not engage in such risky activities, the SEBI and RBI have gone ahead and imposed criminal penalties over the civil liability to act as an extra deterrent.
The researcher believes that the violation of SEBI and RBI regulations of derivatives comes under the term economic offences as formulated by the Malimath Committee Report. To explain this, the researcher shall rely on a real life example, of an Indian case that is sub judice before the Calcutta High Court, though the case is civil in nature, the violators may face criminal penalties also. The plaintiff is a company that was induced into entering a contract of Foreign Exchange Linked Derivatives, where they had no exposure to fluctuations in Foreign Exchange. The Bank did not disclose to the company that purely speculative transactions in India are prohibited as per the RBI guidelines and cannot be enforced as per the Indian Contract Act. If we analyze the case, the five requirements are met as:
- The act being committed is illegal as per the SCRA and the RBI Act,
- The act involves misrepresentation and fraud, as the legal requirements of
contract needing to be unspeculative and a genuine exposure to risk were not disclosed to the company
- As earlier stated, derivative transactions require specialized skill and knowledge
of the financial markets on the part of the bank which the company could not ordinarily be expected to have,
- The objectionable conduct is on the part of the Bank, which qualifies as "group" under the proposed definition
- And lastly, these activities were done with a view to pecuniary gain.
Thus, the violation may be viewed as an economic offence.
The term ‘economic offence’ has got little statutory mention, however, in the Securities and Exchange Board of India (Intermediaries) Regulations, 2007 economic offences has been defined in the definitions section as
(h) "economic offence" means an offence….under the Act or the Securities Contracts (Regulation) Act, 1956 or the Companies Act, 1956
However, to gain a general understanding of the term however, we may look to the Malimath Committee Report.
Derivatives Transactions are meant to hedge against risks, instead they have been the downfall of many a mighty financial institution or corporation. So where are we going wrong? The problem is that the concept of insurable interest seems to be disappearing from derivatives transactions, which renders these transactions purely speculative. Derivatives transactions can cause huge losses and gains in very little time, a feature that makes it both very attractive to investors and also fatal to the economy.
The Indian legal system seems to have understood this problem and therefore has made the requirement of insurable interest crucial to these transactions. Banks are responsible to see that an underlying exposure to risk exist, and must document this exposure for verification by authorities. According to the researcher, violations constitute an economic offence and attract penalties of imprisonment and fine.
However, many investors do not have adequate information about this new kind of financial transaction and fall into the traps laid by banks who often mislead them into betting large sums of money on speculative transactions. Thus the responsibility of disseminating more information about these financial instruments lies on stock exchange regulatory authorities as well as the central bank.
PRACHI JHUNJHUNWALA is third year student pursuing B.A.LL.B (hons) from the W.B. National University of Judicial Sciences, Kolkata.