India: Legal Risk of Entering Into OTC Derivatives Including Currency and Interest Rate Swaps in India

Last Updated: 29 November 2002
Article by Sandeep Parekh

Mr Sandeep Parekh is an Advocate, LL.M. (Securities and Financial Regulations), admitted to the New York bar. Visiting Faculty, Indian Institute of Management, Ahmedabad.

One of the largest risks in signing an over the counter ("OTC") derivatives contract is the uncertainty of the contract being declared void by a court. OTC derivatives contract exclude futures and options that are traded on stock exchanges or other exchanges. The exchange-based derivatives will soon be in the market and there are specific laws which will permit their trading. The Exchanges themselves have framed extensive regulations to regulate such trades and such derivatives contracts are outside the scope of this paper. OTC derivatives contracts are those derivatives contracts which are entered into between two (or more) parties, in other words they are traded by negotiated deals between the parties who are known as counterparties.. The rights of such parties would flow from the contract entered into between them. There are standardised international contracts which suggest standard documentation for entering into such documentation. Though there are hundreds of types of OTC derivatives we shall for the sake of clarity restrict ourselves to foreign currency swaps or interest rate swaps. Such swaps are permitted by the RBI but may fall foul of the Indian Contract Act 1872.

A swap is defined by the Encyclopaedia of Banking and Finance by Charles J. Woelfel (10th Ed.) as

"A financial transaction in which two counter-parties agree to exchange streams of payment over time according to a pre-determined rule. A Swap is normally used to transform the market exposure associated with a loan or bond borrowing from one interest rate base (fixed term or floating rate) or currency of [one] denomination to another."

Swaps are of two primary type (i) Interest swaps and (ii) Currency Swaps.

The RBI under its Exchange Control Manual ("ECM") expressly permits a foreign currency swap or an interest rate swap (presumably based on a foreign currency) if an authorised dealer in Foreign Exchange and another counterparty enter into it.

3C.8 (i) Authorised dealers may arrange foreign currency-rupee swaps between corporates who run exposures arising out of their long-term foreign currency commitments. Entities in the system who do not have any forex exposure but are willing to assume a forex liability in lieu of their long term rupee liability may also become counter parties in the arrangement. (Emphasis supplied)

(ii) Authorised dealers may enter into foreign currency-rupee swaps between entities to assist the exchange of such obligations between them and absorb the residual currency/interest mismatches within their open position/gap discipline.

NOTE: A Swap is a financial transaction in which two counterparts agree to exchange streams of payments or cash flows over a period of time with a view to achieving overall cost reduction for bother parties. Hence it is not the intention that authorised dealers should allow the swap route to become a surrogate for forward contracts for those who do not qualify for forward cover under paragraphs 3C.1, 3C.2 and 3C.6.

Thus under the ECM, it would be permissible to enter into a foreign currency swap with an authorised dealer without a foreign currency exposure.

The Indian Contract Act ("the Act") sings a different tune for entering into swaps. It may be mentioned that the Contract Act being a statutory Act overrides the Exchange Control Manual which are guidelines imposed by the RBI (which have the effect of law but are of inferior power and would be have to cede to a contrary statute in force). In case the guidelines clash with the Act, the Act would prevail. The guidelines cannot permit what the Act prohibits. S.30 of the Act of 1892, reads thus in so far as relevant:-

30. "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".

In Pollock and Mulla's Contract Act, (11th Ed., 1994, pages 478-469), "wager" is described thus: -

"What is wager? "A wager has been defined as a contract by A to pay money to B on the happening of a given event, in consideration of B paying to him money on the event not happening. But Sir William Anson's definition, "a promise to give money or moneys worth upon the determination or ascertainment of an uncertain event," is nearer and more accurate. To constitute a wager "the parties must contemplate the determination of the uncertain event as the sole condition of their contract. One may thus distinguish a genuine wager from a conditional promise or a guarantee". Anson, Law of Contract, 17th Ed., 221, 222)".

In Alamia v. Positive Government Security Life Assurance Co., (23 Bom 191 at pp 209-210) a case of life insurance, Fulton J. said:

"What is the meaning of the phrase "agreements by way of wager" in S. 30 of the Contract Act? ... Can it be that the words mean something different in India from what the corresponding words "agreements by way of wagering" mean in England? I do not see how such an argument can be maintained, or how the fact that the 14 Geo III c.48 is not in force in India affects the question. In Hampden V. Walsh Cockburn C. J. defined a wager as a contract by A to pay money to B on the happening of a given event in consideration of B paying money to him on the event not happening, and said that since the passing of 8 and 9 Vict. c. 109 there is no longer as regards action any distinction between one class of wager and another, all wagers being made null and void at law by the statute. In Thacker V. Hardy,, Cotton L.J. said that the essence of gaming and wagering was that one party was to win and other was to lose upon a future event, which at the time of the contract was of an uncertain nature; but he also pointed out that there were some transactions in which the parties might lose and gain according to the happening of a future event which did not fall within the phrase. Such transactions, of course, are common enough, including the majority of forward purchases and sales."

Wagering contracts may assume a variety of forms, and a type with which the Courts have constantly dealt is that which provides for the payment of differences in stock transactions, with or without colourable provisions for the completion of purchases. Such provisions, if inserted, will not prevent the court from examining the real nature of the agreement as a whole. (RE: Gieve, 1988. 1Q.B 794, C.A.) "The distinction is doubtless rather subtle, and probably lies more in the intention of the parties than in the form of the contract". (Trimble V. Hill, 1879, 5 A.C. 342 and Kathama Natchiilar V. Dorasinga, 1875, 2 I.a. 169, 186).

Speculative transactions must be distinguished from agreements by way of wager. "There is no law against speculation as there is against gambling. (J.H.Todd V. Lakshmidas, 1892, 16 Bom 441, 445-446).

In an article "Are Swaps Gambling Contracts? " by Gillian Hogarth (Baker and Mckenzie, London, June 1993), it is stated that there has always been a residual doubt as to whether a contract for differences, such as an interest rate or currency swap could constitute "Gaming or Wagering" contracts. The author resolves this doubt with the following statement:-

"the case of Morgan Grenfell & Company Limited V. Welwyn Hatfield District Council and Islington London Brough Council (as a third party) 30th April, 1993, in the Commercial Court before Mr.Justice Hobhouse, addresses this question. Mr.Justice Hobhouse handed down his decision on 30th April, 1993. He held that, whilst swap agreements had potentially speculative characteristics, for a contract to constitute a gaming or wagering contract by virtue of Sections 18 of the Gaming Act, 1845 and Section 1 of the Gaming Act, 1892, it must have been the intention of both, and not merely one, of the parties at the time of entering into the contract that the purpose of the transaction was to wager. If the transaction is entered into by parties or institution involved in the capital market and appears to be commercial or financial transaction with a potential for wagering, evidence must be adduced to rebut the inference that the transaction is commercial or financial one to which the law will give full recognition and effect."

For a contract to be void under Section 30 of the Act, there must be an absence of an underlying to the transaction. To quote Anson (p.280, 21st Ed), a recognised authority on Contracts Law: The parties must however contemplate the determination of the uncertain event as the sole condition of their contract and not as a mere incident in the larger transaction of a contract for the sale of goods on certain terms. To distil the law into a single sentence a wager requires a) speculation on both sides that would be determined by a future uncertain event b) absence of underlying c) settlement of differences by a set-off payment.

The ECM expressly by its terms permits entering into a currency swap so long as it is between a bank and a corporate and so long as there is an underlying transaction. By introducing an element of an 'underlying' to the swap, the RBI intended to bring the specified swaps out of the proscription of a wager as contained in Section 30 of the Indian Contract Act. By implication RBI admits that even foreign currency swaps are governed by the Indian Contract Act. If the contract is not a foreign currency swap it would not have the (express-but-limited) safe harbour of the RBI, but would be governed purely by the Indian Contract Act. The RBI permission to let entities enter into a currency swap without an actual currency exposure would similarly be regulated by the case law on wagering contract; which requires that the speculative intent of one party alone would be insufficient to strike down the contract as a wager. However a case where both parties intend merely to speculate, and since every swap contract is settled by differences and since the value of the swap would depend on a future uncertain event such contracts could potentially be declared void by a court of law.

Thus a limited class of people would potentially be faced with their swap contracts being declared void. It is thus extremely important for at least one party to demonstrate in the contract itself that the reason it is entering into the contract is more than mere speculation. It should narrate with all relevant facts how the swap is either a hedge or if it is speculative how it would be set off by say the party’s export obligations. To illustrate, Company X has substantial export orders and it enters into a swap agreement whereby it will be liable to pay Company Y if the rupee moves down in respect to the dollar. If the rupee moves down, company X would lose on the swap but would make more money on account of increased revenues on the export front thus creating a matched books effect, or a hedged position in net.

If either or both parties do not so do, it would be upon the court to infer the intent of both the parties. At the end of the day the party which is the net creditor on the basis of the swap undergoes a risk of a legal default, which it could have easily avoided by mentioning the lack of speculative intent in the swap contract itself. If the loss is very substantial, the debtor party may find it economically feasible to challenge the legality of the contract even if it knew that it did not have any speculative intent when it entered into the contract.Conducting or engaging in the business of swaps is a lawful and legitimate part of the activities of financial institutions. The object of such transactions is not to wager but to insure the possible loss occasioned by fluctuations in interest rates or variation in the rupee value. A certain amount of speculation is involved in these transactions but all speculation is not wager. Speculation too is not implicated by the prohibition on wagering, only speculation which is capable of being set off and which has no underlying, in other words a mere bet on a future event would be prohibited. A swap by definition involves a set-off of payments, however a set-off which will create a hedge would not be speculative and therefore legitimate. This is reinforced by the fact that RBI (by the ECM) permits certain swaps which obviously are not illegal under the Contracts Act. If forex swaps are legal under the Contract Act, there appears no reason why interest swaps or other OTC derivatives would be hit by the wager prohibition, of course subject to the limitations already discussed above.

The author is an Advocate based in New Delhi.

This article is for general informational purposes only and does not represent our legal advice as to any particular set of facts.

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