The lit fuse on a derivatives time bomb in India is getting shorter.
It appears that hundreds of Indian companies that bought these complex cross-currency options and structured products to seemingly protect themselves from foreign exchange risk are now staring at significant losses. And many of them are starting to cry foul.
As a result, banks that sold such products are gearing up for legal battles with clients turned adversaries, predominantly small and medium Indian companies, many with unsophisticated internal risk management practices, who are questioning the very legality of such products.
On one side of this battle are some of the fastest growing and most aggressive banks in India—Yes Bank Ltd, Kotak Mahindra Bank Ltd, Axis Bank Ltd, ICICI Bank Ltd, HDFC Bank Ltd, among others—and powerful law firms, such as Amarchand and Mangaldas and Suresh A Shroff and Co., and AZB and Partners.
(Clockwise from top left) K.V. Kamath’s ICICI Bank; Uday Kotak’s Kotak Mahindra Bank; Aditya Puri’s HDFC Bank;Rana Kapoor’s Yes Bank; and P.J. Nayak’s Axis Bank are some of the big derivatives sellers in India
Arrayed against them are a growing list of small companies, some publicly traded, as well as the well-regarded law firm of J Sagar Associates, a crack team of investigators at auditor KPMG and independent consultants such as A.V. Rajwade, perhaps India’s leading expert when it comes to derivatives.
Because Indian accounting laws do not require companies to report notional losses on account of derivatives contracts, details of losses are just beginning to come in. Experts say that many companies are aware of the losses—indeed, in several cases, the chief financial officer (CFO) has been quietly axed—but will only report them in coming quarters on closing out their contracts.
The implications are significant for companies that have resorted to such instruments to hedge their foreign exchange exposure as well as for a country that considers itself insulated against most global financial risks.
The banks and their lawyers claim the derivatives—a financial term used to describe an instrument whose value is a function of an underlying commodity, bond, stock, or currency (also simply called underlying) and which is used as a risk management and mitigation tool—are legal.
Lawyers and consultants advising the affected firms say the products that were sold violate the country’s Foreign Exchange Management Act, which regulates all foreign currency transactions, and the Reserve Bank of India (RBI) guidelines. At the core of the battle is a debate over whether these were sold for hedging or speculation.
Law firms that Mint spoke to say that at least six companies have filed suits in various courts across India and add that many more such cases are on their way.
The issue first came to light in late November when software firm Hexaware Technology Ltd announced that it had made provisions of $20-25 million (Rs78.8-98.25 crore then) to cover exposure from unauthorized deals entered into by an employee that involved derivatives. The company later reported a net loss of Rs81 crore for the quarter ended December after the actual damage on account of these transactions ended up being Rs103 crore.
Among the companies that have hired law firms to battle the banks are Sundaram Brake Linings Ltd, Rajshree Sugars and Chemicals Ltd and Sundaram Multi Pap Ltd, according to bankers and law firms.
Among foreign banks, Citi is a major player in the derivatives market. Deutsche Bank AG, Standard Chartered Bank and Barclays Bank Plc. have also sold their share of derivatives as have some large and mid-sized public sector banks.
According to Berjis Desai, managing director of J Sagar Associates, whose firm is advising around a dozen affected companies, such transactions are worse than betting on horse races or playing slot machines in Las Vegas.
“Banks can say that the contracts are fine but, under section 30 of the Indian Contracts Act, wagering is not permitted. Nobody can punt on any currency under RBI norms,” Desai said, adding that his clients had entered into such transactions with ICICI Bank, Axis Bank and Yes Bank.
Cyril Shroff, managing partner of Amarchand and Mangaldas and Suresh A Shroff and Co., said there is enough jurisprudence on derivatives contracts all over the world and they are not wagering contracts.
“Firms are coming up with specious arguments to get out of genuine obligations,” added Shroff, who has been advising several banks. Zia Modi, senior partner of AZB and Partners was not immediately available for comment.
The derivatives involved include swaps and options that are a sort of insurance that firms with exposure to dollars or other currencies buy as a protection against any adverse movement in these currencies that can hurt their income (for exporters) or increase their liabilities (for those companies that have borrowed overseas).
Theoretically, a swap is a financial transaction in which two counterparties agree to exchange a stream of payments over time at an agreed price. An option is an agreement between two parties in which one grants to the other the right to buy or sell an asset under specified conditions. Thus, in case of a currency swap, both parties have the right and obligation to exchange currencies. And in the case of options, the buyer has the right but no obligation and the seller, the obligation but not the right to exchange currencies.
Bankers claim there is nothing wrong in such transactions. “Both the buyer and the seller understood the products well but who would have anticipated that dollar would touch 100 yen? It’s a black swan phenomenon...,” said Dipak Gupta, executive director, Kotak Mahindra Bank.
A black swan is a large-impact, hard-to-predict and rare event beyond the realm of normal expectations.
According to Yes Bank’s managing director Rana Kapoor, banking is all about taking calculated business risks and regardless of current market conditions, corporations will continue to use derivatives contracts to manage their market risks.
“Hedging is all about reducing the price risk—not making or saving money. But what these banks enticed these firms into is speculation. This is taking risk to make profits,” said Rajwade, a reputed risk management consultant, whose firm AV Rajwade and Co. has been advising about a dozen small and medium firms that collectively have already reported estimated losses in excess of Rs300 crore arising from their exposure to derivatives.
Deepankar Sanwalka, head of the forensic wing of audit and consultancy firm KPMG India, too, said some of these transactions are in violation of RBI’s derivatives guidelines. “The issue is not as simple as some of the banks are projecting. The documentation of such contracts is not always watertight and if the firms decide to go to court, the contracts can be null and void,” added Sanwalka, who has so far investigated at least two firms that have faced around Rs200 crore of losses on account of their exposure to derivatives. One of them is Hexaware. While Shroff said that all contracts are backed by genuine underlying transactions, Desai of J Sagar Associates claimed there is no underlying transaction for some of the deals that his firm has investigated.
There are two sets of RBI guidelines that banks, consultants and lawyers swear by— comprehensive guidelines for derivatives, a 30-page document, dated 20 April 2007, and a 53-page master circular of risk management and inter-bank dealings, released on 2 July 2007.
According to Alpana Killawala, RBI spokesperson, RBI insists that such transactions must be “suitable” and “appropriate” for the end users. Besides, every derivatives contract must have an underlying transaction. RBI norms also say that when firms enter into such derivatives contracts to reduce their costs, such transactions must not increase “risk in any manner” and should not “result in net receipt of premium by the customer.” RBI itself isn’t conducting a special or separate investigation into the role of banks in the losses some companies have incurred, said Killawala. However, the Indian central bank’s annual inspection exercise is on a high alert for such deals.
Desai of J Sagar Associates alleged that banks have paid premium to these firms upfront to entice them. “Typically, they are paid $100,000 upfront but such payments are not shown as premium...,” he added.
In private, some bankers admit that there could be a few firms that used the same “underlying” for many derivatives transactions that they have entered into with different banks without their (the banks’) knowledge but they vehemently contest allegations of mis-selling. “Every phone call made from our treasury is recorded. You can hear the tape and decide whether we enticed them,” said the CEO of a private bank who did not wish to be named.
Kotak Mahindra’s Gupta said that all derivatives contracts of the bank follow the International Swap Dealer Association (Isda) guidelines. Paresh Sukthankar, executive director of HDFC Bank, said: “We proceed only after getting the board resolution from a firm and a confirmation that their risk management policy is in place.” HDFC Bank also follows Isda norms.
Citibank said it ensures that its clients are provided with adequate scenario analysis and risk disclosures. “We always focus on the ‘suitability’ and ‘appropriateness’ procedures that covers the client’s underlying business model, nature of underlying exposures, sophistication of the management in understanding derivatives, company’s experience in using derivatives in the past and levels of decision making within the company and authorization for transacting derivatives,” said Sanjay Nayar, CEO, Citi India.
Bankers blame the dollar’s weakness against global currencies for the turn of events. Over the past year, the euro has appreciated 17.8% against the dollar, yen more than 16%, and Swiss franc (SF) some 21%, making most of the bets against currency movement go horribly wrong. Thus, a company that transformed its dollar liability into a yen or SF liability through complex derivatives faces significant losses. Typically, these have “knock-out” and “knock in” clauses. While these options protect a firm’s yen or SF exposure against dollar depreciation, this is only till a certain level; once the dollar’s weakness crosses this, the “knock-out” clause is triggered, leading to losses. Similarly, if the dollar rises and touches the “knock in” level, the customer makes money. As the dollar continues to depreciate, losses increase, and companies can either terminate the deals midway or wait till they are mature, hoping that by that time the currency movement would have been reversed.
Accounting norms are not very clear whether Indian firms need to book the notional losses, known as mark-to-market (MTM) losses. No one is sure about the quantum of total MTM losses at this point. The figures floating in the market for such losses are between $2 billion and $7 billion. KPMG’s Sanwalka put the MTM “hole” in corporate balance sheets at around $2 billion. Kotak Mahindra Bank’s Gupta said it could be between $2.5 billion and $3 billion but added that they are “not losses”. Market estimates put MTM losses for Axis Bank’s customers at around Rs400 crore and that for Kotak Mahindra’s around Rs600 crore.
No more option selling
Kotak Mahindra Bank stopped selling such products in November. And other banks said that firms’ appetite for such products has gone down. Risk management consultants, however, said the demand was never there and banks led the firms up the garden path. “Banks have sold structured proprietary products where pricing is non-transparent and risk less than transparent. Globally, banks like complex options as their margin is high,” said Rajwade. Desai of J Sagar added that banks normally target small and medium enterprises (SMEs) to sell such products as these firms are not treasury savvy. Shroff of Amarchand and Mangaldas strongly refuted the allegation of mis-selling. “They were not sold to retail customers...sophisticated treasury managers have bought them.”
Partha Mukherjee, treasury head of Axis Bank, said exposure of the SME clients of banks to such products is insignificant. HDFC Bank said it has not sold any complex structured products to small firms. According to Citibank’s Nayar, Citi’s overall derivatives exposure across SME clients actually favours the clients.
Interestingly, no bank wanted to talk about the court cases. Kotak Mahindra, which had sold the derivatives to Hexaware, settled its dispute with the company by sharing the loss. Meanwhile, to cut losses some of the foreign banks are advising their clients to get into new contracts by shifting currencies. And the more conservative Indian banks are cutting the losses by closing the contracts. “I have cut 120 option contracts in the past few months,” said the chairman of a large public sector bank who did not wish to be identified. According to bankers, the companies need not worry too much at this point as every thing is not lost.
“Accounting norms do not require corporations to MTM their foreign exchange contracts. Hence, clients would need to pay as per the maturity of these transactions and not immediately,” said Chanda Kochhar, joint managing director, ICICI Bank. Accounting Standard (AS) 30 comes into effect in 2011 and till such time, firms are not required to book their derivatives losses. However, Sanwalka of KPMG said that if the derivatives losses are speculative in nature, firms need to book losses immediately. Both Rajwade and Desai say potential losses of some of the firms have already wiped out their entire net worth. Historically, losses for Indian banks on foreign contracts have been insignificant, but if some companies go bankrupt on account of this, banks will be badly hit as they run the risk of credit defaults.
Under the law, Indian banks cannot have a naked exposure to cross-currency derivatives. This means all cross-currency options and swaps of their customers are hedged back-to-back with the same tenure and amount with foreign banks. So, if a company defaults, banks will have to pay up to settle the contracts with counterparties. “The litigations may continue for five years even after the expiry of the contracts. If the banks need to settle such contracts on their own, their profitability will be hit,” said Sanwalka.