Mumbai: A few Indian banks, which are facing lawsuits from former corporate clients who bought complex cross-currency options and structured products to hedge against currency fluctuations and ended up making significant losses, are planning to make the Reserve Bank of India (RBI) a party to such cases.
These banks, none of them is willing to talk publicly because of the sensitivity of discussing their regulator, say they firmly believe the derivatives contracts that were sold have the overall sanction of the Reserve Bank of India Act, which was amended in 2006.
The amended Act defines a “derivative” as an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate and other securities including interest rate swaps, forward rate agreements, foreign currency swaps and options.
“Effectively, derivatives of such nature as permitted by RBI are valid—and not void—if one party to the derivative is an authorized dealer (bank),” maintains H. Jayesh of Juris Corp., a law firm that is giving legal advice to many banks. Incidentally, the firm also assisted RBI, India’s banking regulator, in drafting the amendment to the Act and is a legal adviser to the Fixed Income Money Market and Derivatives Association of India (Fimda) and the International Swap Dealers Association (Isda).
However, one law firm that is advising some of the companies in their legal battles against the banks over these derivatives isn’t buying the idea of RBI becoming a party to the suits.
“These are contracts between banks and corporations to which the regulator is not a party. Hence, RBI is neither a necessary nor a proper party in any such legal proceedings between the bank and the corporations. This is an attempt to confuse the firms,” insists Berjis Desai of J Sagar and Associates, a prominent legal firm that is advising a few companies on such cases.
According to him, if RBI is allowed to become a party to such cases, it will have a chilling effect as the companies, most of which are small and medium enterprises, will think twice before filing civil suits against any banks “in the belief that they may antagonize the RBI.”
Mint first reported on 17 March that many banks, which sold derivatives within India in the past few years, are gearing up for legal battles with their clients who are now questioning the legality of such products.
On the one side of this battle are some of the fastest growing new private banks in India: Yes Bank Ltd, Kotak Mahindra Bank Ltd, Axis Bank Ltd, ICICI Bank Ltd, HDFC Bank Ltd, and their lawyers, such as Amarchand and Mangaldas and Suresh A Shroff and Co., AZB and Partners and Juris.
Fighting them are a growing list of small and medium firms, J Sagar, the forensic division of audit and consultancy firm KPMG India, and independent risk management experts such as A.V. Rajwade, perhaps India’s leading expert on derivatives.
At the core of the battle is a debate whether these products were sold for hedging or speculation.
Lawyers for the banks say they are convinced that these contracts are enforceable, unless they violate the Foreign Exchange Management Act, or Fema, guidelines.
The penalty for those violations can be up to three times the sum involved, or Rs2 lakh if the sum involved is not quantifiable. Lawyers opposing the banks note that no Indian court of law can render assistance to a party, which seeks to enforce a contract that violates Indian exchange control laws.
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. They will show such loss as a contingent liability or even make provisions in their books.
“As soon as a corporate files such a suit against the bank, the bank will be compelled to unwind the trade and immediately pay to the bank’s counterparty on the back-to-back contract... It is anybody’s guess as to how many years it will take before such a complex claim is finally decided as firms can go up to the Supreme Court,” says Desai of J Sagar.
Whether RBI can actually be made a party to such cases is not the only bone of contention between the banks and the companies involved. Lawyers representing these banks are also challenging the view of the companies that RBI’s comprehensive guidelines for derivatives, dated 20 April 2007, and the master circular of risk management and inter-bank dealings, released on 2 July 2007, are the last word on such contracts.
According to one such lawyer, these regulations are effectively RBI’s general permission under Fema and do not “in any manner undo or negate the effect of Chapter IIID of the amended RBI Act” that permits derivatives transactions.
“The master circular and the comprehensive guidelines tell banks how to make markets, manage their risk and procedure to be followed when transacting with a firm while the RBI Act specifically says what one can do in the derivatives market,” said one lawyer of a prominent firm that is advising the banks.
“Economically, not hedging a risk is also speculation. It means that you are taking a view on the currency or interest rate you are exposed to that it will not move at all adversely to you. Also even if exposure is to one currency or type of interest rate, contracting in what appears to be unrelated currencies or interest rates, is nothing but transformation of risk. There is nothing wrong with taking such a view,” said Juris’ Jayesh.
The legal firms that are advising corporations, however, insist that the amended RBI Act does not give permission to banks to, what they claim, indulge in speculation in the derivatives market.