High court upholds legality of derivatives


In one of the first cases of its kind in India, it was recently held by the Madras High Court in Rajshree Sugars and Chemicals Limited v AXIS Bank Limited that derivative contracts could not be considered illegal and opposed to public policy.

The plaintiff, Rajshree, a listed company, is engaged in the manufacture and export of sugar to foreign countries, and as an exporter and borrower had both receivables and payables in foreign currencies. In order to hedge the risk of fluctuating foreign currency exchange rates, on 14 May 2004 Rajshree entered into an International Swaps and Derivatives Association (ISDA) master agreement with UTI Bank (now Axis Bank).

Pursuant to the ISDA agreement, 10 deals were struck between the parties, of which nine had already matured at the time of the dispute arising in relation to the 10th deal. The defendant, Axis, paid US$100,000 to Rajshree on that deal. Six months later, Rajshree sent a letter repudiating the contract with no liability to either of the parties. Axis replied, challenging the claim and contending that the contract was still alive and that it was prepared to work out suitable risk mitigation structures.

Rupees_blurredRajshree argued that it was not bound by the deal, which it claimed to be void from the beginning, illegal, a violation of the Reserve Bank of India (RBI) guidelines, opposed to public policy and unenforceable. Rajshree alleged that Axis had “lured” it to enter into such an exotic contract “with misrepresentations and false promises”. Rajshree sought an interim order of injunction, restraining Axis from initiating any proceedings to recover any amounts it had paid. Rajshree also sought an order directing Axis to deposit all the papers and proceedings relating to the contract, including the transcripts of any tape-recorded conversations, to the court registry.

The primary question was whether the deal could be rejected on the grounds that (a) it was nothing but a “wagering contract” as defined by section 30 of the Indian Contract Act, 1872; (b) it was not supported by an underlying exposure and hence violated the master circulars and the regulations issued by the RBI, and was consequently affected by section 23 of the Indian Contract Act, 1872, and (c) when the whole contract was vitiated and unenforceable, the bank was not entitled to claim any rights under it.

Dismissing the civil suit filed by Rajshree and rejecting all its claims, the high court held that the transaction in question, by its very nature, could not be termed a wager. Although every wagering contract is speculative in nature, every speculation need not necessarily be a wager. Three tests are to be satisfied to determine whether a contract is to be termed as a wager: (a) there must be two individuals holding opposite views regarding an uncertain future event; (b) one of those parties is to win and the other is to lose upon the determination of the event, and (c) both parties should have no actual interest in the occurrence or non-occurrence of the event, but should have an interest only in the stake.

In the present case, the first test is satisfied as there are two parties involved. However, the second test may not be satisfied, since the plaintiff may not always stand to lose. If Rajshree lost in the underlying contract on account of a currency fluctuation, it could be compensated by the hedging, and vice versa. Therefore, neither party can be a winner or loser in absolute terms.

The court also rejected the contention that the deal was a product of misrepresentations by Axis. The court maintained that the only questionable assertion by Axis was that the US dollar would never reach a stipulated level of exchange rate against the Swiss franc. However, even if such a statement had been made, it could not be deemed a misrepresentation: whether or not the exchange rate of the US dollar against the Swiss franc would reach a stipulated level on a future date is something over which neither party had any control.

The court held that as far as commodities, stocks and securities are concerned, transactions in derivatives are age-old. Derivatives in securities and shares are statutorily recognized under Amendment Act 31 of 1999 to the Securities Contracts (Regulation) Act, 1956, while the RBI issued the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000, exercising its powers conferred under section 47(2)(h) of the Foreign Exchange Management Act, 1999. These regulations were created with the professed object of “promoting orderly development and maintenance of foreign exchange market in India”. Clearly, what is expressly permitted by law cannot be deemed as contravening public policy.

Upholding the validity of the derivatives agreement, the court held that there were no grounds on which Rajshree could challenge the deal as illegal and opposed to public policy. The judge said, “It must be remembered that the contract was entered into on 22 June 2007 and Rajshree received one lakh US dollars [US$100,000] on June 27. At the time of deriving a benefit of income, Rajshree had no qualms about the deal.”

The fact that the deal exposed Rajshree to the possibility of a huge financial loss is no ground to declare the contract null and void, illegal or opposed to public policy. In fact, it was not the deal itself that resulted in losses to Rajshree, but rather the fluctuating US dollar. Rajshree, which had benefited in nine out of 10 deals, could not invalidate one contract simply because it incurred such losses. Every business venture involves risk, and the validity of a contract cannot be judged on the basis of the venture’s success or failure.

The ruling in this case is significant because nearly a dozen companies, including Rajshree Sugars & Chemicals, Sundaram Multi Pap, Sabare International, Garg Acrylic, NC Sugars, Precot Meridian and Sundaram Brakes, have so far moved in various courts against banks including ICICI, Axis, Kotak Mahindra, Yes Bank and HDFC, alleging that the foreign exchange contracts they signed are illegal and therefore cannot be enforced.

Therefore, until the legality of derivatives contracts is finally decided by the Supreme Court of India, the issue will remain obscure and inconclusive.

The update of court judgments is compiled by Bhasin & Co, Advocates, a corporate law firm based in New Delhi. The authors can be contacted at [email protected], [email protected] or [email protected] Readers should not act on the basis of this information without seeking professional legal advice.