State of Commercial Laws Scope for challenging a foreign currency forwards instrument

The last few years have seen a drastic increase in the number of foreign currency forward instruments. This piece, based on a reading of the decided Indian cases and landmark foreign cases on this issue, attempts to set out the common grounds that can be raised while challenging such instruments.. I. Introduction.The last few years have seen a drastic increase in the number of foreign currency forward instruments as the Parliament and the Reserve Bank of India (RBI) have endeavoured to popularize the use of such instruments. However, on a perusal of the regulatory framework it becomes apparent that the Parliament and RBI have tried to ensure that these instruments are only used as mechanisms to off-set one’s foreign currency exposure. In order to ensure that these instruments are valid, the issuers of these instruments (most often banks and financial institutions) have to ensure that numerous safeguards are adhered to. The relative ambiguity about what these safeguards are has resulted in a plethora of cases being filed before Courts where it has been pleaded that such instruments are void. This piece, based on a reading of the decided Indian cases and landmark foreign cases on this issue, attempts to set out the common grounds that can be raised while challenging such instruments. These grounds may also serve as pointers to banks and financial institutions, which seek to issue such instruments. Prior to setting out these grounds, it is apposite to explain the typical structure of a foreign currency forward instrument..II. Typical Structure of the instrument.The simplest version of this instrument operates based on the following typical structure: .Condition 1 – If, on a future specified date, the foreign currency to Rupee exchange rate is greater than Rs. X, Party A shall sell to Party B, Y units of the foreign currency at Rs. X per unit of foreign currency. In other words, Party A assumes the risk of such an increase in the exchange rate..Condition 2 – If, on the above-mentioned future date, the foreign currency to Rupees exchange rate is less than Rs. Z, Party A shall sell to Party B, Y units of the foreign currency at Rs. Z per unit of foreign currency. In other words, Party B assumes the risk of such a decrease in the exchange rate..Condition 3 – If, on that date, the foreign currency exchange rate is between Rs. X and Z, neither party sells to the other any currency..Illustratively, if on 15.12.12, the USD/Rs. exchange rate is greater than Rs. 50, then Party A shall sell to Party B USD 1,000,000 at Rs. 50/USD and consequently Party A assumes the risk of such an increase in the exchange rate..If on the said date, the USD/Rs. exchange rate is less than Rs. 48.50, Party A shall sell Party B USD 1,000,000 at Rs. 48.50/USD consequently Party B assumes the risk of such a decrease in the exchange rate..If the USD exchange rate is between Rs. 48.50 and 50, neither party has any obligation to pay..(In most cases these instruments are far more complex variation of this basic structure.).Typically, Party A would be an exporter of Indian goods and would like to hedge its risks by minimizing loss caused by a fall in the price of the Rupee. If the derivatives instrument is directly linked to this foreign exchange exposure of Party A, the derivative instrument would be valid. However, if such a link cannot be established, the instrument could be challenged on the grounds set out below. .III. Typical grounds for assailing the validity of foreign currency options.The reported decisions of Indian Courts on the validity of foreign currency forwards are determinations on a prima facie basis and Courts have refused to grant an injunction restraining a party from making a claim pursuant to such a contract.[i] However, the maintainability of such suits has been upheld.[ii].On an analysis of the statutory regime governing foreign currency forwards, the case laws decided in India and abroad and the facts that typically arise, the following arguments may be used to challenge the validity of foreign currency forwards..A) Whether the entering into of foreign currency forwards (the “Transaction”) is ultra vires the powers of the Company seeking to annul the Transaction..The Supreme Court, in Dr. A. Lakshmanaswami Mudaliar v. Life Insurance Corporation of India[iii], held as follows:.“Power to carry out an object, undoubtedly includes power to carry out what is incidental or conducive to the attainment of that object, for such extension merely permits something to be done which is connected with the objects to be attained, as being naturally conducive thereto.”.Where the Company seeking to argue that the Transaction is void, does not have as one of its objects, the head “derivatives trading” (or any variation of it), the Company can only enter into the Transaction if it can be established that the Transaction is incidental or conducive to the attainment of one of its objects. The Transaction will be incidental or conducive to the attainment of one of its objects only if a link can be established between the business the Company carries on and the Transaction. If the Transaction is a standalone one which is not meant for hedging the business risks of the Company, it would be highly persuasive to argue that such a Transaction is ultra vires the powers of the Company and consequently void..B) Whether the Transaction is a wagering transaction and consequently falls foul of Section 30 of the Indian Contract Act?.(i) Section 30 of the Indian Contract Act reads as follows:.“Agreements by way of wager void – 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.”.(ii) There are three essentials that need to be satisfied for a contract to qualify as a wagering contract:[iv].The contracts must be entered into between two parties/ two sets of parties who hold opposite views on the occurrence of a future uncertain event..One party is to win and the other to lose upon the determination of the event..The parties should not have an actual interest in the occurrence or non-occurrence of the event but have an interest only on the stake..Condition (a) would stand satisfied in most cases. Conditions (b) and (c) would depend on the facts of the case. If and only if there exists a link between the Transaction and the business of the Company and the Transaction is entered into to hedge business risks, Conditions (b) and (c) would stand satisfied as:.It is likely that the parties might suffer a loss under the Transaction but gain overall due to the corresponding profits arising from its business. For instance, if the condition of derivatives trade is that Party A would purchase USD at the price of Rs. 50 in the event of the exchange rate of the USD increasing above Rs. 50 and that this Party A would purchase USD at the price of Rs. 48 if the exchange rate drops below Rs. 48, Party A might be entering into such a contract because it is an exporter and stands to lose if the USD/ Rs exchange rate falls and consequently wants to hedge its risks to minimize such loss. If that is so, an increase in the USD rate might cause a loss arising from the Transaction but Party A would gain overall. Such a scenario would be a win-win scenario and consequently Condition (b) would be satisfied.[v].However, where no link is established between the Transaction and the business of the Company, a Win-Win situation is never possible and Condition (b) would not stand satisfied..If there is no link between the Transaction and the business of the Company, the parties would not have an actual interest in the fluctuation of the foreign currency exchange rate and the Transaction would be purely speculative..(iii) Therefore, if the Transaction is a standalone Transaction not in any way linked to the business of the Company, it is arguable that the Transaction would be a wager and hence void..C) Whether the Transaction is one that is prohibited by Section 18A of the Securities Contracts Regulation Act..(i) Section 18 A of the Securities Contract Regulation Act states:.“Contracts in derivative – Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are- .(a) Traded on a recognised stock exchange;.(b) Settled on the clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchange.”.(ii) Therefore, Section 18A recognizes that those derivative instruments that are traded on a recognized stock exchange and those that are settled on the clearing house of a recognized stock exchange are valid. The logical corollary of this provision is that those derivatives that are neither traded on a recognized stock exchange and nor settled on the clearing house of a recognized stock exchange are void. Going by this interpretation, the private trade of currency forward contracts would be impermissible..(iii) However, the contrary argument is that the above interpretation, based on the maxim expressio unius exclusio est alterius, does not necessarily hold good and that the provision ought to be only interpreted as a declaration of validity of certain kinds of derivative instruments..It is trite that this maxim is a “dangerous master but a useful servant”.[vi] That being so, this argument cannot be used as the fundamental basis to annul the Transaction but can be used to support the other arguments made in this section of the article..D) Whether the Transaction, if entered into by a bank, is in violation of the RBI Regulations..(i) Section 45V of the RBI Act states:.“(1) Notwithstanding anything contained in the Securities Contracts (Regulation) Act, 1956 (42 of 1956) or any other law for the time being in force, transactions in such derivatives, as may be specified by the Bank from time to time, shall be valid, if at least one of the parties to the transaction is the Bank, a scheduled bank, or such other agency falling under the regulatory purview of the Bank under the Act, the Banking Regulation Act, 1949 (10 of 1949), the Foreign Exchange Management Act, 1999 (42 of 1999), or any other Act or instrument having the force of law, as may be specified by the Bank from time to time. .(2) Transactions in such derivatives, as had been specified by the Bank from time to time, shall be deemed always to have been valid, as if the provisions of sub-section (1) were in force at all material times.”.(While the constitutional validity of this provision is debatable, this debate must form the subject matter of a separate article).(ii) In this regard, it is instructive to analyze the contents of Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000 (as amended from time to time), which sets out what kinds of foreign exchange derivative contracts are valid. A perusal of these Regulations make it amply clear that:.– A standalone derivative transaction not entered into for the purposes of hedging the economic risks arising out of one’s business is not permissible as per the RBI regime..– A foreign exchange derivative contract can be entered into only with a dealer authorized by the RBI..– Such an agreement can be entered into only after the authorised dealer, through verification of documentary evidence, is satisfied about the genuineness of the underlying exposure and where the exact amount of the underlying transaction is not ascertainable, the contract is booked on the basis of a reasonable estimate..(iii) These principles have also been recognized in the Master Circular issued by the RBI in July 2006 and are recognized even in the latest Comprehensive Guidelines on Foreign Exchange Derivatives and Overseas Hedging of Commodity Price and Freight Risks- Annex to A.P (DIR Series) Circular No.32, dated December 28, 2010 issued by the RBI..(iv) Therefore, as under Heads A and B above, the essential test is whether the Transaction has been entered into for hedging business risks. Additionally, pursuant to these provisions, the burden is on the bank to ensure that the Transaction is in fact being entered into for the purpose of hedging business risks. If no link can be drawn between the business risks of the party and the foreign exchange forward entered into, the Transaction is liable to challenge..E) Whether the Transaction was entered into under undue influence and consequently voidable at the instance of the party who was unduly influenced?.(i) In most instances the Transaction is not as simplistic as the illustration provided earlier. Further, in many cases, the banks that issue these instruments are in the position of financial advisers to the other party that enters into the Transaction and consequently act in a fiduciary capacity. In such a situation, if the banks induced the other party into entering into the Transaction without disclosing all the risks involved, it may be arguable that the Transaction was entered into under undue influence and consequently voidable at the instance of the party which was unduly influenced..(ii) There also exist cases – most notably the English case of Titan Steel Wheels Limited v. The Royal Bank Of Scotland PLC[vii], where a claim was made against the bank for breach of fiduciary duty. While in that case, on facts, the claim was dismissed; such a claim could be upheld in certain factual scenarios..IV. Conclusion.As has been mentioned, all the cases decided so far decide the issue on a prima facie basis. What remains to be seen is whether any of the Plaintiffs in the suits that have been initiated ultimately succeed. Till such time one of these suits are finally decided, further litigation in this area is expected to continue. This article may be a pointer to future litigants as to grounds that may be used to challenge such instruments and also a pointer to banks to ensure that they plug the loopholes pointed out in this piece prior to issuing such instruments..Anirudh Krishnan is a graduate of NALSAR and completed his BCL at the University of Oxford. He is a qualified solicitor, England and Wales and is currently an advocate in the Madras High Court. He is also Chief Editor,Justice R.S. Bachawat’s Law of Arbitration and Conciliation. He can be contacted at anirudhkrishnan@me.com. The author acknowledges the research assistance provided by Vaishnavi Ravichander, Advocate..[i] Rajashree Sugars v. Axis Bank: AIR 2011 Mad 144, M/s Richa Industries Ltd. v. ICICI Bank Limited: 2012 IAD (Delhi) 204.[ii] Nahar Industrial Enterprises Ltd. v. Hong Kong and Shanghai Banking Corporation: (2009)8 SCC 646, Rajashree Sugars v. Axis Bank: AIR 2011 Mad 144, M/s Richa Industries Ltd. v. ICICI Bank Limited: 2012 IAD (Delhi) 204[iii] AIR 1963 SC 1185[iv] Weddle Beck & Co. Vs. Hackett (1929) 1 K.B. 321 and Ellesmere Vs. Wallace (1929) 2 Ch. 1, quoted with approval in Rajashree Sugars v. Axis Bank: AIR 2011 Mad 144.[v] Rajashree Sugars v. Axis Bank: AIR 2011 Mad 144[vi] D.R. Venkatachalam & Ors vs Dy. Transport Commissioner & Others 1977 AIR 842[vii] [2010] EWHC 211 (Comm)