A lot of the forex derivatives contracts were purely speculative wagers and are not permissible under Indian law which insists there must be a genuine underlying exposure.
Much confusion, both legal and commercial, prevails over the enforceability and validity of forex derivative contracts between Indian banks and many corporates, most of them small- and medium-sized enterprises.
Under Indian exchange control laws, an Indian corporate, being a person resident in India, can enter into a foreign currency derivative contract only to hedge an exposure to foreign exchange risk and not for speculating and chasing profits.
"Genuine underlying exposure" is the possible liability of an Indian party in respect of a transaction already entered into, which is likely to present a forex risk, necessitating risk cover. Such exposures could be risks in respect of forex-denominated borrowings, interest rate variables, export receivables or import payables.
Whether there is such genuine underlying exposure will always be "a question of fact". However, the RBI's guidelines have cast a duty on banks to ensure that they are satisfied, after due diligence, including examining documentary evidence, about the existence of such genuine underlying exposure.
Merely taking a declaration from an Indian corporate that it has an exposure will not suffice. A tape-recorded conversation where the Indian corporate confirms words to this effect will also not suffice, if, in fact, there is no genuine underlying exposure.
Everything centres around this core issue. If there was indeed no such exposure, then the contract will be legally void, being contrary to Indian law. To repeat an age-old first principle of law, a statute (law) shall always prevail over a contract. Legally void would mean the contract would not bind the parties.
No court will enforce it. It is entirely immaterial that the same Indian corporate has derived monetary benefit from earlier contracts of a similar nature and is now crying foul when losing money.
The current situation is not a question of business ethics or respecting contractual obligations. Whatever may be the business equities of a case, if a contract is contrary to the laws of the land, it would be void, unenforceable and will not bind the parties.
This may sound like a commercially dishonest 'bad-loser' defence for an Indian corporate to take. However, that makes not an iota of difference to the crystal-clear legal position. Of course, nothing prevents the banks from contending that the profits of the corporates from similar earlier contracts were also legally void and the Indian corporate should disgorge such past profits.
This author has come across several recent cases where the corporate has agreed to write an option upon the receipt of a premium for doing so. This is wholly impermissible under exchange controls.
Perhaps realising this, banks have tried to disguise the nature of such payment so that it is not seen, as a premium. A court, however, would look at the substance of the payment to reach a conclusion on whether the payment would constitute a premium.
Shockingly, in several cases, the corporate has had absolutely no business to take a punt on forex rate movements.
Take the facts of a typical case. A bank makes an upfront payment of, say, $100,000. The corporate would punt on the movement of the dollar against, say, the Swiss franc or the yen with no stop-loss limit.
As we know, the dollar has had a dramatic decline, and the corporate would have a staggering mark-to-market liability on a punt gone wrong that could exceed its net worth. One cannot find a better example of a completely warped and one-sided risk-reward profile.
Such a contract, without a genuine underlying exposure, would be a speculative wager, which under the Indian contract law, would be void. Thus, such a contract would suffer a double whammy - of legal invalidity under exchange controls and contract law.
It is certainly nobody's case that all OTC derivative contracts are speculative or wagering contracts. They are not. However, in the facts of the example set out above, which is typical of most contracts under the scanner, it is clear as daylight that they are speculative wagers. Such a punt is no better than operating a slot machine in a casino in Las Vegas or betting on a horse race.
There are various other grounds to assail such contracts. These include the bank not explaining to the corporate the exact nature of the inherent risk (mis-selling) or the existence of a conflict of interest between a bank's advisory role for the product and counterparty role in the contract. Some corporates have contended that such conduct vitiates consent due to misrepresentation, thereby making the contract 'voidable', that is, capable of being avoided by the party to which the misrepresentation was made.
Such an approach would but be a secondary defence, to be used only if the contract is held as not being legally void ab initio for being contrary to exchange controls and contract law.
The woes do not end here. In some cases, the charter documents of the Indian corporate, and, in some cases, even of the bank, do not contain the power to enter into derivative contracts. The contract would then be ultra vires the charter documents.
Most such contracts are unsecured, that is, without collateral as security for obligations. Therefore, a bank will not be able to resort to the stringent Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
The only forum would be the Debt Recovery Tribunal. While the expression 'debt' has been defined very widely under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (the existence of debt would itself be in dispute), corporates are bound to argue that the DRT is meant to only recover loans granted by banks and for recovery of dues claimed under any other contract of a bank.
Several affected corporates have started filing civil suits for declaring these contracts to be legally void, and in the alternative, voidable, and for denying their liability. When the bank files DRT proceedings, the civil suit would be regarded as a counterclaim against the bank.
In short, a protracted legal battle with uncertain outcome even on the forum having jurisdiction is on hand.
In many cases, even while the corporate's liability is not crystallised, the corporates have begun filing suits to declare the contracts void. Therefore, the bank would have no option but to unwind the trades.
Meanwhile, where the bank has entered into a back-to-back contract with another counterparty bank, it would have to pay under that contract and seek to recover the loss from the corporate.
Until it does so, which may take several long years of litigation, the bank may have to provide for such losses in its books.
The author is the Managing Partner of J Sagar Associates, which has advised some affected corporates