By Namita Sharma & Kunal Kishore
Introduction
Derivatives have famously been described as ‘weapons of mass destruction’. The use of certain derivative products in India from around 2007–2009 has certainly led to financial destruction of several export companies who entered into these complex agreements, as well as arguably damaging the reputation of Indian banking sector. This article seeks to set out the background to what has happened so far with regard to these transactions, noting the recent change in approach of the banks, controversial elements of the contracts, before considering the legal principles and arguments involved in the case that was put before the Madras High Court in Rajshree Sugars and Chemicals Limited, before drawing some conclusions.
Background and context
During 2007 – 2009, many SMEs (largely export companies) suffered huge losses from currency derivatives. During this time, a number of banks aggressively marketed certain derivative products as an alternative profit making mechanism available to these SMEs. It has been argued that in reality, the majority of these companies did not have enough expertise to fully understand the contracts that they were entering into, and ultimately these contracts exposed them to a risk of huge financial loss. Within a few months of entering into these contracts, the risk of loss became reality.
The common allegations brought by these companies against the banks are likely to be based on the belief that (a) banks did not adequately explain the products and their underlying risks to their (less sophisticated) counterparties; (b) banks did not check whether the products were suitable for the counterparties’ needs, or stated another way, they did not advise on less risky products that would more suitable than those sold; (c) banks did not check on whether the counterparties’ businesses had the capacity to incur the extreme losses (as a result of complex ratcheting/gearing elements of the products) – i.e. would they be able to absorb the losses or could this potentially cause severe damage to the enterprise (e.g. lead to insolvency).
The common factor and underlying thread of all these discussions is “suitability”. The Reserve Bank of India’s “Comprehensive Guidelines on Derivatives” cover “Suitability and Appropriateness Policy”. These guidelines specifically state -“Market-makers should undertake derivative transactions, particularly with users with a sense of responsibility and circumspection that would avoid, among other things, mis-selling.” It is also stated that products should only be sold to those users who understand the nature of the risks inherent in these transactions. Furthermore, the products offered must be “consistent with users’ [i.e. counterparties to the banks] business, financial operations, skill & sophistication, internal policies as well as risk appetite.”
The RBI guidelines further state that when selling derivative products, a market-maker (i.e. financial institutions selling these products) should document, how various aspects of the product work (e.g. pricing and the generic components of the product). Amongst the information that may be shared with the user, the RBI includes “sensitivity analysis identifying the various market parameters that affect the product” and, “scenario analysis encompassing both the possible upside as well as the downsides.”
To read complete article
Introduction
Derivatives have famously been described as ‘weapons of mass destruction’. The use of certain derivative products in India from around 2007–2009 has certainly led to financial destruction of several export companies who entered into these complex agreements, as well as arguably damaging the reputation of Indian banking sector. This article seeks to set out the background to what has happened so far with regard to these transactions, noting the recent change in approach of the banks, controversial elements of the contracts, before considering the legal principles and arguments involved in the case that was put before the Madras High Court in Rajshree Sugars and Chemicals Limited, before drawing some conclusions.
Background and context
During 2007 – 2009, many SMEs (largely export companies) suffered huge losses from currency derivatives. During this time, a number of banks aggressively marketed certain derivative products as an alternative profit making mechanism available to these SMEs. It has been argued that in reality, the majority of these companies did not have enough expertise to fully understand the contracts that they were entering into, and ultimately these contracts exposed them to a risk of huge financial loss. Within a few months of entering into these contracts, the risk of loss became reality.
The common allegations brought by these companies against the banks are likely to be based on the belief that (a) banks did not adequately explain the products and their underlying risks to their (less sophisticated) counterparties; (b) banks did not check whether the products were suitable for the counterparties’ needs, or stated another way, they did not advise on less risky products that would more suitable than those sold; (c) banks did not check on whether the counterparties’ businesses had the capacity to incur the extreme losses (as a result of complex ratcheting/gearing elements of the products) – i.e. would they be able to absorb the losses or could this potentially cause severe damage to the enterprise (e.g. lead to insolvency).
The common factor and underlying thread of all these discussions is “suitability”. The Reserve Bank of India’s “Comprehensive Guidelines on Derivatives” cover “Suitability and Appropriateness Policy”. These guidelines specifically state -“Market-makers should undertake derivative transactions, particularly with users with a sense of responsibility and circumspection that would avoid, among other things, mis-selling.” It is also stated that products should only be sold to those users who understand the nature of the risks inherent in these transactions. Furthermore, the products offered must be “consistent with users’ [i.e. counterparties to the banks] business, financial operations, skill & sophistication, internal policies as well as risk appetite.”
The RBI guidelines further state that when selling derivative products, a market-maker (i.e. financial institutions selling these products) should document, how various aspects of the product work (e.g. pricing and the generic components of the product). Amongst the information that may be shared with the user, the RBI includes “sensitivity analysis identifying the various market parameters that affect the product” and, “scenario analysis encompassing both the possible upside as well as the downsides.”
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[The authors are with Lakshmikumaran & Sridharan, New Delhi]