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Emerging judicial perspectives

In order to benefit from the value differentials between the Indian rupee and other currencies, the past few years have seen various entities entering into derivative transactions with Indian banks on the basis of foreign currency exchange rates.

However, the sharp depreciation of the dollar against the rupee and other currencies earlier this year has led to resultant losses for entities with exposure to foreign currency derivative contracts. These entities, having found themselves in a disadvantageous position, have sought to avoid their liability under these contracts in the face of recovery proceedings initiated by banks. In this context, numerous challenges have been made to the validity of derivative contracts to render them unenforceable against these entities. These challenges rest primarily on the nature of such derivative contracts: that is, on the question of whether they are speculative wagers.

Wagering contracts are void under the Indian Contract Act 1872 and would therefore be unenforceable. Furthermore, under the Indian exchange control regulations, a person resident in India can enter into a foreign currency derivative contract only to hedge an exposure to foreign exchange risk and a contract amounting to a wager to gain profits would not be permissible. Therefore, the presence of an underlying exposure is crucial to ensure that the derivative contract is not a wagering contract. The existence of an underlying exposure is a question of fact to be determined by the authorised dealer in the derivatives concerned.

Recently, Rajshree Sugar Mills, which had entered into a US dollar-Swiss franc option structure with Axis Bank in June 2007, filed a suit before the Madras High Court seeking a declaration from the court that this derivative contract was void and unenforceable on the ground that there was no underlying exposure. It was contended that the contract was purely a wagering contract and that the company was lured into wagering on the movement of the dollar against the Swiss franc by misrepresentations by the bank.

In this case (Rajshree Sugar Mills v Axis Bank), the Madras High Court recognised and adopted the following essentials of a wagering contract as formulated by the English courts:

  • the existence of two persons or sets of persons, with a common intention to wager, each holding opposite views from the other on a future uncertain event;
  • upon determination of the event, one must win and the other must lose; and
  • the actual interest of the parties is not in the occurrence of the event itself but in their stake in the occurrence.

The court also observed that if the performance of the contract in terms of actual delivery can be compelled, the contract cannot be termed a wager.

Based on this, the court held against the company, stating that the contract was not a wagering contract on the following grounds:

  • there was no common intention between the parties to enter into a wagering contract;
  • performance of the contract and actual delivery could be compelled; and
  • the parties had an actual interest in the exchange rates hitting a high or low.

The court also took into account a declaration made by the authorised official of the company stating that the transaction was entered into solely for the purpose of hedging the company's foreign currency balance sheet exposure, and held that this constituted the requisite underlying exposure.

The court proceeded to hold that the contract was comparable (though not identical) to a contract of insurance, where an assured sum becomes payable upon occurrence of a certain event. The court also stated that the contract did not violate public policy in India and could not be deemed as illegal and unenforceable. The mere fact that the deal had exposed the company to financial losses could not in itself render the derivatives contract invalid.

With regard to the company's claim of misrepresentation by the bank, the court clarified that both parties knew the limited extent of knowledge of the other with respect to foreign exchange fluctuations, and the bank stating that the dollar was on the rise could not be considered a misrepresentation. Furthermore, the company had entered into 10 such contracts, of which only the last was challenged. Therefore, the court also stated that the company, having reaped the benefits of nine similar contracts, could not now challenge the last one just because of a disadvantageous change in circumstances.

The judgment in this case has been stayed by the Division Bench of the Madras High Court. However, it supplies a ray of hope to those banks that have sold complex derivatives packages and may well be indicative of the judicial bent of mind in a number of similar cases pending before various courts in the country.

Vandana Shroff

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