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Courting law may not help derivatives-hit cos
May, 23rd 2008

The companies which filed legal suits against domestic banks to get themselves out of the derivatives losses might not find it easy to get an immediate relief from courts. Experts believe that with no specific legislation to regulate derivative transactions and no clear guidelines by RBI on the subject, the possibility of a successful judicial intervention may be far-sighted. Globally, rarely have courts held derivatives trades liable for misselling.

With major players such as ICICI Bank, HDFC Bank and Axis Bank being dragged to courts by domestic mid-sized companies over their burgeoning derivative losses, litigation experts say with no proper regulatory mechanism in place, the judiciary might find it difficult to solve the crises. In cases of litigation emerging out of derivative transactions, the courts have to rely upon feedback from RBI as there are no clear laws or judicial precedents to guide them, law firm Bhasin & Co partner Sanjay Gupta said.

Even as Mr Gupta noted that the judiciarys domain was not to lay down the laws affecting derivative transactions, he expressed apprehension that in the absence of clear rules, the judiciarys stand could differ from case to case. It could vary from judge to judge. The judges can either take a pragmatic or a pedantic approach, he said.

A V Rajwade, a forex and treasury management consultant who is advising companies in this matter, said: There have been no precedents of cases of this kind in India and therefore it is going to be an uphill task. Judges and lawyers are having a difficult time understanding these issues. Globally, such cases have been filed and subsequently settled outside court.

Similarly, Vinod Kothari, an expert on securitization and structured finance, said: When derivatives lead to losses, such litigation happens everywhere in the world. If marketing presentations and documentation can establish any facts that the selling bank was aware of, and the buyer was not aware of and with reasonable enquiries, could not have been aware of, then a liability does come. But rarely have courts held derivatives trades to be liable for mis-selling.

Banks are clearly on a stronger footing. IndusInd Banks executive vice-president wholesale banking group J Moses Harding, said: Legal cases involving the exotic derivative products linked to an underlying bench mark be it a currency rate or interest rate may not be tenable if appropriate due diligence is applied by the banks to ensure that the customer (the buyer) had an understanding of the product, existence of the underlying exposure as per regulatory prescriptions, risk-reward is well laid out through simulations at various levels and execution of proper documents.

Moreover on such deals where a company has enjoyed cash inflows during initial years (and booked as other income in their financials), making it as a legal issue on cash outflows may also not be tenable, he added.

But there are cases when companies knew the risks in the deal. Mr Rajwade said: In some cases, companies knew what they were getting into. But the fact that banks understood the risks does not mean that they were right in violating RBI rules. The wordings in some of these contracts were deliberately vague. To that extent there has been mis-selling in at least some of the complex products.

With the accounting regulator ICAI making it mandatory for companies to disclose their derivative risks by 2011, accounting experts feel that the courts might lift the corporate veil of companies to judge the transparency of their financial transactions.

The mitigant for companies is to ensure that there exist well-laid policies, systems and management reporting in place and for banks is to ensure existence of underlying exposure, confirm customers understanding of these products, evaluation of credit risk to confirm companies ability to meet cash obligations and execution of fool-proof documents.

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