A
derivative transaction is defined as,
“a
bilateral contract or payments exchanged
whose value is derived, as its name
implies, from the value of an underlying
asset or underlying rate, or index.
Today, derivatives transactions cover
a broad range of ‘underlyings’
– exchange rates, commodities,
equities and indices”.
Some
of the more common derivatives transactions
which we know of are forwards, futures,
interest rate swaps, currency swaps,
equity swaps, options and credit derivatives.
According
to the Study by the Group of 30 , the
legal risks of a transaction could be
described as,
“The
risk of loss because a contract cannot
be enforced. This includes risks arising
from insufficient documentation, insufficient
capacity or authority of a counter party,
uncertain legality and enforceability
in bankruptcy or insolvency”.
Accordingly
to Simon James in his book The Law of
Derivatives , the legal risks relating
to derivatives can be divided into product
risks, counter party risks, transaction
risks and handling risks. In addition
to the above, it will be pertinent to
consider as a separate head the risks
arising from an insolvent counter party.
The
main issues which have arisen from derivatives
as a transaction in the United Kingdom
is whether such a transaction would
be a gaming contract or a wagering contract
and the legal implications, if it be
such. Section 18 of the Gaming Act of
1845 of the United Kingdom provides
that “All contracts or agreements
by way of gaming or wagering …….
shall be null and void”. According
to Hawkins J. in Carlill v. Carbolic
Smoke Ball Co. “… a wagering
contract is one by which two persons
professing to hold opposite views touching
the issue of a future uncertain event,
mutually agree that, dependant upon
the determination of that event, one
shall win from the other, that other
shall pay or hand over to him, a sum
of money or other stake; neither contracting
parties having any other the interest
in that contract than the sum or stake
he will win so or lose…”.
Based
on the above, in order for the transaction
to be a wagering contract, there seem
to be two essential requirements.
a)
The possibility that each party would
either win or lose – This principle
was illustrated in the case of Tote
Investors Ltd. Vs. Smoker , where the
game tote which wasoperated by a person
who collected money from betting on
horses and thereafter distributed all
that money to the winner. Since the
operator did not either win or lose,
this was not considered to be gaming
or wagering.
Based on this principle it is likely
that any stock exchange which acts as
a buyer to every seller and a seller
to every buyer, would not be considered
to be involved in gaming or wagering.
Accordingly, if derivatives are traded
through any stock exchange on this basis,
it would not be considered as a gaming
or wagering transaction.
b) Other interest in the transaction
- If a counter party has a sufficient
interest in a transaction independent
of the gain or loss, which it would
make on the transaction itself, it is
unlikely to be a gaming transaction.
Accordingly, if a counter party in order
to hedge its exposure to fluctuating
interest rates enters into an interest
swap agreement, it is unlikely that
the interest rates swap would be considered
as a gaming transaction, since, that
counter party has an underlying concern
in interest rate fluctuations which
are related to the payments to be received
or made under the interest rates swap.
In the case of Morgan Grenfell Vs. Welwyn
Hatfield District Council , Welwyn had
entered into two interest rates swaps,
one with another local authority and
the other a back-to-back transaction
with Morgan Grenfell.
The other local council later argued
that the transaction was a wagering
transaction. Hobhouse J. held that ‘…in
the context of interest rates swap contracts,
entered into by parties or institutions
involved in the capital market, and
the making and receiving of loans, the
normal inference will be that the contracts
are not gaming or wagering, but are
commercial or financial transactions
to which the law will in the absence
of some other consideration give full
recognition and effect.”
Until
recently the absence of delivery obligations
and the settlement of merely the difference
in price was considered to be a factor
indicative of a wagering transaction.
However in the case of Garnac Grain
v Faure Sellers LJ said that “even
where the parties do not expect to complete
the transaction but to trade on differences
in the hope that the result will be
a profit, but if there is an obligation
to fulfill the contract according to
its tenor if circumstances require it
, then the contract is enforceable.”
The
position in the United Kingdom has substantially
changed after the Financial Services
Act of 1986, which now provides that
certain types of contracts which are
referred to therein shall not be void
or unenforceable because of the Gaming
Act. Accordingly, most of the arguments
in the recently decided cases are not
whether a transaction is gaming or not
but whether a particular transaction
falls within the scope of the FSA which
would enable the transaction not to
be considered void or unenforceable
under the Gaming Act.
The
position with regard to gaming in Sri
Lanka is governed by the Gaming Ordinance
No 17 of 1889. The offences under that
Act are primarily keeping a common gaming
place and importing instruments that
may be used for the playing any game
of chance. It is also an offence to
be found in a common gaming place. In
view of the definition of a “common
gaming place’ it is unlikely that
the transactions contemplated in this
Article would contravene our Gaming
Act.
It
is interesting to note that there have
been cases involving derivatives decided
as far back as the 1920’s in Sri
Lanka. In the case of Lebbe Marikkar
v Arulappa Pillai it was held that in
a forward contract to buy and sell a
commodity the mere fact that one party
performs the contract by paying the
difference between the contract and
the market price on the due date does
not make the contract a wagering contract.
For such an inference to be drawn there
must be proof that it was a term of
the agreement between the parties that
the commodity purchased or sold was
not to be taken or delivered under the
forward contract but that the contract
was to result merely in the payment
of the difference.
(It
is my view that it is unlikely that
this position would be taken up by a
Judge now in view of substantial changes
in attitudes which have taken place
over the last 30 years or so with regard
to settlement being made by the payment
of differences).
The
case of Bartleet & Co v Lebbe Marikkar
too involved a futures contract on the
price of rubber wherein the broker sued
for his commission. The defence that
it was a wagering contract was rejected
by Lord Atkin in the Privy Council on
the basis that the broker was not winning
or losing with the price fluctuations
since he was only benefiting by his
commission.
The decisions in the Sri Lankan cases
referred to above which were in the
1920’s and the 1930’s should
always be read in the context of time.
In view of the provisions of our Gaming
Act being much narrower that the UK
Gaming Act and in view of the substantial
changes in judicial thinking which have
occurred recently which have been set
out in the UK cases above it is my view
that it is unlikely under our law that
the financial transactions referred
to in this Article would be considered
to be gaming. However that should not
preclude the parties from structuring
the transactions in a manner which would
support the Judge in giving such decision.
The
general rule is that the party must
have the capacity to enter into a transaction.
In the case of individuals, this would
only mean that such party should not
be a minor or insane person. In case
of corporate bodies, there are two aspects
which must be considered. That is whether
the contract is within the powers of
the corporate entity itself and whether
it is within the authority of the person
who entered into the transaction on
behalf of the corporate entity. In the
case of Rolled Steel Products (Holdings)
Ltd v British Steel Corporation Browne
Wilkinson LJ stated as follows
“….
If the transaction is beyond the capacity
of the company it is in any event a
nullity and wholly void whether or not
the 3rd party had notice of the invalidity
and property transferred or money paid
under such a transaction will be recoverable
from the third party. If on the other
hand the transaction (although in excess
or abuse of powers) is within the capacity
of the company, the position of the
3rd party depends on whether or not
he had notice that the transaction was
in excess or abuse of the powers of
the company….”
Each
of these aspects are considered below
a)
Capacity of the corporate body to enter
into the transaction – The general
rule is that if the corporate body has
being expressly authorized by its constitution
to enter into the transaction, the transaction
would be valid and binding on such corporation,
notwithstanding the fact that it had
been entered into for an improper purpose.
In addition to express authorization,
a corporate body would generally have
the implied power to do all acts, which
are incidental to or consequential upon
their objects. In Attorney General Vs.
Smethwick Corporation , Lord Hamworth
M R said that “the corporation
has exercised their discretion within
the area entrusted to them, and under
those circumstances, it seems impossible
to hold that they are not authorized
to take the further steps which prudence
dictates and modern mechanism renders
possible”.
It should be noted however, that in
the case of statutory corporations,
the rules are much stricter and it is
less likely that such a corporation
would have the implied powers to enter
into derivatives transactions. In the
case of Hazell Vs. Hammersmith and Fulham
London Borough Council a local authority
established a capital market fund for
the purpose of conducting transactions
involved in interest rates movements.
The local authority engaged in a substantial
amount of derivatives transactions including
interest rates swaps, swap options,
caps, flows and collars, forward rate
agreements and gilt and cash options
in 1987 and 1988. The District Auditor
challenged the legality of the aforesaid
transaction and it was held that a local
authority had no power to enter into
these transactions, because they were
inconsistent with the borrowing powers
of the local authority and since they
did not facilitate and were not ‘conducive
or incidental’ to the discharge
by the local authority of its borrowing
functions as limited by the Act.
In the case of Credit Suisse Vs. Allerdale
Borough Council , a local authority
established a limited liability company
to assist in financing a leisure pool
complex. This limited liability company
borrowed money from the Plaintiff’s
bank and such borrowings were guaranteed
by the local authority. The Company
went bankrupt and the bank claimed on
the guarantee. Held that the local authority
had no implied power to guarantee a
loan made to such company since there
were very specific rules which provided
the means for a local authority to obtain
financial resources to enable it to
accomplish its statutory functions.
The use of the company and the giving
of the guarantee were ultra vires the
local authority’s express and
implied powers and therefore the guarantee
was void and unenforceable.
Based on the principles and decisions
set out above, the position seems to
be that even though a company is likely
to have the implied powers to enter
into a derivatives transaction, it is
unlikely that a corporation established
by statute would have such powers. Accordingly,
extreme caution should be exercised
when dealing with any such public entity.
b)
The authority of the person to enter
into the contract on behalf of the corporate
body- A person could either have express
authority, implied authority or apparent
authority to enter into a transaction
on behalf of a corporate entity. Since
derivatives may not in most cases come
within the ordinary business of a corporate
entity (ie other than a Bank) it would
be prudent that the main documentation
be signed under and in terms of a resolution
of its Board of Directors. The main
documentation could provide for the
day to day authorizations to be done
by specified persons within the entity.
In the case of a Bank the Head of Treasury
in all probability could be considered
to have the implied authority to enter
into a derivatives transaction on behalf
of the Bank. The course of dealings
between the parties may also result
in particular persons within for example
the Treasury Department of a Bank and
the Finance Division of a corporate
being considered to have the apparent
authority to enter into a transaction
on behalf of their respective employers.
This
deals with the risks arising from the
entering into of the transaction and
the documentation which is used. A derivatives
contract must satisfy all the general
requirements for there to be a valid
contract. Some of the problem areas
are
(a)
Oral contracts – If transactions
are concluded over the telephone, it
must be understood that there could
be enforcement problems in the event
of any contest by the other party with
regard to the contract itself or its
terms. Accordingly it is prudent that
either recordings be maintained of conversations
or there be immediate written confirmation
of the oral contract.
(b)
Misrepresentation – A misrepresentation
normally involves a false statement
of any material fact which has induced
the other party to enter into the contract.
Generally if there has been an opinion
which has been expressed or if there
is a false statement of law there would
be no misrepresentation. Eg: a view
which is expressed that it would be
advantageous for the counter party to
enter into the transaction since interest
rates are likely to drop in the future
in most instances would be an opinion.
However it could be argued that the
maker of the statement should have had
specific facts in order to make the
statement and accordingly that the statement
is one of fact and not of opinion.
When
a party is acting in an advisory capacity
in a derivatives transaction there could
also be liability in Tort for negligent
statements which are made. Subsequent
to the decision in the case of Caparo
Industries plc v Dickman the following
rules have developed with regard to
liability for negligent advice
(i)
the loss should be foreseeable from
the negligent act; and
(ii)
there should be sufficient proximity
between the advisor and the advisee;
and
(iii)
it should be fair, just and reasonable
that liability be imposed upon the advisor.
(c) Exemption Clauses –
The contractual documents may have clauses
which either exclude or restrict the
liability of one party on the happening
of some event. Whilst there are general
rules with regard to how exemption clauses
should be interpreted, the Unfair Contract
Terms Act No 26 of 1997 (hereinafter
referred to as “the UCTA”)provides
certain limitations on the validity
of exemption clauses. Section 3(2) provides
that a contract term or notice which
excludes or restricts a persons liability
for negligence shall only be valid if
reasonable. Section 10 of the UCTA specifies
the tests which should be applied to
determine whether a clause is reasonable.
It should be noted that the First Schedule
of the UCTA specifies transactions to
which the Act would not apply. The Schedule
includes “ Any contract so far
as it relates to the creation or transfer
of securities or of any right or interest
in securities”. Accordingly the
derivative contracts which result in
the issue of a security would not be
covered by the provisions of the UCTA.
Several
derivative transactions are covered
up by ISDA Documentation which is comprehensive.
Accordingly the insufficiency of documentation
is not likely to be a major issue in
such instances. The Association of Primary
Dealers in Sri Lanka for example has
taken the lead to adopt ISDA Documentation
for its Forward Rate Agreements and
Interest Rate Swap Agreements. The greater
risk would be that either inappropriate
documentation has been used or that
the accompanying Schedules and Confirmations
are not properly filled up.
This
involves the risk arising from the improper
handling of the situation when a dispute
arises. It is necessary that where there
is a breach by the other party that
whatever notices which need to be sent
are sent in the manner contemplated
by the contract and any counter measures
to mitigate losses or settle the dispute
are taken expeditiously. It is extremely
important that all records and documentation
regarding transactions are maintained
and that all actions taken are documented
so that there would be a reliable basis
to justify actions taken in dispute
resolution proceedings which may take
place a long time thereafter.
If
a counter party is insolvent it would
be desirable that the insolvency proceedings
are conducted expeditiously with secured
creditors being settled to the extent
of their security and unsecured creditors
being treated fairly in accordance with
the law. In our country however we see
several instances where companies are
clearly insolvent but are allowed to
limp on until their assets are completely
depleted. A consequence of this is that
in the interim a fundamental principle
in insolvency that creditors are treated
equally is violated.
Several
derivative transactions result in the
settlement of the transaction being
based on the difference between a contracted
rate and the market rate which prevails
on a future date. Accordingly even though
one party (X) has to pay the other (Y)
a certain amount (eg: Rs 110) and Y
has to pay X another amount, (say Rs
108) the derivative transaction is settled
by X paying Y a sum of Rs 2/-. If X
is insolvent the most undesirable thing
for Y would be if the Insolvency Court
does not recognize this netting off
and insists that Y pay in a sum of Rs
108/- to the Liquidator and such sum
would thereafter form part of the general
pool of assets out of which all creditors
(including Y) would get settled. Section
346 of the Companies Act provides as
follows
“
In the winding up of an insolvent company
such rules as are in force for the time
being under the law of insolvency or
bankruptcy with respect to the estates
of persons adjudged insolvent or bankrupt
shall be observed with regard to the
respective rights of secured and unsecured
creditors …”
Section
99 of the Insolvency Ordinance No 7
of 1853 states as follows
“
Where there has been mutual credit given
by the insolvent and any other person,
or where there are mutual debts between
the insolvent and any other person,
the court shall state the account between
them and one debt or demand may be set
against another….”
Based
on the above it seems to be that the
general principles of netting off are
recognized under our law of insolvency
and the hypothetical problem referred
to above may not arise.
In
summary it seems to be that the basic
legal principles to cover derivative
transactions in general are contained
in our law. Legislative intervention
may be required in areas such as securitization
in view of very specific issues which
arise in that field. In view of the
laws delays, however, it is desirable
that an expert panel be set up either
by the Primary Dealers or the Forex
Dealers to deal with disputes which
may arise (which in all probability
would relate to the manner of computing
losses) on a failed trade.
The
more real problem however may be that
banks and merchant banks seem to be
dealing with their clients in an advisory
role as well as being a counter party
to a transaction. In a relatively unsophisticated
market such as ours this duality of
functions may result in actions being
maintained against banks/ merchant banks
for breach of fiduciary duty.
1.
The Law of Derivatives; Simon Jones
(1999)
Mr. Goonewardena is an Attorney-at-Law
by profession. He is also an
associate member of the Institute
of Chartered Accountants of
Sri Lanka, associate member
of the Chartered Institute of
Management Accountants U.K.,
A Chartered Financial Analyst
(CFA), Charlottesville, U.S.A
and holds a Masters Degree in
Business Administration from
the University of Sri Jayawardenepura.
Mr. Goonewardena was a State
Counsel in the Attorney General’s
Department, Corporate Lawyer
at the DFCC Bank, Senior Tax
Manager and subsequently Director
Corporate Services at Messrs
Ernst & Young. He is a partner
at Messrs Nithya Partners, Attorneys-at-Law
where he has been primarily
involved in issues relating
to tax, financial law and telecommunications
law.
Mr. Goonewardena has also been
the Legal Advisor to the Board
of Review of the Inland Revenue.
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