Exotic forex deals will lead to crisis

WITHOUT CONTEMPT

A crisis in banking treasuries is brewing. Banking circles would bill it as India's contribution to the world's financial crisis. At the core of the impending crisis are foreign exchange derivative contracts (forex derivatives) executed between banks having active treasury operations and several small and mid-cap companies. Typically, such contracts are a punt over how the US Dollar would move vis-à-vis other international currencies.

Forex derivatives are aimed at enabling parties to such contracts hedge their risk of exposure to adverse movements in exchange rates. For instance, an Indian resident borrower of a US Dollar loan would have to pay more Indian Rupees to repay the same loan if the US Dollar strengthens against the Indian Rupee. Similarly, when the US Dollar weakens, an Indian exporter would earn lesser Indian Rupees for the same quantum of US Dollar exports.

To hedge against such risks, the Reserve Bank of India (RBI) has prescribed regulations and issued guidelines to enable persons resident in India to enter into forex derivative contracts. However, Indian exchange controls stringently regulate forex derivatives and lay down a plethora of compliance conditions for such contracts to be executed legitimately.

The RBI has prohibited the execution of any forex derivative by a person resident in India unless the object of the contract is genuinely to "hedge an exposure to risk". To ensure that forward contracts in foreign exchange are executed only in genuine circumstances, exchange controls require the party to the derivatives to actually be party to specific underlying transactions exposing it to the risk of forex movements.

Conscious, that hedging of forex risk is important, and that speculative wagering in forex is undesirable, Indian exchange controls permit only resident Indians, who owe a foreign exchange liability, to execute swaps, reflecting movements in exchange rate between such currency and the Indian Rupee.

The RBI has also made it imperative for banks offering such derivative products only to users who understand the nature of the risks inherent in the transactions and to ensure that the products offered are consistent with the user's business, financial operations, skill and sophistication levels, risk appetite and internal policies. Banks have also been mandated to carry out due diligence on "user appropriateness" and "suitability" of products before offering derivative products. The guidelines even require adoption of a "customer appropriateness and suitability policy" for carrying on derivatives business.

According to banking circles, compliance with such imperatives is near-absent. Several banks have sold complicated and exotic cross-currency swaps and other forex derivatives to unsophisticated mid-sized companies that have no genuine exposure to currencies that are subject matter of such derivatives. Without genuine underlying exposure to forex risk, such contracts are purely speculative punts on the movement of two or more currencies.

Immediate sign-on premium amounts have been paid to the companies, which may have been welcomed by company treasury managers as 'money-for-jam'. For instance, an unsophisticated Indian corporate that has no understanding or exposure to the forex rate movements between the US Dollar, and say, the Singapore Dollar, could enter into the derivative, and get an up front amount of say, US $ 100,000, not realising that the sophisticated terms of contract could make a mockery of any prudent risk-reward analysis and expose the company to open-ended liability running into several tens and hundreds of crores with every phase of erosion in the value of the US Dollar.

Contracts that have a residual tenure of more than another year are giving jitters to the market place with the US economy sending awfully unhealthy signals. Worse, several banks, in order to hedge their own risk from such contracts would have entered into back-to-back forex derivative contracts with other banks and institutions.

It is highly likely that the Indian corporate would disown liability and demonstrate that the bank's treasury team took the company's treasury team for a ride. On the other hand, it would be very difficult for the bank to disclaim its liability under its back-to-back forex derivative contract with other banks. It is likely that courts would hold the first part of such a transaction i.e. the deal between a bank and the corporate to be illegal even while holding the derivative between the counterparty bank and other banks and financial institutions to be perfectly legitimate.

Litigation on such contracts has commenced. Vigilant companies that have woken up to what their treasury staff have contracted with the treasury staff of the banks, have filed suits for declaration of the contracts as illegal and un-enforceable. Criminal complaints against treasury employees have been filed. Allegations of failure to make appropriate risk disclosures, of conflicts of interest between the role of the bank as an advisor and as a counterparty, and of contracts being void from the outset due to non-compliance with exchange controls would fly fast and thick.

Sophisticated litigation in unsophisticated dispute-resolution machinery conjures images of a repeat of the 1991 securities scam. After 16 years, the special court is still at work. More importantly, a lot of case law has evolved, at times laying down propositions that none of the parties to the dispute would have contemplated.

The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.

somasekhar@jsalaw.com