Derivatives Case Study

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Mumbai: The first round of an unfolding legal battle on derivatives contracts between Indian banks and their clients appears to have gone to the Coimbatore-based Rajshree Sugars and Chemicals Ltd, after the firm secured a "status quo" order against Axis Bank Ltd from the Madras high court. The case will come up for hearing on Tuesday.

Rajshree Sugars is one of half a dozen firms that have all independently filed cases against their respective banks, alleging they were sold exotic derivatives contracts for "speculative" purposes. The list of firms that have gone to court against their banks that sold such derivatives products includes Sundaram Brake Linings Ltd and Sundaram Multi Pap Ltd, and is likely to grow.

Legal firms expect many more cases to be filed in various courts across India as hundreds of Indian firms that bought complex cross-currency options and structured products to seemingly protect themselves from foreign exchange risk face significant losses.

Mint first reported on 17 March that many banks, which sold derivatives within India in the past few years, are gearing up for legal battles with their clients who are now questioning the legality of such products.

On the one side of this battle are some of the fastest growing new private banks in India: Yes Bank Ltd, Kotak Mahindra Bank Ltd, Axis Bank, ICICI Bank Ltd, HDFC Bank Ltd, and their lawyers, such as Amarchand and Mangaldas and Suresh A Shroff and Co., AZB and Partners and Juris.

Fighting them are a growing list of small and medium firms, J Sagar, the forensic division of audit and consultancy firm KPMG India, and independent risk management experts such as A.V. Rajwade, perhaps India's leading expert on derivatives.

At the core of the battle is a debate whether these products were sold for hedging or speculation.

According to the Rajshree Sugars' "plaint" before the Madras court, it had authorized its chief financial officer (CFO) to deal with Axis Bank "only" to hedge its genuine foreign exchange exposure. In all, 10 transactions were entered into by the CFO and out of these, nine were to reduce the cost of rupee loans but, one of them (contract no. OPT 727) "is tota-lly unconnected with the business and entered into by the CFO without any authority."

This particular transaction, according to the company, is an "exotic" transaction, based entirely on the probable fluctuation of the US dollar and the Swiss franc, and "there is no rupee loan swap or a hedge against export in this deal, thereby making it purely speculative."

The company alleged that the bank "lured" it to enter into such an exotic contract "with misrepresentations and false promises." It also alleged that the company received a net inflow of premium for writing the option in favour of the bank, which is not permitted by Reserve Bank of India norms, and claimed that "the contract is contrary to the law and is, therefore, void."

Partha Mukherjee, head of treasury of Axis Bank, declined to comment, saying the "matter is before the court." P.K. Viswanathan, CFO of Rajshree Sugars, couldn't be reached for comment.

A team of outside forensic experts have been advising the company as part of an attempt to figure out the option agreements.

According to Rajshree Sugars, the company's CFO had started entering into foreign exchange derivatives transactions in 2004 after taking approval from its board for the purpose of hedging their risk or genuine underlying exposure in respect of fluctuation in the market. The board had authorized its CFO to deal with all matters concerning derivatives transactions. The firm, having many term loans outstanding, had entered into currency swap option transactions and interest swap option transactions to reduce the cost of loan and interest costs.

Rajshree Sugars had revenues of Rs202 crore for the year ending 31 December and an export order for nine months of Rs111 crore. The firm has also imported goods and machineries for its units to the tune of Rs5.8 crore. Rajshree Sugars also has foreign currency loans of about $30 million (approximately Rs121.3 crore) as of 31 December.

The complaint filed by Rajshree alleges that "The defendant (Axis Bank) induced the plaintiff (Rajshree Sugars) to enter into the contract by advocating MalmarughanVaikundam (assistant vice-president, treasury markets group, Axis Bank) of the defendant bank to make...misrepresentations to P.K. Viswanathan...that the plaintiff stood to gain an immediate sum of $100,000 and there was virtually zero-risk of the plaintiff being required to make any payment under the contract to the defendant since the US dollar would not ever reach the stipulated exchange rate against CHF (Swiss franc)."

"The contract was entered into on 22 June 2007, when the rate was $1 = CHF 1.2355. On 28 June 2007, the defendant bank paid $100,000 to the plaintiff, which was duly credited to the plaintiff's bank account. This was net inflow of premium which the plaintiff received for writing this option in favour of defendant bank."

The US dollar has since weakened to about 0.985 against the Swiss franc.

"The contract is contrary to law and is, therefore, void," the complaint says, adding that, "In the present case, the plaintiff (Rajshree Sugars), at the time of entering into the contract or even thereafter, had no genuine underlying exposure to hedge. The contract was purely a speculative contract and the plaintiff was lured into a wager or a gamble on the movement of dollar against Swiss franc by entering into the contract."

The foreign exchange derivatives exposure of Indian firms and the underlying risks started coming to light in late November, when software firm Hexaware Technology Ltd said it had made provisions of $20-25 million (Rs78.8-98.25 crore then) to cover exposure from unauthorized deals entered into by an employee that involved derivatives. The company later reported a net loss of Rs81 crore for the quarter ended December after the actual damage on account of these transactions ended up being Rs103 crore.

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Court restrains Axis Bank in Rajshree derivative case

S KalyanaRamanathan / Chennai April 12, 2008

The Madras High Court today passed an interim order restraining Axis Bank from enforcing the forex derivatives contract sold to its client Rajshree Sugars and Chemicals. An injunction was passed today