Games People Play – Derivative Contracts in Bangladesh : Part 1 – (May 2013, Issue 1)

May 18, 2013, by Junayed Chowdhury

The amendment made to the Securities and Exchange Ordinance 1969 brings the definition of ‘derivatives’ into the legal system of Bangladesh.[1] ‘Derivative’ has been defined as including (i) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; and (ii) a contract which derives its value from the prices, or index-of-prices, of underlying securities.[2]

 

The above definition is certainly a welcoming incorporation to the capital market laws of Bangladesh. But the main question is – Is this definition compatible with the prevailing laws of Bangladesh?

 

‘Derivatives’ is not a legal term but a market jargon used to describe futures, options, swaps and other similar transactions. These transactions are, as commonly understood, “derive” from the underlying assets. For example, a stock option transaction involves an option to buy some specific shares in the future at a pre-agreed price. Here, the option “derives” from the shares (known as the “underlying asset”). Essentially, derivative contracts are contract for differences – that is – the difference between the agreed future price and the actual price on that date in the future.

Now comes the crucial question – whether a contract dealing in differences becomes a wager contract under section 30 of the Contract Act 1872.

 

Section 30 of the Contract Act 1872 (the ‘Act’) renders an agreement made by way of wager void. It has been held that to constitute a wagering contract it is essential that the parties never intended to deliver each other but only intended to deal in differences.[3] In other words, for a wagering contract, firstly, both the partiers must be able to win or lose under the contract and secondly, neither party shall have any other consideration from the contract.[4]

 

Let us now consider an example. Say, A took a loan from B Bank on a floating rate of interest. On the other hand A entered into a derivative contract with C Ltd, an investor, that A will pay C a fixed rate of interest amounting to 5% and in return C will pay A’s floating rate of interest to B Bank. In such a contact there is a possibility that both A and C are likely to win or lose. This is because if the floating rate is more than 5% then C loses and A wins and vice versa. This is called an interest rate swap. Here, A and C are dealing only in differences that may exist under or above the 5% interest rate. Thus, it seems that interest rate swap contracts satisfy the “win/lose” characteristics of a wagering contract.

 

The question now is whether there is any “delivery” or “other consideration” aspect in the transaction. If there is other consideration, then the transaction between A and C will not be a wagering contract.

 

The English courts have taken the “delivery obligation” approach to identify whether there was any other interest in the transaction. A “delivery obligation” is easy to identify in the case of, say, commodities or currencies, but harder in the case of interest rate swap. However, English courts recently adopted an approach where they considered whether the transaction was a “real transaction” or was “entered into for commercial purposes”.[5] The court held that in the context of interest rate swap contracts entered into by parties or institutions involved in the capital market and the making or receiving of loans, the normal inference will be that the contracts are not wagering but are commercial or financial transactions to which the law will, in the absence of some other consideration, give full recognition and effect.[6]

Thus, it seems that English courts have recognized a rebuttable presumption that derivative contracts are not wagering contracts. The court will look into the purpose and interest of both the parties and find out whether the purpose and intention of the parties was to wager or not. If either party was not wagering, then the contract will not be a wagering contract. Even if there is an element of wager, provided there was another primary reason for such contract, the court would treat the wagering as a mere subordinate element.

 

The aforesaid case laws exhibit the liberal attitude of the judiciary in respecting the financial objective behind derivative contracts and give some comfort for the transacting parties. However, as we all know, judge-made laws are ever changing depending on global trends. To avoid such uncertainties, it is better to make specific exception to section 30 of the Contract Act and include derivative contracts as an exception to wagering contracts.

 

Written by Junayed Chowdhury, Managing Partner  

 

† Disclaimer: The opinions and comments expressed in this Blawg are not to be regarded or construed as legal advice by and from Vertex Chambers or any of its members. It is highly advisable that any person should seek independent legal advice before relying on any of the contents of this Blawg.