In this article, Smita Singh discusses how derivatives are regulated in India. The article was written while Smita was pursuing DEABL at NUJS.

Understanding Derivatives

The expression “derivative” indicates that it has no independent value. Its value is entirely derived from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. Derivatives can take the form of Forward, Future, Option or any other hybrid contract. They are of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

Futures are legally binding agreement to buy or sell the underlying assets on a future date. These are standardized contacts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. On expiry, futures can be settled by delivery of the underlying asset or cash.

Forwards are over-the-counter negotiated derivative contracts by which one party agrees to deliver underlying assets to another party on a predetermined date at a predetermined price.

Option contract, another species of derivatives gives the buyer or the holder of the contract the option i.e. a right, however without an obligation, to buy/sell the underlying assets at a predetermined price within or at the end of specified period. The seller/writer of the option is required to settle the option as per the terms of the contracts whenever the buyer/hold exercises his rights.

Future contract based on an index i.e. the underlying asset is the index are known as index futures contracts. The option contracts which are based on some index are known as index option contracts. An index derives its value from the prices of securities that constitute the index and this is meant to represent the sentiments of the market as a whole or of a particular sector of the economy.

Currency Derivatives are Future, Forward and Options contracts to buy or sell specific quantity of a particular currency pair at a future date. These allow investors to hedge against foreign exchange risk. Currency futures are exchange-traded contracts and they are standardized in terms of delivery date, amount and contract terms.

In India, derivative products have been introduced in the phased manner. Index futures contracts were introduced in June 2000. Index options and stock options were introduced in June 2001. In November 2001 stock futures were introduced. Sectoral indices were permitted for derivatives trading in December 2002. Trading in Exchange Traded Currency Derivatives (ETCD) began in India in August, 2008.

The regulatory framework for derivatives in securities

Securities Contract (Regulation) Act, 1956 (SCRA) is enacted to prevent undesirable transactions in securities. Initially, Bombay High Court in Brooke Bond India Limited v. UB Limited,: (1994) 79 Comp Cas 346 took a view that that the SCRA, is not intended to regulate private transaction in shares of public limited companies, not listed on the stock exchange. However the Supreme Court in Bhagwati Developers (P) Ltd. v. Peerless General Finance & Investment Co. Ltd., (2013) 9 SCC 584 did not endorse the view of Bombay High Court and made it clear that the provisions of the SCRA apply to public limited company, though they are not listed in the stock exchange.

Regulation of options

Section 2(d) of the SCRA expressly defines “option in securities” to mean a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities. The definition makes it clear that it is not the contract for sale of securities but a contract for sale of a right to sell securities in future. Section 20 of the SCRA specifically provided that all options in securities entered into after the commencement of SCRA or those entered before SCRA but remained to be performed were illegal. Thus options were expressly prohibited under SCRA. However, this provision was deleted by the Securities Laws (Amendment) Act, 1995.

Regulation of forwards under SCRA

The Central Government vide Notification dated 27/6/1969 (1969 Notification) issued under Section 16 of the SCRA (which empowers the Central Government to prohibit certain contracts in specified securities), had prohibited all kinds of contracts for sale or purchase of securities except spot delivery contract or contract for cash or hand delivery or special delivery in any security under SCRA. Any other contract could only be entered into with the permission of the Central Government. The 1969 Notification sought to restrict forward contracts. In 2000, the 1969 Notification was rescinded. Securities Laws Amendment Act 1999 with effect from 22/2/2000 amended the definition of “securities” in SCRA to include “derivatives”. It also inserted the definition of “derivatives” which reads: “Derivate”  includes -(A) 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; (B) a contract which derives its value from the prices, or index of prices, of underlining securities. By the aforesaid amendment, section 18A was inserted in SCRA providing that a derivative contract shall be valid if they are settled in the stock exchange.

Stand of SEBI

SEBI vide its Notification No SO 184(E) dated 1/3/2000 had issued directions having effect similar to that of the 1969 Notification. It is relevant to note that forward contracts which were prohibited by 1969 Notification are not the same as option contract. Unlike an option, a forward contract does not depend upon the exercise of an option by one of the parties. The distinction between a forward contract and options, is noticed by in decision of Division Bench of the Bombay High Court in Jethalal C. Thakkar v. R.N. Kapur, AIR 1956 Bom 74,  as below:

“A clear distinction must be borne in mind between a case where there is a present obligation under a contract and the performance is postponed to a later date, and a case where there is no present obligation at all and the obligation arises by reason of some condition being complied with or some contingency occurring.”

This distinction was also recognized by the Division Bench of the Calcutta High Court in the matter of East Indian Produce Ltd. v. Naresh Acharya Bhaduri [1988]64 Comp Cas 259 (Cal)(DB) wherein it held that restriction on spot delivery contracts applied to contracts for sale or purchase of securities and not options in securities which were separately prohibited under the erstwhile Section 20 of SCRA. In BOI Finance Ltd. v. Custodian (1997) 10 SCC 488, Supreme Court ruled that in case of a ready-forward contract, a ready leg (i.e. purchase or sale of securities at a stated price which is executed on payment of consideration for the spot delivery of the security certificates together with transfer forms) is valid and lawful but the forward leg (i.e. repurchase of the same securities on the later date at a specified price to be paid) is hit by the provisions of the SCRA and accordingly shall be ignored.

Yet and inspite of deletion of Section 20 of the SCRA in the year 1995, SEBI for long took a stand that options are not a spot delivery contracts but forward contracts. In informal guidance note given to Vulcan Engineers Ltd. relating to the purchase and sale of shares of the company at a pre-agreed price under the put/call options, SEBI stated that:

“As [this] (put / call) option would be exercised in a future date…the transaction would not qualify as a spot delivery contract under SCRA S. 2(i), nor as a legal and valid derivative contract in terms of S. 18A.”

In relation to the public takeover of Cairn India Limited where the parties had entered into put and call options arrangements, SEBI took a view that put option and call option arrangements and the right of first refusal do not conform to the requirements of a spot delivery contract nor with that of a contract of derivatives as provided under Section 18A of the SCRA and, therefore the put and call option arrangement along with the right of first refusal are in illegal.

Bombay High Court in the case of MCX Stock Exchange Ltd vs Securities & Exchange Board of India & Ors 2012 (114) BomLR 1002 held as follows:

 “In the case of an option, a concluded contract for purchase or repurchase arises only upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery.”

Bombay High Court thus took a view that once a contract is arrived at upon the option being exercised, the contract would be fulfilled by spot delivery and would, therefore, not be unlawful. However SEBI’s petition for special leave was disposed of by the Supreme Court with the consent of the parties and with an observation that in making amendments in the Regulation, SEBI shall not be bound by any observations or comments made by the High Court in the impugned judgment.

Eventually, by Notification dated 3/10/2013, SEBI rescinded the notification number S.O.184(E), dated the 1/3/2000, and declared that contracts in derivatives, as are permissible under law and options shall be valid provided inter alia the price or consideration payable for the sale or purchase of the underlying securities pursuant to exercise of any option contained therein, is in compliance with all the laws for the time being in force as applicable. With the aforesaid notification of SEBI a long standing debate on validity of options came to be settled.

Regulation under Foreign Exchange Management Act (FEMA), 1999

Derivatives are also subjected to exchange control regulations.

Reserve Bank of India (RBI) originally took a stance that contracts which offer a guaranteed return to the investor are more in the nature of debt as opposed to equity, and hence the same should be covered under External Commercial Borrowing (ECB) norms. Assured returns would allow a private equity investor to floor a minimum return from his investment and eliminate his risk of business exposure to which other equity investors are exposed. This made option contracts akin to debt. Later, RBI issued Circular No. 86 RBI/2013-2014/436 A.P. (DIR Series) dated 9/1/2014 allowing optionality clauses in securities issued to Non Resident Indian (NRI). The optionality clause can oblige the buy-back of securities from the investor at the price prevailing/value determined at the time of exercise of the optionality so as to enable the investor to exit without any assured return.

Derivatives in Foreign Exchange

As detailed in Master Direction issued by RBI on Risk Management and Inter-Bank Dealings (Updated as on March 21, 2017), to hedge direct and/or indirect exposures of Resident Indians to specified foreign exchange risk, they are permitted to book Forward Foreign Exchange Contracts, with the Authorized Dealer Banks.

Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 dated 3/5/2000 as amended from time to time, permitted persons resident in India and persons resident outside India viz., foreign portfolio investors (FPIs) to participate in the currency futures and exchange traded currency options market in India subject to the terms and conditions mentioned therein.

Until recently, non-residents Indians (NRIs)were permitted to hedge their rupee currency risk through over the counter transactions with banks authorised to deal in foreign exchange. With a view to enable additional hedging products for NRIs to hedge their investments in India, RBI by notification No. FEMA. 384/RB-2017 issued on 17/3/2017 has permitted NRIs access to the Exchange Traded Currency Derivatives (ETCD) market to hedge currency risk arising out of their investments in India. This allows NRIs to access the exchange traded currency derivatives market to hedge the currency risk arising out of their investments in India. NRIs may take positions in the currency futures/exchange traded options market to hedge the currency risk on the market value of their permissible rupee investments in debt and equity and dividend due and balances held in NRE accounts.

Commodity derivatives

As per F. No. 1/9/SM/2015 S.O. 2362 (E) and F. No. 1/9/SM/2015 S.O. 2363 (E) SEBI also regulates the commodity derivatives market under SCRA with effect from 28/9/2015.

References

1. http://www.sebi.gov.in/faq/derivativesfaq.html accessed on 27/3/2017
2. https://www.rbi.org.in/ accessed on 27/3/2017
3. Securities Contract (Regulation) Act, 1956