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By Naomal Goonewardena

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.

1. Product Risks

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.

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.

2. Counter Party Risks

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.

3. Transaction Risk

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.

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.

4. Handling Risk

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.

5. Insolvency Risk

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 M Kiritharan

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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