HIGH COURT OF ORISSA : CUTT ACK W.P.(Crl.) No. 344 of 2009 In the matter of an application under Articles 226 and 227 of the Constitution of India. Pravanjan Patra Petitioner Versus Republic of India and Others. Opposite parties For petitioner: M/s. Manoj Kumar Mishra, D.Mishra. For Opp. Parties: Mr.S.D.Das, Asst.Solicitor General forO.Ps.1 and2. M/s. Sourjya Kanta Padhi and Mrs.M.Padhi for O.P.3 M/s.D.N.Mishra, S.K.Panda, U.K.Mishra, S.Swain and Ashok Mohanty for O.PA. PR E S ENT: THE HONOURABLE ACTING CHIEF JUSTICe MR. I.M.QUDDUSI AND THE HONOURABLE KUMARI JUSTICE SANJU PANDA Date of Judgment: 24 -12 -2009 I.M.Quddusi, A.C.J. The petitioner who is a tax consultant has filed this writ petition by way of a Public Interest Litigation praying for issuance of a writ of mandamus directing the opposite parties to hand over tile investigation of offences committed for erosion of Forex Reserve of the Na.ion to an independent agency preferably the Central Bureau of Investigation for threadbare investigation and book the culprits and punish them in accordance with law. He has filed the writ petition basing on the information and documents obtained from different print media as well as the electronic media which he has appended to the writ petition. - 2- 2. Facts of the case are that for almost every developing country, reserves of foreign exchange is one of the most prestigious and valuable asset, as same reflects, not only the country's respect, status and dignity, but also one of the essential requisites for imports, cultural exchange, free movement of its citizens to other countries etc. etc. and for this reason, specifically, a law has been enacted to regulate/ deal with the foreign exchange. FOREX hedging is insuring price of Dollar or any other Foreign Currency which means the exporter or importer who intends to deal with Forex will be allowed to exchange at a particular price upto a particular amount for a particular period despite increase or decease in Forex Price in the market. The Contract created between Companies/persons for such exchange at a fixed price and dealers is called derivative contract. In India, Reserve Bank of India is the only authority to regulate Forest. Dealers are appointed by Reserve Bank of India who are only authorized to buy or sale FOREX. Any individual/Company has to buy or sale FOREX through dealers only. They cannot do it in open market. Because of frequent dropping in Dollar rate as against rupee, it was given to understand to different corporate houses and exporters that there would be further decrease in Dollar rate as against rupee. Thus they were hurried to enter into derivative contracts with Forex dealers. Learned counsel for the petitioner has submitted that when Dollar rate rose substantially, all the business houses were forced to deal with lower rate because of derivative agreement, for example when they were supposed to get Rs.50/- for one Dollar for the price of goods exported, they were paid RsAO/- as determined in derivative agreement. The differential price of RS.10/-was taken by the dealer. When dealers were asked as to what they were getting, they replied that they were getting @ 10 paise per Dollar only. If that be so, where the rest of the money is going and who are the beneficiaries is required to be investigated. The further submission of the learned counsel for the petitioner is that some unscrupulous persons including officials of Bank and Reserve Bank of India and Union of India are hand in glove with some beneficiaries from which they are getting huge incentives at the cost of common citizens. The differential amount of money instead of coming to Forex Reserve of our country is going to Foreign Countries or unknown hands. There are many private and overseas dealers like Morgan and Stanley, Standard Chartered Bank, HSBC Bank, Thomas Cook, Indusind Bank, Citi Bank, ICICI Bank etc. Because of frequent dropping in Dollar rate as against rupee, it was given to ----_._------------=--- ~' I • ·3· understand to different corporate houses and exporters that there would be further decrease in Dollar rate as against rupee. Thus they were hurried to enter into derivative contracts with Forex dealers. Forex dealers entered into derivative contracts with the corporate and export/business firms on long term basis. As per exposure of Indian Economy, i.e. gross total export and import, they were permitted to cover only risk factor and up to 500 Billion Dollars. Interested dealers entered into contract worth 3 trillion Dollars, i.e. six times more than the exposure of India and the RBI merrily consented to this and by this process gambling started. When the business houses were required to enter into contract for 1 lakh Dollar, out of apprehension, they entered into contract for 2 lakh Dollars as a result when Dollar rate rose substantially, all the business houses were forced to deal with lower rate because of derivative agreement. Therefore, according to learned counsel for the petitioner, there is scam of about RS.25 lakh crores. 3. On 23.7.2009, the opposite parties were called upon to show cause as to why the investigation of the case should not be handed over to the Central Bureau of Investigation. On 27.8.2009, the learned Assistant Solicitor General produced letter dated 18.8.2009 of the Director (Judicial) of Government of India, Ministry of Home Affairs addressed to the Director, CBI requesting it to take necessary action in the matter. This Court was of the opinion that the CBI should conduct an inquiry on the basis of the allegations made and also ascertain as to whether there is any violation of the Foreign Exchange Management Act, 1999 and the Regulations made thereunder. Extra copy of the writ petition was served on the learned counsel for the CBI and the matter was directed to be listed on 4.11.2009 asking the CBI to submit a preliminary report on that date. The Reserve Bank of India was also required to keep track of the differential amount in respect of exotic derivative contracts, if any. 4. Pursuant to the aforesaid order, the CBI has submitted an inquiry report. In the report it has been averred that from a perusal of the relevant provisions of the FEMA, Derivative Contracts Regulations and the RBI Master Circulars, it transpires that derivative contracts in foreign currency, both rupee- foreign currency and cross currency are permissible under these provisions, subject to the following terms and conditions: - 4- '". ' I) The authorized dealer, through verification of documentary evidence is satisfied about the genuineness of the underlying exposure; I 11) Options contract involving cost reductions strategies such as the range forward and the ratio range forwards should be drawn in such a manner that there is no net inflow of premium to the corporate and further that such structures do not result in increased risks; Ill) All permissible derivatives including roll over restructure and innovation are to be conducted at prevailing market rate; IV) Any derivative as underlying to any other derivative transaction is not permitted; V) The management of derivative activities should be an integral part of the over all risk management policy and mechanism. It is desirable that the Board of Directors and Senior Management understand the risks inherent in the derivative activities being undertaken. VI) Market makers (banks) should have a "Suitability and Appropriateness Policy" vis-a-vis users in respect of the products offered, on the lines indicated in theswe guidelines. It is further stated in the report that in order to ascertain as to whether any loss was borne by the exporters/corporates and banks, as contended by the petitioner and if so whether any violation of FEMA and the rules and regulations framed thereunder had taken place, a questionnaire was sent to the Reserve Bank of India and Directorate of Enforcement and their comments on the same were called for. Reserve Bank of lndia-vlde their letter dated 27.10.2009, enclosed as Annexure-F to the report, forwarded their comments on the questionnaire. The salient features of the reply, inter alia, are as under: i) Derivative contracts in foreign currency, both Rupee-Foreign Currency and Cross Currency are allowed under provisions of FEMA and rules & regulations framed thereunder, subject to the terms and conditions mentioned in the Regulations, Master Circulars and Comprehensive Guidelines. While - 5- . .r .~ ( I , ""j offering foreign exchange derivative products to their clients, banks are required to be guided by general principles laid down by RBI, particularly those related to "Suitability and Appropriateness Policy". ii) Authorised Dealer (AD) category I banks are authorized to enter into Foreign Exchange Derivative Contracts. As on July 1,2007, there were 84 AD Category I Banks. iii) It was observed that 11 banks had unrealized dues from customers to the tune of RS.755.45 Crores during the period April, 2008 to December, 2008 on account of derivative contracts entered into by them with customers. iv) The unrealized dues of RS.755.45 Crores were primarily due to customers failing to meet their obligations under the contracts or disputing the same. v) Many exporters entered into structured cross currency derivative contracts to hedge their exposure to exchange rate risks. The transactions were undertaken basically to hedge currency risk on their Current and Capital Account transactions. Most of these contracts were structures designed to reduce the hedging cost to the users and were primarily based on a view on the direction of movement of various currencies. Such structures are known as risk transformation structures where the user looks to shift the currency risk from one currency to another or where the pay off is based on movement of one currency against another. vi) Most of the aforesaid structured cross currencies contracts were based on the common view that US Dollar would be appreciating against rest of the currencies in near future. However, the sub prime crisis in US aggravated during the latter part of 2007 with the worsening of credit and liquidity conditions and slow down of housing market. The US economy was suddenly faced with a recessioinary condition. The Federal Reserve Board of USA, in a bid to improve the credit market and liquidity conditions and to provide psychological support to the markets started reducing policy ·6· .-' ( . \.',' rates aggressively while simultaneously injecting liquidity into the system. vii) The above factors led to US dollar depreciating against major currencies and the exchange rate levels envisaged in the structured cross currency contracts signed by the exporters, which were thought to be unattainable hitherto, were breached. As a result, most of the options sold by the users as part of the structured contracts were knocked in and exporters and other customers had to face negative Marked to Market (MTM) position and obligation to pay crystallized losses (in case of completed contracts). viii) Similar losses in derivative contracts were also suffered by exporters in other countries like South Korea, China, Hong Kong, Indonesia, Singapore, Thailand etc. on account of the same reasons. However, the MTM positions (losses) actually show the present value of transactions based on the current prices. Most of the aforesaid structured contracts were long term contracts and, therefore, the MTM position shall remain dynamic and subject to the movement in exchange rates of various currencies. Moreover, apart from incurring MTM losses, the customers also suffered substantial losses in plain vanilla (Indian Rupee-Foreign Currency) contracts due to sudden depreciation of the Indian Rupee vis-a-vis the other currencies. ix) Marked to Market (MTM) losses are basically an accounting concept wherein the financial institution records the value of outstanding financial· contracts at fair value (market value) while preparing financial statements. MTM value, therefore, fluctuates with chance in value of underlying currency rates/interest rates. The MTM is, therefore, dynamic in nature and changes in line with the market movements and. represents the replacement cost of the derivative contracts. As against this, the actual payment/receipt on account of its loss/gain on the derivative transaction will take place at the maturity of the contract depending on the market rates ·7· r prevailing on the date of settlement. The MTM, therefore, signifies only the current value of the contract and consequently its replacement cost, but not the realized gain or loss. x) Reserve Bank of India has been monitoring the gross MTM losses incurred by the Banks. As in December, 2008, the gross MTM gains (corresponding losses to the customers) of 22 banks active in the business of derivatives were Rs. 31,719 Crores, but the crystallized losses ( unrealized dues to the banks) were only Rs.755.45 Crores as enumerated above. Most of the contracts were signed for long term maturities and therefore, the MTM profile of such contracts is likely to undergo changes over the period till maturity of the contracts. xi) xx xx xx xx xii) Some users/customers also undertook hedge transactions in excess of their exposures (Genuine Underlying) in violation of FEMA provisions by making a faise deciaration under the past performance route or the underlying route. This compounded their losses. The provisions of FEMA and rules made hereunder are Applicable to banks and their customers alike. xii) xx xx xx xx xiii) Losses suffered by the customers may not represent the gains made by the banks. Banks are allowed to take open positions in the.forex market, including derivative market, within the limits prescribed by Reserve Bank of India. The Banks are not allowed to take open positions on cross currency contracts. However, banks which meet the specific prudential criteria are allowed to run foreign currency- Rupee option book within the overall net open position and Aggregate Gap Limits approved by Reserve Bank. All other transactions are required to be covered by the banks back to back with another bank in India or an overseas bank. -.. ., -'"'~.~.. '.-" ' . .., _ ----~.-~--- - 8 - . ,./ Therefore, the MTM losses indicated above do not reflect the profits made by the banks. xiv) RBI had constituted an inter departmental Committee to create suitable regulatory environment for derivative transactions. Based on recommendations of the committee, the "Comprehensive Guidelines on Derivatives" were issued by RBI in April, 2007. The guidelines detailed the general principles for undertaking both rupee and foreign exchange derivatives and addressed various other issues relating to derivatives such as board principles for undertaking derivatives transactions. Risk Management and Corporate Governance Aspects, Suitability and appropriateness Policy, Documentation, Identification of Risk and risk measurement etc. xv) Reserve Bank of India carried out special scrutiny in selected banks active in derivative transactions. A Portfolio approach was adopted towards the derivative business offered by such banks, during the course of Annual Financial Inspections 2007 and 2008 Cycles, The RBI held discussions with Chief executives of 22 banks active in the field of derivative transactions to assess the systemic impact The RBI has concluded that this is not a Systemic Issue. xvi) Based on the information gathered during discussions with the CEOs of 22 banks, further actions were taken by RBI, which included i) monitoring of derivative exposures of all banks, ii) strengthening of prudential framework for derivatives and iii) the constitution of Inter-Departmental Group (lOG) to review' the derivative transactions of the banks and recommended appropriate supervisory action, xvii) The lOG examined the observations relating to violation of regulatory guidelines in the AFI reports relating to the year 2007 and 2008 in respect of 22 banks and special scrutiny reports of banks. These violations generally related to failure to verify the underlying of derivative transactions, offering - 9- I _.1 structures resulting in increase in risk and receipt of net premium by the corporate, booking of contracts under past performance route beyond the eligible limits, offering leveraged products etc. xviii) The lOG has identified violations, which are serious in nature, and they are being examined for further action against the banks concerned. In the light of findings of special scrutiny, AFls and meetings with banks, the FEMA Regulations and Comprehensive Guidelines on Forex Derivatives are being revisited. It has been announced by RBI in the Second Quarter Review of the Monetary Policy 2009-10 that the draft guidelines in Forex Commodity and Freight are being placed on Reserve Bank web site by end - November, 2009 for wider dissemination and comments/views. xix) RBI has pointed out the following irregularities/deviations in compliance of FEMA notifications and Guidelines: a) Offering structures that were in violation of extant regulations viz structures that resulted in accordance in risk and net receipt of premium. b) Offering leveraged structures, Leverage has also been used in many derivative structures by the banks and their customers. In such a structure, the customer buys and sells options to reduce his cost. The national principal amount of the said options has been observed to be a multiple of the value of the underlying which compounded the MTM losses of the customers .. c) Not verifying the underlying insufficient underlying exposures: d) Not obtaining declaration regarding amounts booked with other Ads on past performance basis. Users are observed to have utilized the total eligible ;,,;ttmit with not just one bank, but a number of them without their declaring or apparently giving false -10- declarations, on each occasion, about the amount of heading facility already utilized with other banks in this regard. This led to large scale leveraging of the same underlying exposures resulting in multiplying of losses. e) Booking of contracts under past performance basis beyond 50% of eligible limit without obtaining CA Certificate. f) Not ensuring adherence to eligible limits under the past performance route. g) Not carrying out proper due diligence regarding user appropriateness and suitability of the product offered to the customer. h) Not obtaining written acknowledgement from the clients for understanding the risk disclosed. i) The periodical review reports and annual audit reports were not obtained by the banks from the concerned users. j) Even when the transactions were based on underlying exposure, the banks relied on photocopies of documents to ascertain the same. This led to misuse by the clients who used photocopies of the same underlying to enter into different contracts with different banks, which resulted into manifold increase in their losses. xx) Specific comments of the banks with regard to various supervisory issues/concerns arising out of derivative business are being obtained. Further as recommended by lOG, serious irregularities are being followed up with individual banks. xxi) The total national principal amount outstanding in respect of derivative contracts including forward foreign exchange contracts wa~7tth~ the tune of Rs.71 ,71 ,570 Crores (USD 1646 billions) as on March 31 ,2007 and Rs.1, 17,94,707 Crores (USO 2435 billions) as on December 31, 2008 - 11 - respectively. The credit equivalent amount of these contracts was Rs.1,44,545 Crores (USD 34 billions) as on 31.3.2007 and Rs.4,70,304 Crores (USD 98 billions) as on 31.12.2008 respectively. However, the total unrealized dues of the 11 banks on account of derivative contracts with customers, as mentioned earlier, was RS.755.45 Crores (USD 0.16 billions) during the period april, 2007 to December, 2008 xxii) Similarly questionnaires were also sent to the Head Offices of following 8 banks to elicit their responses on the current issues raised by the petitioner in W.P(Crl.) NO.344/2009. i) State Bank of India. ii) HDFC Bank. iii) HSBC Bank iv) Standard Chartered Bank. v) Citi Bank. vi) ICICI Bank. vii) ABN Bank. viii) Axis Bank. 4.10. At the time of writing this preliminary report, responses from the aforesaid banks are awaited. Most of these banks have sought time to furnish the requisite data and information. 4.12. During the course of inquiry, it was learnt that several exporters of Tirrupur, Tamil Nadu had incurred heavy loses in the forex derivative contracts.. His statement is enclosed as Annexure-H. 4.14. Some exporters have also claimed, in their civil suits that they were made to sign the contracts through coercion, misrepresentation of fact and therefore, the I ,~., contracts 'are void (Jnd.et~provisions of Section 19 of the Indian • Contract Act. They have also maintained that the contracts are void under Section 30 of the Indian Contract Act being wagers in nature. r - 12 - 5.2. Further, there are in built provisions in FEMA for initiating action against the defaulters, in case the provisions of FEMA and regulations made thereunder are violated by an individual or concern. FEMA also specifically identifies the Enforcement Directorate and the Reserve Bank of India as the authorities who have been entrusted with the responsibility of making regulations and enforcing the law, 5.3. The petitioner has contended that officials of Reserve Bank of India, Banks and Govt. Officials, in conspiracy with unknown foreign entitles/persons make international and willful projections/forecasts which indicated that the Indian Rupee will strengthen against the US Dollar. By such projections/forecasts, a hype was created in the foreign exchange market. By such projections and forecasts, Banks trapped gullible investors/importers/exporters and sold specially engineered products (foreign exchange derivatives) to fritter away the precious foreign exchange out of the country. However, this apprehension of the petitioner does not seem to be based on any logical conclusion drawn on an in depth examinations of the facts pertaining to derivative transactions. The petitioner has not even named any official from RBI or the. concerned banks, let alone cite any instance which indicates a conspiracy to defraud the national exchequer. RBl's response has clarified that the phenomenon is not restricted to Indian alone and losses have also been suffered by banks and clients in many other countries such as Indonesia, China, South Korea, Hong Kong etc. For this the Reserve Bank of India has already initiated action under the inherent powers available with them. The angle of criminal conspiracy, however, does not seem even a distant possibility '"<'.::."{., . in the etf'ti{e- matter. , , J 5.4. However, .Jr-om the data received from the reserve Bank of India, it is clearly seen that the extend of unrealized dues to the banks, during the relevant period was only RS.755.45 Crores, which is not such a huge amount so as to - 13 - I .} -I ~j cause such a big negative impact on the national economy as apprehended by the petitioner. The MTM position though indicates as major loss suffered by the banks/clients, but the fact remain that MTM position does not reflect the actual unrealized loss and is merely a projection of the current position. 5.5. It is submitted that RBI has also reported that some of the products, especially the cross currency derivative products violated the provisions of FEMA and regulations made thereunder. As regards the counter parties, for the clients, the counter parties were the concerned banks, whereas for the banks, the counter parties were other Indian/foreign banks. 5.7. It is submitted that Reserve Bank of India (or the Govt. of India) had issued clear cut guidelines and the provisions of such guidelines were applicable to both banks and the users (exporters) alike. Violations of the guidelines were committed by banks/exporters, who, in many cases entered into derivative contracts far in excess of their genuine underlying exposure and also tried to use the hedging tools as Profit making tools. In the end it was their greed that proved to be their undoing and not the policy guidelines of RBI or the Govt. of India. If the guidelines had been adhered to, the losses would have been contained, especially in such instances, where the cost reducing strategies led to increased risk profile or where contracts far in excess of the genuine underlying exposures were made. It may be said that there is enough in this world for every one needs but not for anyone's greed. 5.8. The petitioner has contended that the Derivative contracts are financi~t.sc.andalsand are wagers and hence not permitted under la. is a question of law and does not need any comment ?to be made by CBI, which has been entrusted with the task of conducting any inquiry into the matter and not to make comments on legal issues. I ,_-J ·14· 5.9. It is apparent that violations of FEMA and regulations made thereunder have taken place in the forex derivative contracts signed