V. Ramasubramanian, J.

"$ 700 Billion bail out plan", “Wall Street vanished", "Lehman Brothers went belly up", "Bear Stearns consumed", "U.S. National Debt Clock runs out of digits" and "AIG gone up in smoke" are some of the captions which have hit the headlines in recent times. All of those news items have a common denominator, called "derivatives" and this case is all about derivatives.

2. Since this appears to be the first case of its kind in India (subject to correction) where derivatives contracts are challenged as illegal and void and also since the jargon is not too familiar even to P.Ramanatha Iyer (of Law Lexicon) and Black (of Law Dictionary), a brief prelude has become necessary before we plunge into details.

PRELUDE ABOUT DERIVATIVES

3. "Derivatives are time bombs and financial weapons of mass destruction" said Warren Buffett, one of the world’s greatest investors, who overtook Microsoft Maestro in 2008 to become the richest man in the world and who is known as the "Sage of Omaha or Oracle of Omaha". Derivatives, according to him, can push companies on to a spiral that can lead to a corporate melt down. He compared derivatives business to hell, easy to enter and almost impossible to exit. In response to a query as to whether a nuclear war would be the worst case scenario, a famous daily web log commented that "the economic collapse triggered by the popping of the derivatives bubble" presented the worst case scenario.

4. True to the above criticism, the world of finance and investments, was swept by many a tsunami in the past decade and a half. Some of the "derivatives disasters" which plunged several institutions and millions of investors into severe crisis (and even led to the homicide by a 46 year old former IITian of his entire family followed by his suicide in US) are as follows:-

(i) The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, after losing about $1.6 billion through derivatives known as "reverse floaters" whose values move inversely with market interest rates.

(ii) The collapse of the 233 year old Barings Bank when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgment, lack of foresight, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a huge loss that bankrupted the centuries-old financial institution. The loss suffered by the Bank was estimated at $ 27 billion.

(iii) The crumbling of the heavy-into-hedges trading firm known as "Long Term Capital Management" under the weight of derivatives worth $ 1.4 trillion, in 1998. But it was bailed out by the joint efforts of the US Federal Reserve and a few Banks in order to minimise public outcry.

.(iv) The hedge fund fiasco of Amaranth Advisors in September 2006, to the extent of about $ 6 Billion, due to miscalculation of the price of natural gas futures.

.(v) The collapse of the largest investment Bank Lehman Brothers and the leading American insurer AIG, due to extensive exposure to Credit Default Swaps (CDS) threatening a potential collapse of the United States financial system in 2008, leading to a $ 700 Billion Bail out plan whereby the U.S. Treasury agreed to buy out the underlying defaulted and endangered debt instruments from banks, brokerages and other financial institutions in an attempt to keep the countrys credit market from shutting down and creating a global economic crisis.

5. What are these "derivatives" which have gained such a great deal of notoriety? In simple terms, derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The International Accounting Standard (IAS) 39, defines "derivatives" as follows:-

"A derivative is a financial instrument:

.(a) whose value changes in response to the change in a specified interest rate,