Derivatives In Russia--More Than A Gamble?
The economic crisis of 1998 left the Russian financial markets in shambles. One of the areas most affected was the young yet, at the time, sprawling derivatives market. In the aftermath of the crisis, courts declared non-deliverable forwards to be a form of gambling--thereby negating judicial protection of claims. This made it possible for Russian parties to international derivatives contracts, especially banks, to refuse settlement without having to face the consequences. The following article addresses what has and has not changed since 1998 and describes the current practice of derivatives trading in Russia. It then points out current promising developments, and discusses a likely future scenario.
The Current Situation: A Lack Of Legislation
The current state of affairs is that, as in 1998, no regulation exists for fixed-term transactions in either the Russian Civil Code or Federal Laws. On the other hand, the Tax Code does contain provisions concerning the taxation of deals with "derivative instruments of the fixed-term market." So the existence of derivatives is abstractly acknowledged, but without any further definition. A number of regulations issued by the Bank of Russia contain mentions of certain forward deals as well, but also without binding regulations.
Controversial Judiciary Decisions
With such scarcity of legislative foundations, court precedents assume a prominent role. Two types of courts in Russia may deal with disputes concerning derivatives, each of which follows different procedures: the Russian State Commercial Courts (Arbitrazh Courts), and the non-State Arbitration Courts (Commercial Arbitration Courts). Most cases are still brought before the Arbitrazh Courts as these courts are cheaper and take less time to make decisions. They also have the right to issue enforcement orders, which the Commercial Arbitration Courts lack. Moreover, the prior consent of both parties is necessary for a dispute to be settled before the Commercial Arbitration Courts. With respect to international transactions, this agreement can be made part of the contract.
The decisions of the two types of courts differ substantially. The lower Arbitrazh Courts have found that derivatives contracts are to be considered gambling, if clearly defined mutual obligations are absent from the contract at the time it is concluded. Therefore non-deliverable forwards and derivative instruments that, for example, provide for a payment linked to a well-known market index would not be enforceable, as the obligations known on the Trade Date are not mutual (i.e. there would be a one-sided obligation with no corresponding counter-obligation).
A decision in June 1999 by the Supreme Arbitrazh Court, however, defined two situations in which judicial protection for a derivatives contract might be ensured after all. The first of these resembles a definition from the German Civil Code, under which "transactions for a difference," for example arbitrage, are considered to be gambling. And, vice versa, if one of the parties is obliged by the terms of the contract to conclude a real transfer (e.g. of currency), such a deal would not be considered a wagering contract. The second resembles English law, under which transactions concluded with the intention, or in the course of doing business, are not considered to be gambling (e.g. risk insurance, but also investments), and therefore also qualify for judicial protection.
The decisions of the Commercial Arbitration Courts, in contrast to the lower Arbitrazh Courts, have mainly reflected this stance of the Supreme Arbitrazh Court. While a number of decisions have recognized and awarded judgment in favor of claims based on derivatives contracts for one or both of the reasons stated above, enforceability of these favorable decisions remains problematic. To enforce the award of the referring tribunal, it must be legalized by the responsible State Arbitrazh Court. This court regularly refuses to grant the right to enforce, on the grounds of the award being in conflict with existing laws or with public policy. In short, even if a Commercial Arbitration Court awards a judgment in favor of a claim, the history of this kind of case shows that this will not necessarily result in an ability to collect the amount due from the defendant.
The fear in Russia is that courts may equate netting agreements to "normal" set-offs, a stance supported by the Central Bank. According to the Russian Civil Code there may be no set-offs if any party has declared insolvency. In our view, a distinction between netting and set-offs does exist under current Russian law, but recent judicial decisions have gone against this, turning down claims brought by non-defaulting parties. Yet there is a strong legal basis to suggest that this might be decided differently by higher courts from case to case.
The current stance may cause whole sets of bilateral as well as multilateral settlements to dissolve in the event of insolvencies of any party to them, thereby adding a further unpleasant risk component to derivatives contracts.
The Ensuing Legislative Debate
Russian legislators have now recognized that reform is needed. Therefore legislation on this topic has become a prominent point on the reform agenda. Following an initiative from MICEX (Moscow Interbank Currency Exchange) and the Committee on Derivative Financial Instruments, the Duma (the lower house of parliament) started to look at this issue last year.
There are currently two initiatives in the Duma. One proposes the adoption of a separate and comprehensive law on derivatives. This approach also envisages the regulation of derivative instruments solely tailored to the economically important trade of commodities. The second initiative aims at amending existing laws, such as the Civil Code, the Tax Code, and certain other laws on business and banking activities as well as commodity exchanges, to suit trade in derivatives in general.
So far, no agreement has been reached as to whether trades should take place at organized exchanges or solely over-the-counter or who may participate. Finally, it is not clear whether existing authorities will carry out the controls, or whether new state bodies will be instituted.
What Is To Come?
Work on the law is still in progress. Nevertheless, agreement has been achieved by the proponents of the two competing initiatives in order to glean a basic outline of a workable future scenario.
* There is agreement that the risk of contracts being treated
as gambling contracts by the courts needs to be reduced by
* The two initiatives are also agreed that information on the
risk of derivatives transactions needs to, in some instances,
be made available to market participants.
* There is agreement that changes in legislation are to
clarify that netting is not to be treated as if it were a setoff
and therefore to possibly be invalidated in case of insolvency
of the counterparty.
* The deductibility of expenses is to be extended.
Even though uncertainties remain concerning the specifics of the future organization of trades, judging by the current state of discussion it appears that reform of the legislation on derivatives will adequately address the most important issues--legal certainty and accuracy and availability of information. Two caveats remain. First, the timetable for completion of the reform is still rather unclear. Second, this would not be the first Russian reform with excellent propositions--putting it into practice is another matter.
Until reform is completed, derivatives will remain far less effective as financial instruments for risk management in Russia than in other countries. Nevertheless they do still constitute an existing opportunity to reduce risks, but as the netting example shows, mainly for those who are well acquainted with the Russian judicial system and laws.
This week's Learning Curve was written by Max Gutbrod, CIS managing partner at Baker & McKenzie in Moscow.