Upcoming Mallesons seminarsEntities entering into derivative contracts which are forwards having a fixed price.
What do you need to do?Consider whether the decision alters their regulatory profile in respect of those contracts.
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In a recent decision, the Federal Court of Australia has made some unexpected findings that, if taken to their apparently logical conclusion, might be argued to exclude some common derivatives from the Australian financial services regulatory regime. It is an interesting result, particularly in the context of the current global focus of expanding regulatory reach.
The case related to a number of contracts under which the plaintiffs agreed to sell grain at a fixed price to be delivered a number of months in the future. The key issue for the Court was whether these forward contracts were a ‘financial product’ for the purposes of the Corporations Act. If they were, then they would be subject to regulation under the Corporations Act.
The plaintiffs claimed that the forward contracts were ‘financial products’ because each contract was either:
- a ‘derivative’, or
- a facility through which the plaintiffs managed a financial risk.
Each of these terms is defined in the Corporations Act and classification of a product as either of these can attract regulation.
The Court found that the forward contracts were not ‘derivatives’ on two different grounds. First, because the forward contracts had the benefit of an exemption for future sales of tangible property (a finding which is not that remarkable); and, second, because the forward contracts did not satisfy the definition of ‘derivative’ (a finding which is quite remarkable). The judge also made limited comment in relation to whether the forwards were a facility for managing financial risk.
Exemption for sales of tangible property
The Corporations Act provides that an arrangement under which the parties are obliged to buy and sell tangible property (such as grain) and the seller’s obligations are to be settled in the future by, and only by, delivery of that property is not a ‘derivative’. The Court found that this exemption did apply to each forward contract and, therefore, each forward contract was not a ‘derivative’ for the purposes of the Corporations Act.
As this exception was held to apply, the forward contracts could not be ‘derivatives’ or ‘financial products’ and so it was not strictly necessary for the Court to go any further to resolve the issues between the parties. Indeed, had the Court stopped at this point, the decision may not have been that striking.
However, the Court chose to consider whether the forward contracts fell under the general definition of ‘derivative’ and it is at this point that the decision becomes more interesting.
The scope of the general definition of ‘derivative’
The Corporations Act describes a number of elements that must be present for an arrangement to constitute a derivative. However, the only element that the Court considered to be in dispute was whether, under a forward contract:
“(c) the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable)”… (emphasis added)
The plaintiffs submitted that this element was satisfied because the value of the forward contracts varied by reference to the market price of wheat or barley from time to time.
In reaching its decision, the Court stated:
“It seems to me that the answer lies in the meaning of the ‘something else’ referred to in the paragraph. It includes an asset, a rate (including an interest rate or exchange rate), an index or a commodity and things of any nature whatsoever and whether or not deliverable. In my opinion, although the precise boundaries of the definition may be difficult to identify, the matters the plaintiffs relied on, that is, the fact that there is a market for goods and that a party to the arrangement may enter into a transaction, is ‘something else’ for the purposes of paragraph (c).”
Despite this, the Court found that the forwards were not included in the general definition. It appears that the Court was concerned with the breadth of the definition of ‘derivative’ and considered that it ought to avoid “an interpretation … which would catch an ordinary transaction like the sale and purchase of a motor vehicle with the payment of the purchase price today and delivery in one week’s time”. It appears unusual that concern for these types of transactions - which were not relevant to the proceedings before the Court (and, if they were, would be likely to be excluded by the same exemption for sales of tangible property which applied to the forward contracts) - should serve as the basis for reading down the definition of ‘derivative’ so that it did not apply to the forward contracts.
It is a particularly surprising interpretation for the Court to adopt, when the Explanatory Memorandum for the Bill which introduced the definition of derivative into the Corporations Act expressly states that the statutory language “ensures that the definition covers deliverable options and futures contracts under which the consideration remains the same but the value of the arrangement varies by reference to something else”. The Court did consider the Explanatory Memorandum, but it concluded that it was “not … of great assistance”.
Facility for managing a financial risk
The Court briefly considered the plaintiffs’ submission that they were managing a financial risk by entering into the forward contracts before concluding that the pleadings were insufficient to form a view on this question and, in any event, the case did not turn on this point.
This last comment is interesting also, and may serve as a guide that the Court considered the application of the tangible property sale exemption to be the true basis of the decision. This is because if the forward contracts did not fall into the definition of derivatives, they may still have been a financial product if they were a facility for managing a financial risk (and accordingly, the determination as to whether they were such a facility should have been relevant). However, if the forward contracts were not a derivative because they fell within the tangible property exemption then they were automatically not a financial product, whether or not they could have been a facility for managing a financial risk (and accordingly, the determination as to whether they were such a facility should not have been relevant, as the Court noted).
Implications of the Court’s decision
If this case is seen as no more than an application of the tangible property exemption already existing under the Corporations Act then it need not give rise to any concern.
If the decision is taken as authority that forward transactions which have a fixed forward price are not derivatives under the Corporations Act then the decision does create a degree of uncertainty as to the operation of the financial services licensing and disclosure regime to particular derivatives transactions. This is because prior to this decision, transactions of this type have been commonly understood to be a ‘derivative’ for the purposes of the Corporations Act. However, even if this interpretation is adopted, it does not necessarily follow that the transactions are completely outside regulation, as they may still amount to a facility for the management of financial risk (as the Court did not lay any clear guidelines on this point).
Nevertheless, even a possibility that some kinds of derivative transactions are not regulated is likely to come as a surprise at a time when there is a global push for more, rather than less, regulation.
Case: Keynes v Rural Directions Pty Ltd (No.2) [2009] FCA 567