Tag: #contractlaw

Swap Contracts: Concept, Mechanism and Types

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What are Swap contracts?

In the year 1982, Swap Contracts were introduced when the World Bank and IBM entered into an agreement. Swap contracts are one of the four types of financial derivative contracts, where two counter-parties exchange the cash flow of one party for those of the other party’s cash flow for a fixed period.

To understand the system of swap contracts, let us assume that there are two parties. A, who lives in India, goes to the market and notes that the cost of a Samsung mobile is Rs.40000 and the cost of an iPhone is Rs.65000 and B, who resides in the USA goes to the market and notes that the same model of phone that A checked is available for Rs.65000 and Rs.40000 for Samsung and iPhone respectively. Now, these two parties decided to enter into a contract to exchange their commodities and reduce their purchasing cost. This arrangement is defined as swap agreement.

These swap agreements are useful for the financial institutions who want to convert their floating rate to a fixed rate and vice versa. These contracts are executed through a swap bank that works as a matchmaker and assists the transactions between the parties.

Types of contracts

Countless swap agreements exist in the financial ecosystem. Here, we will discuss most commonly used variations:

  1. Interest Rate Swap: Interest rate swap is one of the most commonly used methods in financial derivatives. These swaps do not include the retail investors and the contracts are of an OTC nature and are executed between businesses and financial institutions.

Let us consider an example, Company A, a newly incorporated company with no financial standing in the market, approaches the bank for a loan and the bank says that they will provide the loan but at a variable rate of interest. On the other hand, Company B, which has an excellent financial standing in the market, approaches the bank for a loan. The bank agrees to give the loan at a fixed interest rate with the same time and notional principle. Now, the companies observe that the interest rate for Company A is going to increase and the interest rate for Company B is going to drop, but due to the fixed rate of interest, the Company would still be paying more. Hence, both the companies agree and swap their interest rate nature and are executed between businesses and financial institutions.

Consider another example, where Company A is newly incorporated and does not have any financial standing in the market. It approaches the bank for a loan and the bank says that they will provide the loan but at a variable rate of interest. On the other hand, Company B, which has an excellent financial standing in the market, approaches the bank for a loan. The bank agrees to give the loan at a fixed interest rate with the same time and notional principle. Now, the companies observe that the interest rate for Company A is going to increase and the interest rate for Company B is going to drop, but due to the fixed rate of interest, the Company would still be paying more. Hence, both the companies agree and swap their interest rate.

2. Currency Swap: Currency swap agreements are used by financial institutions that are planning to expand their businesses internationally and require financing. Through swap contracts, the companies get a more favourable loan rate from their local banks as compared to the banks from that country and minimise the risk associated with the currency fluctuation. It involves the exchange of the principal amount along with the interest payments from one currency to another.

For example, an India based company “X” is planning to enter the Australian market and simultaneously, an Australia based company “Y” is planning to diversify their portfolio by purchasing a company in India. For company X, the expansion would require a funding of $22 million and for Y the acquisition would require the same amount of loan. Now, the Indian banks might give Company X a loan at 9% but for Company Y, it will be at 12%. Likewise, Australian banks will give a loan to Company Y at 9% but for Company X it will be at 11%. However, both companies could have an advantage if they borrow in their domestic currencies and enter into a swap contract. In this way, the companies will receive the desired foreign currency at a cheaper loan and the risk factor for currency fluctuation will reduce.

3. Debt-Equity Swap: Debt-Equity Swap agreements are one of the recent additions. They are used to trade the debt or obligations of a company for something that has an equivalent value such as equity, bonds or stocks. This type of contract is used to maintain the debt to equity ratio of the company to keep a good credit rating in the market. The debt-Equity swap value depends on the market rates but the lender may provide a much higher exchange offer. 

For example, Company X suffers a drop in the revenue because of the economic crisis and it has the potential to avoid going bankrupt but due to cash flow problems, they will not be able to make the scheduled instalment. So they approach the bank and offer them 5% equity in exchange for the remaining loan. This swap is called the debt-equity swap.

4. Commodities Swap: Commodities swaps are used to hedge the fluctuation in the commodities pricing and set a fixed price. This will benefit both the buyer and sellers in the market as there will be a fixed selling price and buying price. Generally, it is always the cash flow that swap and not the actual commodities.

For example, if a company is purchasing 1000 gallons of oil and has agreed to pay a fixed price of $2 per gallon, then, at the time of payment if the price increased by 20 cents, the company would be paying $200 extra if the price was not fixed. Now, if the price drops by 20 cents the company will have to pay $200 more. Hence, if the price of the commodities that a company uses as input is floating then the profits of that company will also be volatile, that is the reason the companies prefer to enter into the commodities swap agreements.

Applications of Swap

There are various applications of swaps in the financial markets. Some of them are :

  1. Hedging of Risk: The most important and primary application of swaps is to hedge risk. For instance, Company A is in a contract with a floating interest rate and has reasons to believe that in near future the interest rates will increase significantly. So to save themselves from higher interest rates, the company has to exchange the floating interest rate for a fixed interest rate.

Similarly to hedge against the fluctuation in currency exchange, the enterprises involved in international business enter into currency swaps.

2. Low borrowing rate: The comparative advantage that one company has is exchanged with the advantages possessed by another company. Hence, both the companies are benefitted from the swap and the purchasing cost is significantly decreased.

3. Access to the International market: The companies enter the foreign markets by using the swap system which will help them in avoiding the fluctuation in financial transactions. For instance, if a company of Canadian origin wants to invest in a business entity in the Indian market, they will enter into an interest rate swap agreement with an Indian company, as the rate of interest for a domestic company would be lower compared to that for the company itself.

4. Avoiding bankruptcy: Using the debt-equity swap, a company can save itself from declaring bankrupt. For example, if a company suffers a revenue drop due to a crisis and the cash flow is not enough to pay company’s regular expense, they can offer the bank equity in their company in exchange for the loan to get approved.

Usage

Commercial and comparative advantages are the two basic categories in which swap contracts are used. When a company enters into an agreement where they have to pay a certain interest rate which can be fixed or floating rate, then swaps can reduce the risk of fluctuation in the financial market. Companies that are planning to enter a new market can have a comparative advantage by using the currency swap agreements.

For example, if Indian company wants to expand its business in Malaysia, it is more likely for the company to get a favourable agreement in India. So, by entering into a currency swap, the company can have the finances it needs to expand its business in Malaysia without paying extra interest rates.

Exiting a Swap Agreement

There are three frequently used ways to exit a swap contract before the expiration of the term period. They are:

  1. Buy-out: With the consent of the counter-party the market value of the swap agreement can be calculated and the amount can be paid by the party and this way the company can exit the swap contract.
  2. Sell the Swap: With the consent of the counter-party, the company can sell the swap to a third party at the current market value.
  3. Offsetting Swap: A company can nullify the effect of a swap agreement by entering into a reverse swap contract. For example, if a company is in a swap where they receive a fixed interest rate, then they can enter into another swap with a third party to exchange the fixed interest with the floating interest rate.

The blog is written by Abhinav Bansal  ), B.A.LLB student at Trinity Institute of Professional Studies.

Edited by- Deeksha Arora

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HAMLYN v. HOUSTON & CO.

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Case Number:

CA 1903

Equivalent Citation:

[1903] 1 K.B. 81

Bench:

Collins, M.R. and Methew, J. 

Decided on:

19 November 1902

Relevant Act:

The Partnership Act 1890

Brief Facts and Procedural History:

In this case the defendant company is a partnership company with two partners, Mr Houston and Mr Strong, who represented the company. Mr Houston took care of the functioning of the company and Mr Strong was a sleeping partner. Mr Houston, acting within the scope of his authority, bribed the clerk of the plaintiff’s company and induced him to commit a breach of contract with the plaintiff as a result of which the clerk divulged some of the secret, important information of the plaintiff’s company. This act of Mr Houston was done without Mr Strong’s knowledge. The information was used by Mr Houston in a way to make the plaintiff company, his competitor, suffer the loss. Plaintiff sued both the partners of the defendant company for breach of contract under vicarious liability. The trial court said that both the partners are liable for breach of the contract. The case went to the Court of Appeal.

Contention:

  • Whether or not Mr Houston acted within the scope of his authority in obtaining the details of the plaintiff company?
  • Whether or not Mr Strong is liable for the wrongful act committed by Mr Houston?

The ratio of the Case:

The defendant’s counsel argued that gaining information about your competitor’s business is something that a businessman can do and hence, it is legal. So, what Mr Houston did is legal and that he is not liable for the breach of contract. The court agreed with this argument of the defence counsel and stated that Mr Houston acted as an agent and it is done within the scope of his authority, it is illegitimate and amounts to a breach of contract. This was based on the board risk principle, according to which if the principal is the one who will benefit from the acts of the agent, then he is also liable for the risks the agent goes through, while he is performing the acts delegated to him. In this case, the clerk was an agent of Mr Houston and so he is liable for the risk the clerk incurred, that is, the breach of contract, while delivering the information Mr Houston has asked for.

The decision of the Court:

The Court of Appeal upheld the order of the trial court and said that both the partners of the defendant company, Mr Houston and Mr Strong, are guilty of inducing breach of contract, even though it was committed by only one of them.

This case comment is written by Santhiya V, a 3rd year BBA LLB (Hons.) studying at Alliance University.

Editor- Deeksha Arora

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The Law Of Bailment

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Introduction

Section 148 of the Indian Contract Act, 1872 defines the term Bailment, that upon a contract when one person delivers goods to another for some purpose and when the motive is achieved. That bail was either returned or else disposed of according to the directions discussed earlier in the contract of the person delivering them. Thus the Law of Bailment involves the transfer of possession from one person to another. The title of ownership did not get affected in this case.” bailor” is the one who delivers the goods. And “bailee” is another person to whom goods are delivered.

Essential Elements of the Law of Bailment

  • Delivery of possession.
  • Delivery of Goods upon contract.
  • Delivery of Goods for purpose.

How Bailed goods delivered to the bailee

Section 149 of the Indian Contract Act states that when the bailee made delivery by doing anything which has the effect of putting the possession of the goods of any person authorized to hold them on his behalf. Then, bailment happens between the parties.

Delivery of possession is of two types.

  • Actual delivery- when goods possession is delivered from the bailor to bailee, then actual delivery happens. 
  • Constructive delivery- physical transfer of goods does not happen here. Goods are remaining with bailor only, but something decided which has the effect of putting them in possession of bailee. 

Duty of Bailor

  • Duty of bailor to disclose faults in goods bailed- Section 150 of contract act, binds the bailor to reveal all the defects of goods bailed which he knows. And if he is not doing so, he will be responsible for damage arising from such faults directly to the bailee.

Duty of Bailee

  • Duty of reasonable care
  1. Section 151 of the act binds the bailee to take as much care of the goods bailed to him as a prudent man takes care of his goods.
  2. Section 152 states that if the bailee has taken due care, he is not responsible for loss, deterioration, or destruction of goods bailed.
  • Duty not to make unauthorized use

Section 154 of the provides that the bailee is liable to compensation if he makes any use of the goods bailed that is not according to the conditions of the bailment.

  • Duty not to mix goods
  1. Section 155 of the act states that if the bailee mixes the bailor’s goods with his goods but with the bailor’s consent, the bailor and bailee shall share an interest in proportion to the mixture produced.
  2. Section 156 states that if the bailee mixes the bailor’s goods with his goods which is separable. Without the bailee’s consent, then the bailee is bound to give the expense of separation and any damage arising from the mixture.
  3. Section 157 holds the bailee liable to pay compensation for the loss of the goods by mixing the bailor’s goods to his goods which cannot be separated and mixed without the bailor’s consent.
  • Duty to return goods bailed
  1. Section 160 of the act provides bailee duty to return or deliver goods bailed according to the direction of bailor as soon as the time expired for bailment, or the purpose has been accomplished for goods bailed.
  2. Section 161 states that on account of faults of Bailee the goods are not delivered at the proper time, then it is Bailee’s responsibility for any loss or destruction of the goods from that time.

Rights of Bailee

  • Right of lien – it gives the right to the bailee to retain goods or property until some charges due upon it or services rendered for its improvement to be paid by the bailor.

Two types of lien in bailment-

  1. Particular lien
  2. General lien
  •   Right to sue the wrongdoer

Section 180 of the Act confers the right of the bailee to sue wrongdoers.

Landmark Judgments

  • Hutton v Car Maintenance Co. – In this case, the plaintiff company maintained the defendant’s car. The defendant does not pay some dues. Then the plaintiff’s company took the car into its possession and claimed a lien for expenses. The court rejected the claim. 
  • Ram Ghulam v Government of Uttar Pradesh – In this case, police recovered some stolen ornaments from the plaintiff. But in the police station, they were again stolen. Plaintiff sued the government for the loss. The court dismissed the case.
  • Ultzen v Nicolas – In this case, a waiter took the overcoat of the plaintiff and hung it on behind the chairs. After having dinner, the plaintiff found that his overcoat was missing. He sued the owner for the loss of the coat. The owner was held liable.
  • Shaw &Co.v Simmons & Sons- In this case, the plaintiff consigned books to the defendant, a bookbinder. But the defendant failed to deliver them within a reasonable time. The defendant was held liable for the loss of the books.
  • Installment Supply (P) Ltd v Union of India – In this case, the court held that the Hire-purchase contract is not merely a bailment. But it has two aspects, bailment and an element of the sale.
  • Ashby v Tolhurst – In this case, the court held that the main essence of bailment is the transfer of possession of goods.
  • Jan and Son v A. Cameron – In this case, the plaintiff stayed at the hotel, his article stolen by someone. The court held the Hotelier liable.
  • Morvi Mercantile Bank Ltd v Union of India – In this case, the court held that Railway receipt delivery would amount to delivery of goods.

Conclusion

The position of bailment in India is clear from section 153 of the Contract Act. The law of bailment specifies the rights, duties, and liabilities of the bailee to avoid disputes between the bailor and the bailee. It forms a very vital part of the Indian Contract Act. Bailment is something people enter daily, even without realizing it. Its development with time has been crucial. Therefore, the laws should be dynamic but should also be rigid at the same time. 

The article is written by Megha Patel, a 2nd –year law student at The Mody University of Science and Technology, Laxmangarh, Rajasthan.

The article is edited by Shubham Yadav, pursuing B.com LL.B. from Banasthali Vidyapith.

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