SUIT BY A THIRD PARTY TO A CONTRACT

SUIT BY A THIRD PARTY TO A CONTRACT

Though under the Indian Contract Act, 1872, the consideration for an agreement may proceed from a third party, the third party cannot sue on contract. Only a person who is party to a contract can sue on it.
Thus, the concept of stranger to consideration is a valid and is diuerent from stranger to a contract.

Example: P who is indebted to Q, sells his property to R and R promises to pay ou the debt amount to Q. If R fails to pay, then in such situation Q has no right to sue, as R is a stranger to contract.

The aforesaid rule, that stranger to a contract cannot sue is known as a“doctrine of privity of contract”, is however, subject to certain exceptions. 

In other words, even a stranger to a contract may enforce a claim in the following cases:
(1) In the case of trust, a beneficiary can enforce his right under the trust, though he was not a party to the contract between the settler and the trustee.

(2) In the case of a family settlement, if the terms of the settlement are reduced into writing, the members of family who originally had not been parties to the settlement may enforce the agreement.

(3) In the case of certain marriage contracts, a female member can enforce a provision for marriage expenses made on the partition of the Hindu Undivided Family.

(4) In the case of assignment of a contract / arrangements, a provision may be made for the benefit of a person. He may file the suit though he is not a party to the agreement.

(5) Acknowledgement or estoppel – where the promisor by his conduct acknowledges himself as an agent of the third party, it would result into a binding obligation towards third party. For example, if L gives to M `20,000 to be given to N, and M informs N that he is holding the money for him, but afterwards M refuses to pay the money. N will be entitled to recover the same from the former i.e. M.

(6) In the case of covenant running with the land, the person who purchases land with notice that the owner of land is bound by certain duties auecting land, the covenant auecting the land may be enforced by the successor of the seller.

(7) Contracts entered into through an agent: The principal can enforce the contracts entered by his agent where the agent has acted within the scope of his authority and in the name of the principal. 

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LEGAL RULES REGARDING CONSIDERATION

LEGAL RULES REGARDING CONSIDERATION

(i) Consideration must move at the desire of the promisor: Consideration must be ouered by the promisee or the third party at the desire or request of the promisor. This implies “return” element of consideration. Contract of marriage in consideration of promise of settlement is enforceable.

An act done at the desire of a third party is not a consideration.

In Durga Prasad v. Baldeo, D (defendant) promised to pay to P (plaintiu) a certain commission on
articles which would be sold through their agency in a market. Market was constructed by P at the desire of the C (Collector), and not at the desire of the D. D was not bound to pay as it was without consideration and hence void.

Example: R saves S’s goods from fire without being asked to do so. R cannot demand any reward for his services, as the act being done voluntary.

(ii) Consideration may move from promisee or any other person: In India, consideration may proceed from the promisee or any other person who is not a party to the contract. The definition of consideration as given in Section 2(d) makes that proposition clear. According to the definition, when at the desire of the promisor, the promisee or any other person does something such an act is consideration. In other words, there can be a stranger to a consideration but not stranger to a contract.

Example: An old lady made a gift of her property to her daughter with a direction to pay a certain sum of money to the maternal uncle by way of annuity. On the same day, the daughter executed a writing in favour of the brother agreeing to pay annuity. The daughter did not, however, pay the annuity and the uncle sued to recover it. It was held that there was suflcient consideration for the uncle to recover the money from the daughter. [Chinnayya vs. Ramayya (1882)]

(iii) Executed and executory consideration: A consideration which consists in the performance of an act is said to be executed. When it consists in a promise, it is said to be executory. The promise by one party may be the consideration for an act by some other party, and vice versa.

Example: A pays ` 5,000 to B and B promises to deliver to him a certain quantity of wheat within a month. In this case A pays the amount, whereas B merely makes a promise. Therefore, the consideration paid by A is executed, whereas the consideration promised by B is executory.

(iv) Consideration may be past, present or future: The words “has done or abstained from doing” [as contained in Section 2(d)] are a recognition of the doctrine of past consideration. In order to support a promise, a past consideration must move by a previous request. It is a general principle that consideration is given and accepted in exchange for the promise. The consideration, if past, may be the motive but cannot be the real consideration of a subsequent promise. But in the event of the services being rendered in the past at the request or the desire of the promisor, the subsequent promise is regarded as an admission that the past consideration was not gratuitous.

Example: ’A’ performed some services to‘B’ at his desire. After a week,‘B’ promises to compensate‘A’ for the work done by him. It is said to be present consideration and A can sue B for recovering the promised money.

(v) Consideration need not be adequate: Consideration need not to be of any particular value. It need not be approximately of equal value with the promise for which it is exchanged but it must be something which the law would regard as having some value. Something in return need not be equal to something given. It can be considered a bad bargain of the party.

It may be noted in this context that Explanation 2 to Section 25 states that an agreement to which the consent of the promisor is freely given is not void merely because the consideration is inadequate.
But as an exception if it is shockingly less and the other party alleges that his consent was not free than this inadequate consideration can be taken as an evidence in support of this allegation.

Example: X promises to sell a house worth `6 lacs for `1 lacs only, the adequacy of the price in itself shall not render the transaction void, unless the party pleads that transaction takes place under coercion, undue influence or fraud.

(vi) Performance of what one is legally bound to perform: (consideration must not be performance of existing duty) The performance of an act by a person who is legally bound to perform the same cannot be consideration for a contract. Hence, a promise to pay money to a witness is void, for it is without consideration. Hence such a contract is void for want of consideration. Similarly, an agreement by a client to pay to his counsel after the latter has been engaged, a certain sum over and above the fee, in the event of success of the case would be void, since it is without consideration.

But where a person promises to do more that he is legally bound to do, such a promise provided it is not opposed to public policy, is a good consideration. It should not be vague or uncertain.

(vii) Consideration must be real and not illusory: Consideration must be real and must not be illusory. It must be something to which the law attaches some value. If it is legally or physically impossible it is not considered valid consideration.

Examples: A man promises to discover treasure by magic. This transaction can be said to be void as it is illusory.

(viii) Consideration must not be unlawful, immoral, or opposed to public policy. Only presence of consideration is not suflcient it must be lawful. Anything which is immoral or opposed to public policy also cannot be valued as valid consideration.

Example: A agrees with B to sell car for `2 lacs to B. Here A is under an obligation to give car to B and B has the right to receive the car on payment of `2 lacs and also B is under an obligation to pay `2 lacs to A and A has a right to receive `2 lacs.

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WHAT IS CONSIDERATION?

WHAT IS CONSIDERATION?

Consideration is the price agreed to be paid by the promisee for the obligation of the promisor. The word consideration was described in a very popular English case of Misa v. Currie as:

“A valuable consideration in the sense of law may consist either in some right, interest, profit or benefit accruing to one party (i.e. promisor) or forbearance, detriment, loss or responsibility given, suuered or undertaken by the other (i.e., the promisee).” 

Section 2(d) defines consideration as follows:
“When at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing or promises to do or abstain from doing something, such an act or abstinence or promise is called consideration for the promise”. 

Analysis of Definition of Consideration

(1) Consideration is an act- doing something.

Example- Ajay promises Bhuvan to guarantee payment of price of the goods which Bhuvan wanted to sell on one month credit to Chaitanya. Here selling of goods on credit by Bhuvan to Chaitanya is consideration for A’s promise. 

(2) Consideration is abstinence- abstain from doing something.

Example- Abhishek promises Bharti not to file a suit against him if he (Bharti) would pay him (Abhishek) Rs. 1,00,000. Here abstinence on the part of Abhishek would constitute consideration against Bharti’s payment of Rs. 1,00,000 in favor of Abhishek. 

(3) Consideration must be at the desire of the promisor.

(4) Consideration may move from promisee or any other person.

(5) Consideration may be past, present or future.

Thus from above it can be concluded that: 

Consideration = Promise / Performance that parties exchange with each other. 

Form of consideration = Some benefit, right or profit to one party / some detriment, loss, or forbearance to the other.

ACCEPTANCE

ACCEPTANCE

Definition of Acceptance: In terms of Section 2(b) of the Act, ‘the term acceptance’ is defined as follows: 

“When the person to whom the proposal is made signifies his assent thereto, proposal is said to be accepted. The proposal, when accepted, becomes a promise”.

Analysis of the above definition
1. When the person to whom proposal is made - for example if A ouers to sell his car to B for ` 200000. Here, proposal is made to B.

2. The person to whom proposal is made i.e. B in the above example and if B signifies his assent on that proposal. In other words if B grants his consent on A’s proposal, then we can say that B has signified his consent on the proposal made by A.

3. When B has signified his consent on that proposal, we can say that the proposal has been accepted.

4. Accepted proposal becomes promise.

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DEFINITION OF OFFER/PROPOSAL

Definition of Offer/Proposal:
According to Section 2(a) of the Indian Contract Act, 1872, “when one person signifies to another his willingness to do or to abstain from doing anything with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal”. 

Analysis of the above definition Essentials of a proposal/offer are-

1. The person making the proposal or ouer is called the ‘promisor’ or ‘oueror’: The person to whom the ouer is made is called the ‘oueree’ and the person accepting the ouer is called the ‘promisee’ or ‘acceptor’. 

2. For a valid ouer, the party making it must express his willingness‘to do’ or‘not to do’ something: Mere expression of willingness does not constitute an ouer.

Example: Where ‘A’ tells ‘B’ that he desires to marry by the end of 2017, it does not constitute an ouer of marriage by ‘A’ to ‘B’. Therefore, to constitute a valid ouer expression of willingness must be made to obtain the assent (acceptance) of the other. Thus, if in the above example, ‘A’ further adds, ‘Will you marry me’, it will constitute an ouer.

3. An ouer can be positive as well as negative: Thus “doing” is a positive act and “not doing”, or “abstinence” is a negative act; nonetheless both these acts have the same euect in the eyes of law.

Example: A ouers to sell his car to B for ` 3 lacs is an act of doing. So in this case, A is making an ouer to B. On the other hand, when A ask B after his car meets with an accident with B’s scooter not to go to Court and he will pay the repair charges to B for the damage to B’s scooter; it is an act of not doing or abstinence.

4. The willingness must be expressed with a view to obtain the assent of the other party to whom the ouer is made.

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TYPES OF CONTRACT (ON THE BASIS OF THE PERFORMANCE OF THE CONTRACT)

TYPES OF CONTRACT

 On the basis of the performance of the contract
1. Executed Contract: The consideration in a given contract could be an act or forbearance. When the act is done or executed or the forbearance is brought on record, then the contract is an executed contract.

Example: When a grocer sells a sugar on cash payment it is an executed contract because both the parties have done what they were to do under the contract.

2. Executory Contract: In an executory contract the consideration is reciprocal promise or obligation. Such consideration is to be performed in future only and therefore these contracts are described as executory contracts.

Example: Where G agrees to take the tuition of H, a pre-engineering student, from the next month and H in consideration promises to pay G ` 1,000 per month, the contract is executory because it is yet to be carried out.

Unilateral or Bilateral are kinds of Executory Contracts and are not separate kinds.
(a) Unilateral Contract: Unilateral contract is a one sided contract in which one party has performed his duty or obligation and the other party’s obligation is outstanding.

Example: M advertises payment of are ward of ` 5000 to any one who finds his missing boy and brings him. As soon as B traces the boy, there comes into existence an executed contract because B has performed his share of obligation and it remains for M to pay the amount of reward to B. This type of Executory contract is also called unilateral contract.

(b) Bilateral Contract: A Bilateral contract is one where the obligation or promise is outstanding on the part of both the parties.

Example: A promises to sell his plot to B for `1 lacs cash down, but B pays only ` 25,000 as earnest money and promises to pay the balance on next Sunday. On the other hand A gives the possession of plot to B and promises to execute a sale deed on the receipt of the whole amount. The contract between the A and B is executory because there remains something to be done on both sides. Executory contracts are also known as Bilateral contracts. 

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DIFFERENCE BETWEEN VOID AGREEMENT AND ILLEGAL AGREEMENT

DIFFERENCE BETWEEN VOID AGREEMENT AND ILLEGAL AGREEMENT

Basis of difference	Void agreement	Illegal agreement
Scope	A void agreement is not necessarily illegal.	An illegal agreement is always void.
Nature	Not forbidden under law.	Are forbidden under law.
Punishment	Parties     are     not      liable      for     any punishment under the law.	Parties to illegal agreements are liable for punishment.
Collateral Agreement	It’s not necessary that agreements collateral to void agreements may also be void. It may be valid also.	Agreements      collateral       to      illegal agreements are always void.

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TYPES OF CONTRACT (ON THE BASIS OF THE VALIDITY)

TYPES OF CONTRACT

 On the basis of the validity

1. Valid Contract: An agreement which is binding and enforceable is a valid contract. It contains all the essential elements of a valid contract.

2. Void Contract: Section 2 (j) states as follows: “A contract which ceases to be enforceable by law becomes void when it ceases to be enforceable”. Thus a void contract is one which cannot be enforced by a court of law.

Example: Mr. X agrees to write a book with a publisher. After few days, X dies in an accident. Here the contract becomes void due to the impossibility of performance of the contract.

Example: A contracts with B (owner of the factory) for the supply of 10 tons of sugar, but before the supply is euected, the fire caught in the factory and everything was destroyed. Here the contract becomes void.

It may be added by way of clarification here that when a contract is void, it is not a contract at all but for the purpose of identifying it, it has to be called a [void] contract.

3. Voidable Contract: Section 2(i) defines that “an agreement which is enforceable by law at the option of one or more parties thereto, but not at the option of the other or others is a voidable contract”.

This in fact means where one of the parties to the agreement is in a position or is legally entitled or authorized to avoid performing his part, then the agreement is treated and becomes voidable.
Such a right might arise from the fact that the contract may have been brought about by one of the parties by coercion, undue influence, fraud or misrepresentation and hence the other party has a right to treat it as a voidable contract.

At this juncture it would be desirable to know the distinction between a Void Contract and a Voidable Contract. The distinction lies in three aspects namely definition, nature and rights. These are elaborated here under:

(a) Definition: A void contract cannot be enforced at all. A voidable contract is an agreement which is enforceable only at the option of one of the parties but not at the option of the other. Therefore ‘enforceability’ or otherwise, divides the two types of contracts.

(b) Nature: By nature, a void contract is valid at the time when it is made but becomes unenforceable and thus void on account of subsequent developments or events like supervening impossibility, subsequent illegality etc., Repudiation of a voidable contract also renders the contract void. Similarly a contingent contract might become void when the occurrence of the event on which it is contingent becomes impossible.

On the other hand voidable contract would remain valid until it is rescinded by the person who has the option to treat it as voidable. The right to treat it as voidable does not invalidate the contract until such right is exercised. All contracts caused by coercion, undue influence, fraud, misrepresentation are voidable. Generally, a contract caused by mistake is void.

(c) Rights: As regards rights of the parties, in the case of a void contract there is no legal remedy for the parties as the contract cannot be performed in any way. In the case of voidable contract the aggrieved party has a right to rescind it within a reasonable time. If it is so rescinded, it becomes void. If it is not rescinded, it is a valid contract.

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ESSENTIALS OF A VALID CONTRACT

ESSENTIALS OF A VALID CONTRACT
                                                    
                         Essentials of a valid contract

	As given by Section 10 of Indian Contract Act, 1872		Not given by Section 10 but are also considered essential
1	Agreement	1	Two parties
2	Free consent	2	Intention to create legal relationship
3	Competency of the parties	3	Fulfillment of legal formalities
4	Lawful consideration	4	Certainty of meaning
5	Legal object	5	Possibility of performance
6	Not expressly declared to be void	6	-

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DIFFERENCE BETWEEN AGREEMENT AND CONTRACT

Difference between Agreement and Contract

Basis of differences	Agreement	Contract
Meaning	Every promise and every set of promises, forming the consideration for each other. Ouer + Acceptance	Agreement enforceable by law. Agreement + Legal enforceability
Scope	It’s a wider term including both legal and social agreement.	It is used in a narrow sense with the specification that contract is only legally enforceable agreement.
Legal obligation	It may not create legal obligation. An agreement does not always grant rights to the parties	Necessarily creates a legal obligation. A contract always grants certain rights to every party.
Nature	All agreement are not contracts.	All contracts are agreements.

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WHAT IS CONTRACT?

WHAT IS A CONTRACT?

The term contract is defined under section 2(h) of the Indian Contract Act, 1872 as-
“an agreement enforceable by law”.

The contract consists of two essential elements:

(i) an agreement, and

(ii) its enforceability by law.

(i) Agreement - The term ‘agreement’ given in Section 2(e) of the Act is defined as- “every promise and every set of promises, forming the consideration for each other”.

To have an insight into the definition of agreement, we need to understand promise.
Section 2 (b) defines promise as-
“when the person to whom the proposal is made signifies his assent there to, the proposal is said to be accepted. Proposal when accepted, becomes a promise”.

The following points emerge from the above definition :
1. when the person to whom the proposal is made

2. signifies his assent on that proposal which is made to him

3. the proposal becomes accepted

4. accepted proposal becomes promise

Thus we say that an agreement is the result of the proposal made by one party to the other party and that other party gives his acceptance thereto of course for mutual consideration. 

Agreement = Ouer/Proposal + Acceptance

(ii) Enforceability by law – An agreement to become a contract must give rise to a legal obligation which means a duly enforceable by law.

Thus from above definitions it can be concluded that –

Contract = Accepted proposal/Agreement + Enforceability by law

On elaborating the above two concepts, it is obvious that contract comprises of an agreement which is a promise or a set of reciprocal promises, that a promise is the acceptance of a proposal giving rise to a binding contract. Further, section 2(h) requires an agreement to be worthy of being enforceable by law before it is called‘contract’. Where parties have made a binding contract, they created rights and obligations between themselves.

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THE LAW OF CONTRACT (INTRODUCTION)

The Law of contract: Introduction

As a result of increasing complexities of business environment, innumerable contracts are entered into by the parties in the usual course of carrying on their business. ‘Contract’ is the most usual method of defining the rights and duties in a business transaction. This branch of law is diuerent from other branches of law in a very important respect. It does not prescribe so many rights and duties, which the law will protect or enforce; it contains a number of limiting principles subject to which the parties may create rights and duties for themselves. The Indian Contract Act, 1872 codifies the legal principles that govern ‘contracts’. The Act basically identifies the ingredients of a legally enforceable valid contract in addition to dealing with certain special type of  like indemnity, guarantee, bailment, pledge, quasi contracts, contingent contracts etc.

All agreements are not studied under the Indian Contract Act, 1872, as some of those are not contracts. Only those agreements, which are enforceable by law, are contracts.

This unit refers to the essentials of a legally enforceable agreement or contract. It sets out rules for the ouer and acceptance and revocation thereof. It states the circumstances when an agreement is voidable or enforceable by one party only, and when the agreements are void, i.e. not enforceable at all.

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CREDIT DEFAULT SWAP (CDS) IN INDIA

 CDS in India

In India, RBI has come out guidelines on CDS in corporate bonds in 2011 which was revised in 2013.

As per the guidelines CDS players have been divided into following two categories:

(a) Market Makers: - These are comprised of commercial banks, primary dealers (PDS) and non-banking financial companies (NBFCs). They can buy or sell without any underlying position in the bond i.e. Naked CDS.

(b) Users: - These are comprised of mutual funds (MFs), Insurance Companies, Housing Finance Companies, Provident Funds, Listed Companies and Foreign Institutional Investors (FIIs). They can use CDS only as a hedge tool to offset the risk of an underlying position, and are not allowed to sell CDS other than to exit the existing long positions.

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SETTLEMENT OF CREDIT DEFAULT SWAP (CDS)

 Settlement of CDS

Broadly, following are main ways of settlement of CDS.

(i) Physical Settlement – This is the traditional method of settlement. It involves the delivery of Bonds or debts of the reference entity by the buyer to the seller and seller pays the buyer the par value.

For example, as mentioned above suppose Danger Corp. defaults then SS Bank will pay
$ 10 Million to BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank.

(ii) Cash Settlement- Under this arrangement seller pays the buyer the difference between par value and the market price of a debt (whatever may be the market value) of the reference entity. Continuing the above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will receive 30% of the money owed in case company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million.

To make Cash settlement even more transparent, the credit event auction was developed. Credit event auction set a price for all market participants that choose to cash settlement.

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PARTIES TO CREDIT DEFAULT SWAP (CDS)

 Parties to CDS

In a CDS at least three parties are involved which are as follows:

i. The initial borrowers- It is also called a ‘reference entity’, which are owing a loan or bond obligation.

ii. Buyer- It is also called ‘investor’ is the buyer of protection. The buyer will make regular payment to the seller for the protection from default or credit event of reference entity.

iii. Seller- It is also called ‘writer’ of the CDS and makes payment to buyer in the event of credit event of reference entity. It receives a regular pay off from the buyer of CDS.

Example-
Suppose BB Corp. buys CDS from SS Bank for the Bonds amounting $ 10 million of Danger Corp. In such case, the BB Corp. will become the buyer, SS Bank becomes seller and Danger Corp. becomes the reference entity. BB Corp. will make regular payment to SS Bank of the premium and if Danger Corp. defaults on its debts, the BB Corp. will receive one time payment and CDS contract is terminated.

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USES OF CREDIT DEFAULT SWAP

 Uses of Credit Default Swap
Following are the main purposes for which CDS can be used.

(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer.

(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a bond is swapped against a floating interest stream.

(c) Speculation- CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if compensation received exceeds potential payout.

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MAIN FEATURES OF CREDIT DEFAULT SWAP (CDS)

 Main Features of CDS
The main features of CDS are as follows:

1. CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the category of Forward Contracts.

2. They are normally not traded on any exchange and hence remains free from the regulations of Governing Body.

3. The International Swap and Derivative Association (ISAD) publishes the guidelines and general rules used normally to carry out CDS contracts.

4. CDS can be purchased from third party to protect itself from default of borrowers.

5. Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his investment from insolvency of that company. Thus, this increases the level of confidence of investor in Bonds purchased.

6. The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore, higher the risk attached to Bonds or loans, higher will be premium or cost of CDS.

7. If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is called “naked CDS”.

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CREDIT DEFAULT SWAP(CDS)

CREDIT DEFAULT SWAP (CDS)
It is a combination of following 3 words:

Credit : Loan given Default : Non payment

Swap : Exchange of Liability or Risk

Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt which may be debentures, bonds etc.

Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will be settlement and in case no default takes place no cash flow will accrue to the buyer alike option contract and agreement is terminated. Although it resembles the options but since element of choice is not there it more resembles the swap arrangements.

Amount of premium mainly depends on the price of underlying and especially when the credit risk is more.

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RISK INVOLVED IN CDOs

 Risk involved in CDOs

CDOs are structured products and just like other financial products hence are also subject to various types of Risk.

The main types of risk associated with investment in CDOs are as follows:
(1) Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party to the instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.

(2) Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of interest rates. For example, asset may be based on floating interest rate but the liability may be based on fixed interest rates. Though this type of risk is quite difficult to manage fully but commonly used techniques such as swaps, caps, floors, collars etc. can be used to mitigate the interest rate risk.

(3) Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks as there may be mismatch in coupon receipts and payments.

(4) Prepayment Risk: - This risk results from unscheduled or unexpected repayment of principal amount underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the debtors have a call option. Since, in case of falling interest rates they may pay back the money.

(5) Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find adequate opportunity to reinvest the proceeds when allowed for substitutions.

(6) Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from countries other than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also subject to the foreign exchange rate risk as discussed in the paper Strategic Financial Management.

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TYPES OF CDOs

 Types of CDOs
The various types of CDOs are as follows: 

(a) Cash Flow Collateralized Debt Obligations (Cash CDOs)
Cash CDO is CDO which is backed by cash market debt or securities which normally have low risk weight. This structure mainly relies on the collateral’s risk weight and collateral’s ability to generate sufficient cash to pay off the securities issued by SPV. 

(b) Synthetic Collateralized Debt Obligations

It is similar to Cash Flow CDOs but with the difference that instead of transferring of ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a manner that credit risk of transferred by the originator without actual transfer of assets.

Normally the structure resembles the hedge funds where in the value of portfolio of CDO is dependent upon the value of collateralized instruments and market value of CDOs depends on the portfolio manager’s ability to generate adequate cash and meeting the cash flow obligations (principal and interest) in timely manner.

While in cash CDO the collateral assets are moved away from Balance Sheet, in synthetic CDO there is no actual transfer of assets instead economic effect is transferred.

This effect of transfer economic risk is achieved by creating provision for Credit Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a form of liability.

Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding. Further, for banks, this structure also allows the customer’s relations to be unaffected. This was started mainly by banks who want to hedge the credit risk but not interested in taking administrative burden of sale of assets through securitization.

Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-à-vis cash CDOs. Further, they are more popular in European market due to the reason of less legal documentation requirements. Synthetic CDOs can also be categorized as follows:

(a) Unfunded: - It will be comprised only CDs.

(b) Fully Funded: - It will be through issue of Credit Linked Notes (CLN).

(c) Partially Funded: - It will be partially through issue of CLN and partially through CDs. 

(c) Arbitrage CDOs
Basically, in Arbitrage CDOs, the issuer captures the spread between the return realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of relatively high yielding securities with large spread from open market.

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COLLATERALIZED DEBT OBLIGATIONS (CDOs)

COLLATERALIZED DEBT OBLIGATIONS (CDOs)
Collateralized Debt Obligations (CDOs) is advancement of securitization discussed in the paper of Strategic Financial Management. While in securitization the securities issued by SPV are backed by the loans and receivables the CDOs are backed by pool of bonds, asset backed securities, REITs, and other CDOs. Accordingly, it covers both Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs).

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CREDIT DERIVATIVES

CREDIT DERIVATIVES

Credit Derivatives is summation of two terms, 

Credit +  Derivatives.

 As we know that derivative implies value deriving from an underlying, and this underlying can be anything we discussed earlier i.e. stock, share, currency, interest etc.

Initially started in 1996 due to the need of the banking institutions to hedge their exposure of lending portfolios today is one of the structured finance product.

Plainly speaking the financial products are subject to following two types of risks:
(a) Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange rates.

(b) Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation by the counter party.

While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to mitigate the credit risk. Accordingly, the credit derivative is a mechanism whereby the risk is transferred from the risk averse investor to those who wish to assume the risk.

Although there are number of credit derivative products but in this chapter, we shall discuss two types of credit Derivatives ‘Collaterised Debt Obligation’ and ‘Credit Default Swap’.

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LIMITATION OF CREDIT RATING

LIMITATIONS OF CREDIT RATING
1) Rating Changes – Ratings given to instruments can change over a period of time. They have to be kept under rating watch. Downgrading of an instrument may not be timely enough to keep investors educated over such matters.

2) Industry Specific rather than Company Specific – Downgrades are linked to industry rather than company performance. Agencies give importance to macro aspects and not to micro ones and over-react to existing conditions which come from optimistic/pessimistic views arising out of up/down turns.

3) Cost Benefit Analysis – Rating being mandatory, it becomes a must for entities rather than carrying out Cost Benefit Analysis. Rating should be left optional and the corporate should be free to decide that in the event of self rating, nothing has been left out.

4) Conflict of Interest – The rating agency collects fees from the entity it rates leading to a conflict of interest. Rating market being competitive there is a distant possibility of such conflict entering into the rating system.

5) Corporate Governance Issues – Special attention is paid to

a) Rating agencies getting more of its revenues from a single service or group.

b) Rating agencies enjoying a dominant market position engaging in aggressive competitive practices by refusing to rate a collateralized/securitized instrument or compelling an issuer to pay for services rendered.

c) Greater transparency in the rating process viz. in the disclosure of assumptions leading to a specific public rating.

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CREDIT RATING AGENCIES ABROAD

CREDIT RATING AGENCIES ABROAD 

(i) Standard and Poor’s (S & P) Ratings
S&P Global Ratings have been in the credit rating business for more than 150 years. They are the world’s leading provider of credit ratings. Their credit ratings are important not only for the corporates but also for the government and the financial sector. Their credit rating is basically an expression of opinion about the credit quality of a company i.e. whether that company is able to meet its financial obligations in time or not. S & P is operating in about 28 countries. And, to its credit, if we take all corporate sector investment-grade ratings issued, just 1% has defaulted over the most recent five-year period. 

(ii) Fitch Ratings
Fitch is among the top three credit rating agencies in the world. Fitch Ratings is headquartered in both New York and London. Fitch Ratings' long-term credit ratings are assigned on an alphabetic scale from 'AAA' to 'D'. It was first introduced in 1924 and later adopted and licensed by S&P. It is a global leader in financial information services with operations in more than 30 countries. 

(iii) Moody’s Ratings

Moody’s is an important contributor in the global financial market providing credit rating services that helps in the building up of a transparent and integrated financial market. The Corporation, which reported revenue of $3.6 billion in 2016, employs approximately 10,700 people worldwide and maintains a presence in 36 countries.

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RATING REVISIONS

RATING REVISIONS

Credit Rating is an opinion expressed by a credit rating agency at a given point of time based on the information provided by the company and collected by credit rating agency. However, the information collected from the company at the time of giving credit rating to it is amenable to change.

Therefore, revision of credit rating is required.

To protect the interest of investors, SEBI has mandated that every credit rating agency shall, during the lifetime of the securities rated by it, continuously monitor the rating of such securities and carry out periodic reviews of all published ratings.

Moreover, India Ratings & Research (A Fitch Group Company) continuously monitors the ratings assigned to a particular instrument. In case of any changes in the ratings so assigned, India Ratings discloses the same through press releases and on its websites.

For instance, the CRISIL has updated long term credit rating of Sterlite Technologies Limited to ‘CRISIL AA-/Stable from CRISIL A+/Watch Developing’ and also its short term credit rating have been upgraded to CRISIL A1+ from CRISIL A1/Watch Developing. Additionally, CRISIL has removed its rating on bank loan facilities and debt instruments of the company from ‘Watch with Developing Implications’ and it has also withdrawn its rating on ‘bonds’ at the Company’s request, as there is no amount outstanding against the said instrument.

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CREDIT RATING METHODOLOGIES (FINANCIAL RISK)

CREDIT RATING METHODOLOGIES

(ii) FINANCIAL RISK

Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.

Accordingly, the broadly Financial Risk can be divided into following categories.

(a) Counter Party Risk

(b) Political Risk

(c) Interest Rate Risk

(d) Currency Risk

Now, let us discuss each of the above mentioned risks: 

(a) Counter Party Risk

This risk occurs due to non honoring of obligations by the counter party which can be failure to deliver the goods for the payment already made or vice-versa or repayment of borrowings and interest etc.

Thus, this risk also covers the credit risk i.e. default by the counter party. 

(b) Political Risk 

Generally this type of risk is faced by overseas investors, as the adverse action by the government of host country may lead to huge loses. This can be on any of the following forms :

• Confiscation or destruction of overseas properties. 
• Rationing of remittance to home country. 
•  Restriction on conversion of local currency of host country into foreign currency. 
•  Restriction as borrowings. 
•  Invalidation of Patents 
•  Price control of products

(c) Interest Rate Risk
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.

As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these types is inherent. If any company has borrowed money at floating rate then with increase in floating rate the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.

(d) Currency Risk

This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates. This risk can affect the cash flow adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote, Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).

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CREDIT RATING METHODOLOGIES (BUSINESS RISK)

CREDIT RATING METHODOLOGIES
The general methodology adopted by credit rating companies is to analyze various aspects of a business. They are briefly discussed as below:

(i) BUSINESS RISK
Business risk occurs when there is a possibility of a company earning lower profits than anticipated or incurring a loss. Business risk can be segregated into four categories - Strategic risk, compliance risk, operational risk and reputational risk. We have briefly discussed each one as follows:

(a) Strategic Risk: A successful business always needs a comprehensive and detailed business plan. Everyone knows that a successful business needs a comprehensive, well-thought-out business plan. But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.

We can take the example of Kodak which was able to develop a digital camera by 1975. But, it considers this innovation as a threat to its core business model, and failed to develop it. However, it paid the price because when digital camera was ultimately discovered by other companies, it failed to develop it and left behind. Similar example can be given in case of Nokia when it failed to upgrade its technology to develop touch screen mobile phones. That delay enables Samsung to become a market leader in touch screen mobile phones.

However, a positive example can be given in the case of Xerox which invented photocopy machine. When laser printing was developed, Xerox was quick to lap up this opportunity and changes its business model to develop laser printing. So, it survived the strategic risk and escalated its profits further.

(b) Compliance Risk: Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013, and continuous updating of SEBI guidelines, each business organization has to comply with plethora of rules, regulations and guidelines. Non compliance leads to penalties in the form of fine and imprisonment.

However, when a company ventures into a new business line or a new geographical area, the real problem then occurs. For example, a company pursuing cement business likely to venture into sugar business in a different state. But laws applicable to the sugar mills in that state are different. So, that poses a compliance risk. If the company fails to comply with laws related to a new area or industry or sector, it will pose a serious threat to its survival.

(c) Operational Risk: This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. Operational risk relates to ‘people’ as well as ‘process’. We will take an example to illustrate this. For example, an employee paying out Rs. 1,00,000 from the account of the company instead of Rs. 10,000.

This is a people as well as a process risk. An organization can employ another person to check the work of that person who has mistakenly paid Rs. 1,00,000 or it can install an electronic system that can flag off an unusual amount.

(d) Reputational Risk: Reputational impact mostly follows a decision under business risk. For example closing of project in a country on the ground of viability, (Just like what GM has done in India) creates bad reputation for the company. For example in the above case it is observed that employees are reacting negatively to the decision and feeling insecure.

On the other hand, adding related products down the line adds customer confidence and boost investor’s confidence. For example several Indian banks have embarked on opening e-trading account. This has added to the reputation and market confidence.

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