In India derivative contracts sit at the intersection of securities law, banking law, foreign exchange law and corporate law. A contract is not a valid derivative unless it satisfies Section 2(ac) and Section 18A of Securities Contracts (Regulation) Act, 1956 [SCRA].

SCRA Definition: Derivative includes a security derived from debt instrument, share, loan, risk instrument or contract for differences or any other form of security, and a contract which derives its value from prices of underlying securities.

Four Types Recognized:

1. Forwards - OTC, RBI/FEMA regulated if FX/interest rate
2. Futures - Exchange traded, SEBI regulated
3. Options - Exchange traded
4. Swaps - IRS, Currency swaps - RBI regulated

If it is not traded on a recognized stock exchange and settled through its clearing corporation, it is not a valid derivative contract under SCRA except for spot delivery contracts under Sec 2(i).

I. Regulatory Architecture

1. SEBI - The Principal Regulator for Security Derivatives
Governed by SCRA, SEBI Act 1992, SEBI (Stock Brokers) Regulations, SEBI Master Circular for Stock Exchanges and Clearing Corporations.

2. RBI - For FX and Interest Rate Derivatives
Governed by RBI Act, FEMA 1999, RBI Master Direction on Risk Management and Interbank Dealings, Rupee Interest Rate Derivatives Directions 2019, and Forex Derivatives Directions.

3. Other Regulators:

• FEMA ODI Rules: For FPIs, non-residents
• Companies Act 2013: Sec 179, Sec 186 - Board authorization
• Ind AS 109: Accounting, fair value, hedge accounting
• CCIL / Trade Repository: Reporting of OTC derivatives

II. Detailed Compliance Obligations

A. SEBI Compliance for Equity / Commodity / Currency Derivatives on Exchange

Legality of Contract:
As per SEBI Notification dated 1st March 2000, reiterated by Courts, any contract for sale/purchase of securities other than spot delivery, cash delivery or permitted derivative is prohibited. Private put/call options are illegal.
SEBI clarified that put/call options are illegal because they cannot be considered valid derivative contracts as they can only be traded on stock exchanges and not through private contracts.

Eligible Participants: Only through SEBI registered brokers, with KYC, client registration, risk disclosure document.

Margin and Settlement:
SPAN + Exposure margin, Mark-to-Market daily, settlement via NSCCL / ICCL. Failure to maintain = auto square-off.

Position Limits:
SEBI + Exchange circulars prescribe client-wise, member-wise, market-wide limits. Recent Supreme Court view: exceeding position limits does not void the contract but attracts penalty. The Court held that neither SEBI circular nor NSE circular provided that exceeding position limits would void derivative contracts.

Reporting & Surveillance:

• Daily position reporting to exchange
• Internal audit, compliance report to SEBI quarterly
• SEBI monitors contracts with abnormal volatility - can place on watchlist/ban
• LODR Regulations for listed companies: disclosure of material derivative losses under Reg 30

Prohibition of Fraud: Client code modification, circular trading in derivatives = violation of PFUTP Regulations.

B. RBI Compliance for OTC Derivatives

Underlying Exposure Principle: As per 2024 RBI tightening, threshold for taking FX positions without underlying exposure reduced from USD 100 mn to USD 5 mn, prohibiting rebooking of cancelled contracts. All FX derivatives must have genuine underlying exposure for non-retail users.

Only with Authorized Dealer Category-I Banks: Corporates cannot do IRS / FX options with NBFCs.

Suitability & Appropriateness: Bank must assess client's understanding, board resolution mandatory. RBI's ISDA + Schedule requirement.

Reporting: All interbank and client OTC trades must be reported to CCIL Trade Repository within 30 minutes. From July 1, 2027, AD Cat-I banks must report all offshore OTC FX derivatives involving INR executed by their related entities to CCIL.

SEBI-RBI Joint for Currency Derivatives: SEBI regulates exchange traded Currency Derivatives - margin, position limits and reporting requirements.

C. Corporate & Accounting Compliance

Board Approval: Trading in derivatives is deemed speculative unless for hedging. Requires Articles of Association enabling clause + Board Resolution under Sec 179. If speculative, hits Sec 186 loan/investment limits.

Ind AS 109: All derivatives at Fair Value Through P&L unless hedge accounting criteria met with documentation.

Statutory Audit: CARO 2020 requires auditor to report on derivative losses, MTM.

III. Key Case Laws

1. SEBI's Informal Guidance - Vulcan Engineers & MCX Cases [The Foundation]
SEBI held option would not qualify as legal and valid derivative contract under Section 18A as it was exclusively entered into between two parties and not traded on stock exchange and settled at clearing house. This became the basis for invalidating private PE put options.

2. Edelweiss Financial Services Ltd. vs Percept Finserve & SEBI Notification 2013
Bombay High Court 2019 held:

• Put option in Share Purchase Agreement 2007 was illegal as SEBI treated it as invalid then.
• SEBI Notification dated Oct 2013 allowing pre-emption rights / options subject to conditions is prospective, not retrospective. Court set aside arbitral award that treated put option as valid contract in derivative merely because it contained put option.

Principle: Before 2013, all private options = illegal. After 2013, allowed only if: a) No assured return, b) No transfer of title outside, c) Compliant with FEMA pricing guidelines.

3. SEBI vs Kishore R Ajmera (Supreme Court 2016) - Client Code Modification
SC upheld SEBI's order where broker misused derivatives for fictitious losses to evade tax. Court held large futures positions and client code modifications to shift profit/loss = manipulative fraud under PFUTP Regulations.

4. Reliance Industries - RPL F&O Case (SAT/SC)
SAT held RIL front entities executed F&O trades to avoid detection of breach of client-wise position limits in derivative contracts imposed by SEBI and NSE. Establishes that using fronts to bypass position limits = violation of disclosure obligations under 2001 SEBI Circular.

5. Sundaradam vs State & Rajagopal Reddy vs Padmini Chandrasekharan (1995 SC)
SC: Forward contracts without delivery intention are wagering contracts under Sec 30 Indian Contract Act unless saved by Sec 18A SCRA. If not on recognized exchange, unenforceable.

6. National Spot Exchange Ltd (NSEL) Case 2019 & 63 Moons
Supreme Court held that paired contracts offered by NSEL were not spot delivery contracts but illegal derivatives / non-transferable specific delivery contracts without SEBI approval. Merged NSEL with FTIL.

7. Bank of India vs Swastik Gases (Modern trend on ISDA)
Courts have upheld ISDA Master Agreement netting and close-out provisions, recognizing RBI's 2020 Netting Act.

IV. Compliance Checklist for Legal / Company Secretary

1. Is contract traded on NSE/ BSE/MCX? If OTC, is counterparty AD Bank?
2. Does underlying exist and is documented? [RBI FEMA]
3. Board resolution + Risk Management Policy approved?
4. SEBI 2013 notification conditions met for options? (no assured return)
5. FEMA pricing: Option price not assured, on arm's length basis?
6. Reporting: Exchange daily + CCIL TR + Ind AS disclosure in Annual Report
7. Stamp duty under amended Indian Stamp Act (0.002% for exchange derivatives)
8. GST: 18% on brokerage, not on settlement.

Penalty: Violation of SEBI norms = Sec 15A to 15J - upto Rs 25 crores or 3x profit. Violation of FEMA - upto 3x contravention amount + ED action. Contracts void = no enforcement in court/arbitration.