Dealing with derivatives in an emerging market

Introduction
Transactions
Legal issues and documentation
Comment

Introduction

The Central Bank of Nigeria (CBN) is responsible for developing the Nigerian financial markets and assuring the stability of the financial system. In pursuance of these objectives, on March 22 2011 the CBN issued the Guidelines for Foreign Exchange Derivatives in the Nigerian Market. The guidelines regulate the activities of authorised dealers of foreign exchange in Nigeria (ie, banks, bureaux de change and discount houses) in regard to derivatives transactions.

Under the guidelines, the approved hedging products are:

• foreign exchange options;
• forwards (outright and non-deliverable);
• foreign exchange swaps; and
• cross-currency interest rate swaps (CCIRS).

Notably, authorised dealers are now allowed to offer European-styled foreign exchange call and put option contracts to their customers and in the inter-bank market. The maximum tenor allowed for foreign exchange forwards (and, by implication, foreign exchange swaps and CCIRS) has been extended to five years. Authorised dealers may seek specific approval for longer tenors.

The CBN further disclosed that it was supporting authorised dealers with CCIRS trading liquidity by providing hedges for CCIRS to support projects with long-term foreign exchange exposure. To this end, all CCIRS requests to the Financial Markets Department of the CBN shall be project-backed. The department shall issue detailed guidelines on the CCIRS structures offered by the CBN.

At present, the CBN does not deal in synthetic CCIRS, and therefore principal amounts of the currencies (naira and US dollar) will have to be exchanged. Furthermore, all authorised dealers must ensure that their customers are hedging trade-related foreign exchange exposures in their obligations. Speculation on the naira in this manner is not permitted.

Apart from the CBN, which exercises its overall authority over banks and other financial institutions by regulating the type of derivatives in which they may deal, derivatives in Nigeria are regulated by the Securities and Exchange Commission of Nigeria (SEC).(1) The definition of the term 'securities' under the Investment and Securities Act includes futures, options and "other derivatives".(2)

It appears from Section 54 of the act that where a public company enters into a derivatives transaction, such a transaction must be registered with the SEC.

From the definition of 'securities exchange' under Section 315(3) of the act, every derivatives market in Nigeria must be registered with and regulated by the SEC – this includes the various derivatives markets via which derivatives may be offered, such as exchanges, over-the-counter (OTC) markets and primary markets.

However, at present there are few derivatives transactions in Nigeria as the market is still at a nascent stage.

Transactions

Given the lack of adequate credit monitoring in Nigeria (eg, credit agencies and credit records are relatively new to the Nigerian financial services industry), the use of derivatives is not yet as widespread as in more developed economies. However, Nigerian law has placed some restrictions on the scope of derivatives transactions in which certain persons and institutions may engage.

Commercial banks
By virtue of the CBN Scope, Conditions and Minimum Standards for Commercial Banks Regulations (01/2010), commercial banks may invest in non-convertible debt instruments and, subject to CBN approval, may enter into derivatives transactions.

Merchant banks
In the CBN Scope, Conditions and Minimum Standards for Merchant Banks Regulations 2010, merchant banks may engage in proprietary trading (eg, investing in debt instruments of any person or equity or in hybrid-equity instruments) subject to the provisions of Banks and Other Financial Institutions Act(4) and such rules, regulations, circulars and guidelines that may be prescribed by the CBN. The regulation is silent on whether the CBN's approval is needed to enter into derivatives transactions like commercial banks. It is likely that this silence means that merchant banks, being of a more specialised nature and whose main clients are sophisticated or institutional investors, should be able to invest in derivatives transactions without CBN approval. However, it is expected that the CBN would retain overall oversight over the mode and procedure that such investments may follow.

Investment firms/broker dealers
An investment adviser registered with the SEC may, among other things, make recommendations as to the types of securities to buy or sell. In a similar manner, a broker dealer registered with the SEC may purchase and dispose of securities both on behalf of its clients and for itself, as well as trading on registered securities exchanges and OTC markets.(5) Thus, there is no limit on the capacity of an investment adviser or a broker dealer to enter into derivatives transactions on its own behalf or on behalf of its clients, provided that the investment firm or broker dealer is registered with the SEC.

Limited liability companies
There is no limit on the capacity of either a private limited liability company or a public limited liability company to enter into derivatives transactions, to the extent that the company has the capacity to do so under its memorandum and articles of association and is duly authorised by the appropriate corporate action of the company.

Insurance companies
By virtue of Section 25(2) of the Insurance Act 2004, an insurance company may invest policyholder funds only in the following types of property and securities:

• shares of limited liability companies;
• shares and other securities of a cooperative society;
• loans to building societies, real property, machinery and plant in Nigeria;
• loans on life policies within their surrender value;
• cash deposits on or bills of exchange accepted by licensed banks; and
• such investments as may be prescribed by the National Insurance Commission.

However, insurance funds are distinguished from shareholder funds and the blanket restriction above applies to insurance funds. In regard to shareholder funds, there are still restrictions on the percentage of the insurance company's shareholder funds that can be invested in particular assets. For example, the Investment Policies and Guidelines regulating insurance companies provide that no insurer or reinsurer shall invest in its parent company; and investment of shareholder funds in subsidiaries should be limited to 25% of such funds. It would then stand to reason that the National Insurance Commission may take the view that equity derivatives entered into by an insurance company should also be subject to these restrictions and thresholds.

In addition, the Investment Policies and Guidelines provides that no more than 5% of the total equity investment shall be placed in the security of one company and that investment in foreign securities shall not be recognised for the purposes of determining solvency. These restrictions may qualify and limit the ability of insurance companies to enter into derivatives transactions with shareholder funds.

Pensions funds
The Regulations on Investment of Pension Fund Assets 2008 prohibit pension funds from trading on margin accounts or taking positions with pension fund assets. This restriction is also contained in the Amended Investment Guidelines of December 2010.(6)

In addition, all trading of securities carried out with pension fund assets shall take place on the floor of a securities exchange registered with or recognised by the SEC, or a money market electronic platform open to the public and approved by the CBN or the Money Market Association of Nigeria. Thus, the pension fund cannot trade in OTC derivatives.

State-owned or sovereign-owned entities
Most state or federal government-owned entities in Nigeria are creations of statutes, and the enabling statute would give them the power to:

• hold, manage and alienate movable and immovable property;
• purchase and otherwise hold assets, properties, privileges, contracts, rights, obligations and liabilities; and
• enter into contracts or partnerships with third parties to facilitate the discharge of their duties.

However, the Fiscal Responsibility Act 2007 sets out a framework for the revenue and expenditure of the federal government and its agencies. Where some of the measures set out in the act apply to all levels of government, other measures are merely persuasive towards states and local government, which are thereby encouraged to adopt the prudent fiscal measures set out in the act.

Section 41(1) of the act provides that government at all levels shall borrow only for capital expenditure and human development. Section 44 also provides for the setting of borrowing limits for the federal government and its agencies and corporations. Section 44(2) provides that each borrowing by the government or its agencies and corporations shall be subject to the existence of prior authorisation in an appropriation act or other legislation(7) for which the borrowing is to be utilised. Section 45 provides that all banks and financial institutions shall request and obtain proof of compliance with authorisation and limits before lending to any government body. Lending in contravention of these provisions is deemed to be unlawful.

Therefore, the government and its entities may engage in a derivatives transaction only to further their duties under the enabling act. Where such a derivatives transaction amounts to borrowing, they may do so only if authorised by an appropriation or other act and if it is within the set borrowing limits.

Slightly different rules may apply to the CBN. The Central Bank of Nigeria (Establishment) Act 2007 is the enabling law for the CBN. The act sets down no limitations on the capacity of the entity to enter into any derivatives transactions.

Trusts
The investment of trust funds is governed by the Trustee Investments Act 2004, the Investments and Securities Act 2004 and the rules and regulations made pursuant thereto (the 'SEC rules'). Section 3(1) of the Trustee Investments Act provides that without prejudice to the enabling provisions of any other law, a trustee may invest in the securities specified or referred to in Section 2 of the act. Section 2 refers to:

• federal and state government securities;
• securities issued by government parastatals; and
• shares and debentures of public companies incorporated in Nigeria and quoted on the Nigerian Stock Exchange.

Thus, a trust may not use trust funds in its custody to enter into a derivatives transaction. However, this restriction applies to trust funds in its custody and there is nothing to stop a trust from entering into a derivatives derogating transaction with its own funds, subject to the minimum capitalisation requirement under the applicable laws.

Legal issues and documentation

Innovative financial products usually give rise to novel legal and regulatory issues, and this is particularly true for derivatives.

Documentation
Derivatives, particularly credit derivatives, require effective legal documentation to delineate the rights and obligations of each counterparty to the transaction.

Although the standard documentation developed by the International Swap Dealers Association (ISDA) for derivatives transactions has no direct application in Nigeria, players in the Nigerian derivatives market can use this standard template to document their transactions, amending it to suit the peculiarity of each transaction. Under Nigerian law, parties are at liberty to document their own contract(8) or adopt terms of a contract by reference, and nothing precludes parties from utilising a standard contract such as that developed by the ISDA.

Capacity
Care must be taken to ensure that a Nigerian counterparty has the requisite capacity to enter into a derivatives transaction, as such legal capacity may differ from one entity to the next and would depend on the nature of the limitation on the counterparty. As mentioned above, certain rules and regulations have imposed limits on certain entities' capacity to enter into derivatives transactions.

The effect of a lack of capacity to contract under Nigerian law may range from giving a member of the company the right to obtain an injunction to stop the contract, to rendering the contract illegal or void.(9)

Governing law
The choice of English or New York law as the governing law of a derivatives contract by a Nigerian counterparty will be recognised and upheld by the Nigerian courts, provided that the agreement is not contrary to public policy and does not contravene another relevant law.

Electronic evidence
Until recently, Nigerian law made no provision for the admissibility of electronic evidence, and the question of whether the Nigerian courts will admit an electronic copy of a signed original could not be answered unequivocally. However, by virtue of Section 84 of the Evidence Act 2011,(9) electronically generated evidence is now admissible in evidence.

Validity of security interests
Nigerian law recognises the validity of contractual matters under each security document (eg, questions of offer, acceptance, consideration and formalities) if the document is valid under the governing law.

However, the question of validity of the security interest created will be determined by:

• the domicile of the counterparty;
• the nature of the asset over which security is created; and
• where such asset is deemed to be situated.

It is thus useful to seek legal advice as to how Nigerian law will treat collateral located outside Nigeria when the counterparty is located in Nigeria, and vice versa.

Nigerian law may also impose registration and perfection requirements depending on the nature of the collateral in question.

For a security created under the English Transfer Annex, appropriate opinion must be sought to guard against the risk of re-characterisation. However, in general, the Nigerian courts will enforce the agreement of the parties as long as it is not a sham.

Enforceability of close-out netting
A Nigerian company is typically subject to winding up and arrangement or compromise with creditors if it becomes insolvent. However, banks and insurance companies may be subject to additional insolvency proceedings, while restrictions may apply to the treatment of pension fund assets on the administrator's insolvency.

Insolvency set-off is available only where there have been mutual credits, debts or other dealings between parties.

Comment

Although the market for derivatives in Nigeria is nascent, the statutory regulators are striving to create an environment in which a viable derivatives market could thrive.

A prospective counterparty in a derivatives transaction in Nigeria must ensure that the other party not only is statutorily qualified to deal in derivatives, but also has the requisite approvals where prescribed.

Finally, as derivatives transactions gain traction in Nigeria, further changes are expected in the regulatory and legal regimes to cater for the increased sophistication and complexity of the market.

For further information on this topic please contact Olayemi Anyanechi at Sefton Fross by telephone (+234 1 734 7702), fax (+234 1 454 3272) or email ([email protected]).

Endnotes