A derivative
46This branch of the trail then leads to what is a derivative, the relevant definition of which is (s 761D(1)) -
"Meaning of derivative
(1) For the purposes of this Chapter, subject to subsections (2), (3) and (4), a derivative is an arrangement in relation to which the following conditions are satisfied:
(a) under the arrangement, a party to the arrangement must, or may be required to, provide at some future time consideration of a particular kind or kinds to someone; and
(b) that future time is not less than the number of days, prescribed by regulations made for the purposes of this paragraph, after the day on which the arrangement is entered into; and
(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), including, for example, one or more of the following:
(i) an asset;
(ii) a rate (including an interest rate or exchange rate);
(iii) an index;
(iv) a commodity."
47As a matter of words, the agreement was an arrangement under which each of ILP and CHM must or may be required to provide consideration to the other at a future time. The monetary consideration could be -
ILP paying Legal Costs for CHM;
possibly, ILP providing investigative and management expertise to CHM; and
CHM paying the Early Termination Fee, repaying the Legal Costs, or paying the Funding Fee to ILP.
48The Court was informed that the prescribed number of days was relevantly one day, and there was no issue that any provision of consideration would be at a future time. The issue concerned determination, derivation or variation of the amount of the consideration or the value of the arrangement. (The value of an arrangement to a party to it is not necessarily the same as the consideration it will receive; for example, the costs of performance by that party must be taken into account.)
49The trial judge dealt with this as follows -
"78 In my opinion, the Deed is not a derivative. Section 761D(1)(c) requires the amount of the consideration or the value of the arrangement ultimately to be determined, derived from or vary by reference to (wholly or in part) the value of something else. The word "ultimately" in the subsection plainly qualifies the words "determined, derived from or varies by reference to" (there being no comma before the words which follow the words in parentheses).
79 This is no doubt because it is in the nature of a derivative that the value of the arrangement will (as the word "ultimately" connotes) in every case be affected by (and hence derived from) the value of something else. The Deed does not have this invariable operation, as the facts in the present case demonstrate. The amount of the Early Termination Fee on the particular Change in Control here is not determined or derived from, nor does it vary by reference to the value of, something else.
80 There is, to my mind, a further and fundamental problem with CHM's submission. CHM is the client referred to in s 924A(1), and in that capacity purported to rescind an arrangement whereby it was issued with a financial product. By s 763A, the financial product concerned is a facility through which CHM says it made a financial investment. Section 763B provides for when a person makes a financial investment which in all cases involves an investor giving money or money's worth to another person and envisages that contribution being used or intended to be used in a particular way. That is not this case. Here, it seems to me, if anyone is making a financial investment, it is the Funder, not CHM. The Funder pays Legal Costs and may receive a possible enhanced return. of cl 7.1 of the Charge, and accordingly an Event of Default."
50The reasoning in [78]-[79] is that "ultimately" in s 761D(1)(c) required that all possible outcomes in determining or varying the amount of the consideration or the value of the arrangement be by reference to the value or amount of something else; but that was not so for the agreement, because the Early Termination Fee was a fixed $9 million if (as was the case with CLR's involvement) there was no acquisition of CHM's shares at a strike price.
51With respect, the part played by [80] in the reasoning is not clear. CHM suggested that it was that the agreement was not a derivative because it was not CHM, but ILP, which was making a financial investment. ILP submitted that it went to who was the "client" in s 925A of the Act with the entitlement to rescind, and that it "further illustrates the artificial operation of [CHM's] contentions". I do not understand this last submission. If [80] should be understood as CHM suggested, the reasoning was erroneous. A derivative is a financial product in its own right, whether or not it is within the general definition (s 762A(2)) and so whether or not anyone makes a financial investment under s 763B.
52The parties' submissions went in some detail into matters of grammar and punctuation. The structure of s 761D(1)(c) is difficult, but in my opinion its application in the present case does not turn on "ultimately" or a comma.
53A particular difficulty is that para (a) of s 761D(1) refers to provision of consideration, but when one comes to para (c) it refers also to the value of the arrangement as a factor additional to the amount of the consideration, the affectation of which by itself can satisfy the paragraph. Value to whom, and how is it ascertained? One way this can operate is if the value of the arrangement is seen as an extended correlative of the amount of the consideration, although it is not the same as the amount of the consideration; from the point of view of its recipient under the arrangement, the consideration is one of all the elements in the arrangement from which the value of the arrangement to that party is ascertained. Adopting the trial judge's use of "affected by" as shorthand for the determination, derivation or variation to which para (c) refers, in such a case it is not easy to see that the additional factor adds anything to the working of the definition, since if the amount of the consideration is relevantly affected, so is the value of the arrangement likely to be affected.
54Putting that aside, in my respectful view the word "ultimately" does not "connote" that the value of the arrangement will in every case be affected by the value (or amount) of something else. It allows the effect of the value (or amount) of the something else to be remote, but says nothing of whether the effect must be such that the value of the arrangement is always affected by the value (or amount) of something else. Similarly, although the trial judge did not refer to this limb of para (c), the word "ultimately" does not "connote" that the amount of the consideration will in every case be affected by the amount (or value) of something else.
55Apart from the word "ultimately", the trial judge considered that universal affectation was "in the nature of a derivative". CHM submitted that whether the agreement is a derivative depends on the definition in the Act, not some accepted concept of a derivative, if there be one. I accept that submission.
56The better indicator of whether there must be universal affectation lies in para (a) of s 761D(1), whereby a party must or may be required to provide the consideration. An arrangement may call for a party to provide consideration of more than one kind, depending on future events, one of which is affected by the value or amount of something else and another of which is not. The party "may be required" to provide the consideration of the former kind, if the appropriate future events occur, but this will not necessarily be so. It will be sufficient if the amount of that consideration is affected by the value or amount of something else; and if it is, the value of the arrangement will be affected by the value or amount of the something else. It does not matter that in other future events the consideration which is not affected by the value or amount of something else is the consideration which must be provided.
57On this analysis, universal affectation is not necessary. It may be added that any other reading of the definition would permit it be avoided by the simple expedient of providing for payment of a fixed $1, no matter what happened in relation to the something else and its effect on the amount of the substantive consideration.
58In my view, therefore, the basis on which the trial judge decided that the agreement was not a derivative should not be accepted.
59CHM submitted that the trial judge considered only one way in which the agreement could be a derivative, namely, by regard to the amount of the Early Termination Fee. As to that, it submitted, his Honour was in error because although the Early Termination Fee of $9 million was not affected by something else, in other circumstances the Early Termination Fee could turn on the strike price of CHM's shares.
60Going beyond the Early Termination Fee, CHM did not rely on provision of investigative and management expertise, no doubt recognising that the operative clauses in the agreement did not extend to it; the substance of its submissions was that -
from the point of view of ILP paying Legal Costs for CHM, the amount of the consideration was affected by the value or amount of the costs incurred, the costs ordered to be provided as security or the costs ordered to be paid, each of which was something else;
from the point of view of CHM receiving the benefit of payment of the Legal Costs, the value of the arrangement to it was ultimately affected by the same something elses;
from the point of view of ILP receiving payment of the Early Termination Fee, or repayment of the Legal Costs and payment of the Funding Fee, the value of the arrangement to it may be affected by the value or amount of the Legal Costs and the strike price of CHM's shares (in the case of the Early Termination Fee) or by the value or amount of the Resolution Sum (in the case of the Funding Fee), each of which was something else; and
from the point of view of CHM repaying the costs and paying the fees, the amount of the consideration may be affected by the same something elses.
61In so stating the substance of the submissions, I continue the shorthand of "affected" for ultimate determination, derivation or variation. The amount of the consideration or the value of the arrangement will not always be affected by the something else(s). But it will be affected by the costs amounts and may be affected by the strike price and the Resolution Sum.
62CLR made effectively the same submissions as CHM. It submitted also that the value of the arrangement could not be broken down into the elements of consideration which might be paid or received according to another outcome. It was the overall value, in ascertaining which there entered the prospect of one outcome rather than another. Correctly, in my view, it submitted that the trial judge conflated the two statutory criteria of the amount of the consideration and the value of the arrangement, and did not allow for the different operation of the latter concept.
63ILP's submissions rather abandoned reliance on "ultimately". It submitted that the affectation might wholly characterise the arrangement or do so only in part, but that it had to be "an essential aspect of the nature of any such arrangement". This, it said, came from seeing the definition "though the functional prism intended by the legislature", and in the case of the agreement all permutations of the amount of the consideration or the value of the arrangement to either party "relates directly to [the Federal Court proceedings], as opposed to derivatively to some secondary something else".
64I will return to the legislative intention, and for the present note ILP's explanation of why the value of the agreement was not ultimately determined by reference to the value of something else. The explanation did not similarly address the amount of consideration, but can be extended to it. The explanation was by examples; one where CHM failed in the proceedings so that ILP paid the Legal Costs and CHM did not have to repay them, another where ILP determined the agreement under cl 10.1 and all ILP could get was repayment of the Legal Costs, and the third where there was a Resolution Sum and ILP received repayment of the Legal Costs and payment of the Funding Fee. As to the first two, it was said that the amount of the Legal Costs was "simply a function of itself" and "not a derivative of some other value", and was "self-determining". As to the third, it was said that the value of the Funding Fee was "a function of the outcome of the litigation which is the very subject-matter of the [agreement]", and that ILP realised an interest in the proceedings which was contingent on the damages awarded but there was no something else.
65The submissions as to the first two examples were off the point. The point is not whether the Legal Costs were affected by something else, but whether an amount of consideration or a value of the arrangement was affected by something else, viz, the Legal Costs. As to the third example, the outcome of the litigation could be a something else even as, indeed because, something at the heart of the agreement.
66The definition of "derivative" is extraordinarily wide, one which could catch many arrangements not ordinarily thought of as derivatives. Returning to ILP's submissions as to the legislative intention, there is no satisfactory basis for reading the words down.
67Section 761D was part of the amendments to the Act made by the Financial Services Reform Act 2001. The amendments included introduction of Ch 7, ss 760A and following, amongst which are the provisions concerned with provision of a financial service. By 760A -
" 760A. Object of Chapter
The main object of this Chapter is to promote:
(a) confident and informed decision making by consumers of financial products and services while facilitating efficiency, flexibility and innovation in the provision of those products and services; and
(b) fairness, honesty and professionalism by those who provide financial services; and
(c) fair, orderly and transparent markets for financial products; and
(d) the reduction of systemic risk and the provision of fair and effective services by clearing and settlement facilities.
68More specifically as to derivatives, there was dissatisfaction with the regulation of financial market instruments so far as through the definition of a futures contract in the Corporations Law , particularly following the decision of the Full Federal Court in Sydney Futures Exchange Ltd v Australian Stock Exchange Ltd (1995) 128 ALR 417. The Company and Securities Advisory Committee ("CASAC") recommended "core provisions" for regulation of financial markets and financial market instruments, including a definition of derivatives, and that the definition should employ commercial criteria and be by the "deductive" method of "devising a broad general definition to cover all possible derivatives, with a power (by regulation or administrative discretion) to exempt certain agreements, to avoid over-regulation" (CASAC Final Report, "Regulation of On-Exchange and OTC Derivatives Markets", June 1997, paras 3.31, 3.33-3.35).
69This was taken up by the legislature. The Explanatory Memorandum to the Financial Services Reform Bill stated in para 6.72 -
"The definition of 'derivative' in proposed section 761D has been formulated to replace the existing definition of 'futures contract' in section 72 of the proposed Corporations Act. As recommended by CASAC in its report entitled "Regulation of On-exchange and OTC Derivatives Markets' the definition focuses on the functions or commercial nature of derivatives rather than trying to identify each product that will be regarded as a derivative. The definition proposed by CASAC in its report has been used in developing the definition in proposed section 761D."
70The structure of the definition in s 761D is first to describe an arrangement which satisfies certain conditions (s 761D(1)), and to provide as well for declaration by regulation of things to be derivatives (s 761D(2)); but then to provide that an arrangement in relation to which other conditions are satisfied (s 761D(3)(a)), other specific things (s 761D(3)(b), (c)) and anything declared by regulation not to be a derivative (s 761D(3)(d)) are not derivatives "even if they are covered by the definition in subsection (1)".
71This is in accord with the CASAC method of a wide general definition with exceptions. There are quite broad exceptions where what is involved is tangible property (intended to exclude "a range of transactions involving the future delivery of something, including such things as contracts for the sale of land with a three month settlement period": Explanatory Memorandum, para 6.73 seventh dot point), and where the arrangement is "a contract for the future provision of services". There is the control of a power to exclude by regulation. Furthermore, s 761D(4) excludes an arrangement which would otherwise be caught because the consideration for the sale of property varies according to the CPI or a similar general inflation index.
72Given this deliberate drafting, there is little warrant for reading down the definition in the inclusory s 761D(1). It was intended to be wide; over-width was to be controlled by the subsequent exclusions, including by regulation. Moreover, a derivative is a particular financial product (s 764A(1)(c)), and so something which is a derivative within the wide definition and not within one of the exceptions may still be taken out of the class of financial products by the numerous exceptions in s 765A - which themselves include anything declared by regulation, or by ASIC, not to be a financial product (s 765A(1)(y), s 765(2)).
73The drafting structure has been recognised in Keynes v Rural Directions Pty Ltd [2010] FAFC 100, concerned with contracts for the forward purchase of grain. The Court (Dowsett, Stone and Bennett JJ) said -
"28 The term 'financial product' is critical to the operation of the chapter. The express exclusions contained in s 765A are designed to ameliorate the effect of the very broad language used in the other definition sections which seek to capture many kinds of financial transactions. Section 765A narrows the operation of Ch 7 so as to keep it within the intended bounds. Section 761D(3) is important because it leads to the exclusion of a very large number of everyday transactions, namely sales of tangible property for future delivery. Such transactions are not generally thought to be financial transactions. However it is well-known that there are markets in which contracts for the sale and purchase of "tangible property" are traded. Such markets are more readily seen as being "financial" and therefore appropriately regulated. Where the price of tangible property fluctuates significantly over time, there is always the likelihood that people will seek to profit from such fluctuations. For that reason s 761D(1) catches "arrangements" for the supply of tangible property where the prices are not fixed or the 'values' of the arrangements may fluctuate. However s 761D(3) narrows that effect. Broadly speaking, it does so by excluding from the definition of 'derivative' arrangements for the supply of tangible property where one of the parties is actually expected to deliver the relevant property, and where rights and obligations under such arrangements are not usually traded, or not traded in a recognizable market."
74This may not be a desirable way to legislate, quite apart from the difficulty of tracking through the provisions and seeking to apply sometimes imprecise and convoluted language. However, in my opinion CHM's submissions should be accepted. The agreement was within the inclusory definition in s 761D(1).
75Subject to the exemptions, in my opinion the agreement was a financial product as a derivative.