Understanding Financial Derivatives through the Civil Code/ by Russell Stanley Q. Geronimo

It is one thing to understand derivative transactions in finance, and it is another thing to understand their legal nature within the framework of the law of obligation and contracts. When their contractual validity and enforceability are in dispute, it is lawyers and judges who are called to the task of defining and interpreting their judicial character and effects, not the financial engineers who design them or the fund managers who use them. This paper proposes a way of understanding financial derivatives from the viewpoint of legal professionals, pursuant to the most authoritative statutory guidance on contractual defects: the Civil Code. First, this paper shows why textbook definitions of financial derivatives are inadequate for the purpose of legal analysis, particularly when contractual validity and enforceability issues are involved. Second, it examines the judicial character of the three major classes of derivatives (forwards, swaps and options), and proposes legal definitions that distinguish these instruments from other securities, pooled investments, insurance, and wagering transactions. From this, it extrapolates a general legal definition of derivatives. Finally, this paper applies the proposed legal definitions in examining the legal status of (I) Philippine index futures, (ii) bilateral hedging contracts in the Wholesale Electricity Spot Market, and (iii) Philippine Depository Receipts.