Legal risk optimisation

In July 1993, the Group of Thirty cautioned that the greatest risk facing the derivatives industry was not market, credit or operational risk, but legal risk.1 Despite this warning, quantitatively the industry’s efforts have been on refining pricing models, designing market and credit risk models, and now even attempting to model operational risk. It appears to have devoted little or no resources towards modelling and measuring legal risk.

But the lack of a legal risk model should not be taken as a criticism that the industry has done nothing to address and reduce the legal risks it has faced over the past decade. Its achievements in advancing legal certainty for privately negotiated derivatives are almost unlimited, and include standard documentation, credit support agreements, legal opinions for close-out netting, legal opinions for the taking and enforcement of collateral, and legislation on issues such as the Statute of Frauds, regulatory reforms and close-out netting. Efforts on the legal frontier to date, however, have been focused on the qualitative rather than the quantitative.

Defining legal risk
A derivative is a bilateral contract that derives its value from changes in the value of the underlying financial instrument, reference price, rate or index. The legal risks of derivatives, therefore, are the legal risks of a bilateral contract. The general temptation is to limit the definition of derivatives’ legal risk to the loss resulting from the unenforceability of the contract. To construct a legal risk model, however, we must not be limited solely to the unenforceability issue.

For example, a contract may be enforced, but a single term of the contract may not be interpreted by the courts according to the understanding of a party to the contract at its inception, currently involved in litigation. On May 18, 2000, in Peregrine versus Robinson, the high court in London enforced the contract, but in its enforcement, decided that the settlement amount determined according to market quotation was ‘too low’ to be commercially reasonable. The court ruled that Robinson pay an amount based on loss, which was approximately $78 million higher than the $9.5 million payment due under market quotation. Essentially, the legal risk of derivatives is the loss resulting from all aspects of litigation.

The costs of legal risk
The costs of legal risk are the costs of avoiding litigation and those actually incurred in litigation. The most obvious cost is legal fees. Related costs include any punitive or consequential damages. Another cost would be any loss resulting from the unenforceability or voiding of the contract.

More elusive than the direct costs are the numerous opportunity costs associated with litigation, including senior management, front- and back-office time, reputational harm and public exposure of internal policy. Senior management time is involved at all stages of a lawsuit – from deciding whether to continue litigation or settle, determining what resources will be devoted to the matter, and to actual preparation and giving of testimony. Once the discovery process has begun, back- and front-office staff will have to devote extensive hours to producing various internal reports, potentially including daily mark-to-market and profit and loss reports, and reconstructing the original pricing of the underlying transaction(s) in question. Frequently, no-one will be at the firm that was originally responsible for marketing or executing the transaction. A firm’s demise can potentially result from the public disclosure of internal records that expose a firm-wide culture of ‘gouging’.

Why derivatives are different
Derivatives, due to their nature and relative market immaturity, face more significant and ambiguous legal risk than that of traditional commercial banking or investment products. Unlike a loan, most derivatives transactions are characterised by a mutual two-way credit exposure, meaning both counterparties may have an incentive to litigate in the future. Also, unlike a loan, the credit exposure under a derivatives contract can be potentially unlimited. Derivatives, more than loans or investments, can involve numerous cross-border issues. Because derivatives have only existed in the mainstream of international capital markets since 1981, many conflicts have been settled out of court to avoid the public exposure of being among the first involved in derivatives litigation. Therefore, few court decisions exist on interpreting the relevant contracts. Also, in many jurisdictions, the regulatory status of the product is uncertain. The core of the problem is old law being applied to new products.Litigation claims
Since the January 24, 1991 House of Lords decision in Hazell versus Hammersmith & Fulham, where the House ultimately ruled that all the derivatives transactions were void due to the local municipality’s lack of capacity. most lawsuits involving derivatives contain a claim of lack of capacity and the related claim of lack of authority. Allegations in the New York courts, until amending legislation was passed in 1994, also frequently included Statute of Frauds violation. Other claims generally include common-law fraud, breach of fiduciary duty and negligent misrepresentation. Frequently, a regulatory violation, such as a derivatives contract being an illegally traded futures or security contract, is alleged. Claims are often contract-based. For example, many recent cases have alleged breach of contract in the calculation of the settlement amount upon an early termination event. Litigation also gives rise to claims of civil procedural violations, including the timing and format of procedural filings.

A legal risk model
A rudimentary risk model can be constructed by viewing legal risk in the context of a regression model. Legal risk can be viewed as a function of 14 critical variables. In particular:

LR = f(D,R,P,C,Lo,J,Ch,I,T,E,Cr,St,L,S)where:
LR=legal risk
P=type of products
C=type of counterparties
Lo=location of counterparties
J=judicial decisions
Ch=choice of law/legal environment
I=initial mark-to-market
E=exposure to counterparties
Cr=your credit rating
St=your corporate structure
L=your lawyers
S=your staff.

Proper documentation is vital for managing and controlling legal risk. Also, as most derivatives are now legally enforceable at the time they are verbally agreed, the maintenance of proper verbal documentation is essential. Regulatory restrictions and classifications are also a crucial legal risk factor for derivatives. For example, until the enactment of the Commodity Futures Modernization Act of 2000, US counterparties faced an unsettling possibility that their in-the-money contracts could be voided by their counterparty if the transactions were found to be illegal off-exchange futures contracts.

The type of products and counterparties contribute significantly to legal risk. The legal risk associated with a plain vanilla interest or currency swap is minimal, but the risk associated with an ‘innovative’ Libor-squared or accrual swap is not. The latter products are exposed to claims of lack of transparency and hidden leverage. Similarly, transacting with municipalities and retail counterparties rather than large sophisticated corporations and financial institutions exposes a firm to suitability and breach of fiduciary duty allegations.

Derivatives entered into with counterparties located in the US or the UK generally have greater legal certainty, all else being equal, than transactions entered into with counterparties located in jurisdictions where the legal structure is less certain, such as Indonesia. Legal risk is also a function of existing court decisions. As more derivatives-related cases are litigated in the courts, deciding between the laws of England and the laws of the State of New York could become more problematic.

Any transaction where the initial mark-to-market of the transaction at inception reveals a profit above a ‘normal’ return is potentially at greater risk for future litigation than a transaction that earns a ‘normal’ return. In the early 1980s, it was not uncommon for a currency swap to generate a profit to the intermediating institution of at least 400 basis points due to the existence of market arbitrage. Derivatives were reshaping the borrowing and investment arena by eliminating the currency exposure of borrowers and investors who chose to transact out of their domestic jurisdictions. Today, few pure or large market arbitrages exist, and an institution must give considerable thought as to whether its initial return on a complex product might in the future be reduced due to litigation by an out-of-the money counterparty.

Technology is important not only for refined pricing and risk modelling, but also for reducing legal risk. In times of crisis, such as in Russia in 1998, it is essential that institutions immediately know which counterparties are involved and how the close-out provisions of the relevant documents operate. Given current volumes, manually reviewing the documents is too time-intensive. Institutions should have online automated access that instantly alerts them to any document that has an exception to their standard close-out policy and exactly how that exception operates.

A large credit exposure to any particular counterparty should also be monitored closely. Similarly, an institution’s low credit rating can make it potentially more vulnerable to litigation. Corporate structure is also a factor. For example, more certainty generally exists for commercial and investment banks than for insurance companies as market-makers in derivatives.

The quality and size of the legal staff is also a factor in assessing a firm’s exposure to legal risk, as is their front-office staff. The traders and marketers that are entering into transactions need to be made sufficiently aware that the taped telephoned conversations of their agreements to commit their institutions to a derivatives transaction are a verbal legal contract, which is discoverable should any problems arise on a transaction in the future.

A legal risk limit
The legal risk model is just a starting point in identifying a firm’s optimum amount of legal risk. In quantifying legal risk, the goal is not to eliminate it, but to define the optimum amount. As with all risk, a trade-off exists between the amount of that risk and return. Paralleling what is done in most commercial banks in assigning each counterparty an internal credit risk rating, generally between the numbers of one and five, a rating could be assigned to each one of the variables in the legal risk model regression, with one being the lowest risk and five being the highest risk. In addition to the unique variable ratings, there could be a ‘total’ variable rating such as ‘40’, which would simply be the addition of all the individual ratings of the 14 variables of the model. A firm would be forced to decide, given their credit rating and corporate structure, where they are best suited to take additional legal risk – if it should be in the types of products, counterparties or jurisdictions in which they transact.

Legal risk need no longer be thought of in purely qualitative terms. As legal risk comes to be viewed in a quantitative paradigm, just as any firm’s credit risk manager can assign a credit risk rating for any counterparty, the firm’s legal risk manager will be able to state a similar numeric for the legal risk rating of the firm’s derivatives.

1 Global Derivatives Study Group, Group of Thirty, Derivatives Practices and Principles, Appendix 1, page 43 (1993)2 See above
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