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LEGAL RISKS OF DERIVATIVES. WHAT’S NOT. WHAT’S HOT. Carolyn Jackson PRMIA/ISDA 1Oth July, 2002. Outline. Legal Risk The Costs Legal Risk Model Legal Risk Limit Litigation Time Line. “ Enforceabily presents the greatest risk participants face in derivatives transactions”. Group of 30

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Legal risks of derivatives l.jpg

LEGAL RISKS OF DERIVATIVES

WHAT’S NOT

WHAT’S HOT

Carolyn Jackson

PRMIA/ISDA

1Oth July, 2002


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Outline

  • Legal Risk

  • The Costs

  • Legal Risk Model

  • Legal Risk Limit

  • Litigation Time Line


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“Enforceabily presents the greatest risk participants face in derivatives transactions”

Group of 30

July 1993

Appendix 1, p.43


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WHAT is legal risk?


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WHAT are the costs of legal risk?

  • ambiguity/lack of clarity

  • unenforceability of the contract

  • senior management time

  • front/back office time

  • legal fees

  • punitive/consequential damages

  • reputation

  • public exposure of internal policy


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Current Anomalies

Barings Liquidators vs. Deloitte & Touche

tens of £ millions in legal fees vs the £13,000 fee for two audits


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WHY are the legal risks of derivatives unique from traditional commercial/investment banking products?


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Derivatives Involve

  • Mutual two-way exposure

  • Potentially unlimited exposure

  • Increased cross-border issues

  • Barely 20 year product

  • Uncertain regulatory/tax status

  • Out-of-court settlements

  • Evolving markets

  • Old law/new products


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HOW are the claims brought?

  • Statute of Frauds

  • Lack of Capacity

  • Lack of Authority

  • Common Law Fraud

  • Breach of Fiduciary Duty

  • Negligent Misrepresentation

  • Regulatory Violation

  • Contract Based Claims

  • Procedural Violations


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Modelling Legal Risk?

  • Qualitative vs. quantitative


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The Efficient Portfolio of Legal Risks

there is an optimum amount of legal risk for your firm

risk management generally does not have as an objective

the elimination of risk, but rather, the development of

a framework for managing and understanding the risk


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The Legal Bullet

x

x

Return

Rf

Risk


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The Model

LR = f(D,R,L,J,C,P,I,Lo,T,E,S,Cr,St,Ch)

where:

D = documentation

R = regulation

L = your lawyers

J = judicial decisions

C = type of counterparties

P = type of products

I = initial mark-to-market

Lo = location of counterparties

T = technology

E = exposure to counterparties

S = your staff

Cr = your credit

St = your corporate structure

Ch = choice of law/legal environment


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WHICH variables are controllable?

  • Direct (D,L,C,P,I, Lo, T,E,S)

  • Indirect (Cr, Ch)

  • Uncontrollable? (R,J)


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WARNING!!!!!!

If your firm leads the industry in:

types of counterparties,

types of products,

location,

exposure


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A legal risk limit?

  • If there are credit risk ratings, why not legal risk ratings

  • Why not weight each legal risk factor, as well as have a maximum limit for each factor?


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The Volatility of Legal Risk

  • 1980’s - low

  • 1990s - high

  • 2000-2010 - moderately high

  • beyond 2010 ?????


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1980’s - Derivatives Litigation Time Line

  • Interest /Currency Rate Transactions

  • Statute of Frauds

  • Tax Withholding

  • Regulatory Characterisation


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1990’s - Derivatives Litigation Time Line

  • Leveraged Products

  • Capacity/Authority

  • Suitability

  • Negligent Misrepresentation

  • Fraud

  • Regulatory Characterisations

  • Contract Based Claims


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2000’s - Derivatives Litigation Time Line

  • Credit Derivatives/Insurance

  • “Incorrect/Ambiguous” Documentation

  • Contract Based Claims


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WARNING

WHAT YOU

ARE ABOUT

TO SEE IS NOT

A COMPLETE LIST


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Derivatives Litigation Time Line

1987

1991

1992

1994

Decision

H of Lords

Hammersmith & Fulham

lack of power/authority

Decision

Homestead vs. Life Savings

anticipatory breach of contract

good faith/fair dealing

affirmative defense

Statute of Frauds

$6.2MM

Filed

Lehman v Minmetals

breach of contract

counterclaim

lack of capacity

lack of authority

securities fraud (d)

breach of fiduciary duty

negligence

misrepresentation

mark up fraud (d)

$53.5MM

Decision

Salomon Forex vs. Tauber

breach of contract

affirmative defense

Statute of Frauds

counterclaim

illegal futures

gambling laws

bucket shop laws

$26MM

Drexel vs. Midland

Contract Based, 353M


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Derivatives Litigation Time Line

1996

1995

1998

BT vs. Dharmala

lack of capacity

suitability

misrepresentation

P& G vs. BT

Ohio

regulatory (SEC,CEA)

laundry List

SEITA vs. SBIL

regulatory

fraud

fiduciary duty

lack of capacity


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Derivatives Litigation Time Line

2002

2000

2001

Filed

Korea Life vs. Morgan Guaranty

fraud

negligent misrepresentation

breach of contract

violations of Korean law

violations of NY gambling laws

$90MM

Filed

Eternity vs. Morgan Guaranty

breach of contract

breach of good faith

fraud

negligent misrepresentation

consequential damages

$14MM,$6MM

Caiola vs. Citibank

regulatory

Peregrine vs. Robinson

Contract Based

$78MM

ANZ vs. Soc Gen

Contract Based, $8MM

Griffin vs. Citibank, Tax


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Beyond 2010?


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Conclusion

  • Legal Risk

  • Quantitative

  • Legal Risk Model

  • Towards a Legal Risk Limit


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LEGAL RISKS OF DERIVATIVES

WHAT’S NOT

WHAT’S HOT

Carolyn Jackson

PRMIA/ISDA

1Oth July, 2002


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