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LEGAL RISKS OF DERIVATIVES

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

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  1. LEGAL RISKS OF DERIVATIVES WHAT’S NOT WHAT’S HOT Carolyn Jackson PRMIA/ISDA 1Oth July, 2002

  2. Outline • Legal Risk • The Costs • Legal Risk Model • Legal Risk Limit • Litigation Time Line

  3. “Enforceabily presents the greatest risk participants face in derivatives transactions” Group of 30 July 1993 Appendix 1, p.43

  4. WHAT is legal risk?

  5. 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

  6. Current Anomalies Barings Liquidators vs. Deloitte & Touche tens of £ millions in legal fees vs the £13,000 fee for two audits

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

  8. 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

  9. 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

  10. Modelling Legal Risk? • Qualitative vs. quantitative

  11. 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

  12. The Legal Bullet x x Return Rf Risk

  13. 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

  14. WHICH variables are controllable? • Direct (D,L,C,P,I, Lo, T,E,S) • Indirect (Cr, Ch) • Uncontrollable? (R,J)

  15. WARNING!!!!!! If your firm leads the industry in: types of counterparties, types of products, location, exposure

  16. 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?

  17. The Volatility of Legal Risk • 1980’s - low • 1990s - high • 2000-2010 - moderately high • beyond 2010 ?????

  18. 1980’s - Derivatives Litigation Time Line • Interest /Currency Rate Transactions • Statute of Frauds • Tax Withholding • Regulatory Characterisation

  19. 1990’s - Derivatives Litigation Time Line • Leveraged Products • Capacity/Authority • Suitability • Negligent Misrepresentation • Fraud • Regulatory Characterisations • Contract Based Claims

  20. 2000’s - Derivatives Litigation Time Line • Credit Derivatives/Insurance • “Incorrect/Ambiguous” Documentation • Contract Based Claims

  21. WARNING WHAT YOU ARE ABOUT TO SEE IS NOT A COMPLETE LIST

  22. 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

  23. 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

  24. 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

  25. Beyond 2010?

  26. Conclusion • Legal Risk • Quantitative • Legal Risk Model • Towards a Legal Risk Limit

  27. LEGAL RISKS OF DERIVATIVES WHAT’S NOT WHAT’S HOT Carolyn Jackson PRMIA/ISDA 1Oth July, 2002

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