LEGAL RISKS OF
DERIVATIVES
WHAT’S HOT
WHAT’S NOT
Carolyn Jackson
PRMIA/ISDA
1Oth July, 2002
ALLEN & OVERY
Outline

Legal Risk

The Costs

Legal Risk Model

Legal Risk Limit

Litigation Time Line
ALLEN & OVERY
“Enforceabily presents the
greatest risk participants face in
derivatives transactions”
Group of 30
July 1993
Appendix 1, p.43
ALLEN & OVERY
WHAT is legal risk?
ALLEN & OVERY
WHAT are the costs of legal risk?
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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
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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
ALLEN & OVERY
HOW are the claims brought?
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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
ALLEN & OVERY
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
ALLEN & OVERY
The Legal Bullet
Return
x
x
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
ALLEN & OVERY
WHICH variables are controllable?
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Direct (D,L,C,P,I, Lo, T,E,S)
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Indirect (Cr, Ch)
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Uncontrollable? (R,J)
ALLEN & OVERY
WARNING!!!!!!
If your firm leads the industry in:
types of counterparties,
types of products,
location,
exposure
ALLEN & OVERY
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?
ALLEN & OVERY
The Volatility of Legal Risk
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1980’s - low
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1990s - high
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2000-2010 - moderately high
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beyond 2010 ?????
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1980’s - Derivatives Litigation Time
Line

Interest /Currency Rate Transactions

Statute of Frauds
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Tax Withholding

Regulatory Characterisation
ALLEN & OVERY
1990’s - Derivatives Litigation Time
Line
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Leveraged Products

Capacity/Authority

Suitability
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Negligent Misrepresentation

Fraud

Regulatory Characterisations

Contract Based Claims
ALLEN & OVERY
2000’s - Derivatives Litigation Time
Line

Credit Derivatives/Insurance

“Incorrect/Ambiguous” Documentation

Contract Based Claims
ALLEN & OVERY
WARNING
WHAT YOU
ARE ABOUT
TO SEE IS NOT
A COMPLETE LIST
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Derivatives Litigation Time Line
1987
1991
Decision
Homestead vs. Life Savings
anticipatory breach of contract
good faith/fair dealing
affirmative defense
Statute of Frauds
$6.2MM
1992
Decision
H of Lords
Hammersmith & Fulham
lack of power/authority
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
1994
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
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Derivatives Litigation Time Line
1995
BT vs. Dharmala
lack of capacity
suitability
misrepresentation
1996
P& G vs. BT
Ohio
regulatory (SEC,CEA)
laundry List
1998
SEITA vs. SBIL
regulatory
fraud
fiduciary duty
lack of capacity
ALLEN & OVERY
Derivatives Litigation Time Line
2000
Filed
Korea Life vs. Morgan Guaranty
fraud
negligent misrepresentation
breach of contract
violations of Korean law
violations of NY gambling laws
$90MM
Peregrine vs. Robinson
Contract Based
$78MM
ANZ vs. Soc Gen
Contract Based, $8MM
Griffin vs. Citibank, Tax
2001
Caiola vs. Citibank
regulatory
2002
Filed
Eternity vs. Morgan Guaranty
breach of contract
breach of good faith
fraud
negligent misrepresentation
consequential damages
$14MM,$6MM
ALLEN & OVERY
Beyond 2010?
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Conclusion

Legal Risk

Quantitative

Legal Risk Model

Towards a Legal Risk Limit
ALLEN & OVERY
LEGAL RISKS OF
DERIVATIVES
WHAT’S HOT
WHAT’S NOT
Carolyn Jackson
PRMIA/ISDA
1Oth July, 2002
ALLEN & OVERY