Chapter 26

Legal Risk

Jordana Krohley

INTRODUCTION

Legal risk is not simply a concern for lawyers. Whether you are a CEO, CFO, COO, compliance officer, supervisor or regulator, shareholder or bondholder, chances are that legal risk is more a part of your life than ever. Parties recently impacted by the realization of legal risk include investors who bought a Collateralized Debt Obligation (CDO), entered swaps to hedge an Auction-Rate Security (ARS), invested capital with Bernie Madoff, had Lehman Brothers or AIG as a counterparty, owned General Motors equity or debt, had a derivative contract with the subsidiary of a bank that was nationalized in another country, had an Icelandic credit default swap, held super senior credit default swaps “insured” by MBIA, or had a financially engineered transaction with one of the many regional banks that failed during the financial crisis. Accordingly, the analysis of legal risk is one of the critical due diligence concerns of any participant in the financial markets; a party that neglects this province may suffer civil and criminal penalties, be unable to enforce its contract against a counterparty, or discover that it has an unforeseen liability to another party.

Regrettably, the lack of consensus within the financial industry on how to define legal risk is a fitting indicator of the ambiguity and complexity that characterizes the topic. Legal risk can be conceptualized in different ways for different purposes, often overlapping with other categories of risk. To date, the Basel Committee on Banking Supervision does not define legal risk in and of itself, but rather classifies it as a subcomponent of operational risk.1 On the other hand, legal risk is often associated with market and credit risk. When a counterparty loses a large amount of money on a transaction, reflecting market risk, they may resort to legal action as a means of recovering some of the losses. Similarly, situations of default, reflecting credit risk, invoke questions of contract enforcement, which creates legal uncertainty. Legal risk can also be seen as an environmental risk, because the legal framework in a particular jurisdiction affects the risk of doing business there, or it can be viewed as a strategic risk, affecting a company's decision to move into a particular area of business.

Regardless of the lens through which legal risk is viewed, useful definitions focus on the concept that it consists of two components. First, legal risk arises in addressing questions of substantive law on a transaction-specific level. Since most derivatives are bilateral contracts that derive value from changes in an underlying financial instrument, reference price, rate, or index, the legal risk often lies in the bilateral contract and the counterparties negotiating it. When a problem arises with a contract or counterparty, the determination of rights and remedies invokes questions of law. Second, is the risk that the regulatory environment may impede market counterparties from enforcing their derivatives contracts or impose penalties for lack of compliance with prescribed obligations. Substantive law and regulation often overlap; for example, courts have adopted concepts of financial regulation and best practice in deciding whether a number of substantive law tests have been satisfied. Thus, a useful working definition of legal risk is: the risk that a transaction will not be enforceable because of a failure in the legal framework, the documentation, or by a counterparty that results in the increased probability of loss.

Legal risks associated with financially-engineered products are typically more ambiguous than those attached to traditional commercial and investment banking products. Unlike loans, most derivatives transactions entail two-way credit exposure, meaning that both counterparties may have an incentive to litigate in the future. Yet the relative immaturity of the derivatives market, and the rapid evolution of products, means that relevant judicial precedent on how to interpret novel contract provisions is often scarce. In addition, derivatives, commonly used to eliminate the currency exposure of borrowers and investors who chose to transact overseas, can involve more cross-border issues than loans or investments. The exposure to multiple legal regimes is problematic as these frequently conflict. Furthermore, since derivatives regulation has historically lagged behind the market's evolution, the risk that the law in a given jurisdiction will change during the life of the contract is elevated.

The costs associated with legal risk are high, both for counterparties and the market as a whole. Aside from the evident burden of direct costs in the form of litigation awards, opportunity costs associated with litigation, including senior management's time, front- and back-office resources, reputational harm, and public exposure of internal policy, are similarly damaging. In many cases, financial firms choose to settle cases despite recovering only a portion of losses owed, simply to avoid the expense of litigation. For markets, legal risk poses a significant threat to overall efficiency because it adversely affects the enforceability of contractual rights and obligations, and generates uncertainty.

In his 2003 keynote address at the Derivatives and Risk Management Conference, the then Vice-Chairman and Chief Legal Officer of Lehman Brothers quoted the G30's 1993 pronouncement: “The greatest risk facing the derivatives industry is not market, credit or operational risk, but legal risk.”2 More than a decade later, as the derivative market suffers record defaults by both dealers and their customers alike, and as legal risk becomes increasingly intertwined with other types of risk, understanding it is more critical than at any other time in the market's history. This chapter provides an overview of key legal risks and legal risk mitigation, examines the chief regulatory regimes that govern financially engineered products, and reviews proposed changes to relevant legislation that will profoundly affect the way the market functions going forward.3

KEY LEGAL RISKS

Derivatives invoke myriad legal risks, but a useful starting point in understanding their scope is to survey issues that commonly give rise to litigation. Some of these issues, such as ambiguous documentation, will pose a perpetual risk. Others, such as characterization of products or certain aspects of insolvency, have historically been significantly mitigated by the implementation of legislation designed to improve legal certainty and promote market agility. However, as the financial crisis recalibrates policy makers’ risk appetite and leads them to significantly revise legislation, these issues are likely to resurface or change shape.

Regulatory Characterizations

Historically, derivatives in the United States and the United Kingdom were subject to a common-law rule known as the “rule against difference contracts.”4 The rule permitted wagers on anything from wheat prices to interest rates but, in order for a court to enforce the wager, at least one of the parties to the wager had to hold title to the underlying instrument that was the subject of the bet. A CDS contract, for example, would only have been enforced if one of the parties actually owned the bonds (for example) on which the CDS was written. In this context, synthetic derivative transactions, in which no real dealing in the benchmarked underlying asset occurs, could be characterized as illegal gambling devices rather than legitimate derivatives transactions. Such transactions could be declared unenforceable, enabling the losing party to escape its obligations entirely. Indeed, because of authorities’ concerns over the ramifications of gambling as a matter of public policy, parties to such transactions could in fact be prohibited from fulfilling their obligations even if both wished to. In recent times, these concerns were largely quelled in the United States and the United Kingdom by legislation that protects derivatives from the prohibitions of gambling laws. In mid-2010, however, these protections were partially eliminated in the United States through regulatory reforms enacted in the wake of the financial crisis, meaning that the issue may be revisited in the near future (see the section entitled Regulatory Evolution—United States below for more information).

Another potential pitfall attributable to the regulatory characterization of a derivative transaction is that a party may seek to avoid an obligation by arguing that the transaction, or the combined effect of several transactions, actually constitutes an alternative transaction type, such as a loan. In actions against J.P. Morgan Chase and Citigroup in 2003, for their roles in Enron's manipulation of its financial statements, the SEC based its fraud claims on the theory that both banks engaged in derivatives transactions that were structured in a deliberately complex way to mask the fact that they were, in fact, loans.5 J.P. Morgan and Citibank agreed to pay $135 million and $120 million respectively to settle the actions.

Similarly, in a private action in England, Mahonia Ltd. v. J.P. Morgan Chase Bank, defendant WestLB AG sought to avoid payment on a letter of credit it issued to Mahonia by arguing that the economic effect of a series of swap transactions to which it was a party were actually a loan, and that the transactions’ nature as a loan should have been disclosed prior to issuance of the letter of credit.6 In that instance, however, the court rejected the argument, finding that the existence of price and performance risks, among other characteristics of the transactions supported their classification as “price risk management activities.”

Ambiguous Documentation

Legal risk associated with papering derivatives transactions became more significant with the inception of the swap markets. Unlike exchange-traded futures, which are standardized, the essence of the over-the-counter market is to tailor contracts to the counterparty. Customizing legal documentation widens the margin for error, creating additional risk. The advent of standard documentation has been a powerful countermeasure and a driver of derivatives growth. It creates certainty and predictability about the underlying nature of the financial contract in question and improves investor confidence. Nevertheless, standard contract documentation cannot eliminate problems due to simple human error.

In April 2000, UBS bought $10 million of credit protection on Armstrong World Industries, Inc. from Deutsche Bank AG. Telephone records and the indicative terms and conditions prepared by Deutsche Bank confirmed this. However, a confirmation subsequently sent by Deutsche Bank to UBS in May of the same year referred to Armstrong Holdings, Inc. as the reference entity, which was the indirect holding company of Armstrong World Industries, but which did not assume any of its obligations. In December 2000, Armstrong World Industries filed for bankruptcy. When UBS delivered Credit Event Notices to Deutsche Bank, the latter refused to pay on the grounds that the confirmation related to protection on Armstrong Holdings, not Armstrong World Industries.

Commentators generally believe that UBS would have won its claim (the case, brought before the High Court of Justice in London was settled out of court without disclosure of the settlement terms) since a judge, after looking at the erroneous contract, would amend it if evidence showed that it did not reflect the true agreement between the parties. Nevertheless, the case highlighted the risk involved in faulty contract documentation and the potential losses at stake. In the wake of the case, a consortium of banks, headed by Goldman Sachs, pioneered the creation of a centralized subscriber database called the Reference Entity Database (RED) that legally verifies the relationship between reference entities and reference obligations. RED data helps to reduce errors when affirming or confirming single name or basket trades and ensures correct representation of the underlying credit risk.

Lack of Capacity or Authority

The general rule is that a party must have both the capacity and authority to enter into a transaction. An entity's capacity to contract depends on whether it is within the theoretical ability of the entity itself to enter into the transaction. A counterparty might not be authorized to enter into derivatives contracts if the charter governing its operations, or some other form of legal inhibition, forbids it from engaging in this activity. For example, certain entities created by statute, such as municipalities, are governed by constitutional provisions limiting their ability to create excess indebtedness. Known as the ultra vires doctrine, an entity's lack of capacity to enter into a transaction can be an excuse to renege on obligations later.

In the case of Hazell v. Hammersmith and Fulham, the London Borough Council, a local authority, established a capital market fund for the purpose of conducting transactions involving interest rate movements.7 The local authority engaged in a substantial amount of derivatives transactions, including interest rates swaps. Their positions resulted in major losses as British interest rates subsequently almost doubled. The British High Court invalidated the transactions, holding that the local authority had no power to enter into them because they were inconsistent with its borrowing powers. With the contracts deemed void, the authorities were therefore not held responsible for the $178 million in losses that were, instead, absorbed by their counterparties. A parallel situation arose in the United States in the mid 1990s, when the state of West Virginia lost $280 million in interest rate swaps and sued its broker dealer, Morgan Stanley, claiming that it lacked the requisite capacity to enter into derivatives transactions.8

An entity's authority to enter into a transaction turns on whether the person who entered into it on behalf of the corporate entity had the authority to do so. If the individual who purports to enter into a transaction on behalf of the entity has no actual or ostensible authority to do so, the transaction will generally not be binding on the entity. The entity will, however, be able to ratify the transaction if it wishes to adopt it. This is particularly troubling in the context of a derivative, where the transaction might be ratified if it results in a profit but not if a loss is incurred.

Breach of Fiduciary Duty

If a party to a derivatives transaction enters into a fiduciary relationship with the counterparty but fails to comply with its fiduciary duties, it may incur liability. The principal circumstance in which a fiduciary relationship arises is when a fiduciary knowingly accepts the trust and confidence of his client to exercise his expertise and discretion on the client's behalf. Most of these relationships are unequal, because the fiduciary has specialized skills or knowledge that the other party does not have. For example, a fiduciary relationship might exist between an investment manager and an inexperienced investor such as a municipality. The law forbids the fiduciary from putting himself in a position in which his duty to the beneficiary conflicts with his duty to other customers or where his personal interests conflict with those of the beneficiary; making a profit from his fiduciary position; or using information obtained in confidence from the beneficiary for his own benefit or that of another person.

In a trading relationship, these requirements can be problematic and expose a firm to an action for breach of fiduciary duty. For example, a firm proposing to enter into an equity derivative transaction with a customer may be aware that a second customer is preparing to launch a takeover offer of the company that will likely impact the share price. The fiduciary duty requires disclosing to the derivatives customer all of the information available to the firm, but doing so would breach the firm's duty of confidentiality, exposing it to suit by the second customer.

In a corporation, the inherent risks involved in derivatives transactions expose management's practices and policies regarding these instruments to the possibility of shareholder suits for breach of fiduciary duty. Officers and directors are fiduciaries to shareholders, who are the owners of the corporation, and their main fiduciary duty is to operate the corporation in the interests of the shareholders (i.e. to maximize value). In Drage v. Procter & Gamble, P&G and several of its directors were the target of a shareholder derivative action to recover damages for corporate waste resulting from the defendants engaging in “concededly dangerous derivative leveraged swaps,” resulting in an after-tax charge of $102 million. The complaint alleged that investing in the swaps involved an excessive level of risk, particularly in light of management's inexperience in the field, constituting a breach of the defendants’ fiduciary duty. While the case was dismissed on procedural grounds, it illustrates how management's inexperience with complex financial instruments exposes it to legal risk.9

Fraud

A seller of financial instruments may be liable for fraud if the seller entered into the contract on the basis of a false statement that the seller knew to be untrue, and the buyer acted on that statement to his detriment. The landmark English case Derry v. Peek concerned a company that asserted, in its prospectus, that it had the right to operate trams by steam power rather than by horses, whereas it was, in fact, only able to use steam power if the Board of Trade authorized it to do so.10 When permission was in fact refused, the plaintiff shareholder brought an action for fraud against the directors, but they were not held liable because they had made the statement in the prospectus in the honest belief that it was true.

By contrast, in 2008, state regulators and the SEC filed charges against UBS Securities and UBS Financial Services, accusing the Swiss bank of causing multi-billion dollar losses through fraudulent misrepresentation in the course of its sales activities.11 The allegations centered on the sale of ARSs (shares or debt instruments for which the interest rate is reset at regular intervals), which the bank's financial advisors marketed as being safe and so liquid they were equivalent to cash. The regulators asserted that, in fact, such representations were deceptive, as the ARS market came under tremendous strain, even prompting various UBS insiders to simultaneously dispose of their own ARSs while encouraging investors to purchase them. The securities were left with mounting liquidity risks that eventually blocked thousands of customers across the United States from accessing their holdings. Regulators brought a rash of similar cases related to ARSs against approximately 30 financial institutions. Pursuant to settlement agreements, the banks agreed to buy back billions of dollars worth of ARSs from retail clients, and pay millions of dollars in civil penalties.

Closely linked to the misrepresentation of fact, and often occurring at the same time, is the purposeful failure to state material facts, which is fraudulent if the nondisclosure is misleading. In April, 2010, the SEC filed securities fraud charges against Goldman Sachs for omitting and misstating key facts in sales pitches to potential customers. In early 2007, as the U.S. housing market teetered, Goldman Sachs created and sold a synthetic CDO that hinged on the performance of residential mortgage-backed securities. The SEC claimed that Goldman failed to disclose that a large hedge fund named Paulson & Co. helped pick the underlying securities and bet against the instrument.12 The SEC alleged that, had Goldman Sachs customers known this, they might not have bought the instrument. Even if a jury found that the customers would have bought the product with knowledge of Paulson's role, it could still find in favor of the SEC if it found that those facts were intentionally hidden. In July, 2010, Goldman Sachs acknowledged that its marketing materials contained incomplete information and agreed to pay $550 million to settle the SEC charges, the largest-ever penalty paid by a Wall Street firm.

Breach of Contract

A failure to comply with the express terms of a transaction will naturally give rise to a breach of contract claim. By way of example, in 2010, Lehman Brothers Holdings Inc. and Lehman Brothers Special Finance sued Nomura International PLC, claiming that the latter breached the parties’ swap agreement by, among other things, calculating its loss in bad faith.13 Upon LBHI filing for bankruptcy in September 2008, the contract's early termination provision was triggered, and Nomura was clearly required by the terms of the contract to calculate the settlement amount as of the date and time of that event. On the eve of LBHI's bankruptcy, Nomura had calculated the value of the swap agreement to be significantly in favor of LBSF, yet several days after LBHI declared bankruptcy, Nomura changed the calculation and claimed that that it was in fact owed payment by LBSF. Rather than obtaining market quotations from multiple independent dealers, as required by the swap agreement, Nomura instead admitted that it had calculated sums owed using its own internal models. Based on this methodology, Nomura then revised the settlement amount even higher based on a claim for payments associated with transactions relating to certain Icelandic banks that experienced defaults in November 2008. The inflated claims would deprive Lehman Brothers of hundreds of millions of dollars.

Another breach of contract claim arose in 2009 when two trusts sued MBIA Insurance Corp., a large insurance company, claiming that MBIA had sold substantially all of its assets to an affiliate, leaving MBIA with only dubious assets and their corresponding liabilities, consisting of approximately $232 billion in structured finance products.14 Upon the announcement of this split, MBIA was downgraded by rating agencies to “deep junk” territory. The trusts argued that MBIA's behavior was especially egregious because it had sold them $400 million of notes in January of 2008 without giving notice that it intended to use the proceeds not to invest in MBIA, as was represented, but to fund its separation into good and bad parts, leaving the note holders with the securities of an insolvent company. The trusts argued that this transaction violated contractual promises made in the key agreement governing their rights that MBIA would not “sell, convey, transfer or otherwise dispose of all or substantially all of its assets” unless MBIA redeemed the notes or the transferee assumed MBIA's obligations under the notes.

While a suit for breach of contract can center on a contract provision that clearly forms a part of the contract, as in the cases above, difficulties can also arise where the obligation is not clearly contained within the document. In principle, a statement in a document selling a derivative product, or in some conversation between a trader and the counterparty, may become incorporated as a term of the contract between the parties, particularly where that term is material to the transaction and to the parties’ mutual intentions. Whether such inclusion is appropriate depends on whether an objective observer would conclude that the parties intended the statement to form a part of the transaction. Therefore, legal risk can arise in the course of negotiations where verbal agreements are not accurately and fully reflected in the resulting written contract.

Insolvency

Derivatives markets have repeatedly been afflicted by severe defaults. Examples include the meltdown of Lehman Brothers, the collapse of Enron, and the illiquidity of Metallgesellschaft. If a counterparty to a derivatives transaction becomes insolvent and seeks legal protection under the bankruptcy laws or similar shelters, potential losses can be enormous and recovery of payments slow. In the wake of the collapse of Lehman Brothers in 2008, the U.K. insolvency administrators predicted that it would take many years to finally resolve the inter-company and third-party claims. Moreover, a creditor seeking recovery in the event of a counterparty's insolvency is at odds not just with the latter, but also with other creditors vying for payment. In the Lehman Brothers’ action against Nomura described above, Lehman Brothers claimed that the Japanese bank's arbitrary choice of methodology for calculating amounts owed, reflected a desire to “secure a windfall” from Lehman's bankruptcy at the expense of deserving creditors.15

The cross-border nature of derivatives transactions poses a particularly pernicious problem, as any entity doing business in multiple markets around the globe can raise legal issues that are incapable of resolution by a single country's laws. For example, Long-Term Capital Management, a U.S. hedge fund that took on very sizeable futures positions and engaged in OTC contracts with several dozen counterparties before failing spectacularly in the late 1990s, was organized as a Delaware limited partnership, but the fund it operated, Long-Term Capital Portfolio, L.P., was organized as a Caymans Island limited partnership. While a restructuring deal orchestrated by the U.S. Federal Reserve Bank ultimately enabled LTCM to avoid filing for bankruptcy, the crisis put the bankruptcy codes of the United States and the Cayman Islands on a collision course, as it is possible that both entities would have declared bankruptcy in different jurisdictions. In the event that the LTCM fund had declared bankruptcy in its chartering jurisdiction, the Cayman Islands, there is some uncertainty as to whether the rights of its counterparties to liquidate collateral under the U.S. Bankruptcy Code would have been delayed.

More recently, the multiplicity of bankruptcy regimes governing the collapse of Lehman Brothers, which had dozens of guaranteed subsidiaries around the world, makes the LTCM scenario seem simple. The Lehman Brothers holding company that acted as the “central bank” is now subject to the U.S. Chapter 11 case, along with numerous subsidiaries; Lehman Brothers Inc. is subject to a separate liquidation proceeding supervised by the Securities Investor Protection Corporation; Lehman Brothers International (Europe) and several other British entities are in a UK administration proceeding; and other foreign subsidiaries are subject to insolvency proceedings in their own jurisdictions (for example, in Hong Kong, Australia, Singapore, Japan, the Netherlands, France, and Germany.)

In 2005 and 2006, amendments to the U.S. Bankruptcy Code were implemented with the objective of expanding bankruptcy protections to counterparties and curbing the discretion of bankruptcy judges. However, decisions in the wake of Lehman's collapse depart from the trend of legislative enhancements to the protection of swaps and derivatives under the Code. In a 2010 case, the bankruptcy court addressed a contract provision governing priority of payments to a note holder, Perpetual Trustee Company Limited, and a swap counterparty, Lehman Brothers Special Finance, that held competing interests in collateral securing certain credit-linked synthetic portfolio notes. The court found that the “flip clause” calling for a reversal in priorities in the event of bankruptcy (whereby Perpetual would be entitled to sums otherwise payable to LBSF), was an impermissible ipso facto16 clause prohibited by the Code because it subordinated LBSF's right to payment solely because of its insolvency. Any attempt to enforce note holder priority would constitute a violation of the automatic stay under the Code. Interestingly, the judgment conflicted with that resulting from an earlier parallel proceeding filed in England, where the court held that the flip in priorities was permissible under English law.17 The U.S. bankruptcy judge recognized that the situation called for the parties to “work in a coordinated and cooperative way to identify means to reconcile the conflicting judgments.” However, it remains unclear whether harmonizing the two decisions will be workable.

MITIGATING LEGAL RISK

Legal risk mitigation is the concern of market participants, large and small. Regulatory authorities, charged with investor protection and the management of systemic risk, can mitigate legal risk by continually clarifying and amending legislation to remedy ambiguity and keep up with evolving products. Industry groups are also powerful forces in legal risk mitigation. For example, the International Swaps and Derivatives Association has developed standard documentation and instruments covering a variety of transaction types, and advanced the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives. As a result, there has been great progress in the advancement of legal certainty for privately negotiated derivatives.

The bulk of the burden in mitigating legal risk, however, remains with investors who must ensure that they follow relevant laws, regulations, and business rules. How an organization addresses this challenge depends on its size, likely legal risks, history, and applicable industry practice. But how do firms identify and measure legal risk? The basics of mitigating legal risk are similar to those for mitigating other forms of risk; they require legal risk to be adequately understood and properly identified. However, the lack of either a common definition of legal risk, as it relates to financially-engineered products or long-established market practice, creates uncertainty. Far less ink has been spilled in providing guidance on defining and mitigating legal risk than market, credit, or operational risk. The challenge is for investors and their legal advisers to devise systems and controls that make a constructive contribution to the management of their individual legal risk.

An analysis of an enterprise's risk should naturally be conceived with the key legal issues raised in the section above in mind. The specific qualities of an entity and how it is suited to measuring and handling risk must also be considered. Below is an indicative checklist of the types of issues to be evaluated in an analysis of an entity's legal risk:

• Corporate structure and culture: What is the entity type? Commercial and investment banks have historically enjoyed more legal certainty as market makers in derivatives than have insurance companies. How familiar are employees with ethical issues, such as conflicts of interest and fiduciary duty? How familiar are employees with laws and procedures governing their trade? Traders and marketers entering into transactions need to be made aware that the taped telephoned conversations of their agreements to commit their institutions to a derivatives transaction are a binding verbal contract. What internal upward reporting structure is in place? What diligence practices are in place? How many past instances of misconduct exist? What were the penalties? How often does the misconduct occur in the industry? What is the frequency of government and private enforcement of this risk? When employees understand the “why” behind legal factors they more appropriately align their behavior when faced with “gray areas.”
• Corporate Resources: What is the size and quality of the entity's legal team or resources? Entities may be subject to unexpected legal risk stemming from a simple misunderstanding of their respective rights and obligations under a contract and fail to perform as expected in times of stress as a result. The quality and breadth of legal services will also affect an entity's ability to keep abreast of developments in the law as compliance requirements evolve. What is the size of its staff? What technology does it have at its disposal? Technology is an important variable in controlling legal risk. In times of crisis, relevant contractual provisions must be identified rapidly and, where volumes are high, manual review can be 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. In addition, telephones should be equipped with recording capabilities to capture and preserve oral agreements.
• Jurisdictional considerations. Where do the entity and its subsidiaries operate and what is the nature of the regulatory regime in each jurisdiction? What about its counterparties? Derivatives entered into with counterparties located in the United States or the United Kingdom have historically had greater legal certainty than transactions with counterparties located in jurisdictions where the legal framework is less certain. What is the maturity and sophistication of the body of judicial decisions, administrative rulings, and regulatory interpretations in relevant jurisdictions? Should contracts be governed by the laws of England or the laws of the State of New York?
• Documentation. What measures are in place to ensure accurate and complete documentation? Does the entity subscribe to the Reference Entity Database?
• Type of product. What type of product is being traded? What regulatory restrictions and classifications are invoked? The legal risk associated with a standard currency swap, for example, is minimal, but the risk associated with a Libor-squared swap has historically been exposed to claims of lack of transparency and hidden leverage.
• Counterparties. How large is credit exposure to any particular counterparty? What type of entities are the counterparties? As discussed, transacting with municipalities or retail counterparties rather than large sophisticated corporations and financial institutions exposes a firm to breach of fiduciary duty allegations, and to suits based on claims of lack of authority or capacity.

THE REGULATORY LANDSCAPE

Despite different approaches to the regulation of financially-engineered products worldwide, several common public policy objectives underpin most regimes. Regulators aim to protect the integrity of capital-raising markets (e.g., discourage fraud, manipulation, and other unfair practices); manage systemic risk; protect less sophisticated persons; and oversee institutions for the public benefit (e.g., place restrictions on banks and insurance companies through capital adequacy controls). Some jurisdictions also strive to protect against instruments that provide a speculative outlet on the price of commodities, potentially causing radical swings in the price of those products (e.g., energy or agricultural products that a government deems central to the functioning of the economy or expedient for political reasons), and to guard the monetary system (e.g., through foreign exchange controls to protect the integrity of the local currency and restrict capital outflows).

Navigating derivatives regulation in any market is widely held to be a complex and baffling business. Yet understanding different regulatory rules and schemes is an important tool in an investor's arsenal because the cross-border nature of derivatives markets lends itself naturally to regulatory arbitrage. Financial instruments are often purposefully engineered to combine or isolate certain characteristics in order to achieve desired regulatory consequences. If a restrictive law is introduced in a specific jurisdiction, the business is often transferred to another less restrictive jurisdiction, making the first jurisdiction less competitive. Indeed, in May 1998, when a senior regulator suggested that OTC markets should be regulated, Alan Greenspan, chairman of the U.S. Federal Reserve Board, vigorously opposed the initiative citing the risk that the imposition of new regulatory constraints would stifle innovation and push coveted transactions offshore through cross-border regulatory arbitrage.

Below are case studies of the development and current framework of the regulatory regimes in two key markets: the United States and the United Kingdom.

The United States

Unlike many jurisdictions, no single authority governs the regulation of derivatives in the United States. Derivatives regulation in the United States is essentially a hybrid of “functional” and “institutional” regulation. First, specific types of derivatives, namely, futures and certain options, are regulated as financial products. Second, certain institutions that are already subject to regulation (e.g., banks) may have their derivatives activities scrutinized by their institutional supervisors.

Broadly speaking, transactions in stocks, bonds, and security-based derivatives are regulated by the Securities and Exchange Commission (SEC), and the trading of commodities and futures is regulated by the Commodity Futures Trading Commission (CFTC). Therefore, the regulatory treatment of a derivative instrument will depend largely on the nature of the underlying asset or interest (equity, interest rate, credit or fixed income, foreign exchange, or commodity derivative) and whether it is categorized as a commodity option, or futures contract, or as a security. Where hybrid instruments combine features of a security with those of a futures contract or commodity option, such as a cash-settleable forward contract on a security, the analysis is particularly complicated, because these are subject to both the securities and commodities laws. Within the broad securities and commodities categories, another layer of regulatory implications may be triggered depending on the manner in which the instrument is related to the underlying asset or interest; swaps, options, forwards, and indexed or hybrid instruments may each have different regulatory consequences.

Historically, whether an instrument was subject to the CFTC, the SEC, or both was particularly significant because of an exclusive jurisdiction provision (arguably preempting other applicable regulatory regimes) in the Commodity Exchange Act, and its general prohibition on the offer and sale of futures contracts or commodities options other than on a CFTC-regulated exchange. The resulting tension between the SEC and CFTC, particularly as derivatives instruments evolved, set U.S. regulation of derivatives on a path of ad hoc reforms from the 1970s to the turn of the millennium. Notable among these was the Shad-Johnson Accord of 1983, under which the SEC was granted sole authority to regulate options on securities, certificates of deposit, and stock groups. The regulation of futures, and options on futures on exempted securities and broad-based stock indices, was left to the CFTC. The accord banned futures contracts on individual securities (other than certain exempt securities) and on narrow-based stock indices.

Against this backdrop, the passage of The Commodity Futures Modernization Act of 2000 (CFMA) signaled a radical shift in the regulatory regime, and heralded the era of deregulation commonly blamed for the financial crisis that would crystallize less than a decade after the CFMA's enactment. The CFMA amends the Shad-Johnson Act and, crucially, clarifies that certain OTC derivatives transactions are outside the jurisdiction of the CFTC. Under certain conditions, the Act allows trading of futures contracts based on single stocks and narrow-based stock indices, with oversight being shared by the CFTC and the SEC. The CFMA also preempts any state or local laws that regulate gaming or bucket shops, eliminating concerns that excluded or exempted derivatives transactions could be voided on the grounds that they violated these laws.

In addition to the functional regulation of the SEC and CFTC, banking regulators provide a layer of institutional regulatory oversight. As with functional regulation, institutional regulation has evolved through a series of piecemeal responses to developments and crises in the financial markets. Legislation designed to curb excesses by banks in securities activities in the wake of the Great Depression, principally the Glass-Steagall Act (enacted in 1933) and the Bank Holding Company Act of 1956, confined these activities to a narrow universe. Deposit-taking banks were barred from dealing in, underwriting, and purchasing securities, subject to certain exceptions. However, with the growing internationalization of financial markets, and increasing overlap between securities and banking activities in the last twenty years, banks mounted a campaign to procure greater securities powers. In 1999, Congress passed the Gramm-Leach-Bliley Act, implementing sweeping reforms that repealed long-standing Glass-Steagall restrictions on affiliations between commercial and investment banks, and established a dramatically more permissive environment for securities activities.

The evolution of the regulatory environment in which banks conduct their securities activities did little to resolve its complexity. Each entity, type of activity, or individual transaction remains potentially subject to separate bodies of banking, securities, and commodities laws. While the SEC and CFTC retain regulatory control over securities and commodities respectively, there are three federal banking regulators that may exercise significant authority over entities in a banking group: the Federal Reserve Board, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. The Gramm-Leach-Bliley Act confirms the role of the Federal Reserve Board as the “umbrella supervisor” for banks, but invokes the SEC, CFTC, and state insurance regulators to supplement regulation. This unholy marriage of regulatory schemes leads to jurisdictional and legal uncertainty, as the different bank regulators often reach conflicting conclusions on bank power issues and do not always defer to the SEC on matters pertaining to securities subsidiaries of banking groups, leading to serious asymmetries between some market participants.

The United Kingdom

While the regulatory regime for derivatives in the United Kingdom is less fragmented than in the United States, its development follows a similar trajectory. As in the United States, transactions in derivatives in the United Kingdom were traditionally constrained by the common law “rule against difference contracts.” The process of dismantling this restrictive regime began when the United Kingdom passed its Financial Services Act of 1986 (FSA 1986), “modernizing” its financial laws by eliminating the old rule against difference contracts, and making derivatives, whether used for hedging or speculation, legally enforceable. The 1986 “Big Bang” constituted a wholesale reformation of the regulatory system, reorganizing regulatory agencies across industry lines, and seeking to implement a consistent philosophy of regulation.

Under FSA 1986, the offering of a broad range of instruments, called “investments,” was regulated by limiting the conduct of “investment business” to authorized persons who were regulated (and certain exempt persons). The Securities Investment Board (SIB) was assigned chief responsibility for regulating the financial industry. In turn, it delegated oversight responsibilities to self-regulatory organizations (SROs) that governed different aspects of financial activity. With respect to derivatives activities, regulation was split amongst several SROs but, by 1991, after a series of mergers, the Securities and Futures Authority (SFA) was the principle regulatory body. To obtain authorization to engage in defined investment activities under FSA 1986, firms, dealers, and certain persons (e.g., compliance officers) had to join the SFA, which imposed various strict requirements, such as compliance with its conduct of business rules. Meanwhile, the Bank of England retained supervisory authority over banks. It published the London Code of Conduct, which set out principles governing the conduct of wholesale market dealing in financial products outside of the recognized investment exchanges, including derivatives. While derivatives were included in the definition of “investment” under FSA 1986, and included as financial products subject to the wholesale dealing requirements of the London Code of Conduct, they were not specially regulated in the United Kingdom as instruments in their own right.

At the turn of the millennium, Parliament enacted the Financial Services and Markets Act 2000 (FSMA 2000) that further streamlined this regulatory structure. In particular, the Act harmonized regulatory control by assigning supervision of investment and related financial services in the United Kingdom, including insurance companies, to a single regulatory authority, the Financial Services Authority (FSA), which had been created in 1997 and which now replaced the SIB. The Bank of England shed its bank regulatory and supervisory duties and was instead given new monetary powers. The FSA's Interim Prudential Source Book: Banks establishes the general regulatory regime for U.K. banks, which remained intact under FSMA 2000: only authorized persons (or certain exempt persons) may carry on a regulated activity (“investments” as well as insurance) in the United Kingdom. Likewise, conduct of business rules remain broadly the same under the FSMA 2000 scheme as under the FSA 1986. The definition of the various forms of financial products within the scope of FSMA 2000 are set out in The Financial Services and Markets Act (Regulated Activities) Order 2001 (ROA). The ROA defines the boundaries for regulation of derivative products. Any person conducting business in relation to any of those activities within the ROA's reach must obtain authorization from the FSA.

The FSA's role as the single supervisor of financial services markets, exchanges, and firms arguably renders the United Kingdom's system of supervision of financially-engineered products more cohesive than that of the United States. However, the FSA operates as one pillar of a tripartite system of financial regulation. The other two participants are the Bank of England, which acts as a lender of last resort and is responsible for maintaining a broad overview of the financial system as a whole, and the Treasury, responsible for the overall institutional structure of financial regulation and the legislation that governs it. In this respect, the United Kingdom is not immune to the inevitable frictions that arise from fragmented control. In the wake of the financial crisis, the tripartite system was heavily criticized for awkwardly dividing responsibilities, powers, and capabilities between competing institutions. In particular, the system was maligned for placing responsibility for prudential regulation and oversight of consumer protection and market conduct in the same organization (the FSA). Efforts to abolish the FSA, and once again overhaul the entire regulatory framework, are now underway (see the section entitled Regulatory Evolution— Europe below for more information).

The regulation of financial services in the United Kingdom is also subject to European Union law, effectively broadening the regulatory field. The Markets in Financial Instruments Directive (MiFID) provides harmonized regulation for investment services across the member states of the European Economic Area. To determine which firms are affected by MiFID and which are not, MiFID distinguishes between “investment services and activities” and “ancillary services.” Firms covered by MiFID will be authorized and regulated in their “home state” (broadly, the country in which they have their registered office). Once a firm has been authorized, it can use the MiFID “passport” to provide services to customers in other EU member states. These services will be regulated by the member state in their home state. As discussed, in the United Kingdom, the Financial Services Authority (FSA) is currently responsible for the regulation of these firms and their activities.

International Regulatory Initiatives

The development, adoption, and successful implementation of international standards are valuable counterweights to conflicts among regulatory regimes worldwide. International standards promote financial stability by enabling better-informed investment decisions, improving market integrity, and reducing the risks of financial distress and contagion. The standard-setting groups below are among those leading the charge in formulating broad supervisory standards, guidelines, and statements of best practice in the expectation that individual supervisory authorities will take steps to implement them on a local level.

• Bank for International Settlements (BIS): Hosts meetings for a number of standing committees whose key objectives are promoting monetary and financial stability. Among these are two committees established by the G10 central banks: the Basel Committee on Banking Supervision (formulates broad supervisory standards and guidelines, and recommends statements of best practice in banking in the expectation that bank supervisory authorities will take steps to implement them) and the Committee on Payment and Settlement Systems (monitors and analyzes developments in domestic payment, settlement and clearing systems, as well as in cross-border and multi-currency netting schemes).
• International Swaps and Derivative Association (ISDA): Identifies and reduces the sources of risk in the derivatives and risk management business. Among its most notable accomplishments are: developing standard documentation, notably, the ISDA Master Agreement and related materials; producing legal opinions on the enforceability of netting and collateral arrangements; and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives.
• International Organization of Securities Commissions (IOSCO): Develops and promotes standards for effective surveillance of international securities markets. Its Technical Committee has issued a number of papers in the area of financial derivatives regulation.

REGULATORY EVOLUTION

The predictable reaction to the global financial crisis was a call for stringent reformation of derivatives regulation in markets across the globe. In order to appreciate the direction in which new regulation is heading, it is useful to understand some of the key concerns stemming from the financial crisis that policy makers and regulators are aiming to redress. Testifying before the Financial Crisis Inquiry Commission, Gary Gensler, Chairman of the CFTC, identified and disputed several fallacies held prior to the crisis:

• The derivatives market is an institutional marketplace, with “sophisticated” traders who do not need the same types of protections that the broader public needs when investing in the securities or futures markets. Derivatives are complex financial instruments, and even the most sophisticated parties would benefit from protections. Markets, even amongst institutions, work better when transparency and market integrity are promoted. Transparency would enable banks to determine the liquidity of particular contracts, rather than amassing “toxic assets” that cannot be priced. Lack of information in the OTC market also substantially reduces the ability of the government and other market participants to anticipate, and possibly preempt, building market pressures, major market failures, or manipulation efforts.
• Over-the-counter derivatives do not need regulation because the institutions dealing them are already regulated. The banks that deal derivatives have not been expressly regulated for their derivatives business. Derivatives dealers also operate as affiliates of non-banks, such as insurance companies or investment banks, which are lightly regulated. The derivatives affiliates of AIG, Lehman Brothers and Bear Stearns had no effective regulation for capital, business conduct standards, or recordkeeping. Without capital requirements, banks took on more risk that was backed up by less capital, adding leverage to the financial system.
• Large, sophisticated financial institutions dealing over-the-counter derivatives, as well as their counterparties, are so expert and self-interested that the markets will discipline themselves. The “sophisticated” participants were incentivized to assume risk in order to boost revenues. They were often unable to adequately judge the risks they were assuming due to the complexity and lack of transparency of the instruments they were trading, and the counterparty credit risk involved. In the wake of the global financial crisis, Alan Greenspan publicly confessed to Congress that he had erred in his judgment on the self-regulating power of the market.
• Over-the-counter derivatives are not amenable to centralized trading or clearing because they are customized rather than standardized. In the futures and securities markets, trades are cleared through well-regulated central counterparties. Each counterparty is protected from the other counterparty's default since the clearinghouse stands between the dealer and the counterparty. The lack of clearing in the swaps marketplace left the financial system dangerously interconnected. As concerns about the viability of one firm increased, risk premium had to widen for all other financial firms that may have had exposure to the first entity's problems. Derivatives have become much more standardized over the last decade, and thus more susceptible to central market structures; one Wall Street CEO testified before the CFTC that as much as 75 to 80 percent of the over-the-counter derivatives marketplace is standard enough to be centrally cleared.

Flaws in ways the market was regulated prior to the crisis are easier to identify than fix. In many countries, progress is still in the discussion phase. Reforms that have been enacted have significantly evolved from their original iterations after months of negotiations among lawmakers. And while the G20 has established an agenda for reform, there has been significant variation in national response as differences in each country's existing systems, and fallout from the financial crisis, dictate the measure of change required.

The United States

In July, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, the biggest overhaul of the American financial regulatory system since the Depression, which will fundamentally alter how end users, hedge funds, private equity firms, commodity traders, banks, and broker-dealers use and trade derivatives. In broad terms, the Act creates a comprehensive framework for the regulation of most derivatives transactions, including OTC derivatives, formerly deregulated by the Commodity Futures Modernization Act of 2000.

The most significant aspects of derivatives reform addressed by the Act are: First, it calls for mandatory clearing through regulated central clearing organizations, and mandatory trading through either regulated exchanges or swap execution facilities (in each case, subject to certain key exceptions), and provides a role for both regulators and clearinghouses to determine which contracts should be cleared. Second, the Act creates new categories of regulated market participants, including swap dealers and major swap participants. Third, the “Volcker Rule” restricts proprietary trading in swaps by a “banking entity” and prohibits Federal assistance to any “swaps entity,” including banks, thereby causing banks eligible for federal assistance to “push-out” most of their swap business to a separate affiliate, ostensibly ending “too big to fail” bailouts. The Volcker Rule also prohibits a banking entity from acquiring or retaining any equity, partnership, or other ownership interest in, or sponsoring, any hedge fund or private equity fund, subject to certain exceptions and a transition period.

With respect to jurisdictional allocations, the Act largely follows the historical divisions between the CFTC and the SEC. Derivatives transactions are categorized as “swaps,” which are subject to primary regulation by the CFTC, “security-based swaps,” which are subject to primary regulation by the SEC, or “mixed swaps,” which are subject to joint regulation by the CFTC and SEC.

The Act prohibits state gaming or bucket shop laws from invalidating security-based swaps between eligible contract participants or effected on a registered national securities exchange. Interestingly, however, the preemption from state gaming and bucket shop laws is only provided with respect to security-based swaps and not for other swaps. In fact, the provision of the Commodity Exchange Act that formerly provided a preemption for over-the-counter derivatives, previously excluded from the purview of the Commodity Exchange Act, has been deleted in the Act.

While these provisions herald a profound shift in the U.S. regulatory framework, the ultimate consequences of the Dodd-Frank bill will depend on rulemaking by federal agencies. Rules are generally required to be issued within 360 days of the Act's enactment. Much of the specific impact of the law will therefore become clear only as regulators interpret, implement, and enforce it in that period, and beyond.

The European Union

In the Spring of 2010, The European Commission reached an agreement in principle with the United States on regulation of the derivatives market. The priorities for reform included subjecting the market to substantial supervision and regulation, pushing all trading of commonly traded derivative contracts onto exchanges or other regulated trading platforms, obliging all traders of standard derivative contracts to use central counterparty clearing, and giving regulators full authority to monitor transactions, including setting position limits.

Subsequently, European governments and institutions struggled to agree on a common approach to implementing such reforms. Frustrated with the slow pace of progress, certain countries undertook unilateral initiatives to effect changes. As the Greek debt crisis triggered an increase in bets against the euro, Germany passed the July 2010, Act Aimed at Preventing Abusive Securities and Derivatives Trading Activities, that prohibits naked short selling of all shares and Eurozone government debt instruments traded on a regulated market of a German stock exchange, as well as CDS to bet against Eurozone government bonds. France also proposed legislation to curb naked short-selling. As an example of comprehensive reform on a national level, the United Kingdom issued a proposal in June 2010 to fundamentally reform its financial services regulatory structure, abolishing the tripartite system, resulting in the FSA ceasing to exist in its current form. The proposal will be subject to comments through October 2010, and the government aims to put forward a more detailed proposal in 2011, with the aim of completing primary passage of the legislation by 2012.

Meanwhile, the Committee of European Securities Regulators provided technical advice to the European Commission in the context of its review of the MiFID to improve securities markets’ functioning, transparency, and investor protection. In relation to its advice on transparency in non-equity markets, some of CESR's recommendations focused on defining a phased approach for the introduction of a post-trade transparency regime for structured finance products; extending the scope to clearing eligible sovereign CDS; and enhancing post-trade transparency of derivatives markets.

In June 2010, the EU Parliament adopted a resolution on the regulation of derivatives. Broadly, the resolution called for strict rules to prevent inexperienced users and speculators from building up dangerous levels of risk; asked the European Commission to consider ways to significantly reduce the overall volume of derivatives traded; supported a ban on pure speculative trading in commodities and agricultural products, and the imposition of upper limits on trading in these markets; and stressed that central counterparty clearing facilities need to be strengthened by the introduction of compulsory regulatory standards.

In early September 2010, EU diplomats and lawmakers finally approved an overhaul of the way banks and markets in the region are supervised, set to be endorsed by EU ministers and the European Parliament. The new architecture calls for three new European Union-level watchdogs for the banking, insurance and securities markets sectors, set to be operational by January 2011. Under the proposals, these watchdogs will not supervise companies or markets directly (leaving this to national authorities), but they will be required to draw up common technical rules and standards, and could acquire additional legally binding powers, including over individual companies in “emergency situations.” The European Central Bank is given a central role in assessing future risks to Europe's financial system and allows the ECB president to chair a new European Systemic Risk Council for the first five years.

While the development was hailed as an important step in closing an important gap in financial regulation, some expressed concerns about a drift in rule-making from home soil to Brussels. In London, Europe's biggest financial center, there are fears that Brussels will now attempt to give more powers to the new watchdogs though other legislative initiatives that are in the pipeline, in areas ranging from derivatives to short-selling rules, potentially helping other financial centers to take business from London. As with the United States, much work is in store for Europe before its new regulatory framework is finalized and implemented.

Other Jurisdictions

Regulatory reform efforts around the world have not always mirrored those of the United States and Europe. For example, both Japan and Canada have taken comparatively limited measures of late. Japanese regulations have been progressively tweaked since its financial meltdown of the late 1990s, giving it one of the tightest regulatory environments of any advanced industrialized economy. For its part, Canada was relatively unscathed by the U.S. subprime mortgage crisis, and its reaction to calls for reform have therefore been less acute. Practically the only developed country not to have a national securities regulator, Canada has only recently proposed the establishment of a federal securities regulator by the middle of 2011 to replace its current system of provincial regulators.

The Road Ahead

The coming year promises to be challenging for a broad range of market participants. On the one hand, much effort will be expended on backward-looking endeavors, with a focus on recovering losses sustained in the recent past. For example, investors who found themselves in an unexpected position despite having performed contract and counterparty reviews of AIG, Lehman Brothers, Bear Stearns, the Icelandic banks, and monoline insurers, among others, will continue to determine their rights and remedies under the laws of several jurisdictions. On the other hand, much effort will have to be forward-looking, carefully focused on future regulatory developments in order to retain competitiveness and compliance in a rapidly changing playing field. Below are some examples of upcoming challenges and responsibilities for key market players:

• COOs: The role of the COO for banks and other financial organizations will grow dramatically as legislation calls for new or enhanced controls that include review and authorization protocols, policies, procedures and standards, reengineered workflow, employee training, management training, and system controls. In addition, certain groups that were previously light on compliance professionals, relative to the more mature compliance departments at investment banks, will need to develop their own quickly and effectively. For example, the Dodd-Frank Act eliminates the private adviser exemption, previously relied upon by many hedge funds, which will have the effect of requiring a large number of currently unregistered advisers to register with the SEC.
• Rating agencies: Often under fire for their role in the financial crisis, rating agencies are the target of regulatory reform and will need to understand the obligations imposed on them in the coming year, such as those under the Dodd-Frank Act. In the United States, two key rating agencies, Fitch and Moody’s, announced in July 2010 that they would not allow issuers to include their ratings in prospectuses or registration statements, absent clarification by the SEC on whether they would potentially be exposed to “expert” liability under section 11 of the Securities Act. Prior to the Act's passage, rating agencies had never been treated as experts under the securities laws, since ratings are inherently forward-looking and embody assumptions and predictions about future events that, by their nature, cannot be verified as facts.
• Broker-dealers: The Dodd-Frank Act empowers the SEC to impose a fiduciary duty upon broker-dealers when they conduct business with retail customers. The SEC Chairman stated in a speech in the summer of 2010 that she had long advocated such a uniform fiduciary standard and was pleased that the legislation provided the SEC with the rulemaking authority necessary to implement it. Broker-dealers will need to understand the parameters of this duty and determine what their role as market-makers means in light of it.
• Regulators: the coming year will prove very busy for regulators shaping new laws and implementing them. In the United States, for example, there is a crucial role still to be played by regulators in enforcing the provisions of the Dodd-Frank Act. Much of the legislation is short on specifics, giving regulators broad scope to determine its impact.
• Counterparties: while developments in ISDA contracts and internal procedures, policies and controls have improved legal risk management in financial institutions, the crisis reveals that they are far from “well oiled” machines. Furthermore, new regulation means large institutions may have to reshuffle their businesses, such as pushing out certain derivatives activities into affiliate groups. Smaller organizations will have no choice but to examine their needs and implement technologies that can support best practices and regulatory compliance. Only automation will mitigate internal risk or appease regulators, so the need for better reconciliation and reporting is crucial, especially where the collection of information from predominantly manual processes is compiled.
• Lawyers: Lawyers face a lot of work as they grapple with an onslaught of new rules. In the United States, corporate lawyers, their clients, and in-house law departments are bracing for a big spike in work stemming from Dodd-Frank financial reform, much as they did in the period following the passage of the Sarbanes-Oxley bill in 2002. Similarly, in Europe, much work will have to be done to digest the new regulatory framework expected to become operational in the coming year.

NOTES

1. Basel Committee on Banking Supervision. Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. November, 2005.

2. Thomas A. Russo. Keynote Address at the 13th Annual Derivatives Securities and Risk Management Conference. April 25, 2003.

3. Since derivatives contracts are commonly governed by the laws of New York state or England, these jurisdictions are the focus of discussion in this chapter.

4. Difference contracts were close cousins to futures and options; in a difference contract, the contracting parties would agree to perform by paying the difference between the contract price and the market price at the time of performance, not by actually delivering the good that was the subject of the contract. Thus a “seller” who didn't own wheat and a “buyer” who didn't want wheat might have entered a difference contract for one ton of wheat at a contract price of $1,000 per ton, to be settled in six months.

5. SEC v. J.P. Morgan Chase, SEC Litigation Release No. 18252; In the Matter of Citigroup, Inc., Securities Exchange Act of 1934 Release No. 34-48230; Accounting and Auditing Enforcement Release No. 1821; Administrative Proceeding File No. 3,11192 (July, 28, 2003).

6. Mahonia Ltd. v. J.P. Morgan Chase Bank, Court of Appeal—Commercial Court [2004] EWHC 1938 (Comm) Case No: 2001/1400.

7. Hazell v. Hammersmith and Fulham London Borough Council [1992] 2 A.C. 1, 22.

8. See State v. Morgan Stanley & Co. 459 S.E. 2d 906 (W. Va. 1995).

9. See Drage v. Procter and Gamble et al., 694 N.E. 2d 479 (Ohio Ct. App. 1997).

10. Derry v. Peek, (1889) 14 App. Cas 337.

11. SEC v. UBS Securities LLC and UBS Financial Services Inc., No. 08 CIV 10754 (S.D.N.Y. Dec 11, 2008).

12. Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, 10 Civ. 3229 (S.D.N.Y. April 16, 2010).

13. Lehman Brothers Holdings Inc. et al. v. Nomura Securities Co. Ltd. (Adv. Proc. No. 10-03228) and Lehman Brothers Holdings Inc. et al. v. Nomura International plc (Adv Proc. No. 10-03229) (2010).

14. Third Avenue Trust et al. v. MBIA Ins. Corp., et al., C.A. No. 4486-VCS (Del. Ch. Oct. 5, 2009).

15. In re: Lehman Brothers Special Finance v. BNY Corporate Trustee Services Ltd. No. 09-1242 (Bankr. S.D.N.Y. Jan 25, 2010).

16. Ipso facto clauses are provisions in executory contracts that modify or terminate a contractual right or interest in property due to the bankruptcy or financial condition of a company.

17. Perpetual Trustee Company Limited v. BNY Corporate Trustee Service Limited [2009] EWHC 1912 (Ch).

ABOUT THE AUTHOR

Jordana Krohley (née Cornish) has experience in structured finance and derivatives products, securitizations and international offerings of equity and debt securities, including Rule 144A/Regulation S transactions and private placements in the United States. She was an associate at Allen & Overy LLP in London from 2007 to 2010, working in the International Capital Markets group. The law firm was appointed principal counsel for the International Swaps and Derivatives Association (ISDA), as well as Markit Group in connection with its Reference Entity Database (RED), and Jordana's work included advisory services for both organizations. Prior to being at Allen & Overy, Jordana was a paralegal in the Litigation group at Wachtell, Lipton, Rosen & Katz in New York, from 2002 to 2004. Jordana holds a JD from Vanderbilt University Law School and a BS from Vanderbilt University and is a member of the Bar of the State of New York.