Legal (compliance) risks

Compliance risk is the risk to earnings or capital arising from violations, or nonconformance
with, laws, rules, regulations, prescribed practices, or ethical standards.
The risk also arises when laws or rules governing certain bank products or activities
of the bank’s clients may be ambiguous or untested. Compliance risk exposes the
institution to fines, civil money penalties, payment of damages, and the voiding of
contracts. Compliance risk can lead to a diminished reputation, reduced franchise
value, limited business opportunities, lessened expansion potential, and an inability
to enforce contracts.
Since credit derivatives are new and largely untested credit risk management
products, legal risks associated with them can be high. To offset such risks, it is
critical for each party to agree to all terms prior to execution of the contract.
Discovering that contracts have not been signed, or key terms have not been clearly
defined, can jeopardize the protection that a credit risk hedger believes it has
obtained. Banks acting in this capacity should consult legal counsel as necessary to
ensure credit derivative contracts are appropriately drafted and documented.
The Russian default on GKO debt in 1998 underscores the importance of understanding
the terms of the contract and its key definitions. Most default swap contracts
in which investors purchased protection on Russian debt referenced external debt
obligations, e.g. Eurobond debt. When Russia defaulted on its internal GKO obligations, many protection purchasers were surprised to discover, after reviewing their
contracts, that an internal default did not constitute a ‘credit event’. As of July 1999,
Russia has continued to pay its Eurobond debt. Although investors in Russia’s
Eurobonds suffered significant mark-to-market losses when Russia defaulted on its
internal debt, protection purchasers could not collect on the default swap contracts.
Credit hedgers must assess the circumstances under which they desire protection,
and then negotiate the terms of the contract accordingly.
Although no standardized format currently exists for all credit derivatives, transactions
are normally completed with a detailed confirmation under an ISDA Master
Agreement. These documents will generally include the following transaction
information:
Ω trade date
Ω maturity date
Ω business day convention
Ω reference price
Ω key definitions (credit events, etc.)
Ω conditions to payment
Ω materiality requirements
Ω notice requirements
Ω dispute resolution mechanisms
Ω reps and warranties designed to reduce legal risk
Ω credit enhancement terms or reference to an ISDA master credit annex
Ω effective date
Ω identification of counterparties
Ω reference entity
Ω reference obligation(s)
Ω payment dates
Ω payout valuation method
Ω settlement method (physical or cash)
Ω payment details
Documentation should also address, as applicable, the rights to obtain financial
information on the reference asset or counterparty, restructuring or merger of the
reference asset, method by which recovery values are determined (and any fallback
procedures if a dealer poll fails to establish a recovery value), rights in receivership
or bankruptcy, recourse to the borrower, and early termination rights.