The devil in the detail

The sheer volume and complexity of the contracts a typical company employs has made compliance a daunting undertaking and created the need for new ways of managing document risk. By John Berry

The devil in the detail Documentation risk is nothing new. But one aspect received relatively little attention in the financial markets before the credit crisis threw it into the spotlight – namely, the risk that arises when parties have an incomplete understanding of what their contracts actually say.

It might seem unlikely that sophisticated financial market participants could be exposed to this risk. However, in recent months parties have had to respond to a host of events such as insolvencies and other defaults, mergers and acquisitions, ratings downgrades and net asset value declines – and they have found that the devil is very much in the detail of their underlying ­contracts.

The problem

Even when it seemed that the sun would never stop shining on the financial ­markets, some people could see this risk. For example, in a 2006 study, Ernst & Young noted: “The number of contracts a typical company employs has ­skyrocketed. Contracts have also become ­increasingly complex from a legal and ­technical ­perspective. As a result, ­managing the risks of noncompliance with contractual requirements has become increasingly important.”

Even earlier, in a keynote speech to the 2003 Annual Derivatives and Risk ­Management Conference, Thomas Russo, then vice chairman and chief legal officer of Lehman Brothers, warned: “Just as these transactions are exposed to risk from lack of transparency and hidden leverage, parties may be subject to unexpected legal risk derived from simple misunderstanding of their respective rights and obligations under a contract and, therefore, during times of ­crisis or stress, fail to perform as ­expected.”

Clearly it is important for contracting ­parties to understand their rights and ­obligations and to be able to monitor ­compliance ;under ;their ­contracts. It enables them to utilise available remedies against non-complying counterparties and to ­correct their own failures before consequences are ­triggered. It makes them agile and better prepared to steer themselves through unexpected difficulties, such as the credit crisis, and to take ­advantage of good business opportunities.

Nowhere is this more true than in the over-the-counter derivatives markets. These markets are fast-moving, vast – they had a total notional value of nearly $600tr (£347.57tr) at the end of 2007, according to the Bank for International Settlements – and hugely important to the health of the wider economy.

Just as derivatives transactions are often complex, so too are the contracts that govern them. Moreover, the largest players are now party to literally tens of thousands of them, mainly in the form of International Swaps and Derivatives Association (ISDA) master agreements and credit support ­documents.

In some ways, the importance of all this is reflected in current practices. For example, a great deal of time and effort is expended on the process of entering into these contracts, maybe involving negotiators, lawyers, tax experts, credit officers and compliance ­officers – all of them likely working within a framework of detailed internal policies.

According to a 2006 ISDA survey, more than 50 per cent of ISDA master ­agreements take more than three months to negotiate. So, after all that, why do so many parties have such an incomplete ­understanding of the terms of their ­contracts?

For some, one reason is the sheer volume of contracts that they have to manage. For others, perhaps this aspect of documentation risk did not seem to be a priority when troubled times seemed so far away.

Another reason is universally relevant. The complexity of these documents and the richness of the information in them means that traditional ways of managing the ­information in executed contracts, relying on spreadsheets or basic databases, simply ­cannot provide the capability that parties need.

For one thing, this approach relies ­heavily on manual input: someone somewhere has to enter the data. As a result, the process is both inefficient and prone to error. Second, the coverage of the approach is limited – partly as a result of the reliance on manual input and partly because a spreadsheet, for example, reflects what was considered important at the time it was designed.

But the world is unpredictable: ­unexpected crises occur; courts decide cases in unexpected ways; new laws are passed; tax and regulatory environments change. It is almost certain that the coverage will, at some point, prove to be inadequate, leaving a party with no choice but to conduct ­another manual review of its contracts.

Another major deficiency of the traditional approach is that it does not facilitate analysis of information across multiple agreements. Without this capability, it is extremely difficult for those with large ­documentation portfolios to assess the implications of an event affecting themselves, such as a credit rating downgrade, or a systemic event affecting multiple counterparties. It also means that few, if any, market participants are currently in a ­position to meet some of the key recommendations of the Counterparty Risk ­Management Policy Group III – an industry group that published a report ­entitled ­Containing Systemic Risk: The Road to Reform in August (shortly before the need to contain systemic risk became more evident than ever before).

The report also urged market participants to conduct stress tests based on ­scenarios that “include both firm-specific and systemic events” and to ­“periodically conduct hypothetical simulations of close-out situations, including a comprehensive review of existing documentation, identification of legal risks and issues … and ascertaining the sequencing of critical tasks and decision-making responsibilities ­associated with events leading up to and including the execution of a close-out event”. The idea is that documentation risk must be managed in a systematic way as part of ordinary risk-management ­activities and not just reactively when something ­negative happens. Regulators, no doubt, would agree.

What next?

When the dust settles a little on the current financial crisis, there is sure to be a renewed focus on documentation risk-management by market participants and regulators alike. Some are already looking for new solutions, including buy-side firms that are worrying about counterparty risk for the first time and sell-side firms that have made acquisitions during the crisis. Others are sure to ­follow as documentation portfolios continue to grow and an evolving financial, legal and regulatory environment intensifies the need to bring documentation risk-­management to the same level of ­sophistication as the management of ­market and credit risk.

In the digital age, parties need an online real-time ability to access and analyse the financial, legal and liquidity information in their contracts. There is no doubting the scale of the challenge many are facing.

John Berry is general counsel at ­docGenix