Contractual risk
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Negotiation Anatomy™
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It is tempting to view “risk” as a single, integrated, unitary thing that manifests evenly as a function of the value at stake, and about which complexity and volume of the surrounding legal endeavours — “verbiage”, to our friends in sales — are but a second-order derivative of that value.
But this is to confer upon our learned friends a “best-of” option. The bigger the value, the more room for eaglery.[1]
But we don’t think that is quite right. Different contracts ask us to take different kinds of risk along the airbag - steering-wheel continuum.
Economic risks: airbags and life-rafts
The economic risk that you lose money on the deal because things don’t work out as everyone hoped — there is no market for the product, your investments went south, your product was sideswiped by an innovation you didn’t see coming — these are intractable risks of the physical realm. There is not much your lawyers can do about them, beyond supplying “working airbags and life-rafts” — a fulsome menu of trapdoors, ripcords, alarms, panic rooms, and crashmats to help you bail out should the economic risk come about. But a crash mat is only so much use if you’re traveling at 600mph at the point of impact.
Legal risks: acceleration, brakes, clutch, steering wheel
Then there are intrinsically legal risks where getting the legal docs right will make all the difference. These arise if, due to formal deficiencies in your legal arrangements, you don’t get the value you bargained for. For example, if someone forgets to file a Slavenburg or the security package was not perfected; if you were short a buried cheapest-to-deliver option meaning your counterpart provided something less valuable than you wanted.
Examples
Innate legal risks
Structured products with complex derivative payoffs embedded in them — credit-linked notes, CDO² and that kind of thing — are inherently complicated and it is really easy to screw up the legals in a way that would not have caused loss if you got it right.
Also, deals involving security, third-party credit support, or formal magic incantations (letters of credit, trusts, securities) or punitive regulations (e.g., ERISA, securities regulation) can go wrong purely because of formal deficiencies or because someone misdescribed the risks or the complex outcome was misdescribed.
Economic risks
A loan has a lot of economic risk but the inherent legal risk is actually pretty low: just make sure you have sensible and sensitive default triggers: failure to pay, insolvency, downgrades, cross default and so on. Once the borrower has gone bust there is nothing the legal docs can do to help you.
Hybrid: pure complication risk
Lawyers tend to conflate the two — it is in their interests to; see Büchstein’s special theory of Parkinson’s Law — to regard a loan for say £100,000,000 as an innately risky, legally risky thing. Send for the legal eagles! What will our learned friends do: they will validate your suspicion that lending £100m is categorically different from lending £100, by serving up loan facility documentation running to hundreds of pages, formally complicating what is basically a straightforward arrangement, and thereby introducing a new lawyer of legal risk on top of the already monstrous economic risk.
This is not innate legal risk and it is only a derivative of the economic risk: we call it pure complication risk, and it is, in theory (even if not in practice) entirely eradicable, by disciplined brevity and committed clarity in legal documents.
Three kinds of risk term
Contract negotiation lawyers tend to be more consequence-agnostic than they need to be — both in creating and commenting on drafts. There is a decision-making aspect to this. Some risks are existential, some are mere irritations. Treat them differently when you formulate your positions. Consider three types of contractual provision:
Credit terms
Clauses that address what happens if your counterparty does — or looks like it imminently will — blow up are of mortal significance in a finance contract, where the essence of the arrangement is for the parties to take material present financial exposure to each other: if there is no counterparty, you lose all your money. In service contracts, where a party commits to provide ongoing services for ongoing payments, the “present value” of your exposure is limited, and a counterparty’s failure is less catastrophic: if your building maintenance contractor blows up, you just engage another one. In any case, whatever your exposure, if your counterparty has no assets, it doesn’t matter what the contract says.[2] Can these consequences be ameliorated by the commercial imperative? Generally, no. They are, things like:
Default/Termination terms
These allow you to get out of further obligations and mitigate the incurring of forward losses, but don’t have a lot to say about existing exposures
- Credit mitigation terms: Whatever the contract says about enforceability of security and effectiveness of close-out netting, things which preserve or prefer your claims over whatever assets your counterparty still has, including its contractual claims against you. But security provisions and close-out netting formulations tend to be “verba magicae”: incontrovertible formalities which no legal eagle dares touch.
Regulatory terms
Will this contract put one or other party in breach of law or regulation? Whose fault is it if it does? Who bears liability? What are the consequences? Can these consequences be ameliorated by the commercial imperative? Generally, no.
- Commercial liability: Liability outside the outright failure of your counterparty.
See also
References
- ↑ This is, of course, another way of articulating Büchstein’s special theory of Parkinson’s Law.
- ↑ If you have security or netting rights, QED your counterparty still has some assets left: for example, its claims against you.