Contractual risk
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Negotiation Anatomy™
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It is tempting to view “contract risk” as a single, integrated, unitary thing that manifests evenly as a function of the value at stake, and about which the complication and volume of surrounding legal endeavours — “verbiage”, to our friends in sales — are but a second-order derivative. The more value-at-risk, the more complicated are the docs.
This is true in practice, but not in theory. It is true in practice because of the operation of the special theory of Parkinson’s law, which confers upon our learned friends a “best-of” option. The more the value at risk, the more scope for eaglery.[1] There is money at stake, and so scope to work your magic, and if you do your baffling best, you can leave an suite of documents behind you that are so confusing — so intimidating — that no-one will dare touch them without a trained professional — i.e., you — on hand to vouchsafe its safe passage. This is the basic premise of securities documentation.
But careful theoreticians ought to be able to steer around this ditch. (The “steering” metaphor is deliberate). For different contracts ask us to take different kinds of risk, and these position us at different points along the airbag - steering-wheel continuum.
Only some of those risks demand greater acumen from our legal friends.
Risks lawyers can’t really solve — airbags and life-rafts
The economic risk that you lose money on the deal because things didn’t work out as everyone hoped — there was no market for the product after all, all the investments went south, the flagship product got sideswiped by an innovation no-one saw coming — these are intractable risks of the world of business. They are a fact of life: there is not much lawyers can do about them, beyond supplying “functional airbags and life-rafts” that inflate when you need them. Lawyers have 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.
Risks lawyers can solve — steering, acceleration, brakes
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. This is the basic engineering of safe transport.
Different contracts have different risk profiles
Sometimes, the engine is the trick. Having a vehicle that is responsive, hugs the road, accelerates our of corners, brakes quickly before hairpins makes all the difference. If you want to drive at the grand prix you need a dream machine: this your lawyer can help with. So: structured products with complex derivative payoffs embedded in them — credit-linked notes, CDO² and that kind of thing — are inherently complicated, fine pieces of engineering, and it is really easy to screw up the legals if you don’t get it just 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 a complex outcome. Here you need a proper engineer. An outsourced call centre in Bratislava won’t do.
But sometimes the terrain is the problem. What you need is a Hilux. No fancy electronics, no heated seats, just a decent diesel and Toyota engineering that won’t break down. A commercial 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.
But lawyers tend to conflate the two — it is in their interests to; see the 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.