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Legal risk is risk from uncertainty due
to legal actions or uncertainty in the applicability or interpretation of
contracts, laws or regulations. Depending on an institution's
circumstances, legal risk may entail such issues as:
 Contract
formation: What constitutes a legitimate contract? Is an oral
agreement sufficient, or must there be a legal document? What
documentation is required?
Capacity:
Does a counterparty have the capacity to enter into a transaction? For
example, in 1992, the United
Kingdom's House of Lords determined that the London Borough of
Hammersmith and Fulham lacked capacity to transact in
derivatives linked to interest
rates. Not only were contracts dating back to the mid-1980s with that
borough declared void, but contracts with over 130 other councils were
effectively invalidated. A number of derivatives dealers suffered
losses.
Legality of derivatives transactions: In
some jurisdictions there are issues relating to whether certain
derivatives could be deemed gambling contracts and thus made
unenforceable. This was a significant concern during the early days of
OTC derivatives markets.
Perfection
of an interest in collateral: A claim is
perfected if it is senior to any existing or future third-party claims
in the event of bankruptcy. A perfected interest represents a lien on
collateral. Requirements to perfect a claim can be
complex and vary by both jurisdiction and the nature of the collateral.
Netting agreements:
Under what circumstances will a closeout netting agreement be
enforceable?
Contract
frustration: Might unforeseen circumstances invalidate a
contract? For example, if a contract is linked to an index or currency
which ceases to exist, will the contract become invalid?
Legal risk can be a particular problem for institutions who transact
business across borders. Not only are they exposed to uncertainty relating
to the laws of multiple jurisdictions, but they also face uncertainty as
to which jurisdiction will have authority over any particular legal issue.
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