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.