Legal opinions are a fundamental component of global financial stability. They underpin regulatory acceptance of close-out netting, which reduces financial institutions’ capital costs, risk and legal uncertainty, and are key for financial stability. Yet their current format is unwieldy, overly complex and increasingly no longer fit for purpose, as Akber Datoo, CEO of D2 Legal Technology, explains
The co-architect of the design and drafting of the current incarnation of master trading agreements, Jeff Golden KC (Hon), once stated that “the answer is always netting”. The truth of this statement, in terms of its importance to trading parties for credit risk mitigation and financial stability, has certainly continued to hold true. However, the effectiveness and enforceability of netting under these master trading agreements has grown around the provision of legal opinions to confirm this enforceability. Yet 35 years after the capital markets industry started to utilise these legal opinions for this purpose, very little has changed in terms of the manner in which they are provided. It has simply not kept up with the current demands of a more complex trading environment, regulatory requirements and the increasing role of technology and the digital agenda.
Legal opinion and why it is Important
A legal opinion — also known as an ‘opinion letter’ in pure legal terms — might be defined as “an opinion from lawyers issued in letter form expressing legal conclusions about, and/or legal analysis of, a transaction or matter which is relied on by the addressee of the opinion”.
The main purposes of a legal opinion are:
• to inform the addressee of the legal effect of a transaction or matter.
• to identify legal risks that the addressee should consider further and evaluate.
Within the context of financial markets, and close-out netting in particular, the legal opinion takes on a slightly more nuanced and complex purpose, though its form remains the same.
Payment netting is often confused or conflated with close-out netting. Payment netting takes place during the normal business of a solvent firm and involves combining offsetting cash flow obligations between two parties on a given day in a given currency into a single net payable or receivable. Although important in, for example, managing Herstatt (or “daylight” risk), it pales to insignificance with respect to the benefits offered by close-out netting. This refers to a process involving termination of obligations under a contract with a defaulting party and subsequent liquidation of any resulting damage or gain by combining positive and negative replacement values into a single net payable or receivable.
It is important to be sure that close-out netting is enforceable in the relevant jurisdiction, were the trading counterparty to become insolvent. If not, any exposure to that trading counterparty ought to be viewed on a gross basis (i.e. without combining positive and negative values), rather than a net basis. This is because insolvency administrators might engage in cherry picking, which involves an insolvency administrator demanding performance of contracts favourable to the bankrupt firm but rejecting contracts burdensome to the bankrupt firm. Accordingly, one might be obliged to pay in full on obligations and, yet, with respect to the obligations owed, prove as an unsecured creditor against the insolvent estate of your counterparty. The impact on credit exposures resulting from this can be very significant.
Global standard-setters recognise the importance enforceable close-out netting has with respect to risk reduction in the financial system, both when it comes to setting regulatory capital requirements and developing effective resolution regimes (for example, the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions).
Additionally, by obtaining reasoned, written legal opinions that confirm the enforceability of the close-out netting provisions of master netting agreements that they use, prudentially regulated firms can use net, rather than gross, exposures to calculate their regulatory capital exposures. The regulatory capital savings for large investment banks in the capital markets run into billions of dollars.
Specifically, the regulations require a legal opinion to be obtained in respect of each such master trading agreement — such as the General Master Securities Lending Agreement (GMSLA) — before the regulatory capital benefit can be taken. The legal analysis may differ for some counterparty types — such as insurance companies, due to some specific insolvency rules relating to such entities in some jurisdictions — and agreement type. However, industry opinions are often obtained to provide for generic advice for a particular jurisdiction (of the counterparty) and agreement type, with further analysis required to make this apply to individual facts and circumstances.
This results in large banks needing to maintain large portfolio legal opinions in this way, in some cases running into close to a thousand such opinions. Given insolvency (and other relevant) laws and regulations are dynamic and change over time, the regulatory requirement is to keep this legal advice current and up-to-date — with the increasing expectation being that these legal opinions are refreshed annually. By way of example, earlier this year, updated insolvency laws in the Bahamas meant that a legal opinion in respect of Bahaman bank counterparties changed such that close-out netting can no longer be regarded as enforceable against them.
While these trading agreements, such as the GMSLA, are standard in that most of the terms come from a pre-print, some of the terms and conditions will be amended by the counterparties — which requires further legal analysis to confirm whether any such amendment changes the legal opinion’s view regarding the enforceability of close-out netting. Additional annexes, such as for evergreens, may require additional legal analysis and may therefore not be covered under the scope of the industry (or bespoke) opinion on which a firm might otherwise wish to rely.
The current format of legal opinions
There are a number of issues with the current format of legal opinions which render them impractical for use as a business tool at best — and, at worst, actually contribute to firms’ operational risk.
The first of these issues relates directly to the characterisation of the legal opinion as an ‘opinion letter’. In the case of close-out netting, legal opinions can be far more lengthy than a letter; indeed, some can be hundreds of pages in length and wander across topics of definitions, relevant regulations and legal guidance. Opinions generally provide a discussion with a non-binary conclusion, resulting in the need for further interpretation and evaluation by a legal professional to answer the fundamental question of whether the master agreement can be enforced given particular facts. For example, legal opinions are subjective, when their regulatory purpose is to provide an objective answer.
The second major issue with current legal opinions lies in their paper-based format. That legal contracts are often unsuited to the business needs of the contracting parties is no longer an unsolicited view. Indeed, the Research Handbook of Contract Design advocates for a move from “the model of a contract as text only towards a more open-textured model of contracts that can be visual, text-based, code-based, or hybrid depending on the needs of the audience.” Knowing where, within a document of a hundred pages, the relevant issue is raised — which may mean a netting flag needs to be re-evaluated — is an arduous, manual and therefore costly exercise.
The final, significant problem with today’s legal opinion is one of data management. If a financial institution has legal opinions numbering into the hundreds, let alone thousands, then knowing which legal opinion needs reviewing — according to, for example, legal changes in the relevant jurisdictions, changes to the financial transactions themselves, or even simply unforeseen changes — becomes a Herculean task. Moreover, once the applicable section(s) of the legal opinion(s) are located, the specific guidance must, again, be reviewed and further interpreted.
Applying automation
The current close-out netting legal opinions are, quite frankly, impenetrable to most — if not the majority of — capital markets lawyers, being an extremely niche yet vital area.
To start, it is often not clear what the counterparty scope of a legal opinion is. Many firms fail at this initial hurdle, failing to ensure that the right legal opinion is obtained and reviewed in respect of a trading counterparty. This requires significant counterparty due diligence, from reviews of constitutional documents, prospectuses and various registers. This is an operational task that, all too often, has been left to expensive legal teams to plough through and is operated in a silo from KYC teams, despite the overlap in work required.
Even after the relevant legal opinion has been obtained and reviewed, essentially a long and complex legal opinion needs to be reduced to a “Yes” or “No” for regulatory capital purposes, based on certain facts that need to be ascertained — such as terms of the agreement, features of the transactions and where assets are located. This is, unfortunately, all too often “done in the head of the lawyer”, with little audit trail or working relating to the path to the decision, despite its complexity.
It is no wonder that so many netting determinations are suspect and that the regulators have begun to question prudentially regulated firms on their processes and systems (if any) in respect of close-out netting. In doing so, they are trying to force firms, typically through fines and other demands for action, to improve their management of legal opinions and the netting determinations — should they wish to receive the huge regulatory capital benefits of doing so. This is where automation and data come in, as the current process is just not scalable manually. Also, there is surely too much at stake in terms of financial stability!
The industry has recognised the issues of manual process and an analogue approach to master trading agreements. If the answer truly is “always netting”, we need to ensure the digital journey of the industry — from clause taxonomies and libraries to the common domain model and document negotiation platforms — does not miss out the role of the close-out netting legal opinion. And we need to design for the digital future of such opinions to unlock business value.
