Email Evidence in Lawsuits over Financial Derivatives
The treasury departments of local governments and institutions like private schools have fresh reason to keep their electronic mail for a long time. Sometimes these institutions enter complex financial transactions – derivatives, credit default swaps and the like.
To the players in this “structured finance” market, the bad economy brought surprises. The trades they made did not pan out as expected. A rash of lawsuits has emerged, and the lawsuits have revealed that the documentation for the trades is often confused or lacking. Claire Coe Smith, "Complex Investments Spur Lawsuits in Europe," Wall St J., 28 Sept 09.
A litigation lawyer quoted in the Wall Street Journal observes that in case after case, the formal documentation for these complex trades did not match the intent of the parties. Under close inspection, the formulas written into the contracts don’t work, or the sheer words of the documentation do not allocate risk as expected. This observation suggests that often industry practices outpaced the paperwork and parties did not take time to carefully review what they were doing.
Two Example Lawsuits
Muddled transactions like these have historically concluded in lawsuits and settlements. In the 1990s Orange County, California, settled with Merrill Lynch for $400 million under a lawsuit claiming fraud in the sale of derivatives to the county.
March 2010: School districts in Wisconsin are suing a financial advisor and the Royal Bank of Canada in connection with misunderstood investments in collateralized debt obligations/credit default swaps.
How to Resolve Dispute?
So how does a court resolve a lawsuit over a complex but poorly documented contract?
If the contract was formally written on paper and signed, the surrounding communications among the parties – such as e-mail – may or may not impact the outcome of the case. Contract law embraces a concept called the parol evidence rule, which strives to keep the focus of a contract lawsuit on the words written on the signed paper. It prefers that the court just interpret those words. The parol evidence rule strives to save the court from the effort of interpreting all of the other “external” communications between the parties, such as letters, faxes, emails, web notices, oral conversations and social networking chat. Benjamin Wright, The Law of Electronic Commerce, § 17.5, 2nd ed.
However, if a court finds that the written paper does not “integrate” the whole deal between the parties, then the court may consider the external communications. For example, the court may find that the paper does not integrate all of a derivatives deal because the parties made clear that some of their informal e-mail traffic memorialized a critical part of their understanding.
Reason To Retain Records
What’s more, if the formally-written words are ambiguous, then the court may consider the external communications to interpret what the written words meant. Ambiguity, as we are learning, is apparently common in the documentation of structured finance. Wise treasurers therefore preserve all of their e-mail (and text messages on their BlackBerries) related to these transactions.
Mr. Wright teaches cyber investigations law at the SANS Institute.
Update 2013: Comments embedded in a word processing document could influence court interpretation of final contract printed from that document.