Electronic Data Records Law | How to Win E-Discovery

Structured Finance Computer Documentation

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.

–Benjamin Wright

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.

Internet Terms, Contracts, Disclaimers

Financial Derivatives Yield Unexpected Incentives

Hedge Fund Public Disclaimer of Liability-Responsibility?

Web Notice to Pre-empt Complaints | EMail Disclaimer | Contract Enforcement | Battle of the Forms

The World Wide Web is changing contract and commercial law practices.  As a global medium for broadcasting terms, notices, conditions, and disclaimers, the web empowers business innovators preemptively to warn their trading partners of risk and to disclaim responsibility to prospective counterparties.  Business innovators might therefore use the web to reduce their legal risk.

This blog post presents an advanced idea.  To explain it will require space, so please hang with me as I lay out my argument.  First I will explain how forward-thinking traders like hedge funds can be exposed to new legal liability.  Then I will explain a method for containing that exposure, a method that could apply to more than just hedge funds and financial markets.  

The legal desire to warn others and disclaim liability is acute in the cutthroat world of financial derivatives and structured finance.  Derivatives (which are fueled by efficient digital
technology), especially credit default swaps (CDS), allow aggressive traders to assume unconventional, counterintuitive positions – positions that may surprise and even anger other parties.  Three examples:

1. George Soros says some of the bondholders in the AbitibiBowater and General Motors bankruptcies perversely preferred to dissolve the companies rather than reorganize them on account of the bondholders’ positions in credit default swaps.  “CDS are instruments of destruction that ought to be outlawed,” he proclaimed (emphasis added).  Further, to hold both a bond and a corresponding CDS simultaneously “is like buying life insurance on someone else’s life and owning a license to kill him.” George Soros, “My three steps to financial reform,” Financial Times, June 17, 2009.

2. Some analysts complain about a Fidelity mutual fund that simultaneously held both bonds issued by the distressed Six Flags company and hedged CDS positions relative to those bonds.  According to the analysts, the mutual fund turned down a reasonable restructuring offer for the Six Flags company.  Strangely, the mutual fund preferred that Six Flags sink into bankruptcy where bondholders as bondholders would receive less.  The Economist magazine goes on to observe, “By purchasing a material amount of a firm’s debt in conjunction with a disproportionately large number of CDS contracts, rapacious lenders (mostly hedge funds) can render bankruptcy more attractive than solvency.” “CDSs and bankruptcy: No empty threat,” The Economist, June 20, 2009, p. 79 (emphasis added to highlight that the Economist thinks the mutual fund's behavior was bad and presumably should be punished).

3. Amherst Holdings, a Texas investment firm, “ambushed” some big banks.  The banks were counterparties to which Amherst had sold CDSs so that the banks could hedge their losses on bonds they owned representing defaulting mortgages.  From the sale of the CDSs, Amherst and its associates earned multimillion dollar fees from the banks.  Under the terms of the CDSs, team Amherst would have to pay handsomely as the losses from the defaulting mortgages were allocated under the bonds to the banks.  But then Amherst executed a maneuver that prevented the banks from collecting under the CDSs.  It used a little-known legal loophole to arrange (with the party that services the bonds) for the bonds to be paid in full! The banks were not prepared for this scenario. The result was that team Amherst did not have to pay as expected under the CDSs.  On balance, Amherst made money, and the banks lost the substantial fees they had paid team Amherst for the CDSs.  Some of the banks have complained to industry trade associations that Amherst acted improperly.  Zuckerman, Ng & Rappaport, “A Daring Trade Has Wall Street Seething,” Wall Street Journal, June 12, 2009. Deutsche Bank averred that a maneuver like Amherst’s might be illegal.

In each of these three stories, counterparties or other investors felt the successful traders had acted unfairly, possibly deceptively and perhaps even illegally.

When large sums of money are lost unexpectedly, losers are prone to seek legal or political redress. They might try to claim, for example, that they were victims of fraud or that they were entitled to more disclosure of the other party’s intention, position, or strategy.

Web Notice to Pre-empt Complaints

But in anticipation of the possibility of such legal claims, unconventional traders might take steps long in advance.  They might pre-empt such claims by issuing a general warning and disclaimer. They might conspicuously publish on their Web pages a notice like this:

“Notice. This is notice published by ABC Hedge Fund (the “Fund”) to the attention of any party that may have a direct or indirect relationship to the Fund’s investments, including but not limited to an investor, a counterparty or the issuer of debt, equity or other rights, interests or securities.  Please be advised that the Fund may assume or take advantage of innovative, unconventional or surprising positions.  While the Fund shall always stay in full compliance with all applicable laws, please be alert that the Fund may aggressively pursue trading or investment strategies that are novel or counterintuitive.  Except to the extent the Fund otherwise explicitly agrees in writing, the Fund disclaims responsibility to (a) inform others of its intentions, trading positions or investment strategies, or (b) look out for the interests of others or divine their intentions, strategies or expectations.”

Publication of such a notice/disclaimer would create electronic records suggesting that prospective “victims” had been warned in advance.

How effective might such a notice be?  Although the legal effect of any kind of disclaimer can rarely be certain for all circumstances, support is growing for the proposition that general-distribution legal notices can be delivered by way of publication on the web.  Observe four angles on the topic: