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FINANCIAL RISK MANAGEMENT

into default, the counterpartys reputation and desire to deal fairly no longer
serve as a bulwark against litigation risk. In bankruptcy, all of the bankrupt firms creditors become competitors in legal actions to gain as much
of a share of the remaining assets as possible. Even when legal documents
have been well drawn to provide specific collateral against an obligation
or specific netting arrangements between derivative contracts on which the
bankrupt firm owes and is owed money, other creditors may try to convince
bankruptcy courts that it is only fair that they receive a share of the collateral or derivatives on which the bankrupt firm is owed money. Bankruptcy
courts have been known to issue some very surprising rulings in these
circumstances.
Contractual intention can be voided not only by courts, but also by
regulatory authorities or legislatures, which may issue rules that make certain contractual provisions unenforceable. Financial institutions can and do
mount lobbying campaigns against such changes, but other parties may be
as effective or more effective in lobbying on the other side. Financial firms
often need to analyze what they believe is the prospect for future regulatory
actions in order to determine whether certain current business will prove to
be worthwhile.
More detail on legal risk and how to control it can be found in Chapter 7
of Malcolm et al. (1999).

3.2.2 The Risk of Illegal Actions

The possibility of a firms employees engaging in actions found to be illegal
bears a very close relationship to reputational risk, which is examined in the
next section. Any legal proceedings against a firm have the potential to damage the firms reputation and the willingness of clients to engage its services.
Even when legal proceedings dont result in a judgment against the firm,
the publicity about the allegations and embarrassing disclosures in the legal
discovery process can still impair reputation. And actions that can generate
negative press, even if not rising to the level of illegality, can have a similar
effect on reputation. One of the most effective screens for acceptable behavior remains the classic Would you be comfortable seeing a description of
this practice on the front page of the Wall Street Journal?
The primary focus of legal and reputational risk has always been on the
fiduciary responsibilities owed by a firm to its clients, particularly its less sophisticated clients. But recent cases have extended concern to damages that
the client may inflict on others that the firm may be seen as having abetted.
Section 4.3.2 on the losses in lawsuits of JPMorgan Chase and Citigroup for
having been party to the Enron deception of investors is a good case study
in this respect.