Legal risk in financial markets (and that is not all)
Those who attended the afternoon section of the InvesTO day the last September 26th at Torino Incontra have already heard about it; but for those who were not there that day, InvesT0 Law will deal with an issue less technical than usual, that somebody may call “metaphysical”.
There is so much talk about risk management. There are too many lawyers (inside and outside banks, brokers and businesses of any kind). But what kind of risks do they manage or should they manage? What is it exactly legal risk?
Legal risk includes “ but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements”. But this is just a proposal for its definition, even if very reliable as mentioned in “Basel II” (documents on international regulations and recommendations on bank capitals). Others (such as the famous expert Roger Mc Cormick professor at the London School of Economics) suggest broader definitions which include the risk to take legal action or to be effected by negative consequences caused by defect of form in investment contracts.
Whatever definition you may use, the interest for legal risk management is growing, especially in banking and finance (due to growing fiscal cases and fines caused by the global crisis) but also in any other business and among private investors.
Causes for legal risks may vary (for example the uncertainty for the result of a lawsuit, inaccuracies in drafting a document, doubts about the application of a law, new jurisprudential orientation, etc.).It is not only a matter of risk of non-compliance with regulations. This is the so called “compliance risk”, which is different from legal risk because of its uncertain and external origins.
Because of these “external variables” it is impossible to determine ex ante boundaries and measure, based on mathematic models, of legal risk. This does not mean that it is impossible to evaluate and prevent legal risk.
Legal risk evaluation should be carried out during the process of auditing the operational risk of a bank, financial broker (or any other economic or investment reality), through a process of due diligence that could lead to determine potential causes of legal risk (for example, the accuracy of all the contract documents, regulation updating status and most recent jurisprudential orientation in any kind of businesses, ect.).
In detecting the more suitable method to evaluate the legal risk of a party, it will be necessary to take into account the quantitative and qualitative indicators as, among others:
(i) the amount of losses caused by legal risk in the past years;
(ii) a series of complaints and damage claims made by clients and former clients; and
(iii) the macro-economic situation and the performance of financial markets
It is also fundamental to distinguish legal risk assessment from other process of evaluation that could be somehow similar (for example statutory auditor, rating by external agencies or the quality certification).However, those who perform these type of evaluation are missing an essential element for assessing legal risk: independence.
In order to conduct a proper and useful assessment of legal risk, it is essential to identify a subject who has not only a specific and diversified in-depth expertise within laws and regulations, but also has an independent judgment. The legal consultant has therefore a new role: he is no longer a simple “litigator” to turn to when something is wrong, but he has now a much wider and articulate role. But we will talk about this in the next issue of InvesTO Law!