1 Identifying and Managing Legal Risk Post-Enron by Andrea S. Kramer Partner McDermott, Will &...

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Identifying and Managing Legal Risk Post-Enron

Identifying and Managing Legal Risk Post-Enron

byAndrea S. Kramer

PartnerMcDermott, Will & Emery

<akramer@mwe.com>

Futures Industry Association

Expo

November 7, 2002

byAndrea S. Kramer

PartnerMcDermott, Will & Emery

<akramer@mwe.com>

Futures Industry Association

Expo

November 7, 2002

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Various Ways to Manage RiskVarious Ways to Manage Risk

• Hedging activities

• Insurance

• Diversification and entry and exit strategies

• State-of-the-art contracts, policies, and procedures

• Tax compliance (federal and state)

• Regulatory compliance (federal and state)

• Securitizations and hybrid products

• Hedging activities

• Insurance

• Diversification and entry and exit strategies

• State-of-the-art contracts, policies, and procedures

• Tax compliance (federal and state)

• Regulatory compliance (federal and state)

• Securitizations and hybrid products

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Risk ManagementRisk Management

“Risk management tools have emerged to help market participants protect themselves against uncertain price movements. Wholesale electric power markets, while still developing, are beginning to look like markets for other commodities.”

– FERC Staff Report, 1998

“Risk management tools have emerged to help market participants protect themselves against uncertain price movements. Wholesale electric power markets, while still developing, are beginning to look like markets for other commodities.”

– FERC Staff Report, 1998

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Board of DirectorsResponsibilities

Board of DirectorsResponsibilities

• Clearly establish overall risk philosophy• Approve risk management policies and

procedures• Support management needs for technical

capacities• Evaluate risk management performance• Oversee risk management activities

– designate and delegate various responsibilities– risk management committee

• Clearly establish overall risk philosophy• Approve risk management policies and

procedures• Support management needs for technical

capacities• Evaluate risk management performance• Oversee risk management activities

– designate and delegate various responsibilities– risk management committee

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Types of Risks to AddressTypes of Risks to Address

• Market Risk — the loss in market value of a position due to unexpected changes before position can be liquidated or offset

• Credit Risk — the risk a counterparty is unable to meet its obligations or make payments when due

• Market Risk — the loss in market value of a position due to unexpected changes before position can be liquidated or offset

• Credit Risk — the risk a counterparty is unable to meet its obligations or make payments when due

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Types of Risks to Address(Cont’d)

Types of Risks to Address(Cont’d)

• Liquidity Risk– market risk: can’t easily unwind or offset positions – funding risk: unable to meet payment obligations

when due (such as margin calls)• Operational Risk — Losses due to inadequate

systems, internal controls, human error, or management failure

• Legal Risk — Losses due to unenforceability of a contract, incorrect documentation, or unexpected tax consequences

• Liquidity Risk– market risk: can’t easily unwind or offset positions – funding risk: unable to meet payment obligations

when due (such as margin calls)• Operational Risk — Losses due to inadequate

systems, internal controls, human error, or management failure

• Legal Risk — Losses due to unenforceability of a contract, incorrect documentation, or unexpected tax consequences

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Risks Not Easily MeasuredRisks Not Easily Measured

• Operational Risk

• Legal Risk

• Operational Risk

• Legal Risk

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Risk ManagementOperations

Risk ManagementOperations

• Trading authorizations, approvals, limits, and guidelines

• Approval of new products

• Monitoring operations

• Trading authorizations, approvals, limits, and guidelines

• Approval of new products

• Monitoring operations

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Risk ManagementAdministration

Risk ManagementAdministration

• Master agreements and netting agreements

• Scheduling procedures

• Settlement procedures

• Computer tracking

• Master agreements and netting agreements

• Scheduling procedures

• Settlement procedures

• Computer tracking

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Avoid Trading SurprisesAvoid Trading Surprises

• Set out trading authority and responsibilities

• Proper performance reviews and appropriate compensation packages

• Employee screening and background checks

• Careful and ongoing monitoring to watch for– trading authority and responsibilities– trading model failure– trading deceptions– Front, Middle, and Back Office discrepancies

• Set out trading authority and responsibilities

• Proper performance reviews and appropriate compensation packages

• Employee screening and background checks

• Careful and ongoing monitoring to watch for– trading authority and responsibilities– trading model failure– trading deceptions– Front, Middle, and Back Office discrepancies

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Warning Signals to Prevent Trader Deception

Warning Signals to Prevent Trader Deception

• Must understand and listen to warning signals to avoid surprises

• Need to distinguish between warning signals and “trader talk”

• What may be a warning signal in one situation can be just “trader talk” in another situation

• Must understand and listen to warning signals to avoid surprises

• Need to distinguish between warning signals and “trader talk”

• What may be a warning signal in one situation can be just “trader talk” in another situation

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Adequate Compliance ProgramsAdequate Compliance Programs

• Develop company-wide culture to support internal controls

• Senior management must support compliance efforts• There must be adequate staffing and resources to

perform all compliance functions

• Develop company-wide culture to support internal controls

• Senior management must support compliance efforts• There must be adequate staffing and resources to

perform all compliance functions

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Adopt Ethics CodesAdopt Ethics Codes

• Identify appropriate general conduct

• Provide “aspirational” Codes that express business aims and intent

• Evaluate behavior and transactions as “right” and “appropriate”

• Require employees to acknowledge compliance with the Ethics Code

• Identify appropriate general conduct

• Provide “aspirational” Codes that express business aims and intent

• Evaluate behavior and transactions as “right” and “appropriate”

• Require employees to acknowledge compliance with the Ethics Code

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Compliance Culture and Behavior Compliance Culture and Behavior

• Senior management supports the Ethics Code

• Communicate and reinforce ethical culture throughout company

• Train employees

• Establish and enforce ethical values

• Conduct annual and spot compliance audits

• Senior management supports the Ethics Code

• Communicate and reinforce ethical culture throughout company

• Train employees

• Establish and enforce ethical values

• Conduct annual and spot compliance audits

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Employee AcknowledgementsEmployee Acknowledgements

• Received, read, and understand employee’s responsibilities

• Will conduct activities consistent with terms, philosophy, and spirit of all policies and procedures

• Will comply with all conflict of interest policies • Will protect confidential and proprietary information• All conversations will be conducted on recorded

lines, which may be monitored and taped

• Received, read, and understand employee’s responsibilities

• Will conduct activities consistent with terms, philosophy, and spirit of all policies and procedures

• Will comply with all conflict of interest policies • Will protect confidential and proprietary information• All conversations will be conducted on recorded

lines, which may be monitored and taped

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Corporate Sentencing Guideline Requirements

Corporate Sentencing Guideline Requirements

• Standards and procedures “reasonably capable” of preventing criminal conduct

• Oversight by high-level personnel• Careful delegation of discretionary authority• Effective communication to all employees• Reasonable steps taken to assure compliance• Enforce disciplinary mechanisms • Respond if an offense is detected

• Standards and procedures “reasonably capable” of preventing criminal conduct

• Oversight by high-level personnel• Careful delegation of discretionary authority• Effective communication to all employees• Reasonable steps taken to assure compliance• Enforce disciplinary mechanisms • Respond if an offense is detected

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New Corporate Reform RegulationNew Corporate Reform Regulation

• Proposed Revised NYSE Corporate Governance Standards

• Sarbanes-Oxley Act of 2002

• SEC Rulemaking

• Proposed Revised NYSE Corporate Governance Standards

• Sarbanes-Oxley Act of 2002

• SEC Rulemaking

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NYSE Listing RequirementsNYSE Listing Requirements

• Pending rule changes will substantially raise corporate governance standards

• Mandating “best practices” for all listed companies

• Requires shareholders to vote on equity-compensation plans

• Pending rule changes will substantially raise corporate governance standards

• Mandating “best practices” for all listed companies

• Requires shareholders to vote on equity-compensation plans

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Sarbanes-OxleySarbanes-Oxley

• Public companies

• Officers and directors

• Employees

• Auditors

• Investment bankers

• Attorneys

• Public companies

• Officers and directors

• Employees

• Auditors

• Investment bankers

• Attorneys

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Sarbanes-OxleySummary

Sarbanes-OxleySummary

• CEO/CFO Certification

• More “real-time” disclosure of events

• Audit committee

• Auditor independence

• Accelerated Section 16 reporting

• Retirement fund “blackout periods”

• Prohibit loans to executive officers and directors

• CEO/CFO Certification

• More “real-time” disclosure of events

• Audit committee

• Auditor independence

• Accelerated Section 16 reporting

• Retirement fund “blackout periods”

• Prohibit loans to executive officers and directors

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Sarbanes-OxleyLoan ProhibitionSarbanes-OxleyLoan Prohibition

• Broad blanket prohibition with limited exceptions

• Material modifications not allowed to existing loans

• May cover many compensatory agreements

• SEC guidance unlikely anytime soon

• Broad blanket prohibition with limited exceptions

• Material modifications not allowed to existing loans

• May cover many compensatory agreements

• SEC guidance unlikely anytime soon

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Corporate GovernanceDirectors Duties Have Not Changed

Corporate GovernanceDirectors Duties Have Not Changed

• Directors have fiduciary duties to stockholders• Company must be run for the benefit of the

stockholders• Duty of Loyalty — must act in best interests of

the company, free from conflict with personal, financial, or other interests

• Duty of Care — must make decisions on an informed basis — which requires oversight of risk management and legal compliance programs

• Directors have fiduciary duties to stockholders• Company must be run for the benefit of the

stockholders• Duty of Loyalty — must act in best interests of

the company, free from conflict with personal, financial, or other interests

• Duty of Care — must make decisions on an informed basis — which requires oversight of risk management and legal compliance programs

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Corporate GovernanceBusiness Judgment RuleCorporate Governance

Business Judgment Rule

• Actions taken in good faith and on an informed basis are usually protected from judicial scrutiny and second-guessing

• Courts will not substitute their business judgment for the judgment of the Board acting without self-interest; but lack of self-dealing must be carefully documented

• Actions taken in good faith and on an informed basis are usually protected from judicial scrutiny and second-guessing

• Courts will not substitute their business judgment for the judgment of the Board acting without self-interest; but lack of self-dealing must be carefully documented

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Corporate GovernanceActing on an Informed Basis

Corporate GovernanceActing on an Informed Basis

• Directors need to probe and understand information and transactions under consideration

• Board micro-management is not required — but if in doubt, Board should ask questions

• Directors can rely on internal reports (including financial) if presented by employees reasonably believed to be reliable

• Directors can rely on reports by outside advisors reasonably believed to be qualified

• Directors need to probe and understand information and transactions under consideration

• Board micro-management is not required — but if in doubt, Board should ask questions

• Directors can rely on internal reports (including financial) if presented by employees reasonably believed to be reliable

• Directors can rely on reports by outside advisors reasonably believed to be qualified

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Corporate GovernanceActing on an Informed Basis - Practical Advice

Corporate GovernanceActing on an Informed Basis - Practical Advice

• Directors must understand the operations, profit model, and strategy of the company

• Management team must be committed to provide and update this information

• Directors must study the information provided and ask penetrating questions — no “rubberstamping”

• Directors must understand the operations, profit model, and strategy of the company

• Management team must be committed to provide and update this information

• Directors must study the information provided and ask penetrating questions — no “rubberstamping”

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Corporate GovernanceActing on an Informed Basis - Practical Advice

Corporate GovernanceActing on an Informed Basis - Practical Advice

• Corporate governance guidelines — prepares the Board for critical action by establishing policies

• Review basics (Board composition, setting agenda items, handling Board materials, and attendance of non-directors at meetings)

• Typically deals with holding Board meetings without the CEO or management, selection of a Director to lead such meetings, evaluation of the CEO, and succession planning

• Corporate governance guidelines — prepares the Board for critical action by establishing policies

• Review basics (Board composition, setting agenda items, handling Board materials, and attendance of non-directors at meetings)

• Typically deals with holding Board meetings without the CEO or management, selection of a Director to lead such meetings, evaluation of the CEO, and succession planning

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Corporate GovernanceActing on an Informed Basis - Practical Advice

Corporate GovernanceActing on an Informed Basis - Practical Advice

• Orientation program for new directors (meeting the CEO, the CFO, the heads of the key business units, the general counsel and the auditor)

• Directors manual — a handy reference guide for each director with key information and company documents

• Directors should regularly get copies of media coverage and the analyst reports on the company

• Orientation program for new directors (meeting the CEO, the CFO, the heads of the key business units, the general counsel and the auditor)

• Directors manual — a handy reference guide for each director with key information and company documents

• Directors should regularly get copies of media coverage and the analyst reports on the company

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Corporate GovernanceBottom Line

Corporate GovernanceBottom Line

• Corporate reform regulation raises the bar for Directors in fulfilling their duties, forcing a return to fundamentals

• Directors who do not comply with increased standards and heightened stockholders expectations face increased liability for breach of duty

• Corporate reform regulation raises the bar for Directors in fulfilling their duties, forcing a return to fundamentals

• Directors who do not comply with increased standards and heightened stockholders expectations face increased liability for breach of duty

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Sarbanes-OxleyCode of Business Conduct and Ethics

Sarbanes-OxleyCode of Business Conduct and Ethics

• Listed companies will be required to have and publicly disclose a Code of Business Conduct and Ethics, as well as a separate Code of Ethics for Senior Financial Officers, and must also disclose any subsequent changes or waivers to such codes

• Code of Conduct and Ethics policies currently in place may need refinement, with new financial executives code established once relevant NYSE and SEC rules are finalized

• Listed companies will be required to have and publicly disclose a Code of Business Conduct and Ethics, as well as a separate Code of Ethics for Senior Financial Officers, and must also disclose any subsequent changes or waivers to such codes

• Code of Conduct and Ethics policies currently in place may need refinement, with new financial executives code established once relevant NYSE and SEC rules are finalized

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Sarbanes-OxleyWhistleblower Protection

Sarbanes-OxleyWhistleblower Protection

• Companies cannot discriminate against employees who assist investigations of securities law violations

• Audit committees must, subject to future SEC rules, establish procedures:– for handling complaints regarding accounting or

auditing matters, and– for employees to submit confidential, anonymous

concerns regarding questionable practices

• Companies cannot discriminate against employees who assist investigations of securities law violations

• Audit committees must, subject to future SEC rules, establish procedures:– for handling complaints regarding accounting or

auditing matters, and– for employees to submit confidential, anonymous

concerns regarding questionable practices

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Causes of Legal RiskCauses of Legal Risk

• Inadequate documentation (unintended consequences)

• Counterparty lacks authority

• Transaction not permitted by applicable law

• Insolvency laws limit or alter contractual remedies

• Unintended tax consequences

• Inadequate documentation (unintended consequences)

• Counterparty lacks authority

• Transaction not permitted by applicable law

• Insolvency laws limit or alter contractual remedies

• Unintended tax consequences

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Legal ReviewLegal Review

• Counterparty capacity

• Counterparty authority

• Periodic review of agreements to update for legal and market practice developments

• Customer appropriateness

• Tax compliance

• Counterparty capacity

• Counterparty authority

• Periodic review of agreements to update for legal and market practice developments

• Customer appropriateness

• Tax compliance

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Contract TermsPlanning and Preparation

Contract TermsPlanning and Preparation

• Understand terms of contracts

• Are there liquidated damage provisions?

• Are there curtailment provisions for firm transactions?

• What is emergency power, and under what conditions is it sold?

• Understand terms of contracts

• Are there liquidated damage provisions?

• Are there curtailment provisions for firm transactions?

• What is emergency power, and under what conditions is it sold?

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Why Documentation Is CriticalWhy Documentation Is Critical

• Enforceability and the statute of frauds– does the UCC apply– Qualified Financial Contracts

• Activation of the material provisions

• Bankruptcy and insolvency protections

• Enforceability and the statute of frauds– does the UCC apply– Qualified Financial Contracts

• Activation of the material provisions

• Bankruptcy and insolvency protections

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Documentation ConsiderationsDocumentation Considerations

• Representations and warranties

• Force majeure

• Netting provisions– payments– delivery obligations

• Setoff provisions

• Events of default

• Representations and warranties

• Force majeure

• Netting provisions– payments– delivery obligations

• Setoff provisions

• Events of default

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Counterparty AppropriatenessCounterparty Appropriateness

• Counterparty sophistication

• Counterparty needs

• Transaction complexity

• Maintain contact with counterparty’s senior management

• Avoid counterparty confrontations

• Counterparty sophistication

• Counterparty needs

• Transaction complexity

• Maintain contact with counterparty’s senior management

• Avoid counterparty confrontations

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Typical ContractsTypical Contracts

• Swaps

• Caps

• Floors

• Collars

• Options

• Futures contracts

• Swaps

• Caps

• Floors

• Collars

• Options

• Futures contracts

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DocumentationDocumentation

• Master Agreement– recognized master agreement– homegrown master agreement

• Netting Agreement– cross-product master netting agreement– homegrown netting agreement

• Futures Contracts

• Master Agreement– recognized master agreement– homegrown master agreement

• Netting Agreement– cross-product master netting agreement– homegrown netting agreement

• Futures Contracts

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Connecting The Documentation PiecesConnecting The Documentation Pieces

•Master Agreement

•Schedule (or letter agreement with general business terms)

•Confirmations (with specific deal terms)

•Credit Support Documents

•Master Agreement

•Schedule (or letter agreement with general business terms)

•Confirmations (with specific deal terms)

•Credit Support Documents

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Legal and Risk IssuesLegal and Risk Issues

• Designate principal contact persons

• Confirm counterparty authority

• Obtain consent to recording

• Analyze credit risk

• Provide traders with guidelines

• Confirmations

• Designate principal contact persons

• Confirm counterparty authority

• Obtain consent to recording

• Analyze credit risk

• Provide traders with guidelines

• Confirmations

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GuidelinesGuidelines• Senior management must understand products and

their consequences

• Consider purposes and types of transactions

• Establish counterparty limits reflecting credit issues and underlying economics

• Develop standard master agreements

• Provide for netting, set-off, and unwind provisions

• Monitor compliance with policies, procedures, and controls

• Senior management must understand products and their consequences

• Consider purposes and types of transactions

• Establish counterparty limits reflecting credit issues and underlying economics

• Develop standard master agreements

• Provide for netting, set-off, and unwind provisions

• Monitor compliance with policies, procedures, and controls

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Preparation of Company DocumentsPreparation of Company Documents

• Lawful conduct can become suspect• Avoid poor word choices and ambiguous

expressions• Avoid careless or inappropriate language in

company communications• Avoid “guilt” words (“Please destroy after reading”)• Avoid exaggerated use of power words

(“This program will ‘destroy’ our competition”)• Use care when discussing competition and prices

• Lawful conduct can become suspect• Avoid poor word choices and ambiguous

expressions• Avoid careless or inappropriate language in

company communications• Avoid “guilt” words (“Please destroy after reading”)• Avoid exaggerated use of power words

(“This program will ‘destroy’ our competition”)• Use care when discussing competition and prices

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Beware: Communications Are Not Secret or Confidential

Beware: Communications Are Not Secret or Confidential

• Common sources of damning evidence

• Xerox copies, telephone recorders, e-mail, phone-mail, PC disks, e-calendars, and pocket diaries

• All electronic data, including system databases, system activity logs, word processing files, and transaction data

• Business expressions and marketing terms can appear suspect in a courtroom

• Common sources of damning evidence

• Xerox copies, telephone recorders, e-mail, phone-mail, PC disks, e-calendars, and pocket diaries

• All electronic data, including system databases, system activity logs, word processing files, and transaction data

• Business expressions and marketing terms can appear suspect in a courtroom

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Brief Focus on

Energy Markets

Brief Focus on

Energy Markets

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Regulatory ConsiderationsRegulatory Considerations

• Once a product or practice is identified, is it permissible?– corporate authorizations, policies, and procedures?– compliance with state laws?

• Is the product regulated by the FERC?

• Is the product regulated by the CFTC or SEC?

• Any other regulation? PUC or state insurance commissions?

• If regulated, are there limitations on trading?

• Once a product or practice is identified, is it permissible?– corporate authorizations, policies, and procedures?– compliance with state laws?

• Is the product regulated by the FERC?

• Is the product regulated by the CFTC or SEC?

• Any other regulation? PUC or state insurance commissions?

• If regulated, are there limitations on trading?

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CFTC JurisdictionCFTC Jurisdiction

• Exclusive jurisdiction over futures contracts

• Limited jurisdiction over certain forward contracts of a cash commodity for deferred shipment or delivery (fraud or manipulation)

• Limited jurisdiction over certain spot transactions (fraud or manipulation)

• Exclusive jurisdiction over futures contracts

• Limited jurisdiction over certain forward contracts of a cash commodity for deferred shipment or delivery (fraud or manipulation)

• Limited jurisdiction over certain spot transactions (fraud or manipulation)

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Price ManipulationPrice Manipulation

• Overlap between FERC and CFTC

• Potential conflicts over standards used to determine if there has been manipulation

• FERC will follow CFTC’s definition in Enron investigation

• Overlap between FERC and CFTC

• Potential conflicts over standards used to determine if there has been manipulation

• FERC will follow CFTC’s definition in Enron investigation

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The Commodity Exchange ActManipulation Violations

The Commodity Exchange ActManipulation Violations

• Wrongdoer must have the ability to influence market prices

• Wrongdoer must specifically intend to create an artificial price

• The price of the commodity must be artificial

• Wrongdoer must have caused the artificial price

• Wrongdoer must have the ability to influence market prices

• Wrongdoer must specifically intend to create an artificial price

• The price of the commodity must be artificial

• Wrongdoer must have caused the artificial price

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Competition LawDo’s and Dont’s

Competition LawDo’s and Dont’s

• Trading activities– dealing with competitors– bidding– pricing

• Involvement in associations and group organizations

• Documents

• Trading activities– dealing with competitors– bidding– pricing

• Involvement in associations and group organizations

• Documents

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Trading ActivitiesDealing With Competitors

Trading ActivitiesDealing With Competitors

• Price-fixing in forward markets and real time markets– bilateral contracts issues– day of, day ahead, hour ahead issues– real time imbalance market issues

• 1998 Midwest Price Spike – FERC found a likelihood of conspiracy to send false signals to the market

• Price-fixing in forward markets and real time markets– bilateral contracts issues– day of, day ahead, hour ahead issues– real time imbalance market issues

• 1998 Midwest Price Spike – FERC found a likelihood of conspiracy to send false signals to the market

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Do Not Discuss With CompetitorsDo Not Discuss With Competitors

• Present and future pricing decisions

• Methods of determining or settling prices

• Specific sales or marketing plans

• Evaluation of specific market conditions

• Specific counterpartys for products

• Specific cost of production and selling

• Present and future pricing decisions

• Methods of determining or settling prices

• Specific sales or marketing plans

• Evaluation of specific market conditions

• Specific counterpartys for products

• Specific cost of production and selling

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Trading ActivitiesPricing Issues

Trading ActivitiesPricing Issues

• Avoid implication that information on competitor prices or plans was obtained under a collusive arrangement or through an unsanctioned trade association information exchange program

• Avoid words that imply that a course of action is a matter of “industry agreement” or “industry policy”

• Avoid implication that information on competitor prices or plans was obtained under a collusive arrangement or through an unsanctioned trade association information exchange program

• Avoid words that imply that a course of action is a matter of “industry agreement” or “industry policy”

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Competition Law Violations Red Flags

Competition Law Violations Red Flags

• Substantial price increases

• Fluctuations in supply

• Concentrated suppliers

• Association among suppliers

• Organized efforts and frequent communications among competitors

• Substantial price increases

• Fluctuations in supply

• Concentrated suppliers

• Association among suppliers

• Organized efforts and frequent communications among competitors

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Varying Market Power StandardsVarying Market Power Standards

• “Market power– FERC “just and reasonable” standard– traditional antitrust “power to raise prices

above a competitive level”– CFTC “artificial price” standard

• Market power can occur in niche markets– ICAP

• “Market power– FERC “just and reasonable” standard– traditional antitrust “power to raise prices

above a competitive level”– CFTC “artificial price” standard

• Market power can occur in niche markets– ICAP

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Regulatory Environment in FluxRegulatory Environment in Flux

• The standard for judging trading behavior is still being developed, but it appears to be very broad

• The standard applied and the remedies imposed are likely to depend upon the magnitude of the market price at issue

• The cost/price gap is becoming a proxy for what is considered fair

• There is a high probability that trading behavior and underlying data will be subject to review

• The standard for judging trading behavior is still being developed, but it appears to be very broad

• The standard applied and the remedies imposed are likely to depend upon the magnitude of the market price at issue

• The cost/price gap is becoming a proxy for what is considered fair

• There is a high probability that trading behavior and underlying data will be subject to review