By Akber Datoo, Managing Partner, D2 Legal Technology and Michael Wood and Annie Bradwell, Senior Consultants, D2 Legal Technology

With the wave of post-crisis regulatory changes, from EMIR to MiFID II, to Margin Requirements for Uncleared Derivatives and Liquidity Reporting now in place, regulators are placing increasing scrutiny on the way institutions conduct business – and with the significant implications on regulatory capital relief and an IMM Waiver, growing attention is being placed on just how well organisations understand counterparty positions and the ability to treat exposures as net rather than gross. Is the close-out netting and the treatment of collateral against those exposures supported by robust legal opinions? Are they current and is the correct relief being taken? Annual attestations to regulators are not only more detailed, they are being ever more rigorously scrutinised and a few too many prudentially regulated firms are falling short of expectations.

With too many organisations lacking the ability to correctly link counterparty exposures to legal agreement data, and no processes in place to identify those legal opinions that need to be refreshed, the remediation demands continue to escalate. With firms stuck in a remediate, ignore, remediate again cycle, D2 Legal Technology’s Managing Partner Akber Datoo and Senior Consultants Michael Wood and Annie Bradwell ask just why financial institutions are still not treating the management and refresh of legal opinions as an essential business as usual function.

Introduction

Many of the remediation exercises that have occurred recently stem from regulators asking auditors to investigate and to report back on the processes being used by banks as part of the regulatory capital calculations, with a focus on close-out netting legal opinions. And this focus will only increase with the focus on the balance sheet and leverage and liquidity ratios, and the impact close-out netting has on them.

In addition to the immediate impact on the balance sheet, if the regulator is not happy about the way legal opinions are used by the institution for capital relief purposes, such failure will also raise concerns for the regulator that the business is simply not being run properly, prompting further, deeper investigation. Certainly, the remediation work being undertaken by a number of institutions should be raising questions as to the way the legal opinion process is managed. Indeed, under current regulation, institutions are required to review close-out netting and collateral enforceability opinions as frequently as necessary to ensure continuing enforceability.

Yet according to a survey conducted by D2 Legal Technology of sixteen leading investment banks, 42% of institutions had no policy regarding the frequency of legal opinion renewal and two thirds were unable to point to a formally approved and detailed process in relation to the management of legal opinions and associated data. Institutions are stuck in a cycle of poorly managed remediation, ignore, remediate again. It simply is not sustainable to continue with poorly defined processes that are not adequately supported by internal systems or data.

Poor process

Where is the Business as Usual (BAU) process for this critical influence on the balance sheet? Of more concern: do those involved in netting decisions fully recognise and understand the BAU significance? The fact that the decision to net on an agreement is a regulatory determinant that affects the overall balance sheet of the organisation is rarely recognised across the full end-to-end process. This is not just a matter for client on-boarding, nor a legal department, nor middle office or regulatory capital financial and accounting. It is a fundamental process impacting risk, finance and treasury functions.

Given its significance to the process, legal opinion management and renewal should, if not already in place, become a BAU function considered across the full end to end counterparty management lifecycle; and that means organisations need to start factoring in opinion refreshes as part and parcel of both BAU function and cost.

Of course, this is easier said than done. Netting and collateral opinions typically cut across the multiple front office product segments, creating difficult ownership and cost allocation discussions. Furthermore, while some organisations have just a few hundred legal opinions, others have many more, in some cases up to 2,000, creating a huge task and substantial staffing resource to keep them all refreshed.

Data consistency

However, there is also a massive gap between those organisations with good legal agreement, opinion and trade linkage data visibility and those without. Institutions with poor or inadequate data in this area have to undertake a huge manual task to identify what netting flags have been set against what opinion – and what therefore needs updating. In contrast, institutions with good systems in place and good legal opinion data capture, know what they are netting on and can immediately pick up any flags, identify the affected opinions and make the necessary changes. Despite the BCBS 239 regulation mandating data accuracy and lineage for such key netting data, it simply doesn’t exist at many firms.

This is nothing but sensible – an institution should be able to look at all agreements, see what opinions are in force, in what jurisdiction and for which counterparty types and products. If there have been any changes, for example to the automatic early termination provisions in an opinion or recovery and resolution regulatory change within that region, by simply polling all agreements it is easy to identify those that need remediation. But for institutions that have not done the systematic data capture transformation, it is an enormously difficult job – and one that far too often is still at the bottom of the pile.

While clearly institutions need to prioritise this activity, and ideally make it a BAU process, respondents in the D2LT survey raised concerns about a lack of industry standards that can be supported by detailed policies, procedures and systems for legal opinion management, especially regarding the determination of counterparty types and products, and problems with a lack of jurisdiction-based taxonomies. This is a fundamental need prior to any automation and move to a sustainable industry approach, perhaps underpinned by the ISDA Common Domain Model initiative.

There are signs of a move towards standardising counterparty types across jurisdictions, which will help in the initial data capture aspect of legal opinions. Certainly, agreements are well mapped, and content is more readily available now in systems than it was ten years ago. Questions such as: ‘What branches are on the agreement?’ ‘Is automatic early termination applicable?’ ‘What counterparty type am I dealing with?’ can all be quickly answered – the key now is to integrate the relevant systems and data flows to the legal opinion and to productionise the entire process – through technology and automation.

Understanding liability

Of course, this cannot be done overnight. Institutions need to have tough conversations regarding costing and priorities. But with regulators providing very clear demands regarding the basis of opinion review, simply ensuring industry opinion records are updated in a more process friendly manner would cover a huge portion of the balance sheet.

But the most fundamental step is to acknowledge there is a requirement to improve the current state of affairs and recognise accountability in the end to end process. In today’s regulatory environment someone within an institution is accountable for the close-out netting and collateral decisions. If a lawyer signs off on the legal opinions that are being relied upon for the IMM waiver, that is a personal liability. If that individual does not understand whether the data representation of the legal opinions is correct, whether all opinions are still current, or that there may be opinions with conditions attached that have changed, how can that individual stand by that decision?

Repeated remediation is not a sustainable strategy. From both a corporate and personal standpoint, it is becoming imperative to satisfy the regulator that netting and collateral opinions are in order and that the proper processes for refresh are in place. Managing and refreshing legal opinions has to become BAU.