Legal and Regulatory Framework in the Global Derivatives Market Derivatives and Risk Management in Mexico, May 7, 2001 Diane Genova, Managing Director, JPMorgan

01453sc_97 1 A robust legal framework is essential for the development of an OTC derivatives market  Parties need assurance that transaction is enforceable as written –involves long-term payment obligations –contract may be relied on as a hedge  Parties need to be comfortable that they are in compliance with applicable regulatory guidance

01453sc_97 2 Legal Framework must deal with a number of legal and regulatory issues  Contract Enforceability  Sales Liability  Standard Documentation  Netting and Collateral  Illegality, Force Majeure, Impossibility  Regulatory Considerations

01453sc_97 3 Contract Enforceability  OTC Derivatives are bilateral contracts –they are not securities or futures –governed by general principles of contract law –general contract law must recognize that derivatives are like any other contract –Recent amendments to US commodities laws clarify that swaps are legally enforceable contracts and not off-exchange futures  Counterparty must have capacity and authority to enter into transactions –Some counterparties may need specific statutory or regulatory authority to enter into derivatives –Evidence of authority of counterparty’s representative is important, but possible to rely on doctrine of apparent authority

01453sc_97 4 Contract Enforceability (cont’d.) –Hazell vs. Hammersmith: local authorities in the UK were found to have exceeded their authority by entering into swaps –Lehman vs. Minmetals (Chinese corporations): court found Lehman could not rely on trader’s apparent authority if Lehman knew or suspected that agreements were illegal under Chinese law  Contract Formation –transactions usually executed by telephone –subsequently confirmed in writing –Statute of Frauds issues: in some jurisdictions, certain types of contracts must be in writing –New York State solution: explicitly recognizes transactions executed by telephone –Australian case (Powercor Australia): transactions were binding notwithstanding the absence of signed confirmations

01453sc_97 5 Sales Liability  Appropriateness –regulators may require dealers to ensure that its customers have the capability of understanding the terms and risks of transactions and that sufficient information given to customers to understand risks  Existence of Duties –as a general rule, in order for fiduciary relationship to exist, one party must explicitly agree to undertake a duty of care –parties need to be clear as to the nature of their relationship: is it a fiduciary relationship or an arms length principal-to- principal relationship –Duty of good faith and fair dealing: each party to a contract must refrain from making misrepresentations to the the other –Superior Knowledge: duty to disclose may arise where party has superior knowledge of information, the information is not readily available to the other party and the first party knows that the other party is acting on basis of mistaken knowledge

01453sc_97 6 Standard Documentation  Standard Master Agreements are essential for contracts created in a trading environment –Industry standardization allows parties to focus on the important economic and credit terms rather than on legal boilerplate –Master Agreements create consistent contractual rights applicable across the whole book of derivatives business with a counterparty –Permits a party to terminate and close-out exposures in a declining credit situation –Allows all transactions to be netted for credit, financial reporting and collateral calculation purposes

01453sc_97 7 Standard Documentation (cont’d)  ISDA Master is the standard master agreement accepted globally  Utilizes a flexible architecture: a modular approach –Master Agreement printed form with representation, events of default/termination events, early termination mechanics –Schedule with specific terms tailored to the counterparty –Definitions booklets incorporating standard definitions and market conventions tailored to particular products –Credit Support Documents –Confirmations

01453sc_97 Modular approach in action Master Agreement and Schedule Interest Rate Swap Confirmation Currency Option Confirmation FX Forward Confirmation Commodity Swap Confirmation Equity Option Confirmation Equity Definitions Commodity Definitions FX Definitions 2000 ISDA Definitions Yield: Net credit exposure on transaction

01453sc_97 Netting  Types of Netting –Payment netting –Close-out netting

01453sc_97 Payment netting Single transaction payment netting DealerCounterparty $2mm $3mm Counterparty pays net $1mm

01453sc_97 Close out netting DealerCounterparty ITM $5mm Netting on termination DealerCounterparty ITM $3mm On termination, net claim is $2mm owed to Dealer

01453sc_97 12 Netting (cont’d)  Benefit of close out netting –Exposure reduction--enables parties to do more business with each other –Balance sheet impact –Regulatory capital benefits  Enforceability of close out netting – Recognition of close-out netting is key to legal derivatives infrastructure – Netting legislation adopted in 22 countries

01453sc_97 Collateral --Two approaches  Security Interest Approach –Requires pledge and perfection –Ownership of asset remains with Counterparty –Relies on enforcement of security interest theory –Use of collateral by secured party is an issue –Most common structure in OTC derivatives markets  Title Transfer Approach –Outright transfer of assets –Relies on set-off theory –Most common structure in repo markets

01453sc_97 Legal issues of security interest approach  Issues revolve around “creation” and “perfection” of security interests  Procedural requirements –Filing or notice requirements –Possession requirements –Choice of law/multi-jurisdiction issues –Continuation requirements  Substitution of collateral  “After acquired property”  “In flight” securities  Rehypothecation or “use and abuse”

01453sc_97 Legal issues of title transfer  Recharacterization risk  “Fallback” grant of security interest –Used in repo documentation –Not used in UK Credit Support Annex

01453sc_97 Enforcement of remedies  Bankruptcy/insolvency impediments to enforceability –Stays –Preferences –Superpriorities or “priming”  Procedural requirements –Grace periods and notice requirements –Prior notice of liquidation –Liquidation mechanics - can the secured party buy the collateral? –Requirement of “commercial reasonableness”  Significant variables –Type of debtor –Type of transaction –Type of insolvency proceeding

01453sc_97  Operational Risks –May not call for collateral –Risks in substitution –may mis-mark collateral, swaps, etc.  Legal Risks –Preferences –Stays –Priorities over secured creditors Collateral reduces credit risk but creates legal and operational risk

01453sc_97 18 Illegality, Force Majeure, Impossibility  Off-exchange futures prohibited in some jurisdictions –Law in US recently amended to clarify that OTC swaps are not illegal off exchange futures  Gaming/gambling laws--should provide exception for bona fide commercial transactions  Registration requirements for certain currency transactions--failure to register may result in lack of enforceability of transaction

01453sc_97 19 Illegality, Force Majeure, Impossibility (cont’d)  Force majeure and impossibility –range of actions may affect parties ability to perform, e.g. civil unrest (Indonesia), imposition of exchange controls (Malaysia) –need to have a roadmap as to what happens to the contracts –ISDA force majeure/impossibility provisions

01453sc_97 20 Regulatory Considerations  Safety and soundness of regulated entities –Banco de Mexico 31 points –Federal Reserve derivatives guidelines