Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law Volume 5 Volume 5: Financial Products and Services 9781509949595, 9781509949625, 9781509949618

Volume 5 of this new edition uses the insights developed in Volumes 3 and 4 to deal with financial products and financia

242 94 6MB

English Pages [531] Year 2022

Table of contents :
Preface
Contents
Table of Cases
Table of Legislation and Related Documents
Part I. Secured Transactions, Finance Sales and Other Financial Products and Services
1.1. Civil and Common Law Approaches to Financial Law. Credit Cultures and Transnationalisation
1.2. The Situation in the Netherlands
1.3. The Situation in France
1.4. The Situation in Germany
1.5. The Situation in the UK
1.6. The Situation in the US
Part II. Financial Products and Funding Techniques. Private, Regulatory and International Aspects
2.1. Finance Sales as Distinguished from Secured Transactions: The Recharacterisation Issue and Risk
2.2. Modern Security Interests: The Example of the Floating Charge
2.3. Receivable Financing and Factoring. The 1988 UNIDROIT Factoring Convention and the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade
2.4. Modern Finance Sales: The Example of the Finance Lease. The 1988 UNIDROIT Leasing Convention
2.5. Asset Securitisation and Credit Derivatives. Covered Bonds
2.6. Options, Futures and Swaps. Their Use and Transfers. The Operation of Derivatives Markets, Clearing and Settlement and the Function of Central Counterparties
2.7. Institutional Investment Management, Funds, Fund Management and Prime Brokerage
Part III. Payments, Modern Payment Methods and Systems. Set-off and Netting as Ways of Payment. International Payments. Money Laundering
3.1. Payments, Payment Systems. Money and Bank Accounts
3.2. The Principles and Importance of Set-off and Netting
3.3. Traditional Forms of International Payment
3.4. Money Laundering
Part IV. Security Entitlements and their Transfers Through Securities Accounts. Securities Pledges and Repos
4.1. Investment Securities Entitlements and their Transfers. Securities Shorting, Borrowing and Repledging. Clearing and Settlement of Investment Securities
4.2. Investment Securities Repos
Index

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DALHUISEN ON TRANSNATIONAL AND COMPARATIVE COMMERCIAL, FINANCIAL AND TRADE LAW VOLUME 5 Volume 5 of this new edition uses the insights developed in Volumes 3 and 4 to deal with financial products and financial services, the structure and operation of banking and of the capital markets, and the role of modern commercial and investment banks and their risk management. Sections on products and services address the blockchain and its potential in the payment system, in securitisations, in the custodial holdings of investment securities, and in the derivative markets. The complete set in this magisterial work is made up of 6 volumes. Used independently, each volume allows the reader to delve into a particular topic. Alternatively, all volumes can be read together for a comprehensive overview of transnational comparative commercial, financial and trade law.

ii

Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law Volume 5 Financial Products and Services Eighth Edition

Jan H Dalhuisen Emeritus Professor of Law King’s College London Chair in Transnational Financial Law Catholic University Lisbon Visiting Professor UC Berkeley Corresponding Member Royal Netherlands Academy of Arts and Sciences Member New York Bar Former ICSID Arbitrator and FCIArb With the cooperation of Dr Christian Chamorro Courtland Lecturer University of Sydney

HART PUBLISHING Bloomsbury Publishing Plc Kemp House, Chawley Park, Cumnor Hill, Oxford, OX2 9PH, UK 1385 Broadway, New York, NY 10018, USA 29 Earlsfort Terrace, Dublin 2, Ireland HART PUBLISHING, the Hart/Stag logo, BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc First published in Great Britain 2022 Copyright © Jan H Dalhuisen, 2022 Jan H Dalhuisen has asserted his right under the Copyright, Designs and Patents Act 1988 to be identified as Author of this work. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. While every care has been taken to ensure the accuracy of this work, no responsibility for loss or damage occasioned to any person acting or refraining from action as a result of any statement in it can be accepted by the authors, editors or publishers. All UK Government legislation and other public sector information used in the work is Crown Copyright ©. All House of Lords and House of Commons information used in the work is Parliamentary Copyright ©. This information is reused under the terms of the Open Government Licence v3.0 (http://www. nationalarchives.gov.uk/doc/open-government-licence/version/3) except where otherwise stated. All Eur-lex material used in the work is © European Union, http://eur-lex.europa.eu/, 1998–2022. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. Library of Congress Control Number: 2021057053 ISBN: HB: 978-1-50994-959-5 ePDF: 978-1-50994-961-8 ePub: 978-1-50994-960-1 Typeset by Compuscript Ltd, Shannon To find out more about our authors and books visit www.hartpublishing.co.uk. Here you will find extracts, author information, details of forthcoming events and the option to sign up for our newsletters.

To my Teachers and my Students

vi

PREFACE This is the fifth Volume in this series dealing with modern financial products and facilities and their legal underpinning in national and transnational law especially from the contractual and proprietary points of view. The regulatory aspects will be dealt with in the next Volume. I have been extremely fortunate to be able to cooperate with my former student Dr Christian Chamorro Courtland, now at the University of Sydney, working through and expanding the text, especially in the area of fintech. His contribution is acknowledged on the title page. It is clear that many other parts of the text would benefit from updating and interested younger scholars or practitioners are invited to cooperate in similar ways for the next edition by writing to me. Berkeley, February 2022 Jan H Dalhuisen [email protected]

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CONTENTS Prefacevii Table of Cases xvii Table of Legislation and Related Documents xxv Part I Secured Transactions, Finance Sales and Other Financial Products and Services 1.1. Civil and Common Law Approaches to Financial Law. Credit Cultures and Transnationalisation 1.1.1. Introduction 1.1.2. Legal Transnationalisation and its Most Important Features 1.1.3. Financial Products in Commercial Banking and Capital Markets 1.1.4. Different Credit Cultures. Domestic Law Thinking. The Issues of Legal Transnationalisation and of Transactional and Payment Finality Cross-border Revisited 1.1.5. Local Differences and Similarities in the Legal Organisation of Asset-backed Financing 1.1.6. International Convergence in Secured Transactions and Finance Sales? 1.1.7. The Problems of and Need for Modern Non-possessory Security Interests in Personal Property and the Alternative Use of Finance Sales 1.1.8. Finance Sales and Secured Transactions Distinguished and the Re-characterisation Issue. Different Risk and Reward Structures 1.1.9. Formal International Harmonisation Attempts in the Area of Secured Transactions and Finance Sales. The EU Collateral and Settlement Finality Directives 1.1.10. Notions of Separation, Segregation and Priority. Proprietary and Other Structures to the Effect. Set-off and Contractual Netting Clauses. The Concept of Subordination. Bankruptcy Consequences 1.1.11. Party Autonomy and the Contractualisation or Unbundling of Proprietary Rights for Funding Purposes. The Better Protection of Bona Fide Purchasers and the Lesser Protection of Bona Fide Creditors and the Issue and Requirements of Financial Stability 1.1.12. Autonomous Transnational and Domestic Legal Developments 1.1.13. Uncertainty in International Financial Dealings. The Idea and Technique of Transnationalisation in Asset-backed Funding 1.1.14. The Impact of the Applicable Domestic Bankruptcy Regimes in International Financial Transactions. The US Approach and the EU Bankruptcy Regulation

1 1 7 10 16 23 28 30 36 41 44

50 54 58 61

x Contents

1.2.

1.3.

1.4.

1.5.

1.6.

1.1.15. Fintech and its Challenges and Possibilities. The Legal Consequences. A New World of Finance? 65 The Situation in the Netherlands 65 1.2.1. Introduction: The New Civil Code of 1992 65 1.2.2. Security Substitutes and Floating Charges. The Reservation of Title 69 1.2.3. Conditional and Temporary Ownership: The Lex Commissoria72 1.2.4. Open or Closed System of Proprietary Rights 77 The Situation in France 79 1.3.1. Introduction: The Vente à Reméré and Lex Commissoria. Non-possessory Security Interests and the Modern Floating Charge 79 1.3.2. The Impact of the Notion of the Solvabilité Apparente81 1.3.3. The Reservation of Title 82 1.3.4. The Modern Repurchase Agreement or Pension Livrée84 1.3.5. Finance Sales, Fiduciary Transfers, and the Implementation of the EU Collateral Directive 86 1.3.6. Assignments of Monetary Claims in Finance Schemes, Loi Dailly, Securitisation or Titrisation (Fonds Communs de Créances)88 1.3.7. The Introduction of the Trust or Fiducie in France 89 1.3.8. Open or Closed System of Proprietary Rights 92 The Situation in Germany 92 1.4.1. Introduction: The Development of the Reservation of Title and Conditional Transfers; Floating Charges 92 1.4.2. Sicherungsübereignung and the Conditional Sale 97 1.4.3. Finance Sales 100 1.4.4. Curbing Excess: Open or Closed System of Proprietary Rights. Gute Sitten and Newer Charges 102 The Situation in the UK 104 1.5.1. Introduction: Differences from Civil Law 104 1.5.2. Basic Features of Conditional or Split-ownership Interests. Equitable and Floating Charges. An Open System of Proprietary Rights in Equity? 106 1.5.3. The Distinction between Conditional Sales and Secured Transactions in English Law. Publication Requirements and their Meaning 112 1.5.4. Reservation of Title 116 1.5.5. Finance Sales 117 The Situation in the US 119 1.6.1. Introduction: Article 9 UCC and its Unitary Functional Approach 119 1.6.2. The Unitary Functional Approach and Finance Sales: Problem Areas in Article 9 UCC 123 1.6.3. Proprietary Characterisations 128 Part II Financial Products and Funding Techniques. Private, Regulatory and International Aspects

2.1. Finance Sales as Distinguished from Secured Transactions: The Recharacterisation Issue and Risk 2.1.1. Introduction

131 131

Contents xi 2.1.2. The Practical Differences between Security and Ownership-based Funding. The Recharacterisation Issue Revisited 135 2.1.3. Legal Differences between Security- and Ownership-based Funding. The Operation of Split-ownership Rights in England and the US 137 2.1.4. Practical Issues and Relevance 145 2.1.5. Nature, Use and Transfers of Conditional and Temporary Ownership Rights. The Difference between Them 148 2.1.6. The Duality of Ownership in Finance Sales and the Unsettling Impact of the Fungibility of the Underlying Assets 154 2.1.7. Finance Sales and Sharia Financing 157 2.1.8. International Aspects: Private International Law Approaches to the Law Applicable to Proprietary Rights. Bankruptcy Effects 160 2.1.9. International Aspects: Uniform Laws and Model Laws on Secured Transactions. The EBRD Effort 164 2.1.10. International Aspects: The 2001 UNIDROIT Convention on International Interests in Mobile Equipment (Cape Town Convention) 168 2.1.11. Domestic and International Regulatory Aspects 170 2.1.12. Concluding Remarks. Transnationalisation and the Issue of Party Autonomy in Proprietary Matters. The EU Collateral Directive 171 2.2. Modern Security Interests: The Example of the Floating Charge 174 2.2.1. Types of Floating Charges or Liens. Problem Areas 174 2.2.2. Different Approaches. Comparative Legal Analysis 177 2.2.3. Modern Publication or Filing Requirements. Their Meaning and Defects. Ranking Issues in Respect of Floating Charges 181 2.2.4. Special Problems of Assignments in Bulk 184 2.2.5. International Aspects of Floating Charges. Limited Unification Attempts187 2.2.6. Domestic and International Regulatory Aspects 188 2.2.7. Concluding Remarks. Transnationalisation 189 2.3. Receivable Financing and Factoring. The 1988 UNIDROIT Factoring Convention and the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade 190 2.3.1. Assignment of Monetary Claims in Receivable Financing and Factoring. The Issue of Liquidity 190 2.3.2. Receivable Financing and Factoring: Origin and Different Approaches. The Recharacterisation Issue in the US 194 2.3.3. Factoring: The Contractual Aspects 198 2.3.4. Factoring: The Proprietary Aspects 199 2.3.5. International Aspects. The UNCITRAL and UNIDROIT Conventions. Internationality and Applicability 202 2.3.6. The UNIDROIT and UNCITRAL Conventions. Their Content, Field of Application, Interpretation and Supplementation. Their Role in the Lex Mercatoria206 2.3.7. Details of the UNIDROIT Factoring Convention 208 2.3.8. Details of the UNCITRAL Convention. Its Operational Insufficiency 210 2.3.9. Domestic and International Regulatory Aspects 212 2.3.10. Concluding Remarks. Transnationalisation 212

xii Contents 2.4. Modern Finance Sales: The Example of the Finance Lease. The 1988 UNIDROIT Leasing Convention 2.4.1. Rationale of Finance Leasing 2.4.2. Legal Characterisation 2.4.3. Comparative Legal Analysis 2.4.4. International Aspects of Finance Leasing 2.4.5. Uniform Substantive Law: The UNIDROIT (Ottawa) Leasing Convention of 1988. Its Interpretation and Supplementation 2.4.6. The Leasing Convention’s Sphere of Application, its Definition of Finance Leasing 2.4.7. The Proprietary Aspects of Finance Leasing under the Convention 2.4.8. The Enforcement Aspects in Finance Leasing under the Convention 2.4.9. The Contractual Aspects of Finance Leasing under the Convention 2.4.10. The Collateral Rights in Finance Leasing under the Convention 2.4.11. Domestic and International Regulatory Aspects 2.4.12. Concluding Remarks. Transnationalisation 2.5. Asset Securitisation and Credit Derivatives. Covered Bonds 2.5.1. Asset Securitisation and Financial Engineering. The Problem with Assignments 2.5.2. SPVs and Credit Enhancement 2.5.3. The Layering of Risk 2.5.4. Synthetic Securitisations. Credit Derivatives or Credit Default Swaps. The Total Return Swap, Credit Spread Options and Credit Linked Notes 2.5.5. Excess of Financial Engineering? The 2007–09 Banking Crisis 2.5.6. Abuse of Financial Engineering? The Enron Debacle 2.5.7. Covered Bonds 2.5.8. The Recharacterisation Risk in Securitisations 2.5.9. The Characterisation Issue and Insurance Analogy in CDS 2.5.10. International Aspects 2.5.11. Domestic and International Regulatory Aspects 2.5.12. Concluding Remarks. Transnationalisation 2.5.13. Impact of Fintech on Securitisation 2.6. Options, Futures and Swaps. Their Use and Transfers. The Operation of Derivatives Markets, Clearing and Settlement and the Function of Central Counterparties 2.6.1. Types of Financial Derivatives and Their Operation 2.6.2. The Use of Derivatives. Hedging. Derivatives and Share Ownership 2.6.3. The Valuation of Derivatives 2.6.4. Derivatives Markets and Their Operations. Clearing and Settlement, CCPs, Clearing Members and the Notion of Margin 2.6.5. The Concept of Central Clearing and the Issue of Standardisation in the Swap Markets 2.6.6. The Concept of the CCP and its Potential 2.6.7. Derivatives Risk and Netting for Swaps 2.6.8. Legal Aspects of Swaps. Integration and Conditionality, Acceleration and Close-out in the OTC Markets. The ISDA Swap Master Agreement 2.6.9. International Aspects

214 214 216 219 221 223 225 227 228 229 230 232 232 234 234 237 240 242 247 251 253 254 256 257 258 261 263 265 265 268 272 274 281 285 288 290 293

Contents xiii 2.6.10. Domestic and International Regulatory Aspects 2.6.11. Concluding Remarks. Transnationalisation 2.6.12. Impact of Fintech. Smart Contracts and the Potential Operation of a Permissioned Distributed Ledger Network 2.7. Institutional Investment Management, Funds, Fund Management and Prime Brokerage 2.7.1. Investment Management 2.7.2. Investment Funds or Collective Investment Schemes. Exchange Traded Funds (ETFs) 2.7.3. Hedge Funds and Their Operation 2.7.4. Hedge Funds and Their Regulation 2.7.5. Prime Brokerage 2.7.6. Private Equity 2.7.7. Domestic and International Regulatory Aspects, UCITS 2.7.8. Concluding Remarks. Transnationalisation

293 294 297 300 300 302 305 306 311 312 313 314

Part III Payments, Modern Payment Methods and Systems. Set-off and Netting as Ways of Payment. International Payments. Money Laundering 3.1. Payments, Payment Systems. Money and Bank Accounts 3.1.1. The Notion and Modes of Payment 3.1.2. The Notion of Money as Unit of Account or Unit of Payment. Money as Store of Value 3.1.3. Legal Aspects of Payment. Completeness and the Need for Finality 3.1.4. Bank Transfers and Payment Systems. Pull and Push Systems, Credit and Debit Transfers 3.1.5. The Legal Nature and Characterisation of Modern Bank Transfers. Their Sui Generis Character 3.1.6. Clearing and Settlement of Payments in the Banking System 3.1.7. International Aspects of Payment 3.1.8. Regulatory Aspects of Domestic and International Payments 3.1.9. Concluding Remarks and Transnationalisation 3.1.10. The Impact of Fintech. Permissionless and Permissioned Blockchain Payment Systems with or without the Use of Cryptocurrencies. Promises and Perils 3.1.11. Central Bank Digital Currencies (CBDC) 3.2. The Principles and Importance of Set-off and Netting 3.2.1. Set-off as a Form of Payment and Risk Management Tool 3.2.2. The Evolution and Use of the Set-off Principle 3.2.3. The Expansion of Set-off Through Contractual Netting Clauses. Different Types of Netting. Special Importance in Clearing and Settlement and in Bankruptcy 3.2.4. Use of Contractual Netting Clauses in Swaps and Repos: Contractual Netting and Bankruptcy. The EU Settlement Finality Directive 3.2.5. The ISDA Swap and Derivatives Master Agreement and the Repo Master. The Notions of Conditionality and ‘Flawed Assets’ as an Alternative to the Set-off. The EU Collateral Directive 3.2.6. International Aspects: The Law Applicable to Set-offs and Contractual Netting under Traditional Private International Law. Jurisdiction Issues

315 315 318 319 323 325 329 332 333 333 334 339 343 343 348 353 357 361 364

xiv Contents 3.2.7. International Aspects: The Law Applicable to Netting under Transnational Law 368 3.2.8. Domestic and International Regulatory Aspects of Netting 371 3.2.9. Newer International Attitudes and Approaches to Set-off and Netting Especially in Insolvency 371 3.2.10. Concluding Remarks 373 3.3. Traditional Forms of International Payment 374 3.3.1. Cross-border Payments and their Risks 374 3.3.2. Paper Currencies, Modern Currency Election and Gold Clauses 376 3.3.3. Freely Convertible and Transferable Currency 378 3.3.4. The Effects of a Currency Collapse. Redenomination of Payment Obligations380 3.3.5. Payment in Open Account. Re-establishing Simultaneity Through the Use of Intermediaries 384 3.3.6. Various Ways to Reduce Payment Risk in International Transactions 385 3.3.7. Ways to Reduce Payment Risk Internationally: The Accepted Bill of Exchange 386 3.3.8. Ways to Reduce Payment Risk Internationally: Collection 387 3.3.9. Ways to Reduce Payment Risk Internationally: Letters of Credit. The Different Banks Involved 388 3.3.10. The Types of Letters of Credit 392 3.3.11. The Documents Required under a Documentary Letter of Credit 393 3.3.12. The Right of Reimbursement of the Issuing Bank under a Letter of Credit 394 3.3.13. The Letter of Credit as Independent and Primary Obligation: The Legal Nature of Letters of Credit and the Issue of Strict Compliance. The ‘Pay First, Argue Later’ Notion 395 3.3.14. Non-performance under Letters of Credit: The Exception of ‘Fraud’ 398 3.3.15. Transferable Letters of Credit and Back-to-Back Letters of Credit 400 3.3.16. Ways to Reduce Payment Risk Internationally: Autonomous Guarantees. Standby Letters of Credit 400 3.3.17. Transnationalisation: The Law and/or Rules Applicable to Bills of Exchange, Collections, Letters of Credit and Bank Guarantees. The ICC Rules and their Status. The Modern Lex Mercatoria402 3.3.18. Transnationalisation: The UNCITRAL Convention on International Guarantees and the World Bank Standard Conditions 404 3.3.19. Distributed Ledger Technology and Letters of Credit 404 3.4. Money Laundering 405 3.4.1. Techniques and Remedies 405 3.4.2. Why Action? Remedies and the Objectives of Combating Money Laundering408 3.4.3. International Action. The G-10, the Council of Europe and the United Nations 409 3.4.4. The EU 411

Contents xv Part IV Security Entitlements and their Transfers Through Securities Accounts. Securities Pledges and Repos 4.1. Investment Securities Entitlements and their Transfers. Securities Shorting, Borrowing and Repledging. Clearing and Settlement of Investment Securities 415 4.1.1. Modern Investment Securities. Dematerialisation and Immobilisation. Book-entry Systems and the Legal Nature of Securities Entitlements 415 4.1.2. Securities Transfers: Tiered or Chained Transfer Systems. The Legal Characterisation of the Securities Transfer and its Finality 419 4.1.3. Securities Shorting, Securities Lending, Pledging and Repledging of Securities. The Notion of Rehypothecation 424 4.1.4. Modern Clearing and Settlement. Central Counterparties and their Significance430 4.1.5. International Aspects. EU Settlement Finality and Collateral Directives. The Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary. The Geneva Convention on Intermediated Securities. Transnationalisation and the Modern Lex Mercatoria433 4.1.6. Regulatory Aspects 438 4.1.7. Concluding Remarks. Transnationalisation 439 4.1.8. Impact of Fintech. Permissionless Frameworks and Permissioned Blockchain Off-ledger Securities Trading 440 4.2. Investment Securities Repos 444 4.2.1. The Repurchase Agreement as a Prime Alternative to Secured Lending. Its Legal Characterisation, the Effect of Fungibility, and of the Right to On-sell the Securities 444 4.2.2. The Development of the Repo in Fungible Investment Securities. Securities Lending and the Buy/Sell Back Transaction 449 4.2.3. Margining 451 4.2.4. The Netting Approach in Repos. Close-out 452 4.2.5. The ICMA/SIFMA Global Master Repurchase Agreement (GMRA) 453 4.2.6. International Aspects 454 4.2.7. Domestic and International Regulatory Aspects 455 4.2.8. Concluding Remarks. Transnationalisation 456 Index459

xvi

TABLE OF CASES Arbitration Cases Kozara, The [1974] Journal of Business Law�� 332 Kraut v Albany Fabrics Ltd [1976] Journal of Business Law�� 332 Australia Charles v Federal Commission of Taxation [1954] 90 CLR 598�� 303 IATA v Ansett [2005] VSC 113, [2006] VSCA 242, and [2008] HCA 38��356, 374 Belgium Cour de Cass 9 February 1933 [1933] I Pas, 103�� 81 27 November 1981 [1981–82] RW 2141�� 86 22 September 1994 [1994–95] RW 1264�� 81 17 October 1996 [1995–96] RW 1395�� 86 3 December 2010, Bank Fin 2011, no 2, 120–27�� 87 Tribunal de Commerce of Brussels, 16 Nov 1978�� 21 European Union Case C-341/93 Danvaern Production A/S v Schuhfabriken Otterbeck GmbH&Co [1995] ECR I-2053�� 365 Case C-111/01 Gantner Electronic GmbH v Basch Exploitatie Maatschappij BV [2003] ECR I-4207�� 365 France Cour de Cass 13 February 1834, s 1.205 (1834)�� 92 24 June 1845, D 1.309 (1845)�� 81 19 August 1849, D 1.273 (1849)�� 87 31 January 1854, D 2.179 (1855)�� 81 11 March 1879, D 1.401 (1879)��82, 137

xviii Table of Cases 21 July 1897, DP.1.269 (1898)��83–84 16 January 1923, D 1.177 (1923)�� 87 24 May 1933 [1934] Revue critique de droit international privé 142�� 87 28 March/2 October 1934, D 1.151 (1934)�� 83 21 March 1938, D 2.57 (1938)��82, 137 24 October 1950 [1950] Bull civil 1, 155�� 82 21 July 1958 [1958] II JCP 10843�� 84 21 November 1972, D jur 213 (1974)�� 184 14 October 1975, Bull Civ IV, 232 (1975)�� 184 20 November 1979 (1980)�� 84 14 October 1981�� 21 8 March 1988, Bull IV, no 99 (1988) 20 June 1989, D Jur 431 (1989)�� 84 15 March 1988, Bull Civ IV, 106 (1988)�� 83 9 January 1990, (1990) Gaz Pal 127��86, 220 16 March 1990, Bull civ. IV, no 73�� 84 15 Jan 1991 Bull. civ. IV no 31�� 84 5 Nov 1991, Bull Civ, IV, no 328 (1992)�� 21 15 December 1992, Bull IV no 412 (1992)�� 84 5 April 1994, Bull. Civ IV, no 142�� 350 9 May 1995, Bull Civ IV, no 130�� 350 5 March 1996, Bull IV, no 72 (1996)�� 83 5 March 2002, Bull.civ.IV, no 48 and Nov. 13. 2002, no 00-10284�� 84 Court of Appeal, Versailles, 20 September 1995�� 79 Tribunal de la Seine 30 May 1958, R 731 (1958)�� 332 18 December 1967, G.1-2.108 (1968)�� 332 Germany BGH 25 October 1952, BGHZ 7, 365 (1952)�� 103 28 June 1954, BGHZ 14, 117 (1954)�� 94 22 February 1956, BGHZ 20, 88 (1956)�� 95 30 April 1959, BGHZ 30, 149 (1959)�� 103 38 BGHZ 254 (1962)�� 367 14 October 1963, BGHZ 40, 156 (1963)�� 104 1 July 1970, 54 BGHZ 214�� 94 5 May 1971, BGHZ 56, 123 (1971)�� 94 9 July 1975, BGHZ 64, 395 (1975)�� 104 BGHZ 71, 189�� 219 BGHZ 95, 39�� 219 24 November 1954, [1955] NJW 339�� 352 23 September 1981 [1981] NJW 275�� 99 11 July 1985 [1985] NJW 2897�� 367 OLG Cologne, 2 February 1971, 47 NJW 2128 (1971)�� 332

Table of Cases xix RG

2 June 1890; RGZ 2, 173 (1890)�� 97 23 December 1899, RGZ 45, 80 (1899)�� 98 10 October 1917, RGZ 91, 12 (1917)�� 98 5 November 1918, RGZ 94, 305 (1918)�� 98 20 March 1919, RGZ 79, 121 (1912)�� 98 4 April 1919, RGZ 95, 244 (1919)�� 95 11 June 1920, RGZ 99, 208 (1920)�� 103 14 October 1927, RGZ 118, 209 (1927)�� 98 9 April 1929, RGZ 124, 73 (1929)�� 98 9 April 1932, RGZ 136, 247 (1932)�� 103 4 April 1933, RGZ 140, 223 (1933)�� 95

Netherlands Amsterdam Court of Appeal 9 July 1991 [1994] NJ 79, [1992] NIPR 418�� 77 16 April 1931, W 12326 (1931)�� 69 Crt Alkmaar, 7 November 1985, NIPR, no 213 (1986)�� 366 HR 25 January 1929 [1929] NJ 616�� 69 21 June 1929 [1929] NJ 1096�� 69 3 Jan 1941 (1941) NJ 470, Heartwoods Bank v Los�� 69 13 March 1959 [1959] NJ 579�� 69 17 June 1960 [1962] NJ 60�� 69 17 Apr 1964 [1965] NJ 23��22, 202 6 March 1970 [1971] NJ 433��66, 69 8 December 1972, NJ 377 (1973), 22 Ars Aequi 509 (1973)�� 332 7 March 1975 [1976] NJ 91�� 69 3 October 1980 [1981] NJ 60��69, 99 22 May 1984 (1985) NJ 607�� 21 18 September 1987 [1099] NJ 876�� 69 19 May 1989 [1990] NJ 745�� 370 11 June 1993 [1993] NJ 776��22, 202 5 November 1993 [1994] NJ 258�� 69 18 January 1994 [1994] RvdW 61�� 71 17 February 1996, Mulder v CLBN [1996] NJ 471�� 68 16 May 1997 [1997] RvdW 126��22, 202 5 September 1997 [1998] NJ 437�� 70 16 June 2000, NJ 733 (2000)�� 70 NJ 196 (2004)�� 79 17 February 2012, Dix v ING [2012] NJ 261�� 68 1 Feb 2013 NJ 156�� 68 11 June 2014, NJ 407 (2014�� 74 14 Aug 2015, NJ 253 (2016)�� 70

xx Table of Cases United Kingdom Aectra Refining and Manufacturing Inc v Exmar NV [1994] 1 WLR 1634�� 365 Alderson v White (1858) 2 De G &J 97�� 115 Aluminium Industrie Vaassen BV v Romalpa Aluminium Ltd [1976] 2 All ER 552�� 116 Aneco Reinsurance Underwriting Ltd v Johnson & Higgins Ltd [2002] 1 Lloyd’s Rep 157�� 301 Armour and Others v Thyssen Edelstahlwerke AG mour and Others v Thyssen Edelstahlwerke AG;> [1990] All ER 481�� 106 Automobile Association (Canterbury) Inc v Australasian Secured Deposits Ltd [1973] 1 NZLR 417�� 115 Bank of Baroda v Vysya Bank Ltd [1994] 2 Lloyd’s Rep 87�� 392 Barclays Bank v Levin Brothers 1976] 3 All ER 900�� 332 Bechuanaland Exploration Co v London Trading Bank [1898] 2 QBD 658�� 20 Beckett v Towers Assets Co [1891] 1 QB 1�� 112 Belmont Park Investments PTY Ltd v BNY Trustee Services Ltd [2012] 1 All ER 505�� 350 Borden (UK) Ltd v Scottish Timber [1979] 3 All ER 961�� 116 British Eagle International Airlines Ltd v Compagnie Nationale [1975] 2 All ER 390�� 356 Caparo Industries Plc v Dickman [1990] 2 AC 605�� 301 Carreras Rothman Ltd v Freeman Matthews Treasure Ltd [1985] 1 All ER 155��115, 349 Carreras Rothmans Ltd v Freeman Matthew Treasure Ltd [1985] 1 Ch 207�� 349 Chase Manhattan Bank v Israel British Bank [1979] 3 All ER 1025�� 116 Chaw Yoong Hong v Choong Fah Rubber Manufactory [1962] AC 209�� 114 Clough Mill Ltd v Martin [1985] 1 WLR 111��115–16 Compaq Computer Ltd v The Abercorn Group Ltd (1991) BCC484��116–17 Crumlin Viaduct Works Co Ltd, In re [1879] II Ch 755�� 109 Despina R, The [1977] 3 All ER 374�� 332 Dublin City Distillery v Doherty [1914] AC 823�� 110 Equitable Trust Co of New York v Dawson Partners 27 Lloyd’s L Rep 49 (1927)�� 397 Farina v Home (1846) 153 ER 1124�� 109 Foskett v McKeown [2001] 1 AC 102�� 325 G&E Earle Ltd v Hemsworth RDC (1928) 140 LT 69�� 117 George Inglefield Ltd, Re [1933] Ch 1��113–15 Goodwin v Roberts [1876]1 AC 476�� 20 Government Stock v Manila Rail Co [1897] AC 81�� 110 Green v Farmer (1768) 98 ER 154 (KB)�� 348 Harlow and Jones Ltd v American Express Bank Ltd & Creditanstalt-Bankverein; > [1990] 2 Lloyd’s Rep 343�� 21 Helby v Matthews [1895] AC 471�� 118 Holroyd v Marshall [1862] 10 HL Cas 191��109, 117 Illingworth v Houldsworth [1904] AC 355�� 110 Independent Automatic Sales v Knowles & Foster [1962] 1 WLR 974�� 116 Interview Ltd, Re [1973] IR 382�� 116 IRC v Rowntree and Co Ltd [1948] 1 All ER 482�� 114 JH Rayner &Co v Hambros Bank Ltd [1943] 1 KB 37�� 391 Joseph v Lyons (1884) 15 QBD 280�� 111 Kelcey, Re [1899] 2 Ch 530�� 117

Table of Cases xxi Lehman Brothers International (Europe) (In Administration) aka Pierson v Lehman Brothers Finance SA, Re EWHC 2914 (Ch), 232 (2010)�� 439 Lehman Brothers International (Europe), Re [2009] EWHC 2545 (Ch)�� 429 Lehman Brothers International (Europe), Re [2012] EWHC 2997 (Ch)�� 429, 437, 457 Lloyds & Scottish Finance Ltd v Cyril Lord Carpet Sales Ltd (1979) 129 NLJ 366�� 115 Lomas v JFB Firth Rixson [2012] EWCA Civ 419�� 296 Lybian Arab Foreign Bank v Banker’s Trust Co [1988] QB 728�� 325 McEntire v Crossley Brothers Ltd [1895] AC 457�� 115 Manchester, Sheffield and Lincolnshire Railway Co v North Central Wagon Co (1888)13 App Cas 554�� 115 Miliangos v George Frank (Textiles) Ltd [1975] 3 All ER 801�� 332 Miller v Pace (1758) 1 Burr 452�� 318 Momm v Barclays Bank International Ltd [1977] QB 790�� 321 MS Fashions Ltd v BCCI [1993] Ch 425�� 115 National Westminster Bank plc v Spectrum Plus Ltd [2005] 2 AC 680 and UKHL 41�� 110 North Western Bank v Poynter [1895] AC 56, no 3051; [1895] All ER 754�� 106 Ocean Estates Ltd v Pinder [1969] 2 AC 19�� 108 Olds Discount Co Ltd v John Playfair Ltd [1938] 3 All ER 275�� 114 Picker v London and County Banking Co (1887) 18 QBD 512 (CA)�� 20 Polsky v S&A Services [1951] 1 All ER 185�� 114 Power Curber Int’l Ltd v Nat’l Bank of Kuwait SAK [1981] 2 Lloyd’s Rep 394�� 21 Raffeisen Zentralbank Osterreich AG v Five Star General Trading LLC [2001] 3 All ER 257�� 22 Rogers v Challis (1859) 27 Beav 175�� 117 Ryall v Rolle (1749) 1 Atk 165�� 81, 108–9 Salomon v A Salomon & Co Ltd [1897]AC 22�� 110 Service Europe Atlantique v Stockholm Rederiaktiebolog Svea, The Folias [1977] 1 Lloyd’s Rep 39�� 332 Sewell v Burdick (1884) 10 AC 74�� 112 Sharpe, Re [1980] 1 All ER 198��81, 109 Shipton, Anderson & Co (1927) Ltd v Micks Lambert & Co [1936] 2 All ER 1032�� 349 Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142�� 115 South Australia Asset Management Corp v York Montague Ltd [1997] AC 191�� 301 Stein v Blake [1995] 2 WLR 710�� 115, 345, 349 Syrett v Egerton [1957] 3 All ER 331�� 117 Tatung (UK) Ltd v Galex Telesure Ltd (1989) 5 BCC 325�� 116 Taurus Petroleum Limited v State Oil Marketing Company of the Ministry of Oil, Republic of Iraq [2017] UKSC 64�� 403 Thomas v Searles [1891] 2 QB 408�� 108 Twyne’s Case (1601) 76 ER 809�� 109 United Railways of Havana and Regla Warehouses Ltd, Re [1961] AC 1007�� 332 Watson, Re (1890) 25 QBD 27�� 114 Welsh Development Agency Ltd v Export Finance Co (Exfinco) BCC 270 (1992)��113–14 Wickham Holdings Ltd v Brooke House Motors Ltd [1967] 1 All ER 117�� 111 Wilson v Day [1759] 2 Burr 827�� 109 Winkfield, The [1900–03] All ER 346�� 118 Yorkshire Woolcombers Association Ltd, Re [1903] 2 Ch 284�� 110 Zahnrad Fabrik Passau GmbH v Terex Ltd [1986] SLT 84��161, 188

xxii Table of Cases United States Adler v Ammerman Furniture Co 100 Conn 223 (1924)�� 139 Agnew, Re 178 Fed 478 (1909)�� 144 Appleton v Norwalk Library Corp 53 Conn 4 (1885)�� 142 Babbitt & Co v Carr 53 Fla 480 (1907)�� 138 Bamberger Polymers International Bank Corp v Citibank NA 477 NYS 2d 931 (1983)�� 391 Bank of California v Danamiller 125 Wash 225 (1923)�� 142 Barbour Plumbing, Heating &Electric Co v Ewing 16 Ala App 280 (1917)�� 138 Barton v Mulvane 59 Kan 313 (1898)�� 139 Beatrice Creamery Co v Sylvester 65 Colo 569(1919)�� 143 Beck v Blue 42 Ala 32 (1868)�� 139 Begier v Internal Revenue Service 496 US 53 (1990)�� 428 Benner v Puffer 114 Mass 376 (1874)�� 143 Bevill, Breslett and Schulman Asset Management Corporation and SS Cohen v The Savings Building and Loan Co, In the matter of USCA 3rd Cir, 896 Fed Rep 2d, 54(1990)�� 124 Blackford v Neaves 23 Ariz 501 (1922)�� 140 Blackwell v Walker Bros 5 Fed 419 (1880)��142–43 Brainerd &H Quarry Co v Brice 250 US 229 (1919)�� 29 Brian v HA Born Packers’Supply Co 203 Ill App 262 (1917)�� 142 Bryant v Swofford Bros Dry Goods 214 US 279 (1909)�� 139 Burch v Pedigo 113 Ga 1157 (1901)�� 139 Burrier v Cunningham Piano Co 135 Md 135 (1919)�� 142 Call v Seymour 40 Ohio St 670 (1884)�� 140 Carolina Co v Unaka Sporings Lumber Co 130 Tenn 354 (1914)�� 142 Chase & Baker Co v National Trust & Credit Co 215 F 633 (1914)�� 125 Chicago R Equipment Co v Merchant’s Nat Bank 136 US 268 (1890)�� 140 Clinton v Ross 108 Ark 442 (1912)�� 143 Cohen v Army Moral Support Fund (In re Bevill, Breslett and Schulman Asset Management Corp) 67 BR 557 (1986)�� 124 Columbus Buggy Co, Re 143 Fed 859 (1906)�� 139 Competex SA v La Bow [1984] International Financial Law Review�� 332 Coonse v Bechold 71 Ind App 663 (1919)�� 141 Cushion v Jewel 7 Hun 525 (1876)�� 138 Davis v Giddings 30 Neb 209(1890)�� 140 Day v Basset 102 Mass 445 (1869)�� 138 Dole Food Company, In re, Delaware Chancery Court 2017�� 422 Donald v Suckling (1866) LR 1 QB 585�� 143 Dunlop v Mercer 156 Fed 545 (1907)�� 139 Executive Growth Investment Inc, Re 40 BR 417 (1984)�� 125 Fairbanks v Malloy 16 Ill App 277 (1885)�� 138 Faist v Waldo 57 Ark 270 (1893)�� 144 Ferguson v Lauterstein 160 Pa 427(1894)�� 139 Fields v Williams 91 Ala 502 (1890)�� 142 Finlay v Ludden & B Southern Music House 105 Ga 264 (1898)�� 138 Frank v Batten 1 NY Supp 705 (1888)�� 144

Table of Cases xxiii Frank v Denver & RGR Co 23 Fed 123 (1885)�� 139 Franklin Motor Car Co v Hamilton 113 Me 63 (1915)�� 138 General Electric Credit Corp v Allegretti 515 NE 2d 721 (III App Ct 1987)�� 29 General Ins Co v Lowry 412 F Supp 12 (1976)�� 122 Goldstein v Securities and Exchange Commission, DC Cir 23 June 2006 451 F3d 873�� 310 Goodell v Fairbrother 12 RI 233 (1878)�� 144 Grand Union Co, In re 219 F 353(1914)�� 125 Granite Partners, LP v Bear, Stearns &Co 17 F Supp.2d 275, 300–04 (SDNY 1998)�� 444 Greene v Darling 10 Fed Cas 1141 (DRI 1828)�� 351 Hall v Nix 156 Ala 423 (1908)�� 139 Hanesley v Council 147 Ga 27 (1917)�� 143 Hanson v Dayton 153 Fed 258 (1907)�� 138 Harkness v Russell & Co 118 US 663 (1886)�� 140 Hatch v Lamas 65 NHS 1 (1888)�� 138 HB Claflin Co v Porter 34 Atl 259 (1895)�� 140 Holt Manufacturing Co v Jaussand 132 Wash 667 (1925)�� 142 Home Bond Co v McChesney 239 US 568 (1916)�� 125 Horn v Georgia Fertilizer & Oil Co 18 Ga App 35 (1916)�� 142 Howland, Re 109 Fed 869 (1901)�� 144 Hydraulic Press Manufacturing Co v Whetstone 63 Kan 704 (1901)�� 138 ITT Commercial Finance Corp v Tech Power, Inc 51 Cal Rptr 2d 344 (1996)�� 175 Ivers & P Piano Co v Allen 101 Me 218 (1906)�� 140 James Baird Co v Gimbel Bros, Inc 64 F 2d 344, 46 (1933)�� 122 Jonas v Farmers Bros Co (In re Comark) 145 BR 47, 53(9th Cir, 1992)�� 124 Jordan v National Shoe and Leather Bank 74 NY 467 (1878)�� 351 JWD Inc v Fed Ins Co 806 SW 2d, 327 (1991)�� 29 Kentucky Wagon Manufacturing Co v Blanton-Curtis Mercantile Co 8 Ala App 669 (1913)�� 142 Kham & Nate’s Shoes No 2 v First Bank of Whiting 908 F 2d 1351 (1990)�� 122 KMC v Irving Trust Co 757 F2d 752 (1985)�� 177 Knowles Loom Work v Knowles 6 Penn (Del) 185 (1906)�� 140 Krause v Com 93 Pa 418 (1880)�� 139 Lehman Bros. Special Financing Inc v BNY Corporate Transaction Services Ltd, 422 BR 407 (SDNY 2010)�� 352 Lehman Brothers Holdings Inc, et al (Metavante) Case No.08-13555 (2009)�� 296 Lombard-Wall, In re 23 BR 165 (1982)�� 124 Lombard Wall Inc v Columbus Bank & Trust Co No 82-B-11556 Bankr. SDNY 16 Sept 1982�� 124 Louisville & NR Co v Mack 2 Tenn CCA 194(1911)�� 142 LTV Steel Co, Inc v US, 215 F3d 1275 (2000)�� 254 Lutz, Re 197 Fed 492 (1912)�� 139 Lyon, Re Fed Cas No 8, 644 (1872)�� 142 Major’s Furniture Mart Inc v Castle Credit Corp 602 F 2d 538 (1979)�� 125 Mann Inv Co v Columbia Nitrogen Corp 325 SE 2d 612 (1984)�� 128 Maxson v Ashland Iron Works 85 Ore 345 (1917)�� 139 Midland-Guardian Co v Hagin 370 So 2d, 25(1979)�� 29 Murray v Butte-Monitor Tunnel Min Co 41 Mont 449 (1910)�� 140

xxiv Table of Cases National Live Stock Bank v First Nat’l Bank of Geneseo 203 US 296 (1906)�� 29 Nebraska Dept of Revenue v Loewenstein 115 SCt 557 (1994)�� 124 Newell Bros v Hanson 97 Vt 297 (1924)�� 142 Newhall v Kingsbury 131 Mass 445 (1881)�� 142 Oriental Pac (US) Inc v Toronto Dominion Bank 357 NYS2d 957 (NY 1974)�� 21 Otto v Lincoln Savings Bank 51 NYS 2nd 561 (1944)�� 351 Paris v Vail 18 Vt 277 (1846)�� 143 Perkins v Metter 126 Cal 100 (1899)�� 140 Peter Water Wheel Co v Oregon Iron & Steel Co 87 Or 248 (1918)�� 142 Pfeiffer v Norman 22 ND 168 (1911)�� 138 Phillips v Hollenburg Music Co 82 Ark 9 (1907)�� 141 Pittsburgh Industrial Iron Works, Re 179 Fed 151 (1910)�� 143 Prentiss Tool & Supply Co v Schirmer 136 NY 305 (1892)�� 144 Reese v Beck 24 Ala 651 (1854)�� 139 Rodgers v Rachman 109 Cal 552 (1895)�� 142 RTC v Aetna Cas & Sur Co of Illinois 25 F 3d 570, 578–80 (7th Cir, 1994)�� 444 Savall v Wauful 16 NY Supp 219 (1890)�� 144 Scott v Farnam 55 Wash 336 (1909)�� 138 Sears, R & Co v Higbee 225 Ill App 197 (1922)�� 140 Sinclair v Holt 88 Nev 97 (1972)�� 29 Smith v Gufford 36 Fla 481(1895)�� 142 Smith v Long Cigar & Grocery Co 21 Ga App 730 (1917)�� 144 Solus Alternative Asset Mgmt LP v GSO Capital Partners LP, No 18 CV 232-LTS-BCM, 2018 WL 620490 (SDNY 29 January 2018)�� 297 Sound of Market Street, Inc v Continental Bank International 819 F 2d 384 (1987)�� 390 Spina v Toyota Motor Credit Corp 703 NE 2d 484(1998)�� 428 State ex rel Malin Yates Co v Justice of the Peace Ct 51 Mont 133 (1915)�� 140 State v Automobile 122 Me 280(1925)�� 142 State v White Furniture Co 206 Ala 575 (1921)�� 141 Swann Davis Co v Stanton 7 Ga App 688 (1910)�� 142 Thayer v Yakima Tire Service Co 116 Wash 299 (1921)�� 142 Thomas Furniture Co v T&C Furniture Co >120 Ga 879 (1909)�� 143 Tufts v Stone 70 Miss 54 (1892)�� 139 Undercofler v Whiteway Neon Ad Inc 152 SE Ed 616, 618 (1966)�� 129 Union Machinery & Supply Co v Thompson 98 Wash 119 (1917)�� 144 Van Bommel v Irving Trust Co (In re Hoyt) 47 F2d 654 (SDNY 1931)�� 427 Van Marel v Watson 235 Pac 144 (1925)�� 142 Whitsett v Carney 124 SW 443 (1910)�� 140 Winton Motor Carriage Co v Blomberg >84 Wash 451 (1915)�� 139 Young v Phillips 202 Mich 480 (1918)�� 140

TABLE OF LEGISLATION AND RELATED DOCUMENTS Australia Payment System and Netting Act 1998, s 16�� 361 Belgium Bankruptcy Act 1997, Art 101�� 81 CC (Civil Code) Art 1249�� 88 Art 1690��67, 69, 88

Brazil Civil Code��35, 66 Canada Uniform Personal Property Security Act 1982�� 220 European Union Alternative Investment Fund Management Directive (AIFMD)�� 43, 310, 313–14

Art 4(1)��424

Bank Recovery and Resolution (BRRD) Directive�� 372 Art 68��346 Arts 68–71��346 Art 69��346 Art 70��346 Art 71��346

Bank Winding-up Directive�� 351, 361, 364, 372 Bankruptcy Regulation 1346/2000��61, 63 Art 2(9)(viii)��204

xxvi Table of Legislation and Related Documents Art 2(g)��64, 204 Art 3(1)(4)�� 64

Brussels Convention�� 365 Art 16(5)��160

Collateral Directive 2002/47/EC��9, 41, 43, 47, 53, 69, 86–87, 135, 171, 173–74, 180, 182, 188–89, 350–51, 358, 361, 364, 371–73, 424–25, 429, 433, 436, 438, 446, 455, 457

Preamble��437 Art 2(1)(a)��424 Art 2(1)(d)��437 Art 7��372, 437 Art 9��438

Consumer Credit Directive (87/101)

Art 4�� 44 Art 4(3)�� 43 Art 7�� 43 Ann I�� 43

Cross-Border Insolvency Regulation 1346/2000�� 63 DCFR (Draft Common Frame of Reference)�� 35, 43, 53–54, 65–66, 104, 134, 137, 152, 172–73, 182, 188, 190, 234, 373 Directive 2000/35/EC combating late payment in commercial transactions�� 42 Art 4(3)�� 43

Directive 2006/73/EC, Art 19�� 424 Directive on the activities and supervision of institutions for occupational retirement provision 2003/41/EC�� 310 Directive on the prevention of the use of the financial system for the purpose of money laundering�� 411

Art 3��411 Art 6��411 Art 8��411 Art 9��411 Art 11��411 Art 13��411

EBRD Model Law on Secured Transactions��44, 146

Art 1��132 Art 1.1��167 Art 1.2��167 Art 2��167 Art 4��167 Art 4.3.4��167 Art 4.4��167 Art 4.5��167 Art 5��167 Art 5.4��167 Art 5.7��167 Arts 5.8–5.9��167 Art 5.9��167

Table of Legislation and Related Documents xxvii Art 6.8��167 Art 8��167 Art 8.1��168 Art 9��132, 167 Art 12.1��168 Art 17��168 Art 17.3��168 Art 18.1��132, 167 Art 21��168 Art 24��168 Art 24.1��132 Art 26��168 Art 28��168 Art 28.3.6��168

ECB Statute, Art 18.1�� 449 European Contract Principles (PECL)�� 373 European Market Infrastructure Regulation (EMIR)��261, 275, 281, 284, 286, 288

Recital 64��296 Art 2(1)��282 Art 2(3)��282

Fifth Money Laundering Directive��412–13 Fourth Money Laundering Directive�� 412 MiFID (Markets in Financial Instruments Directive), Art 13(7)�� 424 Regulation (EC) No 1103/97, Art 3�� 383 Regulation on jurisdiction and enforcement of judgments in civil and commercial matters (Brussels I) 2002, Art 22(5)�� 160, 365, 368, 383 Regulation on the law applicable to contractual obligations (Rome I) 2008�� 203, 223, 258, 293, 295, 370, 403 Art 4��204 Art 4(1)(h)��370 Art 9��379, 383 Art 12��208, 370 Art 12(1)(d)��367 Art 14�� 166, 208, 257 Art 14(1)��203 Art 14(1) and (2)��202 Art 17�� 367, 369–70

Rome Convention on the Law Applicable to Contractual Obligations 1980�� 202–4, 223, 367, 370, 403 Art 10(1)(d)��367 Art 12�� 22, 166, 203, 208 Art 12(1)��203 Art 12(1) and (2)��202 Art 12(2)��203–4

Second Money Laundering Directive�� 412 Securities Financing Transactions Regulation�� 456 Settlement Finality Directive�� 9, 43–44, 47, 135, 180, 346, 351, 357–58, 364, 371–72, 423, 431, 433, 435, 438, 455

xxviii Table of Legislation and Related Documents Preamble��436 Art 3��436 Art 3(1) and (2)��436 Art 5��436 Art 7��436 Art 8��436 Art 9��361 Art 9(1)��436 Art 9(2)��454

Third Money Laundering Directive (2005/60/EC)�� 412 Transparency Directive�� 330 Treaty on European Union (TEU), Art 50�� 384 Treaty on the Functioning of the European Union (TFEU), Art 114�� 64 UCITS (Undertakings for Collective Investments in Transferable Securities) Directives�� 304, 309–11, 313–14

Art 22��427

France Act dealing with accounting matters, Art 12�� 90 Bankruptcy Act 1985��83, 85, 218

Art 37��292, 361 Art 47 bis�� 85 Art 115�� 83 Art 117��81, 85 Art 121�� 83

CC (Civil Code)��78, 87, 89

Art 1130�� 81 Art 1138�� 92 Art 1179(1)�� 84 Art 1184�� 81 Art 1321�� 69 Art 1321ff�� 88 Art 1347-7��345 Art 1348��345 Art 1374-1��347 Art 1584�� 82, 86, 92–93 Art 1610�� 81 Art 1654�� 81 Art 1656�� 81 Art 1659��132 Arts 1659ff��69, 80 Art 1690��67, 88 Art 1692�� 29 Art 2011�� 90 Arts 2011–2031�� 90 Art 2014�� 90 Art 2015�� 90

Table of Legislation and Related Documents xxix Art 2018(2)�� 90 Art 2023�� 90 Art 2062�� 87 Art 2074�� 87 Art 2075�� 79 Art 2078�� 87, 111–12 Art 2085�� 31 Art 2279�� 81 Art 2367�� 83 Arts 2367-2372�� 83 Art 2369�� 83 Art 2371�� 83 Arts 2372-1–6��80, 90 Art 2372-3��80, 90

CMF (Monetary and Financial Code)��58, 89–90, 220, 361

Art L211�� 87 Art L211-36-1��351 Art L211-40��351 Arts L213-43 to L214-49�� 88 Arts L214-43 to L214-49��88–89 Arts L313-7 to L313-11�� 86, 88, 219 Arts L313-23 to L313-35�� 67 Art L431-7��292 Art L432-6�� 85 Art L432-7�� 86 Art L432-15�� 85

Code de Commerce

Art 91�� 87 Art 109�� 87 Art L311-3��327 Art L621-28��292 Art L622-7��350

Decree 89-158�� 88 Decree 93-589�� 88 Decree 97-919�� 88 Decree 98-1015�� 88 Law of 8 August 1913�� 80 Law of 21 April 1932�� 80 Law of 29 December 1934�� 79 Law of 22 February 1944�� 79 Law of 18 January 1951�� 79 Loi 66-455�� 86 Loi 83-1, Art 47�� 84 Loi 87-416�� 85 Loi 88-1201�� 88 Loi 92-868�� 85 Loi 93-1444�� 88

Art 8��292 Arts 12ff�� 84

xxx Table of Legislation and Related Documents Loi 93-6�� 88 Loi 94-475, Art 59�� 83 Loi 96-597��85, 88 Loi 98-546�� 88 Loi 2007-211�� 90 Loi Dailly 1981�� 67, 80, 87–89, 179, 184–85 Ordonnance no 2006–346 du 23 mars 2006 relative aux sûretés��80, 83 Germany Bankruptcy Act

s 1�� 94 s 26�� 93 s 43�� 94 s 54��352

BGB (Bürgerliches Gesetzbuch)��43, 92–93, 96–97, 102, 137, 332 s 137��104 s 138��200 s 138(1)��103 s 158�� 92, 95–96 ss 158-63��151 s 159�� 96 s 161�� 92, 96–97, 104 s 163��153 s 244(2)��332 s 388�� 345, 348, 352 s 389��347 s 398��93, 95 s 401�� 29 s 413�� 95 s 449�� 93 s 566��220 s 870��141 s 929�� 95 s 931��100, 141 s 932��95, 100 s 950�� 94 s 1229��112 ss 1234ff��111

Code of Civil Procedure, s 771�� 144 Consumer Credit Act 1991, s 3(2)(1)��102, 219 HGB (Commercial Code), s 340b��101, 351 Insolvency Act 1999�� 48, 86, 93, 181 s 47�� 94 s 50�� 98 s 51�� 94 s 91�� 97 s 94��352, 361

Table of Legislation and Related Documents xxxi s 96��352 s 103�� 94, 97, 144 ss 103–105�� 93 s 104��101, 448, 452, 454 s 104(2)��352 s 104(3)��352 s 107��144 s 107(1)��94, 97 s 173�� 99

Reorganisation Act 1935, s 27(2)�� 98 International

Basel Accords/Concordat��20, 249–50, 293, 364, 371, 381, 456 Basel I�� 371 Basel II�� 249–50, 381 Basel III�� 456 Bretton Woods Agreements 1944��268, 379 CISG (Convention on the International Sale of Goods)�� 169, 206, 210, 212, 223–25, 231–32 Art 1(1)(b)��206 Art 7��206 Art 7(2)��403 Art 9��207

Convention for the Suppression of the Illicit Traffic in Dangerous Drugs 1939�� 410 Convention on Narcotic Drugs 1964�� 410 Convention on Psychotropic Substances 1971�� 410 Council of Europe Criminal Law Convention on Corruption�� 411 GATS (General Agreement on Trade in Services)�� 377 GATT (General Agreement on Tariffs and Trade)�� 377 Geneva Convention on Substantive Rules for Intermediated Securities 2009��165, 433 Art 2��165 Art 4��165 Art 11��165 Art 31(3)(c)��165

Hague Convention on the Law Applicable to Agency�� 403 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary�� 56, 161, 433, 438 Hague Convention on the Law Applicable to Trusts and their Recognition�� 57, 77, 91, 172, 223 ICC Uniform Rules for a Combined Transport Document 1991�� 394 ICC Uniform Rules for Collection��21, 387, 389, 392, 402–4 Art 3(a)(iii)��387

ICC Uniform Rules for Contract Guarantees�� 403 ICC Uniform Rules for Demand Guarantees Art 2(b)��403 Art 20��403

International Currency Options Market Terms�� 361

xxxii Table of Legislation and Related Documents International Foreign Exchange Master Agreement�� 361 International Opium Convention 1912�� 410 ISDA Master Confirmation Agreement�� 362 ISDA Model Netting Act�� 372 ISDA Swap and Derivatives Master Agreements�� 4, 14, 17, 20, 244, 267, 282–83, 286–87, 289–90, 295, 360–64, 369 Overseas Securities Lenders Agreement�� 361 PSA/ISMA Global Master Repurchase Agreement��448, 453 Statute of the International Court of Justice, Art 38(1)�� 18 TBMA/ISMA Master Agreement��361, 453–55, 457 Art 1(c)��453 Art 6(a)��453 Art 6(i)��454 Art 7��453 Art 10(a)��454 Art 10(c)��454 Ann II��453

UCP (Uniform Customs and Practice for Documentary Credits)��20–21, 61, 389–90, 392–94, 397–98, 402–4

Art 4��395, 402 Art 5��395 Art 6(b)��392 Art 8��392 Art 9��390 Art 9(a)(iv)��393 Art 9(b)(iv)��393 Art 12��390 Art 12(c)��391 Art 13��392 Art 14(b)��391 Art 14(c)��391 Arts 14ff��390 Art 15��396 Art 16(a)��391 Art 18��394 Art 19��394 Art 20��394 Art 21��394 Art 22��394 Art 23��394 Art 24��394 Art 25��394 Art 28��394 Art 38��400

UK-Italian Full Faith and Credit Treaty�� 332 UNCITRAL Arbitration Rules 2010, Art 21(3)�� 365 UNCITRAL Convention on International Guarantees�� 404

Table of Legislation and Related Documents xxxiii UNCITRAL Convention on the Assignment of Receivables in International Trade 2001��20, 42, 154, 165–66, 173, 183, 188, 190, 192, 197–99, 201–2, 205–7, 210, 213–14, 404

Art 1��166 Art 1(3)��206 Art 1(a)��205 Art 2�� 201, 210–11 Art 2(a)��211 Art 3��205, 211 Art 5��211 Art 6��212 Art 7��206, 212 Art 7(2)��211 Art 8�� 186, 211–12 Art 9��193, 211 Art 11��207 Art 11(2) and (3)��212 Art 15��193 Art 18��208, 211 Art 19��208, 211 Art 22��212 Art 27��186, 212 Art 28��211 Art 29��208 Art 30�� 207–8, 212 Art 42��212 Ann

Arts 1ff�� 212 Arts 6ff�� 212 Arts 9ff�� 212 UNCITRAL Model Law on Credit Transfers�� 324 UNCITRAL Model Law on International Commercial Arbitration�� 167

Art 17��399

UNIDROIT Convention on International Finance Leasing�� 164, 168, 197, 214–34, 359

Preamble��224 Art 1�� 225–26 Art 1(1)(a)��227, 231 Art 1(1)(b)��227 Art 1(2)(a)��231 Art 1(2)(c)��227 Art 1(3)��227 Art 1(5)��227 Art 2��227 Art 3��225, 227 Art 4��233 Art 4(1)��227 Art 4(2)��224 Art 5��229

xxxiv Table of Legislation and Related Documents Art 6��229 Art 6(1)��225 Art 6(2)�� 224–25 Art 7��224, 227–29, 233 Art 7(3)��228 Art 7(5)��228 Art 8��226, 234 Art 8(1)�� 229–30 Art 8(1)(a)��231 Art 8(1)(c)��227 Art 8(2)��227, 230 Art 8(3)��229 Art 8(4)��227 Art 9��230 Art 9(2)��227 Art 10�� 230–31 Art 10(1)��231 Art 10(2)��231 Art 11�� 230–31 Art 12�� 230–31 Art 12(6)��231 Art 13��230 Art 13(2)��227 Art 13(3)(b)��229 Art 13(4)��229 Art 13(6)��230 Art 14�� 227–28 Art 14(2)�� 227–28 Art 17��223, 232

UNIDROIT Convention on International Interests in Mobile Equipment 2001�� 42, 168–69, 171, 173, 183, 234

Art 2��168 Art 2(3)��168 Art 3��166 Art 5��169 Art 7��169 Art 8��169 Art 10��169 Art 15��169 Art 16��169 Art 29��169 Art 30��169 Aircraft Protocol�� 169–70 Railway Equipment Protocol��170 Space Assets Protocol��170

UNIDROIT Factoring Convention��42, 165, 190, 192, 197–98, 201, 206–11, 214, 224

Art 1��208 Art 1(1)(c)��209

Table of Legislation and Related Documents xxxv Art 1(2)��198 Art 1(2(c)��207 Art 1(2)(c)��186 Art 2��206 Art 3��206 Art 4��210, 221 Art 4(2)��209 Art 5��207 Art 5(b)��186 Art 6��207, 209 Art 7��210 Art 8��186, 207, 209–10 Art 9��207, 209 Art 10��209

UNIDROIT Principles of International Commercial Contracts�� 373 Vienna Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances 1988�� 410 Vienna Convention on the Law of Treaties, Art 53�� 18 Netherlands Bankruptcy Act 1896

Art 26�� 74 Art 35(2)�� 70, 179, 209

CC (Civil Code)�� 8, 34, 37, 41, 65, 72, 80, 107, 134, 148, 156, 178, 190, 202 Art 3.13(2)�� 78 Art 3.38��72, 104 Art 3.38(2)�� 72 Art 3.53�� 72 Art 3.81��41, 77 Art 3.84(2)�� 68 Art 3.84(3)�� 38, 68–69, 74, 76, 153, 202–3, 218, 445 Art 3.84(4)��38, 41, 71–72, 74–76, 93, 95, 104, 147–48, 445 Art 3.85��75–76, 147, 445 Art 3.86�� 72 Art 3.91�� 41, 73, 141 Art 3.92��38, 41, 70–72, 135 Art 3.92(2)�� 71 Art 3.94(1)�� 67 Arts 3.94(3) and (4)�� 68 Arts 3.94–97�� 67 Art 3.115(3)�� 73 Art 3.129��347 Art 3.231�� 70 Art 3.235�� 71 Art 3.237�� 67 Art 3.239��67–68

xxxvi Table of Legislation and Related Documents Art 3.242��143 Art 3.246(1)��68–69 Art 3.246(5)�� 68 Art 3.247��140 Art 3.295��107 Art 5.14(2)�� 70 Art 5.15�� 70 Art 5.16��69–70 Art 6.22�� 72 Art 6.127��345 Art 6.142�� 29 Art 6.203�� 72 Art 6.236(f)��345 Art 6.236(g)��345 Art 6.269�� 72 Arts 7.39ff�� 72 Art 7.53�� 69 Art 7.53(3)��446 Art 7.54�� 69 Art 7A.1576(h)�� 72 Art 7A.1576(t)�� 72

Law concerning the Supervision of Transactions in Investment Securities, Art 2�� 76 Switzerland Private International Law Act 1987, Art 148(2)�� 367 ZGB Art 717�� 78 Art 717(2)�� 78 Arts 884-887�� 78

United Kingdom Act for the Relief of Debtors of 1729, 2 Geo II, c. 22, sec 13�� 348 Bank Recovery and Resolution Order 2016�� 350 Banking Act 2009�� 350

s 47��350 s 48(1)(d)��350 s 48Z��350

Bankruptcy Act 1914, s 38(c)�� 81 Bankruptcy Rules 1986�� 347 Bills of Sale Act 1854�� 115 Bills of Sale Act 1882�� 110–11, 113

s 4��111

Collective Investment Schemes Order 2001, Art 21�� 304 Common Law Procedure Act 1854, s 78�� 108 Companies Act 1986

Table of Legislation and Related Documents xxxvii s 298��116 s 395��116

Companies Act 2006�� 110 Enterprise Act 2002��25, 110, 180

sch B1, para 3��25, 110

Factoring Act 1823�� 195 Financial Services (Open-ended Investment Companies) Regulations�� 303 Financial Services and Markets Act 2000�� 309

s 235��303 s 236(1)��303 s 237(1)��303

Hire Purchase Act 1965�� 111 Insolvency Acts��97, 116

s 15(2), (3) and (9)�� 45 s 107��349 s 126��350 s 130(2)��350 s 178��349 s 283��81, 109 s 323��349 s 323(2)��115

Insolvency Rules 1986�� 349 Limited Liability Partnership Act 2000�� 303 Moneylenders Act 1900�� 111 Partnership Act 1890�� 303 Pawnbrokers Acts 1872–1960�� 110 Sale of Goods Act 1979�� 111

s 16��179 s 17��108 s 19��116 s 24��108, 111 s 25(2)��111 s 29(4)��109

Statute of Frauds 1677�� 109–10, 138 Temporary Insolvency Act, 4 Anne, c 17, sec. II (1705)�� 348 Torts (Interference with Goods) Act 1977, s 3(2)�� 108 United States Bankruptcy Code��9, 62–63, 86, 123–24, 130, 133, 254–55, 266, 285, 292, 294, 312, 351–52, 356, 372, 446

2005 amendments�� 43 Ch XV�� 64 s 101��351 s 101(25)��266 s 101(38A)��351 s 101(47)��124, 444

xxxviii Table of Legislation and Related Documents s 101(49)��124 s 101(53B)��292 s 361�� 62 s 362�� 45–46, 49, 125, 130, 351 s 362(a)(5)�� 62 s 362(a)(7)��351 s 362(d)�� 62 s 363��64, 125 s 363(b), (c) and (f)�� 45 s 364�� 25 s 364(d)�� 62 s 365��129, 144, 180, 351, 361 s 365(e)��351 s 365(e)(1)��292 s 503(b)(1)(A)�� 63 s 506�� 63 s 506(b)�� 62 s 506(c)�� 63 s 506(d)�� 62 s 510�� 49, 103, 123 s 522(f)�� 63 s 541�� 63 s 544�� 63, 121–22 s 547��62, 255 s 548�� 62 s 553�� 47, 49, 351 s 554�� 63 s 555��124, 455 ss 555ff��130 ss 556ff�� 63 s 559�� 38, 130, 171, 254, 351, 448, 454–55, 457 ss 559-62��124 s 560�� 130, 292, 351 s 561�� 266, 292, 351 s 562��351 s 741(7)��124 s 1129�� 62 s 1325�� 62

California Civil Code, s 2874�� 29 Commodity Futures Modernization Act 2000�� 258 Dodd-Frank Act 2010��242, 261, 275, 285, 287, 310, 352, 358, 456 s 724(a)��428

Electronic Funds Transfer Act��324, 328 Federal Consumer Protection Act�� 324 Federal Deposit Insurance Act�� 352 Federal Deposit Insurance Corporation Improvement Act (FDICIA)�� 352 Federal Tax Lien Statute (FTLS)�� 122 ss 6321(h)(1)��122 ss 6321ff��122

Table of Legislation and Related Documents xxxix Financial Netting Improvements Act�� 351 Investment Advisors Act 1940�� 310 Restatement (Second) of Contracts 1981, s 340(2)�� 29 Sarbanes-Oxley Act�� 261

s 401(c)��256, 258 s 705��258

UCC (Uniform Commercial Code)�� 8, 21, 24, 28–29, 33, 35, 39, 43, 58, 70, 118, 120–25, 128–29, 132, 137–39, 141, 145–46, 154, 156, 166, 177, 179, 181, 193, 200, 230, 322, 391, 417, 428, 430, 446 Art 2�� 58, 123, 125 Art 2A�� 8, 38, 58, 123–24, 128–30, 133, 155, 171, 178, 182, 218, 221, 224, 254, 359, 448 Art 4��324 Art 4A�� 58, 321–22, 324, 326, 328 Art 5�� 8, 390, 396 Art 8��58, 124, 416–17, 423 Art 9��8, 25, 33, 38, 41, 44, 51, 59, 62, 81, 104, 109–10, 119–20, 125, 128, 133, 154–56, 160, 167, 170–71, 173, 175, 181–82, 188, 190, 194–97, 201, 208–9, 216–18, 221, 254–55, 428, 446 s 1-201(9)��121 s 1-201(29)��121 s 1-201(35)��58, 119 s 1-201(37)�� 58 s 1-201(a)(35)��120, 126, 217, 227 s 1-203��126, 128 s 1-209(9)��178 s 1-301��166 s 1-302��120 s 1-304��121 s 2-105�� 58, 120, 178 s 2-106(1)�� 123–24 s 2-210��20, 185, 189, 193, 211 s 2A-103��124 s 2A-103(1)(g)��129, 221 s 2A-103(1)(j)��221 s 2A-209(1)��221, 231 s 2A-301�� 129, 218, 221 s 2A-307(2)�� 129, 218, 221 s 4A-108��8, 324 s 4A-207��328 s 4A-209��321 s 4A-211��321 s 4A-303��322 s 4A-405��321 s 5-102(9)(b)�� 8 s 5-103��395 s 5-107��390

xl Table of Legislation and Related Documents s 5-108��397 s 5-108(e)��391 s 5-109��403 s 5-109(a)��398 s 8-102(a)(7)��416 s 8-106(d)��427 s 8-502��423 s 8-503��417 s 8-503(e)��423 s 8-504(a)��418 s 8-504(b)��417, 427 s 8-510��423 s 9-19(a)(1)�� 58 s 9-101(1)��204 s 9-102��182 s 9-102(1)(a)��38, 119 s 9-102(2)��38, 119 s 9-102(2)(42)��127 s 9-102(44)��127 s 9-102(a)(11)��29, 121 s 9-102(a)(52)��121, 128 s 9-103(3)��204 s 9-108�� 127, 143, 178 s 9-109��126 s 9-109(a)��119 s 9-109(a)(3)�� 125–26 s 9-109(a)(5)��124 s 9-109(a)(5–6)��217 s 9-109(d)(13)�� 8 s 9-109(d)(4)�� 58 s 9-109(d)(5)��124, 126 s 9-109(d)(7)��126 s 9-201��126 s 9-203�� 29, 119, 121 s 9-203(1)(c)��127 s 9-203(b)(2)��122, 177 s 9-203(b)(3)(A)��120, 178 s 9-204��24, 58, 121, 127, 177 s 9-204(a)��120 s 9-204(b)��120 s 9-204(c)��120 s 9-205��125 s 9-207(c)(3)��428 s 9-308��121 s 9-308(a)��120, 177 s 9-308ff��120 s 9-309��119 s 9-309(2)�� 125–26 s 9-310��119, 128 s 9-312��395

Table of Legislation and Related Documents xli s 9-314��427, 429 s 9-314(c)��428 s 9-315�� 48, 121, 178 s 9-315(a)��121 s 9-317��121 s 9-317(a)(2)��122, 128 s 9-318�� 119, 195, 254 s 9-320��121, 126, 128, 178 s 9-320(b)��121 s 9-322�� 120–21 s 9-322(d)��121 s 9-323��121, 128 s 9-324��121 s 9-324ff��120 s 9-330��121 s 9-336��121, 178 s 9-404�� 20 ss 9-404ff��193 s 9-406(d)��211 s 9-502��127 s 9-503��29, 127 s 9-504��127 s 9-513�� 29 s 9-601�� 119–20 s 9-601(a)(2)��395 s 9-607�� 120, 126, 171, 195, 201, 254 s 9-607(c)��125 s 9-607(c) and (d)��196 s 9-608��120, 126, 195, 201 s 9-609��120 ss 9-610ff��128 s 9-618��138 s 9-403(b)�� 29

Uniform Conditional Sales Act 1918��33, 139–40, 142–43

s 3��143 s 6��138 s 7��144 s 9��143 s 16��139 s 20��139 s 24��139 s 27��141

Uniform Trust Receipt Act 1922�� 33

xlii

Part I Secured Transactions, Finance Sales and Other Financial Products and Services 1.1. Civil and Common Law Approaches to Financial Law. Credit Cultures and Transnationalisation 1.1.1. Introduction It was argued in Volume 1 that the evolution of modern commercial law is now largely financerather than trade- or mercantile driven. Much of what was said in Volumes 3 and 4 on contract and property law, the latter in particular in respect of movable assets including intangible monetary claims, serves in this connection as a basis for the discussion of the contractual and proprietary or other preferential, segregation or bankruptcy aspects of modern financial products and facilities, their creation, transfer, and effect or protection in the international commercial and financial flows, relevant more in particular in an insolvency of the counterparty. This is bankruptcy resistancy and the quest for its legal backup becomes a main issue in finance and has much to do with property law. In German, it is called Insolvenzfestigkeit. Deeper down, it is a matter of risk management in which both contract and movable property law play vital roles, more in particular where they come together and party autonomy is allowed a measure of flexibility in the creation of newer proprietary rights foremost in the context of assetbacked funding, like floating charges or finance sales in repos and finance leases, or in matters of preferences in particular through set-off and netting facilities. They complement, as we shall see, the older secured transactions, but parties may also be able to create other forms of separation or segregation as in (constructive) trust facilities. The distinction between contractual and proprietary rights in this connection is typical for civil law but was always less sharp in common law as we have seen where the accent is more in particular on separation and segregation, but it is a useful analytical tool everywhere to provide greater clarity and to obtain a deeper insight into the legal nature of financial products and the protections they afford participants in particular in situations of insolvency. Newer proprietary structures, more separation and segregation facilities, or extended preferences and the protections they offer, illustrate that modern financial products often operate not merely to produce a profit, to hold assets, and facilitate their transfer or trading, where liquidly becomes a key issue, or to achieve payment, but are also used as more advanced risk management tools or instruments. This is true in secured transactions and finance sales but also for swaps and other derivatives when operating as hedging instruments, and these products may then have a dual purpose. Another double use may be found in the set-off, which is traditionally a way of payment, but became a prime risk management tool through netting agreements. For banks,

2 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services risk management of this nature is indeed a central issue in which modern contract and movable property law is used and adjusted around an expanded notion of party autonomy in the creation of newer proprietary rights, separation facilities, or preferences, using assets better and protect more effectively against the insolvency of counterparties. To demonstrate how these products work and legally operate, also transnationally, will be the main objective of this Volume. The next Volume will deal more in particular with the regulation of the intermediaries, especially commercial and investment banks that use these products and facilities in their different functions or provide them to clients, a discussion that will centre on the issues of financial stability, conduct of business, and market integrity. It was earlier established that risk management, liquidity, transactional and payment finality and segregation, the latter especially in bankruptcy, then become major issues, in particular in international finance. Seen from the risk management perspective in banks, secured transactions (including floating charges), finance sales (like repos and finance leases), set-off and netting facilities (especially in swap and repo trading), the potential creation of newer preferences or segregation (and constructive trust) facilities by contract (for example in collection or custodial arrangements) or otherwise, and the use of hedging instruments (notably in swaps, options and futures) and their liquidity, thus become one comprehensive (legal) narrative in the provision of funding and financial services in the international flow of goods, services, money, information and technology. Modern payment facilities may be added. For bank management, this narrative is often geared to the regulatory capital adequacy and liquidity requirements, as will be discussed more extensively in Volume 6. In this connection, it may be considered that in commercial banking we have in essence deposits and loans, although, as we shall see, the payment function of banks is also an important feature of their activity, closely connected with the deposit-taking function. The deposit-taking and loan-providing functions are basically contractual in nature. So are many other services. Even the basic hedging instruments, like swaps, options and futures are contractual. Trading in these assets and facilities is a major aspect of modern banking business and a key part of risk management, more difficult as we have seen if the facility is pure contract but commercial banks that deal in swaps must also find a way trade in them to preserve maximum flexibility. So, they must in foreign exchange and often also in investment securities and repos. This may be closer to property but there are still issues in repos and modern custodial holdings. So there are in asset backing of loans in secured transactions (like floating charges) or in finance sales segregation, preferences and payment finality. Receivables and even loans are at least to some extent traded in securitisations.1 The important issue is always liquidity, transferability, or unwinding, and how that is or may be done in respect of these different products. One consequence of the in origin contractual nature of many of these products and services is indeed that they may be more difficult to transfer; it is a constant concern in the banking industry and a serious challenge to the liquidity of banking products. The basic rule is that assets or rights can trade, but liabilities or duties cannot. Thus, in a contract the asset side is (mostly) tradable without consent of the counterparty, but the liability side is not, so that a contract as a whole is not commonly transferable without consent of the other party, who thus obtains a veto. It is simply a matter of credit risk: whom you pay may not be very relevant, and you may be redirected by your creditor without your consent as long as you get a discharge upon your payment, but who pays you is a matter of credit risk, and you are unlikely to be indifferent and allow your debtor to put someone else in his/her place without your consent. 1 It raises the further question of the effect on the connected security and similar asset-backed protection. See for this issue n 28 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 3 It means that a contract as such cannot easily trade and that the asset side must be separated from the liability side in order to trade, which may be difficult as both are likely to be closely related. It was the subject of Volume 4, section 1.5. Yet as we have seen, especially if there are monetary collection rights like trade receivables, they may increasingly be separated out and assigned. That is property law, and one may note here a drift from contract to proprietary right, exactly to make transfers easier. It was submitted that monetary claims are here transnationally increasingly treated as promissory notes that became negotiable under the older lex mercatoria especially important in securitisations. For other contracts like derivatives, special trading facilities may be created and put in place in central counterparties or CCPs: see section 2.6.5 below for options, futures and swaps. This is then considered a clearing issue as we shall see. For the others we use netting facilities to limit risk, as we shall also see. There is also increasingly a facility to trade at least sales agreements as long as the old debtor remains a guarantor of the obligation. That is Section 2-220 UCC in the US. In the capital markets, we have other services and products, and the situation looks simpler, more proprietary. The financial products are here in essence few: bonds and shares, with the former being a debt instrument and acknowledged promissory note, and the latter being a corporate participation certificate often also expressed in the manner of a negotiable instrument. To this effect, both are (at least traditionally) expressed ‘to bearer’ or ‘to order’ and operate as documents of title or proprietary instruments. They transcend any contractual characterisation in the underlying relationships and are pieces of property or assets in that sense. This is then pure property law, which facilitates tradability and liquidity, although even here care must be taken that related obligations are not incorporated in the document that should be simple, even if the Eurobond takes here some liberties that the international marketplace has accepted. The important consequence is that these products, when properly worded, are easily transferable in the international marketplace. Thus, the Eurobond became an instrument of transnational law (see Volume 1, section 3.2.3). Shares issued and traded in these markets remain here largely domestic, products of local company laws, unless embodied in depository receipts, but they can still be traded transnationally in the international marketplace as negotiable instruments if so expressed. As already mentioned, the way in which these capital market instruments are now mostly held in custodial systems may still create complications in their legal characterisation and the transnationalisation process (see section 4.1.5 below), but that may be considered a detail for the moment. The essence is that these instruments may be transferred, and that the new ownership needs to be respected by all, which is the essence of a proprietary right.2 The goal is then always to enhance the liquidity of these instruments (see Volume 4, section 1.1.3). Another consequence is that in a bankruptcy of the holder or custodian, the owner can retrieve these assets (in p rinciple) if they can be identified or traced. There is segregation or bankruptcy resistance in this context. Again, it is in essence proprietary as is transactional and payment finality in such deals. Similarly, if these assets may be given as security for ordinary debt, the lender or security holder can retrieve them out of a bankruptcy of the investor/owner. This is indeed in the nature of a proprietary right that can ignore all others unless older. Here again, we enter the area of risk management, in this instance in the form of asset-backed security, of which real-estate mortgages are perhaps the most common and best-known type, but bonds and shares can function as security in a similar way and between banks are so used all the time (although now more commonly part of their repos trade). 2 Again, all rights supporting the asset (in the case of a bond, a monetary claim), at least if proprietary, eg a security interest in some other asset, like a mortgage, transfer at the same time to the new owner, see the previous fn and n 28 below.

4 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Importantly (and often confusingly), even contractual rights may do so more generally, and then figure as assets in their own right, as we have already seen, at least on the asset (not liability) side (which again raises the issue of separation), receivables being the most important example. In so-called floating charges, these security interests may extend to entire classes of assets (either in the form of tangible assets or contractual right), which may be in transformation from commodity to final product, to receivable upon a sale, and finally payment in bank accounts, allowing for a better protection of working capital advances to make the production process possible. This facility remains contentious in many legal systems, mainly because assets are no longer individualised and may even be future whilst the interest may shift into the replacement asset retaining its original rank. This asset substitution is well known in equity in common law countries, as covered in Volume 4, which countries may have here the advantage: see further the discussion below, particularly in section 2.2. Again, there are other forms of risk management in terms of proprietary protection or assetbacked funding notably in finance sales, where assets are not given as security but are temporarily or conditionally transferred for funding purposes. For bonds and shares, this may then result in finance repos. These finance sales present in many legal systems a newer method of risk management, also still underdeveloped in civil law, as we shall see below in section 2.1, and again better known in equity in common law countries. So are trust structures and the segregation facilities they offer, in finance especially through constructive trust notions, notably, in client accounts and collection or custodial arrangements, it was already mentioned also. The proprietary status of finance leases as another type of finance sale may, however, remain uncertain, precisely because it may not be sufficiently clear whether they are proprietary or contractual, and their status remains problematic in many civil law countries. They could still be purely contractual, which suggests a different status and legal treatment, especially in the manner of their protection and the legal status of the underlying asset. It only confirms that legally, there often still is ambivalence and there are here important characterisation issues as will also be discussed more extensively below in section 2.1. Even in common law countries, the situation may not always be clear. In fact, when it is an issue whether a financial structure is contractual or proprietary, as may also be the case for repos, it was already mentioned that the financial practice may accept alternatives like the set-off mechanism as the better protection in a bankruptcy of the counterparty rather than the proprietary characterisation and repossessing facilities, at least between parties who habitually engage in repo-ing investment securities between themselves. As we shall see in section 4.2.5, there is here an important (ICMA/SIFMA) industry global master netting agreement in place. It confirms the central importance of set-off and netting in modern risk management, again especially important if the underlying instruments are or may remain contractual. For swaps where the contractual nature was never in doubt, we have the ISDA Master Agreement promoting bilateral set-off also in the OTC markets. Both in the ISDA and ICMA/SIFMA Master Agreements, the essence is that they reduce the mutual exposure between the same parties engaging in transactions of this nature, the result being that regardless of a bankruptcy of either party, their mutual (swap or repo) positions are netted out in full so that only one amount needs to be paid either by the bankrupt or the other party. In the first case, the non-bankrupt parties will pay the bankrupt only after all their counterclaims on the bankrupt have been accounted for in full and paid off. In that sense, these counterclaims become preferred and are not each cut down to the bankruptcy percentage. The result is an important preference: the bankrupt estate can only cut down these claims after it has allowed in full for what it owed the non-bankrupt parties. This type of set-off is normally limited, however, to mutual mature claims in the same currency—some countries also require connexity between the mutual claims—but by contract, thus as a matter of party autonomy,

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 5 it may be possible in many legal systems to extend the set-off to immature and other claims (for example, in other currencies or even to the delivery of other assets like investment securities in repos) while including valuation clauses in such contracts. It may also be possible to limit or eliminate the connexity requirement in this manner and there is a modern tendency to broaden this set-off facility in order to make risk management in this manner in banking ever more effective, which then becomes an aspect of party autonomy supported by customary law, meaning recognition in the community it concerns, although potentially still subject to public policy considerations and constraints, as we shall also see since it works at the expense of common creditors. It proved a particularly effective form of the extension of protection and promotion of risk management, now mostly favoured by regulators and then respected in bankruptcies of counterparties. But there is more. In fact, it was already said in Volume 4, section 1.1.3 that contractually created user, enjoyment and income rights in underlying assets tend towards proprietary protection as a matter of transferability and liquidity, potentially promoting at the same time better risk management in finance. The rights then transfer with the asset. Rights of way were shown as an example. They may operate as servitudes, therefore as a proprietary right that transfers with the asset, or may remain purely contractual when they do not so transfer but remain in place even though the asset has gone, which means that the seller will be in default when it comes to performance thus inhibiting the transfer and liquidity of the asset.3 At least among professionals this is undesirable, hence the pressure towards proprietary status. Again, in such cases, the combination of contract and property poses in particular the question of the use of party autonomy in proprietary matters to create proprietary rights or similar forms of segregation, conceivably allowing new types of protected funding to arise. At least in the professional sphere, contractually created user, enjoyment, and income rights may thus become enforceable against third parties, or against certain classes of them, notably professional insiders, finding subsequently a wider recognition in the community or trade it concerns. That is ‘custom’, which at the domestic level is often expressed in statutory texts or case law. At the transnational level in the international marketplace, it is especially important in respect of conditional or finance sales, and in respect of the use of future commercial and resulting cashflows in floating charges. It is also important in (constructive) trusts. It was already said that party autonomy in support of netting clauses, their possible expansion of the set-off facility, and the (extended) preferences so created, and their effect in terms of risk management and bankruptcy protection or resistance also received increasingly acceptance in the relevant trade now foremost at the transnational level through custom or general principle in the international marketplace, in domestic bankruptcies often reflected in amendments to the relevant bankruptcy acts. It was already noted also that the equitable principles as developed in common law countries serve here as example of greater flexibility. They allow indeed for a larger measure of party autonomy in these matters, subject, in so far as finance sales, floating charges and trust structures or constructive trusts are concerned, to the protection of bona fide purchasers, or now even purchasers in the ordinary course of business of commoditised products against such charges or facilities. They may ignore them, meaning that they need not worry about them when they buy the underlying assets. In this manner, professional parties may be able to create all kinds of collateral backing for indebtedness, leading to priorities in execution or appropriation rights subject to the protection of the public at large against them, therefore operative only between insiders 3 Income rights may thus be expressed in a proprietary usufruct or purely contractually. Even if only expressed as a contractual temporary income right, in the Netherlands, they may become a usufruct rather than treating them as finance sales as we shall see, see the discussion at n 292 below.

6 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services like banks and major suppliers. Whilst party autonomy of this nature thus becomes a major risk management tool, again the key is that it is not allowed to affect the normal commercial flows and the liquidity of the assets operating therein in as far as the public is concerned. They are thus protected against these types of interests (whether in movable or even immovable property or intangible claims, such as receivables). It follows that only professionals, such as other banks and major suppliers, who are aware of them because they know of them and are likely to use them themselves, have a search duty. They do not affect outsiders, therefore the public, who may ignore them and have no investigation duty even if there is a register or other form of filing: see more particularly the discussion in Volume 4, section 1.10. The protection of the ordinary commercial flows is considered the higher interest here and a matter of public policy or protection of the public at large. Nobody would dare to buy anything if it was otherwise. It follows that there are here two layers of liquidity: the rights go with the assets so that their transfer is no longer inhibited by contractual impediments, but they are cut off at the level of the bona fide purchasers or the public at large so that the ordinary flows in them are not impeded any further either. Both, transferors and transferees thus benefit from greater liquidity although in very different ways. In the area of set-off and netting, again, we see party autonomy operating in netting agreements through which extra protection is created, which comes also from equity in common law countries. An important aspect is here, however, that bona fide outsiders, notably the common creditors, are not or no longer protected. As we shall see below in section 1.1.11, the tendency is indeed better to protect bona fide purchasers (or purchasers in the ordinary course of business of commoditised products) against all kinds of new charges or preferences in the international commercial flows, but bona fide creditors are increasingly losing out as a result of newer financial products or structures. This is ultimately also a matter of public policy or the public interest as will be shown below, motivated in particular by the needs of better modern risk management in banks, which is then favoured and preferred by regulators aiming for greater stability of the financial system. This loss of protection of bona fide common creditors may on the other hand be one of the reasons why there has been a move toward ‘disintermediation’ (or decentralisation) and a drive to innovate and create new financial products that protect them better. Since 2010, innovations in financial technology (or ‘fintech’) have started to permit retail consumers to conduct business without an intermediary, which may allow them to take back their property rights by directly holding new financial products such as crypto-currencies and other crypto-assets. It could mean that the concepts of credit and sales price protection may be transformed. This discussion will be started below for payments, securitisations, derivatives trading in CCPs, and custodial holdings of investment securities: see sections 3.1.10, 2.5.12, 3.6.12 and 4.1.8, see further also section 1.1.15 below. Newer insights and ways of dealing continually affect the creation, status and operation of financial instruments, especially the need for floating charges directed towards the use of future commercial/cashflows as security, and finance (or conditional/temporary) sales particularly in repos and finance leases, and then also derivatives, securitisations, and credit derivatives, and no less (electronic) payment systems, set-off and netting mechanisms, even the way modern investment securities are held and transferred in custodial arrangements, not to forget better segregation mechanisms in constructive trusts. Again, fintech may open new avenues altogether. This Volume will principally be concerned with the operation and characterisation of these newer products and facilities into law (local or, more rationally, transnational customary law) and their status in bankruptcy, which remains local (and in international cases poses the question of proper bankruptcy jurisdiction): see further section 1.1.14 below. The reason that bankruptcy remains local longer is that enforcement is a typical sovereignty issue, which cannot easily be

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 7 transnationalised without the creation of an international enforcement authority. The alternative is a broader recognition in insolvency proceedings of transnationalised security interests, floating charges, finance sales, (constructive) trusts and set-off facilities. The true issue is then whether these structures speak for themselves as international law, recognised and enforced as such, or still need prior domestication. That is a matter of legal risk concerning modern financial products or techniques which will be considered while discussing the most important financial products, including their social and economic settings. Again, it may be asked whether fintech might add to these newer approaches and more fundamentally change them and the way in which transnationally they operate. It is conceivable, but cannot yet be predicted with certainty, that more radical change may be at hand, which could have a far-reaching effect and further shake up of typical domestic legal constraints. This is particularly relevant for banks, as this radical change could affect not only their role in the payment system, but also in the closely connected deposit-taking function, and consequently in their lending facilities. Risk management may potentially also be fundamentally affected.

1.1.2. Legal Transnationalisation and its Most Important Features For international finance, it is posited that the ultimate issue is transnationalisation, which is likely to be pragmatic, increasingly favouring the above forms of party autonomy supported by custom to operate and define its limits in the international flows of goods, services, money, information and technology. These flows now exceed in size by far any domestic ones, even in the largest countries like the US or in associations of countries like the EU. It was argued in Volume 1, section 1.5 that this activity and its size and impetus are at the heart of the emergence of a new transnational commercial and financial legal order of which the modern lex mercatoria is the private law expression, whilst international minimum standards balance its market forces as a matter of public policy, if only to keep these markets clean. This new order and new law are supported by the fact that most of the activity in these flows, which are in constant transformation from commodity to end-product, receivables and payments, and may constantly move between countries, has no clear national connection whilst much of it is virtual or, like services and receivables, could never be easily located because of the absence of a physical element (it was already mentioned in the previous section). For the practical aspects and details in matters of financial facilities and risk management, it was posited that legally the approach in equity in common law countries provides often the better analogy as was more fully discussed in Volume 4 from a property perspective and is to that extent repeated and summarised in this Volume. The common law of contract and movable property being derived from and having been developed in commerce is here closer, even if the courts in England may still have great problems applying transnational law of this nature directly, especially in local bankruptcy situations.4 Civil countries missing this close connection are so far as hesitant, as we have seen. Much centres then on the issue of party autonomy in the creation of proprietary and other preferential or segregation facilities, which, when third parties are affected, needs the support of customary law, meaning recognition in the trade or community it concerns, here the globalised business community. It was already said that it is subject to the protection of the ordinary flows of commoditised products which cannot be so charged or encumbered and safeguards the purchasing public or consumer. Transnational public policy will

4 See

for the Lehman cases, Vol 2, s 2.4.2.

8 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services dictate here the minimum standards, although it was submitted from the beginning that they and their formulation to balance the international marketplace, present the greatest challenge to legal transnationalisation. In this connection, important other trends have also been identified. First, the law in this area is professional law (that is, it deals with ‘sophisticated’ or ‘institutional’ participants) as most clearly borne out in the US by the UCC.5 It is best, therefore, always to clearly separate this discussion from ‘retail’ consumer issues (important as they may be). Another aspect of these modern developments, driven by modern finance, is that the legal regime, meant to provide security or similar protection for financiers in a bankruptcy of the party seeking funding or engaging in hedging, is becoming increasingly product-specific. This was also highlighted in Volume 4. In this connection, it is quite possible, and is in fact the US approach, to maintain different proprietary notions and concepts according to product or facility.6 The increasing impact of party autonomy or financial structuring manifests itself here also. The common law has a further advantage in that it is by its very nature much less interested in systemic limitations and systemic thinking in that sense. This was also identified as a special feature of modern transnational professional law—see Volume 1, section 1.1.6 and Volume 4, sections 1.3.10 and 1.10, and it will be further examined in Part II below. Yet another important aspect in these modern legal trends in international finance is that in respect of professional creditors and their rights and the ways they rearrange and manage their risks, it is necessary not to confuse the discussion with issues concerning the protection of common creditors and equality amongst creditors. The discussion is thus to be separated from the special protection of more in particular bona fide common creditors, which was traditionally often connected with the concept of the debtor’s appearance of creditworthiness (in France) or of apparent ownership (in England). It was already mentioned, and is important in the context of netting clauses, but the issue is broader: see further section 1.1.11 below. First, as far as common creditors are concerned, they are often taken to be consumer or smaller creditors, raising their own special protection concerns. In this connection it should be realised that in business the most important common creditors are not small trading parties, but rather large banks or professional suppliers who remain unsecured in much of their lending or credit-providing functions (because this may give a higher yield for banks, or debtors may not have enough valuable security available, or non-secured sales credit may become a competitive issue). In a bankruptcy, these common creditors usually get nothing, or at best a small percentage. That is their risk, is commonly well understood, and was always so.7 Thus, although the 5 See Article 9 on secured transactions which, in its new 1999 text, tends to address itself principally to professionals (therefore, excluding consumer transactions, cf eg s 9-109(d)(13)). In Art 4A (s 4A-108) on electronic payment, consumers are explicitly excluded. They are also excluded in Art 5 from the practice of issuing letters of credit (s 5-102(9)(b)). Naturally equipment leases under Art 2A are professional products too. This confirms the assumption that, because of the specialised nature of these arrangements, they cannot be handled or are less suitable or even dangerous for non-professionals: see for the notion of professionals, Vol 1, s 1.1.10 and for relationship thinking Vol 3, s 1.1.1. 6 This has also already been noted in Vol 1, s 1.1.10 and Vol 4, ss 1.1.6 and 1.10.1. 7 Even where, as in the Dutch Civil Code of 1992, a conscious effort was made to reduce security interests and statutory preferences or liens in order to create more room for common creditors, the practical result is not that they get more, but only that the rights among various classes of preferred creditors and finance sale buyers are reshuffled. To protect common creditors better, the only way would seem to be giving them a fixed percentage of the assets, say 10 per cent. That would be a statutory preference. It would then still have to be accepted that the major banks and suppliers as (often) the largest common creditors, at the same time would be the main beneficiaries of such a system, except if this priority were limited to smaller traders and consumer claims, which then becomes a matter of definition.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 9 common creditors’ interests are now often considered a special public concern, notably in the bankruptcy of a counterparty (where it translates into greater protection of the paritas or par conditio creditorum), it may be questioned whether, as a general proposition, that remains or was ever correct. Contrary to what is often still thought in civil law analysis, no major public order issue or fundamental principle appears to be at stake, at least not in respect of the largest creditors of this nature. Another consideration is that, since in practice and statistically common creditors get very little in a bankruptcy and have accepted that, it is indeed better to put the emphasis on proper risk management instead, and therefore, on a system of priorities and established preferences, even allowing their variation and extension through a substantial degree of party autonomy, transnationally supported by customary law, in the manner already described. Smaller common creditors could be given a fixed percentage of liquidation proceeds or their economic equivalent in reorganisation proceeding.8 In fact, it is a serious misconception to think that bankruptcy is about equality of creditors and that that should dominate the discussion and inspire the legal framework. It is often repeated but it was never true; it was always about ranking, and consequently, risk management; the special position of secured credit was always recognised, it was the whole point behind secured transactions.9 Bankruptcy distribution was never equal (except per class), but (in common law terminology) it is equitable, and what is equitable in this respect has mostly become a matter of statutory definition in national bankruptcy laws. It is or has become a matter of public policy, not in terms of equality, but rather in terms of defining the different rights of separation/repossession and affects the segregation possibilities and the different priorities or preferences in the context of distribution of the bankrupt estate’s proceeds after the sale of its assets. On the other hand, in bankruptcy reorganisations, concessions may now have to be made by various, even secured, creditors, again that is public policy, even if in principle these facilities are likely to be transnationally reinforced by modern floating charges, finance sales, and set-off and netting concepts or facilities, which have strong party autonomy and customary law overtones as we have seen. As a consequence, bankruptcy is likely to play out increasingly differently among professionals, not in the least where they benefit from forms of party autonomy in rearranging their risks in the manner described and it is now not uncommon for national bankruptcy statutes to give way to special needs in this connection, especially in the area of set-off and netting, even if it takes some of this back in modern reorganisation proceedings, in which connection the US Bankruptcy Code was already mentioned. Its various amendments in these areas testify to it, as did earlier the Settlement Finality Directive and Collateral Directive in the European Union (EU). Transnationally operating funding operations and set-off/netting facilities or constructive trust protections may thus increasingly impose on domestic bankruptcies and force recognition, an issue already mentioned in the previous section. Although this is necessary and welcome, it was already noted also that these newer transnational products may not yet be directly recognised in these local bankruptcies but require local statutory intervention and recognition (rather than mere correction pursuant to domestic public policies). Transnationalisation is thus still in its infancy probably even more so in civil law perceptions, as it challenges in particular its traditional numerus clausus notion of proprietary rights. Nevertheless, we have seen the early manifestation and consequences of transnationalisation 8 It has been observed nevertheless that there is here a more fundamental difference between civil and common law, the former more debtor- and the latter more creditor-oriented, see WJ Bergman, RR Bliss, CA Johnson and GG Kaufman, ‘Netting, Financial Contracts and Banks: The Economic Implications’, Federal Reserve Bank of Chicago Working Paper No 2004-2 (January 2004) 7, the idea being that in civil law ex ante negotiated contractual arrangements may be more vulnerable in bankruptcy. 9 See also IF Fletcher, The Law of Insolvency 5th edn (London, 2017) 1-006.

10 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services in the legal characterisation of the Eurobond (see Volume 1, section 3.2.3), and the practices, repo activities, and custodial holdings developed in it (see sections 4.1 and 4.2 below), and it is confirmed by the transnationalising status of ICMA Master Agreement confirming the set-off and netting practices in the repo markets, also already mentioned (see further sections 4.2.4/5 below). It is also the approach in the ISDA Master for swaps (see section 2.6.8 below). This transnationalisation is potentially extended to all forms of finance sales (see section 2.1 below), which has a particular bearing on finance leases, repos and forms of receivable financing. But we may see the consequences no less in the law of assignments for financial purposes, as indeed in receivable financing and also in securitisations (see section 2.2.4 below), where bulk assignments of future claims become necessary and consequently individual notice requirements and other local formalities are increasingly abandoned (even domestically in countries like France and the Netherlands, which still had them), while many other aspects of assignment now also need reconsideration in this transnational context: see earlier Volume 4, section 1.5. Finally, new thinking is also apparent at the transnational level in the area of payments, see section 3.1 below and in the types of investment securities (shares and bonds) and their holding through security accounts and their transfer in modern book-entry systems, discussed in Volume 4, Part III, which in many respects resembles payment through the banking system. They will be further summarised in section 4.1 below. In modern international finance, this is the progression of the modern lex mercatoria, its sources of law, and their hierarchy. Under its sway, these various modern financial products or facilities, and the way they operate even domestically are becoming increasingly disconnected from the general (domestic) systems of (proprietary) law and finds its true support in transnational customary law. This may be easier in common law jurisdictions, which basically have no comprehensive system of doctrinal law, but pragmatically now also in civil law countries like France through a multitude of incidental statutory amendments geared towards special financial products such as repos and securitisations: see section 1.3 below. It has already been said that their status in a bankruptcy, especially of a party needing funding, is then another major focus and potentially acquires an altogether different dimension at the transnational level. To repeat, equity—a facility civil law never had, and where as a consequence in commercial and financial dealings the greatest differences between civil and common law may be found— may be more important here than typical notions of commercial law, which never developed that far, even in common law countries such as England. It is demonstrable that especially in the transnationalisation of commercial and financial law and practice, these notions and interests increasingly assert themselves, and are then borrowed predominantly from the equity tradition in common law countries. In Volume 1, section 1.1.6, it has already been said that these developments and the dynamics they bring especially to movable property law are moving to the centre of the transnationalisation of the law among professionals, particularly important in their financial dealings. That is the consequence of globalisation and affects all that wish to benefit from it. Here, traditional references to the lex situs of the assets (if at all identifiable if they are moving or intangible) as the applicable (domestic) law of these structures, breaking up the international flows and transactions in them into domestic pieces, become increasingly redundant or unmanageable and destructive as we have also seen.

1.1.3. Financial Products in Commercial Banking and Capital Markets In the previous sections reference was made to several financial structures. Financial products of this nature typically emerge in the commercial banking industry or in the capital markets.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 11 These are the two main environments in which money is recycled from savers or capital providers to those who are in need of money: see more particularly Volume 6, section 1.1.1. Indeed, it is in connection with this recycling of money (including payments or the transfer of investment securities) that financial products are foremost likely to result. It was further argued that they acquire their most modern forms in the international flows of goods, services, technology, money, information and technology, where banks recycle money and provide major funding, whilst capital markets may do the rest. In commercial banking, depositors transfer their money to banks, who take deposits from the public, and become owners of this money, leaving the depositors as contractual claimants only. If we ignore their money creating function, it is easiest to assume that the banks provide loans out of the moneys so obtained to customers or borrowers who can demonstrate their creditworthiness. It follows that the banks extend these loans at their own risk, therefore not on behalf of their depositors, and make a business out of this activity: see for the details of this activity further Volume 6, section 1.4. Deposits and loans are the most important banking products, the one forming the main liability class for a bank (that is, the deposit), and the other the main asset class (that is, the loan). Deposits may be call-deposits or time-deposits. The first may be reclaimed by depositors at will (usually from their current or checking account), the latter only on their maturity date. For the present discussion, loan products are more interesting, and may take many different forms. They may be unsecured and result in that case usually from consumer overdrafts, credit cards or other consumer borrowing facilities. In business, unsecured lending may also result from overdrafts, but may equally emerge from large standby credits often arranged for special purposes such as a takeover pending refinancing of the merged companies. In that case, these loans will often—in view of their size—be syndicated among many banks. Other types of unsecured lending may result from project financing, the essential feature of which is that repayment will only be made out of (and the liability be limited to) the cash flow of the project for which the income will be ring-fenced. It limits the borrower’s obligation to repay principal and to service the debt (meaning the payment of interest) to the amount of the project’s cash flow (or more likely only to a portion thereof, as the cash flow must also be used to pay other expenses, such as salaries of those employed in the project, maintenance costs and restocking expenses). Here we are in essence in the area of contract law. Secured lending is best known in real-estate acquisitions. Apartments or houses are commonly bought with the proceeds of bank loans secured on the property so acquired. These are mortgages, which are non-possessory security interests in immovable property or real estate. This facility gives creditors/banks a right to take possession and to enforce or execute their mortgage, which is a property interest in the asset, in case of a default of the debtor. A bank will then sell the property, satisfy its outstanding claims out of the sale proceeds and return the overvalue, if any after costs, to the debtor.10 This is also called repossession (and foreclosure). Here, we are in essence in the area of property law. Movable property may also be given as security, in which connection the term ‘collateral’ may be used. Under the old-fashioned pledge, possession of the property was required by the creditor. Thus, one could give one’s jewellery as security for a consumer loan. Additional connected requirements were specificity of the asset, which had to exist and as such be identifiable and set aside; that at least became the attitude of nineteenth-century civil law, as noted in Volume 4, sections 1.1.3 and 1.7.1. The pledge as a specific possessory security interest in

10 This ignores for the moment the fact that mortgages in common law were traditionally conditional sales, which were differently treated as we shall see in s 1.5.1 below.

12 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services this sense still has a meaning in the pledging of shares or bonds which are investment securities, but even there less so now that these securities are mainly held as intangible entitlements against an intermediary custodian: see Volume 4, Part III and section 4.1.1 below. Again, as between banks, they are now more likely to be repo-ed than pledged. As we have seen, in business, the possibility of giving non-possessory security over business assets, especially equipment, inventory or stocks, receivables and even sales proceeds (cash), is now more important. This ultimately goes to the use of future cash flows backing up present or future funding needs. As these assets are needed in or may result from the business, they cannot be transferred to the possession of the creditor/bank; it would be the end of the business. As in real estate, here too, non-possessory security interests had to be developed, but also had to cover more ground. As noted, in common law countries, often these security interests are floating charges, which allow the (non-possessory) security interest to attach to a class of assets, which may vary in composition and size or be in transformation as part of the production and sales process: see more particularly section 2.2.1 below. In terms of identification, the essence is an adequate description in the relevant document, no more; there is no need for any physical identification or setting aside as objective physical requirements. Future replacement assets may be included, which can also be in bulk. Although this remains substantially problematic in traditional civil law system thinking, as we shall see, these charges in order to be fully effective, may shift into replacement assets, retaining their original rank, and may even cover the whole business, including its future (movable) assets, physical or non-physical, as in the case of receivables. Hence, the idea of the use of future cash flows as security for debt. In this manner, in a more advanced legal environment, non-possessory security interests in movable property became possible and were much expanded. Compared to real-estate security, which was also non-possessory, this meant, however, less security for the lender, since movable assets might more easily disappear or could be sold to bona fide purchasers (or buyers in the ordinary course of business of commoditised products), who might be unaware and take free of such charges. Yet it is better than nothing, and now very common in common law jurisdictions. Rather than legally disallowing them altogether, in common law countries it is left to the creditors, usually banks, to decide whether they are helpful to them, but are still substantially restrained in many civil law countries, where there are great differences in this area as a matter of policy, or rather systemic thinking, often caused by the continuation of nineteenth-century concepts in terms of the physicality and identification of assets. To repeat, under floating charges proper, as in the case of inventory, the idea is rather that the assets may be transferred in bulk or as a class, dependent only upon an adequate description in the contract creating these charges, without therefore any specification or setting aside of individual assets, which as the case may be, are in full movement and transformation, as such prospective or future. Such a more general contractual description will then be sufficient to effectuate the proprietary transfer (as a form of security) and will also describe the extent and coverage of the charge. Clearly, this is substantial progress from the more classical notion that only specific, individualised assets could be transferred in property, which remains mostly the civil law idea. It follows that there may be less innate protection for the creditor because of the fluidity of the asset or facility—but more is captured in the charge as collateral. Again, it is for the creditor to decide the use, not for the law to make it impossible. These proprietary rights could thus also be created in future (replacement) assets and be traced therein, therefore even in assets that do not yet exist. They may as such be transferred in advance, as it were. A final connected major innovation was then that these assets were sold free and clear of the charge (to make these assets readily saleable), in return for new inventory being a utomatically included in the security. Legally, this gives rise to the notion of tracing and

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 13 of the shifting lien. The same goes for continuation of their original rank in the receivables, if credit is extended for a purchase; the charge can even extend in this manner into the proceeds or cash. Again, these aspects remain essentially problematic in civil law, but were so also at law in common law countries: as we have seen, equity made the difference; the trade-off was that purchasers in the ordinary course of business were protected against these charges. Therefore, retail consumers can buy cars and bicycles out of inventory free and clear and do not have a duty to search whether the particular asset is encumbered, as already noted. Only other banks or suppliers have a duty to search, and normally are better able to do so. Registers of these charges can help find them, but the general public can even ignore these registers. That is quite different for mortgages in land registers. The floating charge here reflects modern business needs, but also respects the free flow of commoditised assets in particular amongst the general public once they have left the production chain. As just mentioned, for many civil law countries, the key legal problem remains here that it is systemically difficult to create proprietary rights in assets that are not individually identified and set aside or may not yet exist. The US, in Article 9 UCC, has developed here a statutory approach. English case law (in equity) comes close, but gives the resulting charge a low priority, see section 1.5.2 below. Other countries may rely on specialised arrangements, which may produce a less perfect floating charge. As we shall see, among the main civil law systems, only German case law was able to accept this to some extent by allowing the inclusion of all assets that are contained in a certain space and by contractually stretching the notion of present assets to include their replacement: see section 1.4.1 below. In France, only since 2005 has statute intervened to make these charges possible, in 2008 joined by a kind of trust-like security facility (fiducie gage) although not all details are settled: see further section 1.3.1 below. All creditors may attempt to negotiate these types of security interests (to the extent developed under applicable domestic laws or as transnational law may now support), but since banks are the most common types of creditors and make it their business and are professionals, they are the most likely to negotiate these protections and be the prime beneficiaries. As already mentioned, other important modern banking products may be found in finance leases, repurchase agreements (repos), and receivable financing or factoring. Again, they are not exclusively for banks, but mainly used by them or their specialised subsidiaries. This is the field of finance sales, producing conditional or temporary ownership rights, which again may raise significant legal issues, especially in civil law countries which are less familiar with conditional and temporary ownership concepts and did not commonly use them in finance (except for reservation of title and hire-purchases). In common law this was again the preserve of equity. The main difference is that upon default they allow for appropriation of the asset by the creditor rather than requiring an execution sale with return of the overvalue. There is a different risk and reward structure: see section 2.1 below. The common law mortgage was originally also a type of conditional sale under which upon a repossession the lender became the full owner whilst the borrower was discharged for the deficit. On the other hand, if there was overvalue, it would be for the bank. As equity abhorred forfeiture, a special protection was then created in the equity of redemption, which gave the debtor more time, see sections 1.5.1/2 below. Eventually the mortgage as a pure security interest also developed. Foreign exchange products and derivatives have also become important for banks, especially trading in swaps: see section 2.6.4 below. It was already said that derivative products such as options, futures and swaps have become important modern market-risk hedging products and risk management tools, especially in respect of banks’ investment portfolios, which usually contain large government bond holdings. To manage or eliminate risk further, banks may also use the technique and facility of asset securitisation, or seek to balance their credit risk with

14 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services credit derivatives, especially credit default swaps (CDS), as we shall see in section 2.5.3 below. This is the area of financial structuring or financial engineering and often involves the transfers of risks to special purpose vehicles (SPVs), which may transfer these risks to the investing public by issuing bonds. These bonds may be secured by the cash flow accruing to the SPV and may then be called collateralised debt obligations or CDOs. Again, these modern banking products are often risk management tools and may raise significant legal issues where, particularly in the case of the more modern ones, we may enter uncharted waters in many domestic legal systems. That is legal risk. For a number of important Western countries, these issues and particularly the proprietary consequences will be summarised below in sections 1.2–1.6 and transnationalisation for international transactions in these facilities, products or services. It has already been mentioned also that another important function of modern commercial banks is their role in the payment system. Virtually all individuals and all legal entities depend on their banks for payment services. For most customers these services are largely ancillary to their holding a current or checking account with their bank, but the way payments are now achieved through the banking system also produces a number of important legal issues, again with special ramifications in international payments: see Part III below. In the international flows these are all key facilities, and it is essential that the law supports them and accepts similar structures in floating charges, finance sales or through trusts or in the facilitation of international payments and their finality. To repeat, one obvious and prime objective is to allow an international manufacturing or extraction business and connected sales and collection process to be given as asset backing for its financing by way of a floating charge, which to be effective may need legal transnationalisation. It may be repeated in this connection that in the traditional nationalistic or private international law approach, these flows and the transactions in them would have to be cut up in domestic pieces, often still different for contractual, proprietary, and enforcement aspects. It makes a transnational floating charge impossible as it is unlikely that these domestic pieces could add up to any efficient international regime. As already mentioned, in many civil law countries floating charges are still not easy to create, not even locally and then use very different techniques. So transnational law must come to the rescue, also in matters of transactional and payment finality, which is no less a proprietary issue. An international payment and money transfer system is a key banking function in a globalised environment and then also requires an important form of transnationalisation of the applicable law to remain credible and safe. Another area is the activity in derivatives, especially swaps, which constitutes the largest financial market segment by far where the ISDA Master Agreement holds sway, supported by transnational customary law, as we have seen and as will be covered in much greater detail below. So much for banks and banking products. In the capital markets, the situation in respect of the recycling of money is quite distinct from that found in the commercial banking system and other financial products and services arise, as already noted in section 1.1.1 above. Internationally, the Eurobond market is the example and constitutes the largest capital market in the world, operating in practice substantially under a transnationalised regime or customary law: see Volume 1, section 3.2.3. Here one finds no banking intermediation. Entities in need of capital—usually governments, companies, or banks—issue bonds (and the latter two also shares) to raise funding directly from the public. Again, bonds and shares (also called stocks or equities and together now often referred to as investment securities) are the basic capital market products that issuers issue and sell directly to the investing public, which are those individuals or legal entities with excess savings. Instead of making deposits with commercial banks, they thus become investors in capital market products (investment securities). There may still be a type of bank involvement, but in such cases, banks operate principally as capital market intermediaries and are then called investment banks, their role being very different and multifunctional. They are likely to

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 15 provide a multitude of services (see more particularly Volume 6, section 1.5 below). First, unlike commercial banks, they do not normally provide capital themselves and do not therefore become investors; they take no business risk in that sense. They operate basically for a fee, foremost as advisers to new issues of securities, in which capacity they help in pricing, marketing, and listing of the relevant investment security on the exchanges (if such listing is being sought) and sell them to investors being the general public. These advisory—primary market or new issues market— functions may, however, be supplemented by an underwriting facility. This is very common; here investment banks take risk. Underwriting guarantees to the issuer the placement of the issue at the agreed price. It means that if the underwriter is not successful in the placement of the investment securities on offer, it must buy the unplaced part of the issue itself. Investment banks usually form underwriting syndicates among themselves to spread this risk. Investment banks may further serve as intermediaries in the secondary market in which the security issue trades. They may then be brokers, investment advisers or fund managers for their clients, again earning a fee for the service, but here also they could take their own risk in becoming market makers when they will trade and offer prices to whomever wants to sell or buy investment securities and take the attendant risk as traders. Investment banks thus become counterparties to sellers and buyers. Market making is an important function in professional OTC markets, as notably the euro-securities markets are. It is now less common in formal stock markets or regular stock exchanges where there operates rather a matching system between sellers and buyers. Much of this will be the subject of the discussion in Volume 6, but a number of legal issues in particular connected with the holding or custody and transfer of modern investment securities (already discussed in Volume 4, Part III) will be summarised in this Volume, in which connection their clearing and settlement will also be revisited (see section 4.1.4 below). That will also be done for derivative markets and their functioning (see section 2.6.4 below), in which investment banks may also participate. Another issue here is the settlement risk, which may be reduced through close out netting facilities especially through the use of Central Counterparties (CCPs) in derivative markets, as we shall see in section 2.6.5 below. Investment advice and fund management will be covered in section 2.7 below. There may result some confusion as to terminology. We usually talk about financial products, financial services and financial markets. As just mentioned, in commercial banking, the activity concentrates on products like deposits and types of loans, either secured or unsecured in the various ways discussed. There are also foreign exchange, swaps, repos and securitised products. There may even be credit derivatives. Internally these are important risk management tools for commercial banks as we have seen, but, as in the case of swaps and credit derivatives, they may also be banking products offered to clients. One could say that these are products which are then associated with the facilities a bank offers to the public in terms of its own exposure. It takes a risk. On the other hand, in the case of a service, there should not be an own risk for the bank, it gives advice for a fee. In payments, the commercial bank’s involvement looks like a service, for which it may ask to be paid, although it is likely to use its own money to complete the payment transactions as we shall see and there is then an own risk also. This may be an important, often ignored, reward for customers keeping deposits with the bank for little interest. There are further important issues of clearing and settlement and finality of the payment. In the capital markets, there are investment securities as products, and (investment) banks normally operate as advisors, but as already explained, they may take a risk in underwriting and trading. In that connection, investment banks will also need to use risk management tools and hedging techniques, but for the rest the accent is more on services such as advice on issuing activities and the structuring of new issues, sales and placement activity for the issuers, and brokerage and investment advice for investors. Participation of investment banks in custody, clearing and settlement suggests

16 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services further services. The point to make here is that whether one refers to products or to services is not itself fundamental, even if it is perhaps more common in connection with commercial banking activities to refer to financial products and in connection with investment banking activities to financial services. That does not mean that commercial banks may not also offer services, such as for payments. Investment banks trade products, like investment securities, and engage in custody holding and security entitlement activity. What is more important is to determine the risk they take. Financial markets are more in particular connected with trading and it concerns its infrastructure. Capital markets offer special facilities for the issuing and investing public and may be formal or informal. In OTC markets, they may be maintained by investment banks as market makers, for example, for Eurobonds: see further Volume 6, section 1.1.17. The relevant market services may also include listing, regular publication (of financial news) facilities, clearing and settlement. They need not be provided by one exchange or the same entity and may be offered competitively. Regular stock markets are usually more formal and are now mostly independent companies. The same goes for modern option and futures exchanges, which provide possibilities to take and unwind future and option positions, also increasingly swaps, as will be discussed in greater detail in section 2.6.5 below. Their operation goes beyond the capital markets and commercial banks will also be heavily involved. There are many other markets in finance: foreign exchange markets are important, so are the repo markets, as we have seen. To repeat, all these financial products or services, trading, clearing and settlement facilities and risk management tools may present important legal issues, first at the level of private law but also in terms of regulation and supervision (as we shall see in the next Volume). It was already said that legally, the question may also often be whether these are contractual or proprietary. Services are normally contractual. Much bank exposure also is, for example in derivatives as noted, but in trading we are more likely to face proprietary issues and of course no less in asset backed funding. In fact, wherever liquidity, finality and proper risk management are to be considered, we are likely to face proprietary issues. In section 1.1.1 above, the particular problems associated with the transfer of contract positions were already mentioned also, overcome partly by the use of promissory notes or, in the case of modern derivative instruments, through the operation of CCPs. These structures are largely inspired by the need for protection against the bankruptcy of the counterparty, usually the party seeking funding, or by the intricacies of risk management. Set-off and netting concepts may produce further protection, as we have seen, by creating preferences for creditors in a bankruptcy distribution of their debtor. Again, risk management takes here centre stage. Other legal problems are discussed in Volume 6, section 1.1.2, especially those connected with the stability of the financial system and the protection of investors or depositors or market integrity. Here we meet important regulatory or public law issues, the need for regulatory co-operation in an international context, particularly in the EU, and must consider the considerable legal challenges financial regulation presents. They will be discussed in this Volume only to the extent that regulation is product specific and has private law effect.

1.1.4. Different Credit Cultures. Domestic Law Thinking. The Issues of Legal Transnationalisation and of Transactional and Payment Finality Cross-border Revisited It has already been said that the subject of this Volume will be foremost commercial banking products and facilities, particularly their proprietary status if the financing is asset-backed, the

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 17 role of party autonomy in this connection, especially in the creation of floating charges, finance sales, and trust or similar segregation structures (subject to public policy constraints, particularly in terms of the protection of the commercial flows against these interests as we have seen), and the so-called bankruptcy resistance (or Konkursfestigkeit) of these various banking products or facilities, that is, their protected status in a bankruptcy of either party, usually a bank (as lender, deposit taker or borrower) or a client (usually as depositor or borrower), and therefore the risk management facilities concerning them. Especially transnationally, customary law support may be needed to create sufficient third-party effect and support newer structures. There is then also the status of netting agreements and of other preferences and separation facilities to consider, and no less the operation of derivatives. As shown, these facilities remain on the whole more specifically contractual, although the netting facility leads to an extended preference in a bankruptcy distribution, a type of party autonomy that in its effect therefore goes also well beyond the contractual, now increasingly favoured even by public policy, and at least for swaps and repo netting under the ISDA and ICMA Master Agreements, supported by transnational custom. Again, there is also the nature of bank payments and investment security transfers and repos to consider and the protections existing here in terms of finality. It was shown that the legal issues that arise in these connections are more proprietary in nature, then mainly a segregation issue in bankruptcy. In all of this, it was shown that one major issue is legal risk in terms of risk management, therefore the risk that these products will not fully function under applicable law or that they may function differently from what may have been intended, in particular that they may not prove to be sufficiently bankruptcy resistant in the relevant bankruptcy jurisdiction. Again, the use of future cashflows in floating charges and finance sales or trust structures to support funding or adequate segregation springs to mind; so, do finance sales and netting arrangements. In cross-border transactions or in financial facilities operating cross-border, there are considerable further risks in this regard. It was already shown also that the reliance on and sole application of local laws may function as an extra risk by itself and may break up international financial products and facilities from a legal point of view, which may have a serious impact on their efficient operation transborder. In this regard, if we look more carefully at commercial banking products especially, it may be observed at the outset that there are still considerable differences in credit cultures between countries, that is, in the types of funding techniques and financial structures most commonly used by commercial banks and their clients. Naturally, that is reflected in the applicable domestic legal regimes and in the particularities and limitations—including the proprietary and bankruptcy ramifications or public policy constraints under which these products function and are protected locally. This has already been noted in the previous sections, particularly in respect of non-possessory security interests, especially floating charges, but also in finance sales. However, in recent years, the internationalisation and globalisation of the markets, including the financial markets, have tended to reduce these cultural differences by favouring new banking products that may have a more global application. One may think here of project finance, finance leasing, and repo financing, or receivable financing, products that are now universally used. So are derivatives and securitisations. Set-off and netting is a key issue for swaps and repos in the international marketplace. Yet it was shown that as long as the law in these areas remains basically domestic and therefore parochial, the applicable law is still likely to reflect historic differences, which cramp the transnationalisation style for no good reason, and may legally still break up financial products and facilities along the borders of the countries involved. This occurs especially when (a) assets located in different countries are involved in asset-backed schemes, more in particular when they start moving and transforming in the production and distribution chains, (b) payments or investment securities transfers must be effectuated between entities in different countries, or (c) a

18 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services netting of rights and obligations arising in different countries is envisaged. One question is then whether the change in culture and the move towards internationalisation of the relevant products, services, and facilities itself supports or even demands their renationalisation or favours legal transnationalisation. The characterisation of modern financial products into national laws is one of the major concerns of this series, followed by the more rational need for transnationalisation of the legal regime concerning them, which should also affect their treatment in bankruptcies, the latter remaining, however, mostly still more local in structure and effect for reasons already set-out in section 1.1.2 above. Only fundamental principle supported by transnational practice or custom, general principle, and a transnationally autonomous notion of party autonomy may overcome this and broaden the scope for recognition of foreign products and practices in local insolvency proceedings (subject only to local public policy checks). This is the operation of transnational law or, in commerce and finance, of the new lex mercatoria or law merchant. It was submitted in Volume 1, and it is crucial for a proper understanding of what is happening, we borrow here the method of public international law as enunciated in Article 38(1) of the Statute of the International Court of Justice (supplemented by Article 53 of Vienna the Convention on the Law of Treaties for peremptory rules or fundamental principle), supplemented further by a view on the hierarchy of the norms that thus become applicable to transnational transactions. Again, this is in essence the world of fundamental and general principle, of custom and practice, and of party autonomy, sometimes supplemented by uniform treaty law where existing and sufficiently accepted. The proposition was that domestic laws retain here only a residual function and apply only when all else fails. In the meantime, one reason why domestic laws based on local credit cultures may have a tendency still to remain so dominant, in the mind of many, in asset-backed and other funding is exactly that these funding arrangements often imply some form of proprietary protection for the creditor involving assets of the debtor. As we have seen, secured transactions thus mean to give the creditor a special right in the debtor’s assets upon the latter’s default and bankruptcy. Especially proprietary protection is in this connection in the more classical view often still perceived as being a typical product of an objective national property law, or lex situs, therefore potentially different for assets in different countries even if they back up the same project or indebtedness whilst these assets are in constant movement between countries or in full transformation as part of an international manufacturing and sales process or production chain or are intangible so that their situs can hardly be established. It has already been said that the search for an objective law in property is not wrong per se, but its nationalism increasingly is, and party autonomy needs here more room in professional dealings, but is also transnationally still a limited concept that can only work, it was submitted, if there is a good protection of the ordinary commercial and financial flows against such interests as a public policy issue, relevant also as proprietary protection and segregation are obtained at the expense of others, in bankruptcy notably other creditors. These are valid issues, but again, there also is often still thinking of property rights as only physical and locatable. It is less of a policy issue, but rather an approach based on an identification and individualisation of the asset, as such a more theoretical hindrance rejected earlier in this series: all rights are intangible, so are all obligations, never mind the nature of the underlying asset in respect of which they are asserted. Second, in respect of many of these underlying assets, there is in any event no longer a fixed or proper location, quite apart from the fact that many, like monetary claims, but also services, are intangible. Even where goods are physical, they may be in constant movement and transformation, as just mentioned, and may then also include intangible services and technology. In fact, a service contract may be economically more important than the asset it serves. It may be repeated that in all international flows, goods, services,

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 19 money, information and technology are increasingly commingled and often virtual. National culture based on physicality, especially in respect of proprietary rights nevertheless continues to dominate the discussion, even in international commerce and finance, and then still shape the financial products, especially when asset backed. As mentioned before, only transnationalisation, through established international custom and practices, general principle and an internationally autonomous notion of party autonomy, may be able to produce a more neutral alternative, an issue explored more fully in Volume 1, section 3.2.2 in the context of the emergence of the modern lex mercatoria and further discussed in Volume 4, section 1.10. Again, in this book, in a legal sense, physical notions of property are fundamentally rejected, at least in respect of movable assets including claims. It follows that the concept of the lex situs as the applicable domestic law is also challenged. It has already been said (in section 1.1.2 above) that a new transnational financial law, which could then also cover classes of (present and future) assets in different countries, would also have to be increasingly respected in local bankruptcies, even if the applicable local bankruptcy laws and the system of proprietary rights and creditors’ priorities did not know them. This would in fact not be different from the recognition of any other foreign proprietary interest under present international law rules (see Volume 4, section 1.8.3). Even at present, this requires a form of transformation or adaptation so as to make such interests fit in the relevant local bankruptcy scheme of priorities and enforcement. Transnational facilities can no longer be simply ignored and would in principle have to be accepted as valid and operative in a similar manner. It would be a question of direct international law acceptance without prior domestication and barring local public policy. Indeed, sometimes local bankruptcy law is already formally amended in such situations, as under international pressure many such laws have, for example, allowed broader notions of set-off and netting, increasingly promoted or even formulated at the transnational level: see also sections 3.2.6ff below. This is a continuing process, increasingly to apply directly to all transnationalised financial products and claims or facilities suggesting respect for their operation, and therefore, greater scope for their recognition even locally, again barring public policy considerations of which the simple preserving of local laws could not or no longer be one. It has already been posited in this connection also that true globalisation of financial products substantially depends on our acceptance of newer transnationalised proprietary and other notions of protection resulting from international financial practices in which party autonomy may play an important role and that the modern lex mercatoria as transnational law is likely increasingly to reflect and express this.11 This was very much the message of the first four Volumes in this series, and is the logical and necessary back-up and consequence of banking as a worldwide activity that must obtain deposits, provide (cheap) liquidity (by giving loans or overdrafts) everywhere, and make payments transnationally. This is often considered an essential part of our modern economy, which is based on credit for all in a globalised marketplace. The pitfalls in terms of financial risk and stability are increasingly clear (and are discussed in Volume 6 below), but for the present discussion, this state of affairs is accepted as fact and a fundamental feature of modern finance. The transnationalisation of proprietary interests and other protections through international practice in the professional sphere is then more particularly favoured from the perspective of reducing legal risk and promoting financial stability overall. In view of the immense size of the international commercial and financial flows (the OTC derivatives market alone being thought to cover USD equivalent of more than $607 trillion

11 See for the objectivation of the notion of party autonomy in this connection, supporting its transnational status, especially Vol 3, ss 1.1.4 and 1.1.5.

20 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services outstanding at end-June 2020),12 it is not as far-fetched as it may once have seemed, and it will be more fundamentally considered in the light of the development of these modern financial products and practices in this Volume. In this connection, it was noted in Volume 1, section 1.4.4 that, whatever the aims of nineteenth-century nationalism in private law may have been, unification through an autonomous process of transnationalisation, and therefore through the force of custom and practices in private law was never entirely eradicated, including in civil law countries, even in respect of the proprietary aspects of international transactions. One may think of the law concerning bills of lading,13 negotiable instruments (especially Eurobonds) and Euromarket practices including clearing and settlement,14 the law of international assignment,15 of set-off and netting,16 of letters of credit (Uniform Customs and Practice for Documentary Credits—UCP) and trade terms (Incoterms).17 12 BIS, OTC Derivatives Statistics at End-June 2020, www.bis.org/publ/otc_hy2011.htm. 13 See WE Haak, ‘Internationalism above Freedom of Contract’ in Essays on International and Comparative Law in Honour of Judge Erades (The Hague, 1983) 69. It is sometimes also suggested that international mandatory customary law overrides the jurisdiction of the forum actoris (of the plaintiff therefore), see JP Verheul, ‘The Forum Actoris and International Law’, in ibid, at 196. 14 It is often said that the negotiability of Eurobonds derives from the force of market custom: see the older English cases on international bonds law: Goodwin v Roberts [1876] 1 AC 476 and Picker v London and County Banking Co (1887) 18 QBD 512 (CA), which relate to Russian and Prussian bonds and emphasised that the financial community treated these instruments as negotiable regardless of domestic laws; see further P Wood, Law and Practice of International Finance (London, 1980) 184. See also Bechuanaland Exploration Co v London Trading Bank [1898] 2 QBD 658, in which it was accepted in connection with the negotiability of bearer bonds that ‘the existence of usage has so often been proved and its convenience is so obvious that it might be taken now to be part of the law’. Modern case law does not exist confirming the point, but in England these cases are still considered good law. See for the explicit reference in this connection to the custom of the mercantile world, which may expressly be of recent origin, Dicey, Morris and Collins on the Conflict of Laws, 14th edn (London, 2006) r 222, 1800. The transnational status of Eurobonds is probably not affected, even now that in most cases they have become mere book-entry entitlements in a paperless environment. Also, the way these instruments are repo-ed or given in security, cleared and settled is also transnationalised. 15 Important issues of individualization, notification, and documentation arise especially in respect of the use of receivables in modern financing, where local law impediments to bulk assignments in this regard must be increasingly removed and a reasonable description and immediate transfer upon the conclusion of the assignment agreement is becoming normative. Future (replacement) receivables are increasingly likely to be able to be included so that questions of identification and sufficient disposition rights no longer arise either. Exceptions derived from the underlying agreements out of which these receivables arise are increasingly ignored, especially any third-party effect of contractual assignment restriction, whilst others are limited to situations in which the assignment gives rise to unreasonable burdens: see also ss 2-210 and 9-404 UCC and Vol 4, s 1.5.3 and below s 2.2.4. The promissory note as negotiable instrument, with its independence from the underlying transaction out of which it arises, becomes the better transnational analogy here, perhaps aided by the UNCITRAL 2001 Convention on the Assignment of Receivables in International Trade, although it has not received sufficient ratifications and is certainly not as clear and advanced as it could have been: see s 2.3.8 below. 16 In this connection, in the swap and repo markets, the ISDA Swap Master Agreements and the ICMA Global Master Repurchase Agreement may also acquire the status of transnational custom in the areas they cover, at least in the London and the New York markets where they mainly operate. This may be particularly relevant for their close-out and netting provisions in the event of default. The status of contractual bilateral netting with its enhancements of the set-off principle and its inclusion of all swaps between the same parties, leading to a netting-out of all positions in the case of default at the option of the non-defaulting party and ipso facto in the case of bankruptcy, could otherwise still remain in doubt under local laws if not properly amended. In the 1996 Amendments to the 1988 Basel Accord on Capital Adequacy, the netting principle was internationally accepted: see Vol 6, s 2.5.5 below. We are concerned here with so-called soft law, but nevertheless a most important international acknowledgement of the concept of netting, although still subject to the condition that the law of the country of the residence of the counterparty (or its place of incorporation) and of the branch through which the bank acted as well as the law applicable to the swap must accept the netting concept (which had required changes or clarifications in the domestic law of several countries). 17 The idea of the UCP being transnational customary law is associated with the views of the Austrian Frederic Eisemann, Director of the Legal Department of the ICC at the time and was first proposed by him/her at a 1962

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 21 The important and connected issue of finality also arises and has already been mentioned several times.18 It may be seen that we are here concerned with the key legal infrastructure of the international financial markets, which can hardly any longer be suitably covered by domestic laws of all kinds. Where a generation ago, this international market might still have been peripheral to domestic markets and domestic legal systems, it has now moved to the forefront, the size of the international markets being far greater than that of even the largest domestic markets.19

King’s College London Colloquium—see Le credit documentaire dans le droit et dans la pratique (Paris, 1963) 4. This approach was followed in England by Clive Schmitthoff, although in his/her view always in the context of some national law. See for France, Y Loussouarn and JD Bredin, Droit du commerce international (Paris, 1969) 48. In France, their status as international custom is now well established: see also J Puech, Modes de paiement, in Lamy, Transport, tome II, No 324 (2000). See also B Goldman, ‘Lex Mercatoria’ 1983 (3) Forum Internationale; Trib De Commerce de Paris, Mar 8, 1976; (1976) 28 Le Droit Maritime Français 558 (Fr); Cour de Cass, 14 Oct 1981, Semaine Juridique II 19815 (1982), note Gavalda and Stoufflet; Cour de Cass, 5 Nov 1991, Bull Civ, IV, no 328 (1992) (Fr). In Belgium their status as international custom was accepted by the Tribunal de Commerce of Brussels, 16 Nov 1978, reprinted in (1980) 44 Revue de la Banque 249. In Germany, see N Horn, ‘Die Entwicklung des internationalen Wirtschaftrechts durch Verhaltungsrichtlinien’ (1980) 44 Rabels Zeitschrift 423, but the German doctrine remains uncertain, especially because of the written nature of the UCP and its regular adjustments, which is seen there as contrary to the notion of custom: see CW Canaris, Bankvertragsrecht, 3rd edn (Berlin, 1988) Pt I, 926. In the Netherlands, the Supreme Court has not so far fully accepted the UCP as objective law. See Hoge Raad, 22 May 1984 (1985) NJ 607. The lower courts are divided. So are the writers with PL Wery, De Autonomie van het Eenvormige Privaatrecht (Deventer, 1971) 11, and this author in favour: see Jan Dalhuisen, ‘Bank Guarantees in International Trade’ (1992) 6033 Weekblad voor Privaatrecht Notariaat en Registratie 52. English law does not require any incorporation in the documentation: see Harlow and Jones Ltd v American Express Bank Ltd & Creditanstalt-Bankverein [1990] 2 Lloyd’s Rep 343 (concerning the applicability of the ICC Uniform Rules for Collection (URC), which are less well known, but nevertheless subscribed to by all banks in England); Power Curber Int’l Ltd v Nat’l Bank of Kuwait SAK [1981] 2 Lloyd’s Rep 394 (Lord Denning MR) considering the UCP as such, also with reference to the fact that all or practically all banks in the world subscribe to them, which seems the true criterion in England). For the US, see Oriental Pac (US) Inc v Toronto Dominion Bank 357 NYS2d 957 (NY 1974), in which the force of law of the UCP was accepted ‘to effect orderly and efficient banking procedures and the international commerce amongst nations’. In the US, the Incoterms and UCP are matched by similar rules in Arts 2 and 5 UCC, which may leave open the question of their operating as international custom in the US, but they would likely have that status in international cases and then supersede any conflict of law rules in this area. 18 In terms of the legal characterisation of transfers and their finality, important issues arise in securities transfers and in payments, especially those through the banking system. They centre around fraudulent or defective instructions, the meaning of acceptance of the transfer or payment, the question of capacity and intent, and the transfer and its formalities (eg in terms of existence, identification and delivery of the assets) and acceptance. In terms of transnational general principle, which may well be in the process of becoming customary in a mandatory manner, the necessary finality may here be underpinned by: (a) de-emphasising the role and subjectivity of capacity and intent while giving these notions an objective meaning (they may even be assumed); (b) the abstract nature of all transfers in the German tradition (separating them from any underlying contractual or instruction defects); (c) the independence of the transfer or payment obligation and of the transfer and payment itself as derived from the negotiable instrument and the letter of credit practice; (d) the bona fides of transferees once they have been credited or have received the assets in respect of any defect that may attach to the title—in other words the underlying assets (securities and cash) may be assumed to be clean; (e) justified reliance of transferees and especially payees who were owed the relevant assets or moneys and received them. It may thus be shown that transnationalisation may provide a considerable support function, especially in this key aspect of finality of international transactions. 19 As for the notion of international property rights, in air and sea transport with the connected bills of lading and negotiable instruments, and now also in international finance, they remain unexplored, but the idea may be less unusual in the context of public international law and in intellectual property: see eg R Churchill and AV Lowe, The Law of the Sea, 3rd edn (Huntingdon, NY, 1999); M Roggenkamp et al, Energy Law in Europe (Oxford, 2001) paras 2.01ff; S McCaffrey, The Law of International Watercourses (Oxford, 2001) Ch 5; P Birnie and A Boyle, International Law and the Environment, 2nd edn (Oxford, 2002) Chs 1, 5, 6, 7 and 10; D Gillies and R Marshall, Telecommunications, 2nd edn (London, 2003) Ch 4; C Tritton, Intellectual Property in Europe, 2nd edn (London, 2002) Chs 2–6.

22 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services However, upon a denial of a transnational approach, in international financings it would still be a question of private international law to determine which local law prevails, if necessary, in the different aspects of the transaction and different for the various countries of operation. As just mentioned, and as we have seen in Volume 4, sections 1.8 and 1.9, in proprietary matters it will then normally still be the domestic law of the country of the situs of the asset (assuming that it is tangible and does not habitually move) that takes over. It is the consequence of the continuation of a physical approach to property law, also in respect of movable assets. In a more modern environment, at least for intangible assets, notably monetary claims, a more abstract or constructive situs concept would thus have to be used or invented. The considerable problems and uncertainties which arise in terms of the application of a domestic law when assets move or are intangible were explained in that connection, as well as the trend towards fundamental and more rational modern transnationalisation in the international flows. Aliso from this perspective, a greater measure of party autonomy may be needed to overcome these problems,20 even in the law of tangible movable property, a subject already introduced in section 1.1.1 above, although its effects and limits may still be poorly understood (in terms of the numerus clausus and protection of the commercial flows as we have also seen). In section 1.2 below, for each product discussed therein, the conflicts of laws approach pointing to the applicability of domestic laws only and the transnationalisation approach will be discussed and contrasted. It was understood and already mentioned that, whatever the objectively applicable proprietary rule may be or allow, it is clear that exactly because of the effect on other creditors, this protection cannot be freely assumed or arranged with the counterparty, therefore between creditor and debtor as a private contractual matter only, but ultimately depends on authorisation under the objective law, traditionally indeed leading to the notion of a limited number of proprietary rights, or, in civil law, to the so-called numerus clausus, which also limited asset-backed financing to a narrow number of clearly defined types under national law per country (see also more particularly Volume 4, section 1.2.2). In payments, and especially in set-off and netting as a form of payment but more so as a modern risk management tool, it could then also still lead to substantive limitation, assuming always that these transactions and facilities could still be properly located. The set-off implies here a strong preference, as we have seen, and as will be discussed more extensively below in section 3.2. Creditor’s protection is the traditional argument against 20 For assignments of receivables, greater latitude is now sometimes assumed in civil law, and parties might at least be able contractually to choose different domestic laws of assignment. Particularly in more recent Dutch case law, even in the proprietary aspects of assignments, sometimes the law of the underlying claim and in other cases the law of the assignment have been upheld as applicable following Art 12(1) and (2) of the 1980 Rome Convention on the Law Applicable to Contractual Obligations rather than on the law of the debtor or that of the assignor. This allows for some party autonomy and a contractual choice of law in proprietary matters. There are in the Netherlands three Supreme Court cases in this connection, the last two of which have elicited considerable international interest: see HR 17 Apr 1964 [1965] NJ 23; HR, 11 June 1993 [1993] NJ 776; and HR, 16 May 1997 [1997] RvdW 126. See for a discussion of the first two cases, JH Dalhuisen, ‘The Assignment of Claims in Dutch Private International Law’ in Comparability and Evaluation: Essays in Honour of Dimitra Kokkini-Iatridou (The Hague, 1994) 183, and for the last one THD Struycken, ‘The Proprietary Aspects of International Assignment of Debts and the Rome Convention, Article 12’ [1998] Lloyds Maritime and Commercial Law Quarterly 345. See more recently in England in support of the law of the assigned underlying claim, also for the validity of the assignment (in respect of an insurance policy) Raffeisen Zentralbank Osterreich AG v Five Star General Trading LLC [2001] 3 All ER 257. See for a recent defence of full party autonomy in these matters, and therefore, the acceptance of the use of private international law as a route to open up the numerus clausus system of proprietary rights in civil law in respect of claims (without much emphasis on the equivalency test), A Flessner and H Verhagen, Assignment in European Private International Law, Claims as Property and the European Commission’s Rome 1 Proposal (Munich, 2006).

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 23 party autonomy in these matters which may through netting clauses expand the preference and attendant protection. As noted before, modern needs to manage risk have allowed more room for party autonomy also in this area, which was more developed in equity in England and later in the US (see further section 1.1.11 below). It may easily be observed that application of merely domestic laws in this area curtails the international liquidity-providing and risk management function of banks, which is now perceived as a necessary facility if we wish to retain the benefits of globalisation, and the inroad in the rights of (common) creditors that may is increasingly accepted, see again section 1.1.11 below (although empirically hardly established as we shall see). The development of t ransnationalised legal structures is preferable in a highly leveraged society and should only be curtailed if a clear public policy or public order argument against them can be formulated, and it can only be repeated that the mere preservation of domestic legal systems for their own sake or even the position of common creditors may no longer be of that nature. Clearly, from the perspective of the funding provider (or bank), the key remains the objective validity of any arranged security or similar interest as a proprietary right in a bankruptcy of the counterparty/debtor, either under the applicable domestic law, or now rather under a demonstrable transnationalised legal framework. Again, the natural direction of transnational law in this area is that of equitable proprietary rights in common law countries, which was able to introduce a more dynamic concept of movable property law—see also Volume 1, section 1.1.6—with its concepts of trusts (including resulting and constructive trusts), conditional and temporary ownership rights, and floating charges: see further Volume 4, in particular sections 1.1.1 and 1.10.2 and section 1.5 below. It also maintains a more liberal approach in the equitable set-off. Nevertheless, the handicap of the dominance of local laws can still not be ignored and much of what follows still reflects this.

1.1.5. Local Differences and Similarities in the Legal Organisation of Asset-backed Financing Unless we are willing to follow newer globalising financial structures and accept the transnational practices and customs forming in that connection, that is to say the transnationalisation of law at least in international finance and its related products, services and facilities, especially in asset-backed financing and set-off and netting facilities, the business community must continue to cut up international transactions into domestic pieces and manage the related legal risk. It will find that in respect of each piece, there may often still be different local regimes, notably for the contractual and proprietary or enforcement aspects. Affected parties must then continue to work with the substantial differences and limitations local laws present and with the often parochial approaches they follow, or otherwise try to work and structure around them as best they can.21 But the result is that the international financial business is handicapped for no obvious reason

21 See for an overview J-H Roever, Vergleichende Prinzipien dinglicher Sicherheiten (Munich, 1999); U Drobnig, ‘Vergleichender Generalbericht’ in KF Kreuzer (ed), Mobiliarsicherheiten, Vielfalt oder Einheit? (Baden-Baden, 1999), who also summarises a number of options to proceed to greater harmonisation at EU level; see earlier U Drobnig, ‘Legal Principles Governing Security Interest’ Doc A/CN.9/131 and Annex in (1977) VII UNCITRAL Yearbook 171; see for the (limited) EU involvement also EM Kieninger, Mobiliarsicherheiten im Europäische Binnenmarkt (Baden-Baden, 1996) and for a summary, EM Kieninger, ‘Securities in Moveable Property within the Common Market’ (1996) 4 European Review of Private Law 41–66; see further PR Wood, Comparative Law of Securities and Guarantees (London, 1995).

24 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services except legal peculiarism, and will continue to find it particularly hard to use classes of assets located in different countries, or cashflows originating in them to back up and protect indebtedness, especially to attract working capital for their international operations. It may also find it hard or harder to enforce (an amalgam of) domestic security or similar interests and netting facilities in foreign bankruptcies, more so when assets have moved in their next production phase. Modern risk management on the scale now required will thus be handicapped also. If we limit ourselves for the moment to traditional security interests, these local differences are principally reflected in: (a) the types of security interests domestic laws allowed financiers to create in their debtors’ assets to support and protect their funding activities in terms of mortgages, pledges and non-possessory security interests in chattels and intangible assets; (b) the formalities surrounding the creation of these security interests (like documentation, publication and for (tangible) movable assets especially the requirement of possession); (c) the possibility of bulk transfers for security purposes; (d) the types of present or future assets or assets in transformation that could be included especially in floating charges using future cashflows; (e) the type of past, present or future debt they could insure; (f) their continuation in replacement assets as a form of shifting of the interest retaining its original rank; (g) the protection of bona fide purchasers or purchasers in the ordinary course of business of the secured assets; (h) the enforcement of the protection and type of priority they offer, therefore in the execution of the security interest in the case of default, especially in the bankruptcy of the debtor, and any duty to return overvalue; (i) alternatively, any right of appropriation, particularly in finance (or conditional/temporary) sales. It should also be noted in this connection that between different countries in this area, the types of interest may be the same on its face, but the details may still differ greatly, and the protection may in fact be quite different. Even the characterisation of the reservation of title may become problematic, also in the professional sphere: it is sometimes (as in the US) considered a mere secured interest rather than a conditional ownership right of the seller subject to an execution sale in the case of default. There is also the problem of its shift into replacement goods and proceeds, which, where allowed, may transform it into a type of floating charge or security interest upon conversion. Just using a common term may therefore not mean a great deal. In this way, differences exist in a number of important aspects of other similar facilities, even between common law countries, which all have comparable security interests, substantially inspired by the rules of equity, as we have seen. Thus, the priority of the floating charge in England dates from the moment it attaches or crystallises, which occurs only at the moment of default. As a consequence, these charges give the creditor a low status—just above the common creditors. In the US, under the UCC, these charges, on the other hand, date back to the moment of filing or publication, even in their transformation into other (replacement) assets, and are thus much more potent and could well be the highest. In fact, in the US it is now possible to give virtually all one has or may possess as security for all one owes or may owe in the future with a rank as of the filing date (section 9-204 UCC). It follows from this different attitude to ranking that the use of future assets and income streams more generally is still constrained in countries like England. There is also the aspect of the different powers given to the creditors under these v arious facilities. In England, the implicit power of house banks, benefiting from floating charges covering

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 25 future assets, to virtually monopolise the credit supply to clients, subject to these charges and dictate future credit terms has come in for some serious criticism.22 Excess security normally results and is not easy to free up. In practice, this criticism may be less valid in the US, as it is easier and common for debtors there to pay off their debts (without penalty unless otherwise agreed) with the help of successor banks in a situation where there is often more competition between banks. The result is less risk that the debtor must eventually return to the first bank.23 Under the US Bankruptcy Code (section 364), the courts may in any event release excess security that may build up under this system. Although Article 9 UCC is rightly admired in Europe (particularly in the aspect of its perfection and its publication requirements, which in truth protect very few—see section 1.6.1 below), (a) its sweeping approach to secured lending, (b) the power it creates over debtors, (c) its negative attitude towards conditional sales, reservation of title, and other modern asset-backed financing techniques by re-characterising them as secured transactions (often even finance leases and presumably also repos, as we shall see in section 1.6.2 below) and (d) therefore its limitation in risk management tools even among professionals, may, upon further consideration, find less favour elsewhere. The result of the present differences in traditions and views on secured transactions and finance or other types of conditional or finance sales may be more striking in civil law, even between close neighbours like the Netherlands, Germany, France or Belgium. Belgium did not even accept the effectiveness of the reservation of title in bankruptcy until a change in the bankruptcy law in 1997, as French bankruptcy law did for France in 1980.24 In the meantime, the fiduciary sale (as a form of finance sale) was outlawed by Belgian case law, although especially reinstated by statute for transactions conducted through the book-entry system of Euroclear in Brussels.25 In France, non-possessory security interests in chattels were limited to certain types of assets only. Especially for the American observer, this all appears old-fashioned, provincial and unsophisticated, although it is unclear whether in the final analysis it makes much difference to the development of the economy at large. It is undeniable that the US legal approach supports an easy credit policy and culture. It may itself be a product thereof and not so much its cause. A similar situation exists in the UK. The tradition on the European Continent may suggests a difference. At least in Germany, it is less credit oriented and society used to be less highly leveraged or geared as a consequence. However, it should never be forgotten that security and similar interests to protect funding are always last resorts. A good financier will never extend credit on the basis of security alone. S/he wants to see a proper cash flow that can support the payment of interest and principal in the case of a loan or prevent a repurchase in the case of a conditional sale. Repossession is an admission of misjudgement and an undesirable ending, even if better than nothing. 22 There was also the possibility under floating charges for the chargee to appoint an administrative receiver to collect in the case of default quite separate from any bankruptcy proceedings. Although not against the traditional principle of repossession in bankruptcy and separate recovery, this became quite disruptive when under newer legislation for corporate reorganisations secured creditors could also become involved. Thus, the Enterprise Act 2002, effective 2003, abolished this contractual and private execution facility. The administrator appointed under the new reorganisation procedure (which succeeded the earlier ‘administration’ that gave secured creditors veto power) must restructure the company and deal with the rights of all creditors in that context—see sch B1, para 3. S/he is an officer of the court. While on the one hand this suggests lesser autonomy of secured creditors under private contracts, it must be noted on the other that their rights are being greatly extended under private netting agreements. 23 See for the UK the 1981 Cork Report and further JH Dalhuisen, ‘The Conditional Sale is Alive and Well’ in JJ Norton, and M Andenas (eds), Emerging Financial Markets and Secured Transactions (International Economic Development Law) (The Hague, 1998) vol VI, 83, 86. 24 See s 1.3.4 below. 25 See Vol 4, s 3.1.6.

26 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services All the same, in order to avoid inherent constraints of a more doctrinal nature, modern financing started to look for some more flexible alternatives, and now depends increasingly on other types of proprietary protection, even domestically. Hence the finance sales, financial leases and repos being already identified as prime examples, although their proprietary effect is still denied in many civil law countries. Nevertheless, in modern legal systems like those of Germany and the US, the whole development of non-possessory security in chattels during the nineteenth and twentieth centuries depended at first on precisely this sort of imaginative use of conditional ownership (as the reservation of title still does). Legally, they often appear to operate behind modern financial products and keep re-emerging all the time when the system becomes too inflexible: see below section 2.1 and as noted earlier in Volume 4, section 1.7. This led to the Sicherungsübereignung in Germany, as we shall see in section 1.4.2. To repeat, instead of the debtor granting to the lender a security interest in an asset or class of assets of the debtor to support the creditor’s loan, the party requiring funding engages in a sale of their own assets subject to a right (and duty) to repurchase them later. It makes the ownership rights in the underlying assets conditional or temporary. As in a repurchase agreement, there is no loan proper, but the seller will use the sale proceeds to satisfy his/her funding needs subject to a right to regain the assets later, while s/he may retain the use of them in the meantime, an aspect that may be discounted in an extra reward for the financier. To repeat, the result is that ownership notions rather than notions of security are used to facilitate the funding and that the ownership of the relevant assets is likely to be split for the time being between the parties. It follows that, in the case of default, instead of execution and return of the overvalue to the party needing the financing, the financier will be concerned with a full appropriation of the assets if the counterparty fails to tender the repurchase price in a timely way. That would make the financier the unconditional owner of the asset. Even though it can be said that ownership concepts are more universal in this respect and perhaps more flexible than security interests and easier to understand—the reason perhaps why in modern international finance these structures are often preferred—there may still be important domestic legal differences and limitations in the use and acceptance of these alternative modern structures when used for financing purposes, especially in civil law. Again, short of transnationalisation, these limitations and uncertainties unavoidably impact on the effectiveness of the financiers’ protection obtained in this manner. Common law jurisdictions are in principle comfortable with conditional and temporary proprietary rights. They always were part of the law of real property where estates were commonly granted conditionally or for certain periods; hence, the well-known concept of future interests. They were later transferred in equity to chattels and intangible assets (or personal property): see further Volume 4, section 1.3.1. Consequently, bona fide purchasers, or more recently even, all buyers in the ordinary course of business, were protected against any (equitable) beneficial (or conditional or temporary) ownership rights so created. As already mentioned, several times, at least in civil law countries, the domestic law position is often less settled, in any event much less than it is for secured transactions. This may perhaps prove an advantage of sorts and may provide some flexibility in financial structuring; however, since under the traditional private international law approach the law of the situs of the asset applies also to these conditional or temporary proprietary interests, the more modern international financial practices would remain dependent on local laws and their limitations. Ultimately, parties can still not ignore the substantial differences and uncertainties which local laws present, especially in the area of finance sales and floating charges, unless, again, they can make out a case for transnational law to apply. Even then local bankruptcy laws as a matter of (local) public policy may still produce important impediments.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 27 All the same it might prove easier in respect of intangible assets such as receivables in receivable financing. To repeat, they have no proper situs, at least not in a physical sense, and this may favour transnationalisation supported by party autonomy to a greater degree than is normally accepted for tangible movable assets, allowing the parties to substantially define their proprietary regime, or at least choose a more suitable domestic law (thus abandoning by contract the lex situs principle): see also Volume 4, section 1.9.2. As for tangible movable assets, transient assets like ships and aircraft or oil rigs on the high seas (being the subject of finance leases), or international assets like (euro) bonds being used in repos (even if taking the form of investment securities of the modern custodial entitlement type, which have a largely coincidental location with the custodian: see Volume 4, section 3.2.2), may likewise sooner be considered subject to transnationalisation (supported by a form of party autonomy backed up by transnational customary law, subject to a better protection of bona fide purchasers or even all buyers in the ordinary course of business of commoditised assets as we have seen). At least party autonomy, choosing an alternative domestic legal regime, might then be more acceptable—and one might ask why this regime could also not be transnationalised more generally. Again, in a transnationalised approach, the impact on outsiders, particularly third parties such as bona fide purchasers or competing creditors, remains an important issue and a potential constraint on the introduction of new proprietary structures and their protection cannot result from pure party autonomy. It is supported by transnational public policy favouring the liquidity of the commercial flows and better risk management therein, again, meaning that these charges or rights only operate against professional insiders like banks and suppliers who should know and use these structures themselves, but they do not affect the general public, notably consumers who can buy the relevant products free and clear of any such charge. As has been said before, this concerns important issues of finality of transactions.26 It requires further support by established practices or industry custom transnationally (see for this evolution Volume 1, section 3.2.2, Volume 4, section 3.2.3 and section 1.1.10 below), the key of which was considered to be the further development of what in common law jurisdictions are called equitable proprietary rights, now at the transnational level, the reach of which is then cut off at the level of the bona fide purchaser or the purchaser in the ordinary course of business of commoditised products. The next few sections will deal more extensively with these differences in the areas of secured transactions, finance or conditional sales, and other proprietary options in the context of modern funding techniques using movable or personal property, whether chattels or intangible assets. Reservation of title, being itself a conditional sale, will be discussed as a similar legal structure, although it is not a funding device proper, and therefore, not a banking product, but rather a sales-price protection device. For secured transactions and finance sales, the relevant legal issues have already been briefly analysed in Volume 4, section 1.7 and there will be further elaboration in section 2.1 of this Volume, preceded by detailed comparative law studies of the Netherlands, France, Germany, the UK and the US. For finance lawyers, the key is to try to understand what these structures mean in law, what the issues in their legal characterisation are, and how they might be better handled by defining them more properly and subsequently by transnationalising them. They know of the tensions that have developed in international financings through the often historical, coincidental and sometimes irrational limitations local laws present, but we are still less aware of (a) the increasing need to overcome them through better transnational legal support for the international financial practice, and (b) the means of getting there, mainly through a better intellectual underpinning

26 See

n 18 above.

28 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services of the modern lex mercatoria or the transnational law merchant. It aims to develop new facilities in the same way as it developed much earlier negotiable instruments, especially promissory notes and bills of exchange, in order to facilitate the international mercantile practices of those days. Indeed, it has already been said that the traditional negotiable instruments and even bills of lading and international bonds present here some examples in terms of transfer, bona fide purchaser protection, and finality where transnationalised concepts always remained relevant. We may now increasingly see a similar moving forward in a much broader array of financial products, especially in finance sales, but also in floating charges.

1.1.6. International Convergence in Secured Transactions and Finance Sales? Regardless of the broad legal divergences under national laws in respect of financial products and potentially the protections they offer to creditors and investors when asset backed or relying on set-off, there have always been some important similarities even in security interests. These products may have a common origin, often in Roman law, but may also have developed commercially in parallel ways that may reduce the differences. Thus, both in civil and common law, security interests: (a) are normally proprietary in nature and give as a consequence (in civil law terminology) an in rem or proprietary right in the underlying assets to the creditor, which (subject to any rights of bona fide purchasers, especially in respect of chattels so used) the secured creditor can maintain against all the world, and therefore retain against the owner/debtor as counterparty and any third parties (unless an older proprietary interest holder) even if the owner/debtor sells the assets (whether or not in possession of the creditor); in French this is referred to as the droit de suite (see Volume 4, section 1.1.1); (b) give as a consequence priority to the oldest security interest holder in the asset (the principle of prior tempore, potior iure or first in time, first in right), who may ignore all others, in French referred to as the droit de préférence (see also Volume 4, section 1.1.1); (c) allow the secured creditor to seize or repossess the asset upon the default of his debtor (if s/he has not already taken possession),27 therefore in principle as a segregation or self-help remedy, sell it, and subsequently set off the secured claim against the proceeds while returning any overvalue to the defaulting debtor, but retaining an unsecured claim on the debtor for any undervalue; and (d) are accessory to the debt, and therefore, benefit any assignee of the claim, while, on the other hand, they are automatically extinguished with the debt (upon payment).28 27 The execution sale will in principle leave other secured interests (higher or lower) in the asset unaffected, that is to say that the buyer in an execution sale buys subject to these prior rights, unless there are other statutory provisions which may allow buyers in execution sales to buy free and clear. This means that the security interest holders will divide the proceeds according to rank. 28 In civil law, provision may sometimes be made to the contrary, as is done in the German Grundschuld, and the security need therefore not be accessory per se. The Grundschuld is a secured borrowing facility that survives the repayment of the debt, and is transferable separately from it. The existence of this type of facility exists only for land and is marked in the land registers, but the change of interest holder results from the transfer of the paper. It is also possible to embody both claim and accessory security in one document, as is common in asset-backed securities and may also be seen in so-called chattel paper in the US under s 9-102(a)(11) UCC. In common law, the accessory nature of security interests is less developed as a concept than it is in civil law (see also nn 235 and 279 below) and may need agreement of the parties or statutory support. Where the assignor in the assignments of

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 29 Yet, as we have seen in the previous section, there remain considerable variations in the details, such as formalities, possession or publication requirements, the types of assets (including future assets) and debt (including future debt) that can be covered, the potential shift of the security into replacement goods and proceeds, and in the type and manner of disposition upon default. To repeat, the main differences are here (a) in the operation of so-called floating charges covering whole classes of changeable assets like inventory and receivables, presupposing therefore the possibility of a bulk transfer at the same time and, (b) in the conditional sale for finance purposes or financial sales. Applicable bankruptcy laws may create or assume further differences, while laws protecting bona fide purchasers of the secured asset may also undermine the effectiveness of the security interest, especially in chattels when sold to unsuspecting third parties in the ordinary

legal claims (as distinguished from equitable claims) may retain a function in the actions against any debtor, the survival of the supporting security interests may not be in doubt, but upon his/her release the situation may be less clear. In the case of a novation, the supporting security would in any event be lost. For reservation of title and other types of conditional sales, the accessory nature is often rejected also in civil law (unless parties agree otherwise): see nn 77 and 165 below, but cf also n 124 below, plus accompanying text. As in common law most security interests are derived from conditional sales (except for the possessory pledge in chattels), this may additionally explain why in common law the accessory nature of secured interests is much less considered. The question remains what a security interest still means upon the assignment of the claim it insures without the simultaneous assignment of the security interest itself. In such cases, the assignor could be considered paid so that the security interest is effectively at an end and the assignee continues with an unsecured claim. It would of course affect the value of the assigned claim and the proceeds the assignor is likely to receive. Another approach is to consider the assignor the constructive trustee for the assignee in respect of the benefit of the security. In the US, on the whole, the response has increasingly been in favour of the accessory nature of the security interest. See for English law n 235 below, and for the US also n 279 below. It is often seen as incidental to the debt and transferring with it: see AL Corbin, 4 Corbin on Contracts (St Paul, MN, 1951) s 907, following National Live Stock Bank v First Nat’l Bank of Geneseo, 203 US 296 (1906) and followed by Brainerd & H Quarry Co v Brice 250 US 229 (1919). See for more recent case law also Sinclair v Holt 88 Nev 97 (1972); General Electric Credit Corp v Allegretti 515 NE 2d 721 (III App Ct 1987), and JWD Inc v Fed Ins Co 806 SW 2d, 327 (1991). Section 9-206(1) (old) UCC (last sentence) made it clear that upon an assignment, the debtor may not raise the implicit transfer of the security interest to the assignee as a defence against its effectiveness: cf also s 9-403(b) (new). Section 340(2) Restatement (Second) of Contracts (1981) assumes that the assignor holds the collateral in constructive trust for the assignee. The California Civil Code, s 2874, accepts on the other hand, that a security follows the debt it insures. As a consequence, the assignee of the secured claim would be able to repossess the collateral without any further action of transfer of the security interest to him/her being required: see also RA Anderson, Anderson on the Uniform Commercial Code, 3rd edn (Rochester, NY, 1994) s 9-503(43) and Midland-Guardian Co v Hagin 370 So 2d, 25 (1979). However, in the case of promissory notes where the security interest is not marked on the note itself (which is uncommon), the situation may be different, which would mean that, upon transfer, the security interest supporting the note may lapse. Again, in chattel paper, the close connection between the claim and the security interest is recognised by statute: s 9-102(a)(11). The automatic end of the security interest upon payment would in the US appear to follow from ss 9-203 and 9-513 (s 9-404 old) UCC, which make the security interest conditional on the continued existence of a secured obligation. If an assignment is for cash, the assignor may be considered to have been paid, and it is then a question of interpretation as to how far the security interest survives for the benefit of the assignee. The question of the accessory nature of security interests is not problematic in civil law (at least if there was an assignment of the entire right and not merely a security or conditional assignment): see for the survival and shift of the accessory or supporting rights upon assignment Art 1692 of the Code Civil (CC) in France, s 401 of the Bürgerliches Gesetzbuch (BGB) in Germany, and Art 6.142 of the Civil Code (CC) in the Netherlands. In Roman law, the accessory nature of security interests was obviously maintained when the assignee at first only operated on the assignor’s behalf, even though for his/her own benefit: see C 4.10.6 and D 18.4.6, but was later extended to all assignees: see C 4.10.7. Forms of personal guarantees, like sureties (but not always bank guarantees, like first demand guarantees or letters of credit), may be equally accessory or incidental to the main claim, and may therefore, also benefit assignees in civil law. In the US, this possibility is sometimes also considered: see B Ryan, ‘Letters of Credit Supporting Debt for Borrowed Money: The Standby as Backup’ (1983) 100 Banking Law Journal 404.

30 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services course of business of the debtor. In common law, this protection remains exceptional in principle, but is now usually provided by statute, although it exists in equity more generally in respect of any adverse beneficial or equitable ownership rights, as we have seen. In that case, it is implicit in the nature of an equitable proprietary right. Nevertheless, for the more traditional security interests, there is some international communality in concept and operation. As already suggested, the evolution of conditional and temporary ownership rights and related options—still underdeveloped in civil law—might show some further welcome international approximation as an alternative to, rather than a substitute for, secured transactions. Although historically they cannot be completely separated from secured transactions, since they played an important role in the development of non-possessory security interests in several countries at the end of the nineteenth century, there remains confusion, but it follows from the foregoing that they are different structures and must be clearly distinguished from secured transactions. Generally, they differ from security interests, especially as they: (a) allow in the case of default appropriation of full ownership by the buyer or finance provider who is therefore entitled to any overvalue in the asset, while the seller or fundraiser is released from its debt if there is undervalue (unless there is a contractual different arrangement); (b) are not accessory; (c) present a duality of ownership under which each party’s interest in the asset is in principle independently transferable, resulting in conditional or defeasible titles for either (or their successors); and (d) depend for their effectiveness in bankruptcy on conditions (or equitable expectancies) being able to mature against a bankrupt at the same time the bankruptcy has been declared. It was already said that the reservation of title is the more traditional example of a conditional sale, even in civil law, explicitly recognised in Germany and the Netherlands. To repeat, it is not a funding technique, but a sales-price protection device. As such it fulfils a different function and is not a banking or financial product proper. It is nevertheless an important example, although historically the conditional sale in fact figures large in the development of all non-possessory security interests everywhere (including the real-estate mortgage in England) and is also relevant (although now less so in the US where there is statutory law in this area—see also sections 2.1.1ff below) for the modern finance lease and repo (but less for investment securities repos because of the fungible nature of many of these securities, as we shall also see, in section 4.2 below, and the right of the repo buyer normally to on-sell the securities). It has already been said that history shows that the conditional sale tends to re-emerge whenever the prevailing system of security interests becomes too confining, and that may also be relevant for lease and repo funding.

1.1.7. The Problems of and Need for Modern Non-possessory Security Interests in Personal Property and the Alternative Use of Finance Sales As far as secured transactions proper are concerned, the non-possessory real-estate mortgage and the possessory pledge in chattels are the traditional examples of international convergence. The real-estate mortgage is indeed universally used, even though in common law it was traditionally perceived as a conditional sale (which made an important difference upon default, as we shall see) and could also be embodied in a trust-like structure, especially in the US, where the house owner may as a consequence become the trustee of the dwelling house for the lender as beneficial owner; an ordinary execution sale may then follow upon default. The mortgage is commonly associated with house financing, although no less relevant in commercial property funding.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 31 Its essential features are that the interest of the lender is in a specific well-defined existing asset, and normally supports a loan with a fixed principal amount (although in continental Europe, banks as mortgagees often include all the mortgagor may owe them from time to time), but not necessarily with a fixed interest rate, although there is usually a fixed maturity. It has already been mentioned that the more specific feature of a real-estate mortgage is that it is non-possessory, which means that the secured asset is left with the debtor. That is so also when it is a conditional sale. Even though non-possessory, it is at least in an asset (real estate or immovable property) that could not be hidden or lost. This is unlike the traditional pledge in movable assets, which can easily be hidden and as a consequence required the creditor to take physical possession of the asset for the security interest to be valid. That became so everywhere and is in common law manifested in bailment. At least for movable property, it seemed the more natural situation, as it gives the creditor tangible protection who then also does not need to fear that other creditors may create similar interests in the property, or that the asset may be abused or lost by the debtor. There is also no need to search for and retrieve or repossess the asset in order to execute the interest in it upon default of the debtor. It follows that the possessory pledge became the more suitable security interest in chattels, and that the (non-possessory) mortgage came to be associated mostly with real-estate security. Nineteenth-century law reflected these patterns in many civil law countries, but this approach is relatively recent, and certainly not complete. It is of some interest in this connection that in pre-codification law, especially in France, there was a possessory charge, or a vifgage (or vivum vadium), in respect of real estate, which allowed the creditor to take the land and amortise the loan (plus accrued interest) through the income received out of this property. The French antichrèse is the remnant (Article 2085 CC), and the result was a possessory security interest in land with user, income and enjoyment rights for the creditor. In England, under a traditional real-estate mortgage, this is still a possibility upon default. On the other hand, Roman law and the ius commune—which is the pre-codification civil law built on it, and which prevailed in most parts of Western Europe until the nineteenth century (see Volume 1, section 1.2.4)—had been more liberal in allowing the mortgage or hypothec as a non-possessory security interest, also in movables. This remains the position in common law, where even now the chattel mortgage subsists in the nature of a conditional sale, as we shall see, as a non-possessory interest in individualised chattels, although sometimes, like in England, it is subject to a registration requirement if used outside the commercial sector to prevent abuse, which became common in the nineteenth century, and is then called a bill of sale. In the US there was a break, however, and while chattel mortgages re-emerged later in the nineteenth century under some State law, they were then likely to be treated as non-possessory security interests rather than conditional sales, and became subject to publication requirements: see section 2.1.3 below. More common was, however, the possessory pledge as a form of bailment. It can be said, and has already been mentioned, that in nineteenth-century continental European thinking, therefore in codifications countries, there was an underlying trend which moved to a more physical attitude to proprietary rights once they were more clearly separated from obligatory rights. This was explained above as a continuation of an anthropomorphic attitude in property law (see Volume 4, section 1.1.5), supplemented by a similar attitude in contract law that was there directed towards psychological intent notions. In property, it crystallised in an emphasis on identification and specificity of assets, soon connected with the disposition facility, which in that approach could not be abstract either, and could not then concern future assets or the transfer of assets in bulk. It blocked a rights-based approach, which is necessary to develop a more advanced system: see also the discussion in Volume 4, section 1.10.3 and section 1.1.1 above.

32 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services This being the case, for security interests, in civil law, the emphasis fell increasingly on physical possession or, alternatively, sometimes on a system of publication if the security interest was non-possessory, therefore mainly in land (later often extended to ships and aircraft), once land registration started to operate. Thus, through publication, the creditor’s position under the real-estate mortgage became reinforced and safeguarded against other (later) creditors and the owner and his successors in interest by requiring filing of the charge in land registers, which were progressively created in the nineteenth century. Where such publication was not practically feasible, as remains still mostly the case with chattels and claims, non-possessory security interests were abolished altogether, and the nineteenth-century civil law codifications eliminated them in favour of the possessory pledge. Security of this nature involving monetary claims as collateral was largely ignored. They raised in particular the question whether a creditor so secured could collect the receivables instead of being obliged to conduct an execution sale upon default. Thus nineteenth-century civil law no longer encouraged hidden non-possessory proprietary rights like security interests or even usufructs (life interests) or servitudes in chattels, let alone in monetary claims. In the meantime, the full (unregistered) ownership right in chattels became almost universally weakened in civil law through the protection of the bona fide purchaser if legally acquiring physical possession or a sufficient form of control. In common law, this applied to the sale of goods, but only through statute, affecting merely the sale (and not the pledging) of chattels (see for the so-called nemo dat rule and its progressive abolition for chattels, Volume 4, sections 1.4.8–1.4.9). As explained above, it had a much broader and basic reach in equity where it cut out all equitable proprietary interests, probably without the purchaser taking physical possession, in all types of assets as a more general principle, in fact as a result of the rule that these interests were valid only among a group of insiders who knew or were supposed to know of them when acquiring the underlying assets. In this approach, in civil law, publicity was increasingly seen as the equivalent of possession, in the sense that it demonstrated both the creditors’ or others’ proprietary interests in immovable, and as the case could be, in movable assets also. In the case of security interests in intangibles such as receivables, it was the notification given to the debtor that was more recently equated with this publicity, and the lack of it tended equally to rule out the perfection of security interests in them, even in countries that did not normally require such notification for the assignment of intangibles itself. Yet, in truth publication, physical possession, or notification were never the true justification for proprietary rights (see also Volume 4, section 1.1.2), which did not absolutely depend on them, although they could be better supported in this way and especially undermine any bona fide purchaser protection, assuming that a search duty could be imposed or could be presumed to exist on buyers of the underlying assets, as it certainly did in respect of land. But this proved in practice unfeasible in respect of movable assets, which could hardly be so recorded. In civil law, the consequence of this approach to security interests was nevertheless that non-possessory security interests in chattels without publication (for which there was mostly no facility except for chattel mortgages in England), and in intangibles without onerous notification requirements to the debtors under the relevant receivables, were deemed invalid during much of the nineteenth century.29 Informal means of publication, or simple knowledge of all concerned, was not then deemed sufficient to make them effective against third parties either. The continuing

29 See, for the earlier continental European approach based on Roman law and the changes at the beginning of the nineteenth century, WJ Zwalve, Hoofdstukken uit de geschiedenis van het Europese privaatrecht, 1 Inleiding en Zakenrecht [Chapters from the history of the European private law, 1 Introduction and Property Law] (Groningen, 1993) 388.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 33 facility of non-possessory security in personal property, at least in England, gave it a relative advantage, if only operating in the nature of a conditional sale mainly in commerce and finance. In England, the trust concept helped in the development of newer non-possessory equitable charges, which derived from the possibility that trusts could be used as an alternative security device that was much more flexible in the aspect of physical possession, which could be left with the borrower/trustee, rather than the lender beneficiary. They could then also continue into replacement assets or proceeds as a matter of tracing, resulting in shifting interests: see also section 1.1.3 above. Similar equitable interests could result upon conditional sales of movable assets which were converted into finished products as already mentioned several times. This raised, however, the spectre of overvalue, which could easily arise, particularly when other goods were incorporated in production chains. At the same time, it posed the question of the position of other conditional owners of commodities or semi-finished products converted into the same end-product. Various conditional owners were then likely to be pooled as interest holders and would need to share at the same level of priority or preference in the asset. Here the idea of a disposition and recovery from proceeds with a return of overvalue came in, even in England, borrowed from the pledge. In this situation, the debtor became liable for any undervalue, and there was no release. Here, we see the beginning and origin of the floating charge as an equitable proprietary right or charge in its own right, not operating, therefore, as a conditional sale. In the US, in the nineteenth century, chattel mortgages, reservations of title, conditional sales especially of equipment, factoring of inventory and receivables (or collection agreements), and trust receipts were meant to fill the void left by the absence of non-possessory security in chattels and receivables as ways to finance them at law. Later, trust receipts, which were pieces of paper signed (mostly) by car dealers and given to their financiers, were also used in this connection. They evidenced the financiers’ equitable or beneficial interests in the cars the dealers held in inventory, which would induce the financiers to pay the car manufacturers for this stock. The diversity in security and related interests that were so made available in the US in the case of chattels and intangibles (see section 2.1.3 below) led at an early stage to some uniform law— the Uniform Conditional Sales Act (1918), and the Uniform Trust Receipt Act (1922)—but they were not universally adopted, and only the UCC in Article 9 achieved fundamental consolidation after 1964. The key was that all these (equitable) interests, if meant to back up payment or other obligations, were converted by statute (in the UCC) into security interests. In funding transactions, the conditional sale and its derivatives were thus technically eliminated, while the appropriation of the asset in the case of default (with the release of the debtor and retention of any overvalue by the creditor) was also abandoned. This also affected the reservation of title. It may have seemed intellectually satisfying, but practically it created, as already mentioned, all kinds of problems, particularly with finance leases and repos: see also section 1.6.2 below. It limited the risk management facilities and was probably not wise. In any event, definitional and characterisation issues could not be avoided and there were problems with finance leases from the beginning and with repos later, only to demonstrate that a statute of this nature is not all powerful and autonomous in these matters and cannot defy economic realities based on different risks and rewards, as we shall see shortly. On the European Continent, modern business requirements eventually also demanded a return of non-possessory security in chattels and intangibles, even without publication or notification, first in order to be able to use inventory and equipment as collateral for loans to finance these assets themselves, and subsequently, to use receivables in a similar manner to provide for their funding. As a consequence, at the end of the nineteenth century, case law started to allow these hidden non-possessory charges back in many civil law countries, at first in the form of

34 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services conditional sales. The result was, however, greater divergence and variation in detail, for example, as between the German Sicherungsübereignung and the Dutch fiduciary sale or fiducia. Indeed, they both started also as a form of conditional ownership by the financier of certain assets of the debtor (see for the older ius commune tradition in this area Volume 4, section 1.7.3), but in a bankruptcy of the counterparty this facility soon developed in Germany in the direction of a weak preference in the proceeds of an execution sale, especially in a subsequent bankruptcy. In the Netherlands, on the other hand, it evolved into a security interest proper. It was therefore stronger and retained an independent execution or repossession right for the buyer, also good as a self-help remedy in a bankruptcy of the seller, as will be discussed in greater detail in section 1.2.1 below.30 The next step was to allow these (hidden) charges to shift automatically into replacement assets and proceeds. This is a development into the direction of a floating charge, but was by no means completed in civil law everywhere, already noted, much easier to achieve for example through a contractual clause to the effect in Germany than in the Netherlands, as we shall see below. A particular proprietary problem here is the inclusion of future assets, and therefore, of assets that do not as yet exist and may not even be identifiable except as to type, and the need to retain the original rank or priority (at least to the extent it concerns replacement goods). Here again, common law countries maintained their traditional advantage through the equitable right of tracing of the interest into replacement goods and proceeds and its lesser preoccupation with identification and disposition or delivery issues in equity (which also concerns the facility to transfer assets in bulk). The original rank could thus also be retained, indeed an important feature of the floating charge in the US, introduced by statute, but not in England. At issue here are some of the more fundamental differences between civil and common law, already discussed in Volume 4. In the new Dutch Civil Code of 1992, ultimately the non-possessory security interests in chattels and un-notified security interests in intangibles found a statutory base, but were limited in essence to existing identifiable assets. They remain to all intents and purposes still hidden charges although subject to a registration requirement, but only to clearly identify them and establish their date and therefore their rank. This is not a publication facility, but it does do away with the former informality in this area. A shifting of the interests into replacement goods and proceeds with the retention of the original rank is not part of this system and cannot easily be achieved by agreement between the parties either. Future assets cannot be included in the older charge; at least, this would not be effective if the assets physically accrued to the debtor only after its bankruptcy: see section 1.2.1 below.31

30 In Germany, this meant in bankruptcy a shift from the stronger Aussonderungsrecht to the weaker Absonderungsrecht (see also text at nn 164 and 177 below), and therefore, a loss of the proprietary status and execution right of the creditor in the asset in exchange for a priority right in the distribution of the proceeds. This was unlike the situation in the Netherlands where in a bankruptcy of the debtor the creditor was able to claim or repossess and execute the asset himself, but with a return of any overvalue: see also the text at nn 70 and 173 below. 31 New Dutch security law is generally restrictive and still puts considerable emphasis on the identification of the asset and the specificity of the debt at the time of the creation of the charge. It is in consequence not easy under new Dutch law to include future assets and future debt and create a true floating charge over an entire business. Whatever the policy objectives behind this approach—and they are not fully clear—it gives debtors less flexibility to use their (future) assets as security for other debt: see further also nn 66ff below and accompanying text and there remains confusion. Absolutely future claims cannot be assigned, but a certain percentage of a securities portfolio may be as long as that means a given and precise percentage, even of an uncertain quantity. In this sense, probably all of a certain class of present and future assets is transferable, as it may suggest sufficient identification.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 35 On the other hand, in Germany, the important Sicherungsübereignung, leading to the normal non-possessory security interest in chattels, remains completely informal. There is no publication need or possibility. The contractual extension to replacement goods and proceeds does not seem to give rise to major problems in that country as these types of future assets are perceived to be substantially identified, while a degree of party autonomy is here conceded so that by contract the parties can make arrangements that do substantially add up to a floating charge: see for greater detail section 1.4.4 below. Bona fide purchasers of chattels so encumbered are, however, protected, but only in respect of physical, movable assets. In England, non-possessory floating charges (a term not found in the text of the UCC in the US, but used in the Official Comment) on entire companies, were developed in case law at the end of the nineteenth century. They were introduced by statute in Scotland in 1961, although to a lesser extent absorbed in the prevailing credit culture there. As mentioned above, they are equitable security interests (unlike mortgages and bills of sale, which are conditional sales resulting in legal interests, and therefore, not subject to bona fide purchaser protection). In the meantime, the idea of publication of non-possessory proprietary interests in chattels became in England an important feature of bills of sale in the personal sphere (mainly to avoid abuse of small debtors by professional moneymen) as already noted, but, for professionals, English law only requires publication of (floating) charges on whole companies. As mentioned before, these charges have a low priority, as they take their rank only from the moment of crystallisation (and not publication), which is normally upon default. It means that they rank just above the unsecured creditors, but below any other secured creditors, a problem fundamentally overcome in Article 9 UCC, as we have seen, which relates the priority back to the date of the original security instrument and its filing. It was a major US innovation tied to filing and practically of the greatest importance for banks. This will be discussed in greater detail in sections 1.5 and 1.6 below. Here, the key point is that in the more traditional approach, short of legal transnationalisation, modern funding practices, even if international, still must adjust to what domestic law will allow in terms of proprietary protection of a creditor. But it is also apparent that this domestic law sometimes had to change to accommodate new (international) financing needs. It was already said that the transnationalisation of the funding practices in the commercial sphere will pose further challenges to these domestic laws, and will ultimately lead, it is posited, to full transnationalisation of the legal regime in the international flows. What is clear is that in newer legal developments in this area, therefore notably in the development of non-possessory proprietary interests, usually two important recurring features are found: first, the adjustments are initially mostly made through case law, and secondly, they are then often achieved by using the technique of a conditional or temporary sale of the asset. These developments were, however, not always successful or complete, especially in France, where at the beginning of the twentieth century some specific statutory non-possessory charges were created in certain types of chattels, each with very different facilities and requirements. It could even cover a business (fond de commerce), but only in a limited way. Statutory law in 2005 in France made a fuller floating charge possible (see section 1.3.1 below). As we shall see, new Dutch law is regressive and particularly the shifting of these charges into replacement goods or other future assets remains a serious problem, but, largely with the exception of Germany, this is also the case elsewhere in civil law countries, even in the newest codifications; cf for example, the Brazilian Civil Code of 2002. In the EU, the Draft Common Frame of Reference (DCFR) that figured as some model for an EU civil code, is also regressive, as we have seen in Volume 4, section 1.10.

36 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services

1.1.8. Finance Sales and Secured Transactions Distinguished and the Re-characterisation Issue. Different Risk and Reward Structures As we have seen, the funding technique of the conditional sale and transfer as an alternative to secured lending was established at an early stage in the English real-estate and chattel mortgages, and later in the US and in the German rediscovery of non-possessory security rights in chattels. The operation of the conditional sale in finance, or of what is then called a finance sale, may require some further explanation. Assuming one has some assets, the key is to appreciate that it is generally possible to raise cash promptly by either selling them or taking out a loan on the security of them. Rather than conceding a security interest in certain assets to support a loan, these assets could thus also be sold to someone who would pay for them. It is the payment for the assets that provides the liquidity or funding in that case, rather than the granting of a loan: see further Volume 4, section 1.7. These alternatives, although obviously quite different, may become more similar if the sale of assets in these circumstances is made conditional upon repayment of the purchase price by the seller/debtor to the financier at an agreed moment when the assets retransfer to him/her, while the seller normally retains the user rights during the period. That is one difference with the situation when the assets were given as security, and these facilities do not become the same; in fact, they remain fundamentally and legally quite different. This is so not only because the financier in a conditional sale would normally not obtain possession and use of the relevant assets, this being a great advantage for the party needing the financing and allowing him the use of these chattels, whilst non-possessory security in them remained impossible. That was indeed mostly the motivation for these conditional sales, even in civil law, at the end of the nineteenth century, when non-possessory asset-backed funding through chattels and intangible assets became a necessity. The other difference was that there resulted a different situation upon default, including the failure to tender the repurchase price on the appointed date. It would allow the buyer to keep the assets without any need for an execution sale and a return of the overvalue. In principle the seller would not be liable for any undervalue. Although the arrangement could lead to physical possession by either seller or buyer, in financings of this sort, possession would normally be retained by the seller (except in investment repos, as we shall see). Furthermore, the buyer would be able to recover or retain the assets in full ownership in the case of a failure by the seller to tender the repurchase price on time or to accept the goods when tendered by the buyer. In civil law, the buyer might possibly revindicate them as owner if not already in physical possession of the asset or otherwise initiate a tort action for wrongful possession by the seller. On the other hand, a seller would be entitled (at least if they were not fungible assets) to revindicate the asset from the buyer upon tendering the repurchase price on the agreed date, implicit if the repo seller obtained possession from the start (as is normal in the case of securities repos). The subsequent development was nevertheless that if there was a clear loan—that is a conditional sale with a repayment clause to which an agreed interest rate structure was added, or with a clause requiring regular interest payments on the purchase price to the buyer during the repurchase period—the courts in both Germany and the Netherlands (although in different ways, as we have seen, especially in the manner the repossession and disposition were conducted) would start to apply the rules of secured transactions to these conditional sales. This is the re-characterisation issue. It principally meant that in such cases in the event of default, there had to be an execution sale and a return of overvalue to the seller, even if in Germany that was less clear for the Sicherungsübereignung (as a non-possessory interest in chattels) outside a bankruptcy situation

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 37 when, however, the lending contract was interpreted to demand it unless expressly agreed otherwise (a proper proprietary re-characterisation happens then only in bankruptcy). In the process, the proprietary interest even became accessory to the debt, and was therefore unaffected by either an assignment of the secured claim or a sale of the secured asset, another clear sign of a secured transaction, although again in Germany only a contractual obligation of the financier to retransfer the interest is implied outside bankruptcy unless clearly stated otherwise. Courts, at least in England, proved less willing, however, to convert these interests into a security interest, at least if there was no interest rate structure and the mere agreeing to the seller paying a fee (often discounted in the repurchase price) for this facility was not considered the same. Thus, as we shall see in section 1.5 below, true repurchase agreements (not therefore limited to investment securities for which the term ‘repo’ is more often used) could be entered into instead and did not acquire the characterisation of secured loan financing. Upon default, there would as a consequence not be an execution sale with a return of overvalue to the debtor. The interest would not be accessory either or survive an assignment of the claim or a proper sale of the asset. Instead of a disposition, the financier would appropriate the asset upon default and keep it, including any overvalue. In fact, the financier might have become the unconditional or full owner automatically. On the other hand, full ownership would revert to the seller upon timely tender of the repurchase price (whether or not accepted). The justification for this different approach is ultimately in the different risk and reward structure. Even where modern non-possessory security interests have been developed in this manner, from the point of view of the party requiring financing, there may thus still be clear reasons for the alternative type of funding presented by finance sales or repurchase agreements in the sense just explained. First, using the sales channel may be cheaper and more efficient especially in respect of investment securities; entering in to securities agreements may take more time and be more costly. The party needing the funding may also raise a larger amount of money in a sale, secured lending often being confined to only 80 per cent of the asset’s value. Furthermore, a sale of the asset would often shorten the balance sheet, while a secured loan would lengthen it. There could also be tax advantages, for example, in finance leases. Most importantly, conditional sales may present a cheaper alternative to secured loan financing. The other side of it is that, in the case of a default in timely tendering of the repurchase price, there is likely to be appropriation of full title by the buyer without a return of any overvalue. That is the risk and trade-off. This overvalue is less likely to occur where 100 per cent of the commercial value of the asset is paid by the financier at the outset as is normal. But even then, the price of the assets, particularly in modern investment securities repos or during times of high inflation, could vary considerably and increase during the repurchase period. Again, this underlines the different risk and reward structure in the sale and repurchase agreement as a conditional transfer compared to secured loan financing and hence a true funding alternative to the secured loan and different risk management instrument. It was already noted that the structure of the conditional sale may be used, particularly in the modern financing techniques of the investment securities repos, but no less in finance leasing and in factoring of trade receivables. These may all (depending on their precise terms) be considered examples of conditional sales producing separate, specialised funding facilities. In this connection one then also speaks of ‘finance sales’. They will be further discussed in Part II of this Volume. In the meantime, the reservation of title and hire-purchase as purchase money protection structures also emerged. They are in most countries (expressly so in the German and Dutch Civil Codes, but no longer in the US) more especially retained in the form of a conditional (or sometimes delayed) sales, and may provide important clues as to how the conditionality of finance sales and their effects on the title transfer should be handled, at least in civil law.

38 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Nevertheless, there remains considerable confusion in the area of characterisation of finance sales. Often it is argued that, economically speaking, finance sales are secured loans and that therefore all rules of secured lending and loan credit protection should be applied. This is now in essence also the US statutory approach in Article 9 UCC, but, as mentioned before, it is on the whole undesirable and confuses everything. It ignores the basic economic differences in these financial structures as expressed in the different risks and rewards, and would appear to be a structural mistake in the US, important and advanced as it is in many other aspects. It was already said that it deprives the financial practice of an important alternative funding facility and is giving rise to all kinds of problems in the structuring of modern funding alternatives. It may also be noted in this connection that in Sharia financing the conditional sale is favoured, while secured lending, being interest related, is not. Thus, conditional sales are at the heart of much Sharia financing. However, as we have seen, in the US under Article 9 UCC, therefore by statute, conditional sales of chattels and intangibles are now normally converted into secured transactions: see section 9-102(1)(a) and (2) (old). The latest text of 1999 in section 9-109 is less explicit on the point, but there is no change. Again, in the US even the reservation of title is characterised as a security interest subject to the disposition duties of the creditor in the case of default by the debtor who is entitled to any overvalue in the asset. The modern funding facilities through finance lease, repurchase agreements and factoring are similarly threatened. This has created great problems. In order to prevent these, but also for other reasons, a new Article 2A has been added to the UCC for so-called equipment leases. Case law in the US considers repos and certain forms of factoring or securitisations not affected by the conversion threat either.32 The federal Bankruptcy Code, section 559, clarifies these issues now also, at least for investment securities repos in bankruptcy situations. In the Netherlands, the new Civil Code of 1992 (Article 3.84(3) CC) is no less wary of what it considers security substitutes (although hardly aware of newer financial products). It outlaws them altogether by in principle denying them any proprietary effect, therefore, not even converting them into secured transactions. The Code fails to define, however, what these substitutes are, and there is no clear line. Nevertheless, the status of modern finance sales was endangered, and it is left to Dutch case law to sort matters out. Courts are trying to correct the situation in order to preserve these modern financing facilities, which are in legal commentaries indeed increasingly identified as conditional sales.33 At least the new Dutch Code did confirm the conditional sales nature of the reservation of title (Article 3.92 CC) and allows (in the abstract) pure conditional sales with proprietary effect in Article 3.84(4), without, however, defining the parties’ interests under them. This leaves, as just mentioned, for all such financing, including equipment leasing, serious doubt as to their proprietary operation. The legal approach, notably in England, has indeed been to appreciate the different risk and reward structures in security- and ownership-based financing, which results from their fundamental economic difference, and to apply the rules of secured lending (with their abhorrence of appropriation or forfeiture, and a need for a disposition and a return of overvalue to the debtor) only in true loan situations when there is a clearly agreed interest rate structure, which is not normally the case in finance sales or in the sales-price protection schemes of reservation of title and hire-purchase.34 In other words, a formal criterion is used here, and the courts do not

32 See text at nn 248 and 251 below. See also S Vasser, ‘Derivatives in Bankruptcy’ (2005) 60 The Business Lawyer 1507. 33 See text at nn 89ff below. 34 See ss 1.5.3–1.5.4 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 39 normally look behind the declared structure.35 Even so, the conditional sales approach is seldom fully developed in the modern finance sales in common law: see section 1.5.2 below and for the extensive old case law in the US on the subject, section 2.1.3 below. Yet common law is on the whole comfortable with conditional or temporary ownership, in equity also in chattels and receivables (although the UCC in the US deviates here by statute from the established common law pattern for chattels and intangible assets, as we have already seen), but this has not led to a clearly defined type of ownership right. In common law, there may also be an important overlap with bailment, especially in finance leasing and repos, in which parties may relate to each other as bailor and bailee, which gives another set of protections. However, it also creates a separate set of complications.36 All the same, as a basic proposition, it remains justified (although less so now in the US) and necessary always clearly to distinguish between security-based and ownership-based financing or funding techniques. Upon closer examination, it is indeed apparent that in modern finance the conditional sales technique inherent in ownership-based funding is often preferred as is clear from the popularity of financing through repos (even if more difficult to characterise as a conditional sale in the case of fungible securities, which are not individually returned, but are defined as to their sort or per class (see, however, section 4.2.2 below), finance leases, and (some forms of) factoring of receivables. These financing techniques are now of great importance, and will be discussed in detail in Part II below. The repos of investment securities amount to billions of US dollars (equivalent) per day and serve largely to fund the short-term or more speculative acquisition of investment securities by banks. In the meantime, finance leases are thought to be used in more than 12 per cent of all equipment financing, while the factoring of receivables and their securitisation are no less significant. To summarise, the newer financial instruments beginning with the reservation of title and more particularly the finance lease and repo of investment securities, may legally be characterised as: (a) split-ownership structures, (b) secured transactions, or (c) purely contractual arrangements. In the first characterisation, there is a balance between the rights of two owners during the transaction period; in the second there is an immediate transfer of ownership, for example to the buyer 35 Of particular interest in this connection is the real estate mortgage in England (and also in the US). As already mentioned, the common law mortgage was a conditional sale. It meant that the lender/bank bought the asset and that the mortgagor obtained the purchase price, usually used to pay the acquisition price of the property to the original seller. In this structure, there was traditionally appropriation of the asset by the lender/bank upon default, but since the mortgage normally has a clear interest rate structure attached to it, this appropriation right became balanced by the right or equity of redemption of the debtor: see also text at n 202 below. It was meant to achieve a similar form of protection for the defaulting debtor as the disposition requirement of the asset does in secured lending in other countries, leading to preserving the overvalue for the defaulting debtor. But the equity of redemption only gave the debtor/mortgagor additional time to recover full title and allowed him/her only indirectly to retain the overvalue in this manner. The situation also remained different in that any undervalue could no longer be recovered if the financier chose to obtain full ownership (by petitioning for the foreclosure of this equity of redemption if the debtor did not take advantage of it) when the sale to the financier became complete. On the other hand, where there was no true loan, as indicated by the absence of an agreed interest rate structure, the right of redemption was unlikely to apply. That is clear, at least in England, in the case of finance leasing, repurchase agreements, and in the factoring of receivables, and certainly also in the reservation of title as purchase money security. This is an important insight, and may support the view that the true distinction is indeed in the existence (or not) of a formally agreed interest rate structure. 36 See also n 239 below and accompanying text. See for the earlier attempts in case law to define the rights of both parties under a conditional sale in the US: see nn 277ff below.

40 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services under a reservation of title or to a lessee subject to a security interest of the seller or lessor with the need of a disposition in the case of a default and return of overvalue; while in the last characterisation there is no immediate transfer of ownership, which remains with the seller or lessor, at least until full and unconditional payment. The disadvantages of the second alternative are obvious: the disposition need and return of overvalue gives the defaulting party a strong position if the price of the asset has risen (for example, because of inflation or pursuant to market conditions) and takes away from the financier the store of value that is in the asset. That may be all the more obvious in a repo if the investment security that has been so sold has increased in value. In the third alternative, the buyer and lessee have no protection in an intervening bankruptcy of the seller or lessor and might be forced to surrender the asset. In a repo, this latter characterisation may impose itself, however, if the investment securities are fungible and may be sold by the repo buyer or further repo-ed by him, which is normal: see also the discussions in section 4.2 below. The consequences of a contract characterisation are habitually countered by netting agreements, as already mentioned before, assuming there are many reciprocal transactions. They imply an immediate set-off of mutual claims upon default, including a valuation of the assets to be returned or delivered. Again, in all of this, it should be remembered that in international proprietary transactions the principle of the lex situs still favours national laws, although it could technically also accommodate transnational custom and practices or even party autonomy. In any event, secured transactions often remain too localised in their applications to be useful in international financial transactions and there may be more room for convergence and harmonised transnational interpretation in the area of finance sales. Perversely, it may even help that in ownership-based financing, the details of conditional ownership itself and the rights of both seller and buyer under it often remain unclear under domestic laws, although less so in common law countries and may (unexpectedly) allow for some greater flexibility. In fact, as was pointed out in section 1.1.4 above, transnationally, the conditional or finance sale presents a technique which may indicate a greater commonality in use, and therefore, a better financier’s protection as opposed to secured transactions. This should also guard against the re-characterisation problem. Thus, there may here be more room for overriding structures that have become accepted and customary in international finance and that could as such enter and be supported by the transnational law merchant, or modern lex mercatoria, as more fully explained in Volume 1. Whether that implies sufficient protection in bankruptcy still depends on the applicable local bankruptcy laws, however, assuming that the assets are within reach of the relevant bankruptcy court. This issue will be revisited below in section 1.1.14. It has already been noted that in cases where the asset is transient or intangible, through transnationalisation or even under local laws some degree of party autonomy may also be more readily accepted, which in the latter case may allow for a more appropriate domestic proprietary law to be chosen than that of the lex situs—all the more important if these assets need to be transferred in bulk, may be future, and are spread between various countries; however, it remains debatable how third parties might be affected in their rights by this type of party autonomy and choice of some more amenable domestic law. Alternatively, these assets could be deemed to be located at the place of the owner to achieve a unitary regime under the latter’s local law. Perhaps a case can also be made for this in respect of repos in fungible assets, the situs of which cannot be known until the return moment. Again, it is the thesis of this book that ultimately under transnational law, notably international custom, these structuring facilities should be extended to all international financings supported by assets regardless of their location and that local bankruptcy law should respect the transnational law in this regard unless public policy prohibits it.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 41 In civil law, there is another issue. For public policy reasons, it tends to limit (often by statute) the types of proprietary rights, as was discussed more fully in Volume 4, section 1.2.1. Again, this is the issue of the numerus clausus of proprietary rights (see also section 1.1.4 above). Although each proprietary right might still allow some structuring on the basis of party autonomy, there is a limit to it and in civil law the allowed proprietary rights are few in number. Even under the new Dutch Civil Code, it remains unclear how conditional ownership rights, in principle recognised in Articles 3.92 and 3.84(4) CC, can be properly fitted into this (closed) system of proprietary rights (Article 3.81 CC). Particularly when tested in local bankruptcies, foreign or transnationalised proprietary rights may still come up against these confines, then as a matter of public policy. For them to prevail, international recognition, taking the form of acceptance of established transnational custom or practice supporting transnational proprietary rights, would have to become apparent, again barring public policy. In respect of assets in the US, there would still be the question of re-characterisation into a security interest under Article 9 UCC, also in a US bankruptcy, as we have seen.

1.1.9. Formal International Harmonisation Attempts in the Area of Secured Transactions and Finance Sales. The EU Collateral and Settlement Finality Directives The considerable differences in security interests and the legal uncertainties in modern conditional or finance sales or even in set-off and netting arrangements have troubled the more internationally oriented legal community to the extent it is aware of them. It is unclear whether these differences are a noticeable handicap for international trade, for example in terms of the status of the reservation of title when goods move across borders or in the treatment of general charges on inventory subsequently moved to other countries. There is at least no widespread evidence of it in the EU or in domestic case law, even for the reservation of title. The main reason is probably that these creditor protections are commonly lost upon the sale of these goods to bona fide third parties, and they are often destined to be sold in this way. As already noted, another aspect, no doubt, is that security interests and conditional sale protections are meant only as a last resort. No funding would result at all if there were any immediate prospect that the resulting proprietary protections would have to be invoked. It all matters, however, in particular in a bankruptcy. Fortunately, bankruptcy remains a rare occurrence, and security interests and conditional sales or even netting arrangements are seldom tested for their effectiveness in the case of default, although bankruptcy protection through these facilities, when operating cross-border, remains a major legal concern and substantial source of ingenuity and income for lawyers in terms of legal risk management as we have seen. In modern, large-scale, internationally promoted finance structures, the differences and uncertainties are becoming more obvious and are unsettling and thus undesirable. The use of repos in foreign investment securities, mainly amongst banks, of finance leases in aircraft that habitually move across borders, and of factoring of receivables involving foreign debtors is most likely impeded, at least from as legal point of view, by the present uncertainties short of transnationalisation under which these structures are recognised for what they are: internationally operating equitable interests in a common law sense, supported by transnational custom and practices developing in the world of professional dealings. The problems with a transnationally working floating charge have also been demonstrated in the above. The same goes for transnationally operating netting agreements. Again, in a time of few bankruptcies, problems are less

42 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services obvious, and they remain substantially hidden, but that is not to say that they do not exist and inhibit funding or, as importantly, make it more costly to obtain. Some international efforts have been made to alleviate the problems in this connection, but they have not amounted to a great deal, and it may be asked whether there is the proper insight for treaty law to move forward. In 1988, UNIDROIT came with Conventions on Factoring and Finance Leasing. They may have been a good first start, but are not particularly enlightened and have had few ratifications so far: see further sections 2.3.5 and 2.4.6 below. UNCITRAL produced a Convention on the Assignment of Receivables in International Trade and UNIDROIT a Convention on International Interests in Mobile Equipment, both in 2001: see respectively sections 2.3.4ff and 2.1.10 below. With the exception of the Mobile Equipment Convention, they have had little success, and are likely to require a great deal more thought and much more political will to make a true difference. Industry rather than academic support would seem vital. The financial community is rightly wary, so far, of these efforts. The reason is that it never asked for it and that it is hardly consulted on the texts, which could easily undermine the flexibility in the financial structuring financiers seek. In any event, uniform treaty law by its very nature tends to be a compromise between academics and bureaucrats; it is as such unlikely to be practice-driven. It has the additional disadvantage of not being easily adjustable to new needs and developments as treaty law is notoriously difficult to amend. As far as the loss of flexibility is concerned, again with the possible exception of the Mobile Equipment Convention, there is as yet little indication that in these international efforts the nature and importance of conditional or finance sales, as distinguished from secured transactions, are properly understood and their operation facilitated. Nor is the need for transnationally operating floating charges. It may be another reason why these efforts seem to become less rather than more popular. Short of adverse international public policy considerations or minimum standards, they should facilitate rather than curtail the international funding practices and the flexibility they seek and need. As just mentioned, at the EU level, the disparities have not elicited great concern so far either, and it is unlikely that a serious attempt will soon be made to harmonise the securities interests EU wide if only in chattels and receivables, or that an effort will be made to develop conditional or finance sales in regional harmony.37 There is also a lack of EU competency. Efforts in 37 Within the EU, some efforts at harmonisation were made in the past: see Drobnig (n 21) 32. As early as the 1960s, there was a proposal from the banking industry to deal with the extraterritorial effect of non-possessory securities in movables based on recognition of these securities if properly created at the original situs of the asset and entered into a central EEC register. The EEC Commission at the time reacted positively, but wanted national registers and also the inclusion of the reservation of title. The effort, which became closely connected with the development of private international law rules for all patrimonial law, was abandoned after the first expansion of the EEC in 1973, but a text was prepared: see Doc XI/466/73, published by U Drobnig and R Goode, ‘Security for Payment in Export and Import Transactions’ in RM Goode and KR Simmonds (eds), Commercial Operations in Europe (Boston, MA, 1978) 378–82. In 1980 there was another proposal (Doc III/872/80, unpublished) concerning reservation of title only, now allowed to be effective EC wide without registration, including the agreement to shift the lien into proceeds. This project was not pursued. In the meantime, Drobnig in his report to UNCITRAL of 1977 (n 21) 226, stated that ‘mere recommendations, even if emanating from an international organisation of the highest repute, will not command sufficient moral or other support for adoption by any sizeable number of States’. Although UNCITRAL subsequently, after the emergence of the UNIDROIT Factoring Convention of 1988, concluded that unification of the law of security interests in goods was in all likelihood unattainable, it made its own attempt in the area of receivables in 2001, as we have just seen. A further effort was the introduction of one notion of reservation of title into the Directive 2000/35/EC of 29 June 2000 combating late payment in commercial transactions, which also envisaged an accelerated collection procedure. It followed a Recommendation in this area of 12 May 1995, which did not contain a reference to

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 43 the 2008–09 Draft Common Frame of Reference (DCFR) made by an EU-supported group (see Volume 1, section 1.4.21 and Volume 4, section 1.11) in this area as part of what this group saw as a fuller codification of private law in the EU, even for professional dealings, was never convincing, if only because finance sales were not considered (as at least the Collateral Directive had been able to do, as we shall see shortly). The area of temporary and conditional ownership rights remained unexplored. The DCFR now reserves a special place for reservation of title as purchase money security; its nature as conditional sale is abandoned. The finance lease as sale or lease-back is considered a security interest and does not stand alone. So surprisingly is the repo. Hire-purchases are on the other hand sorted under the new regime for reservation of title, as is the finance lease, assuming the lessee may acquire the full ownership at the end of the lease. Otherwise, it is a mere contract. Equitable interests and their operation were limited to formal trusts and for the rest barely understood, even in a project that was also intended for England: see again Volume 4, section 1.11. On the other hand, the example of the US until the introduction of the UCC has shown that great differences may subsist in this area per country or state long after the unification of whole countries. There was a similar situation in Germany upon unification of that country after 1870 until the introduction of the Civil Code (BGB) in 1900. In both the US and Germany there was, however, from early on, a federal or national bankruptcy Act. It worked without any harmonisation of the security interests and conditional sales.38 In 2002 the EU enacted a Directive on Financial Collateral (see further sections 2.1.12 and 4.1.5 below) and tried to remove a number of impediments to modern financial structures. The collateral rules aim to safeguard financial obligations that give rise to cash settlements or delivery of financial instruments and set-offs (Article 2(1)(f)). This was a practitioner-led effort in a specific area that proved successful, particularly in professional dealings (those with natural persons are excluded) involving central banks, IMF, BIS and CCPs or depositories in custodial systems of securities holdings, though it is said that in practice the Directive finds little application. Fund management under UCITS or the AIFMD in the EU (see Volume 6, sections 3.5.14 and 3.7.7) may also get involved. The Collateral Directive meant to enhance the risk management facility in the financial service industry more generally and was not particularly geared to any form of reservations of title. Under the earlier proposals [1998] OJ C168/13, Member States, pursuant to Art 4(1), had to ensure that sellers retained their reservation of title in goods if they informed the buyers of it at the latest at the moment of delivery, but this could apparently be part of general sales conditions. In so far as the Directive did not cover the details of the reservation of title, Member States had to define the effect, particularly the effect on third parties acting in good faith. It did not say which Member State was here competent in international sales (Art 4(3)) even though the measure was inspired by the problems raised in commercial transactions between Member States, although not limited to them. The final text was simplified and stated that Member States should provide in conformity with the applicable national provisions designated by private international law that the seller retains title to goods until they are fully paid for if a retention of title clause was expressly agreed between the buyer and the seller before the delivery of the goods. Member States may adopt or retain provisions dealing with down-payments already made by the debtor. As only payments in commercial transactions were considered in this Directive, the rules for reservation of title appear not to apply to sales to consumers, although Member States may of course extend these rules to them as well. In the context of Directive 87/101 [1987] OJ L42 concerning consumer credit, Arts 4(3) and 7, Annex I, 1 v and vi, and 4 ii, gave certain minimum protection to consumer debtors requiring in essence full disclosure of any security interests. This does not amount to any kind of harmonisation of these interests or of the position of credit providers. 38 Cf also the 2005 amendments to the US Bankruptcy Code, which in the financial area centred on the enforcement in bankruptcy of ipso facto termination clauses, exemption of close-out, netting and financial collateral clauses from the automatic stay, and the exemption of payments made thereunder from preferential treatment prohibitions, all areas not covered by the UCC. This is reminiscent of some of the aims of the EU Settlement Finality Directive: see Vol 4, s 3.1.5 and also s 4.1.5 below.

44 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services asset-backed funding, but significantly it accepted the fundamental distinction between secured transactions and finance sales in respect of investment securities of the book-entry entitlement type. It dispensed, in the process, with all formalities in the formation including any filing requirement for the validity of any of these interests, and with formalities of execution of the collateral (like prior notice or court approval allowing the taking of cash, of the securities or selling them (Article 4) regardless of the provisions of otherwise applicable domestic laws in the EU and local bankruptcy laws, which could notably not have any retroactive effect in regard of the collateral or set-off facilities so created either). It also introduced what effectively was a kind of (possessory) floating charge on securities and their proceeds, while also including cash accounts in the collateral. Within the flexible rules laid down, much depends on the simple contractual description of asset and interest and ways of enforcement. Earlier the EU had adopted the Settlement Finality Directive (see Volume 4, section 3.1.5 and further section 4.1.5 below), which dealt with some domestic bankruptcy problems in terms of finality of financial transactions (especially repos) in intervening bankruptcy situations and any resulting preferential treatment, but did not deal with collateral proper or with other asset-backed funding devices.39 Efforts by the European Bank for Reconstruction and Development (EBRD) in this area, in the form of its 1994 Model Law on Secured Transactions, have had some support in Eastern Europe: see section 2.1.9 below.

1.1.10. Notions of Separation, Segregation and Priority. Proprietary and Other Structures to the Effect. Set-off and Contractual Netting Clauses. The Concept of Subordination. Bankruptcy Consequences For the purposes of the discussion in this Volume, the key issues for financiers are separation and priority, especially relevant in a bankruptcy of the counterparty. In other words, when in a bankruptcy, may some party, in this case the financier of the bankrupt debtor, lay claims to assets of the bankrupt estate and segregate them (that means take possession from the bankruptcy trustee or retain these assets if already in possession) and claim them as its own? Also, when may a priority right be asserted to the sales proceeds in an execution sale of these assets, and who may initiate and conduct it in such cases? Or when may there be a set-off of mutual contractual or other claims (either by statute or under netting clauses), which also leads to a form of priority/preference? May other instances of separation or priority arise? Issues of separation of assets and differences in ranking as part of execution sales in or outside bankruptcy emerge all the time in both civil and common law. For bankruptcy, it is often said that equal distribution is the essence of modern bankruptcy law, but in truth it is equitable (not equal) distribution which in modern times is a matter of statutory definition in terms of ranking and set-off or netting facilities: see the discussion in section 1.1.1 above. Indeed, it is the separation and otherwise the ranking or priority (and their potential variation in reorganisation proceedings) that is the essence of modern bankruptcy. It is not any overriding interests of common creditors, even though often still presented that way, which remains a common misunderstanding. Equality only exists within the same rank. As each secured creditor is likely to constitute a rank of its own, in practice there is likely only to be equality in the lowest rank: that of the unsecured creditors (and perhaps also in the class of attached but unperfected security interest holders under Article 9 UCC in the US and in the UK in respect of beneficiaries of floating charges upon

39 See

also the observation in n 38 above for similar needs in the US.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 45 their crystallisation after default). The doctrinal reason is that the common creditors are likely to have only obligatory claims, which rank pari passu per se, whilst proprietary claims by their very nature are ranked, mostly according to time. Only in modern reorganisation proceedings may the needs and details of the survival plan suspend the separation or priority and demand concessions in respect of secured claims. It could even interrupt a set-off, or at least the operation of contractual netting clauses. It should be clear from the foregoing that separation and priority in this sense are foremost associated with the operation of proprietary rights. At least that is so in civil law. In common law it may be argued that especially in respect of the equitable proprietary rights, separation in bankruptcy is considered a connected but a more independent issue and it does not automatically follow. In civil law, full owners of assets in the possession of the bankrupt may commonly reclaim them subject to any temporary user rights they may have given the bankrupt before the bankruptcy. This is the droit de suite, which together with the droit de preference best explains the nature of proprietary rights: see more particularly Volume 4, section 1.1.1 and further also section 1.1.6 above. So, if I left my bicycle in the shed of my friend who has gone bankrupt, I may go and retake it unless I have given him/her some user’s right. In that case, the trustee might want to retain that benefit for the agreed period, or even sell the user right off at the best price for the time that it still lasts, at least if it is transferable and has some market value. Importantly, in this category, sellers benefiting from a reservation of title in assets still with the bankrupt may also figure. If there are security interests, they will also be proprietary, and therefore can be pursued in principle in the bankruptcy and lead to a repossession facility upon the bankruptcy if the asset is not already in the possession of the creditor (now subject in the US to a short stay under section 362 of the Bankruptcy Code). As we have seen in the previous sections, an autonomous execution sale will follow upon which the creditor will satisfy its claim, only returning any overvalue to the bankrupt estate. As such, the repossession facility is one of the clearest expressions of private control and separation. The proprietary nature of these rights suggests at the same time a ranking according to time (the prior tempore, potior iure or ‘first in time, first in right’ principle) as a security interest holder with a proprietary right can ignore all others except older ones.40

40 The principles of ranking themselves may be summarised as follows: the older right prevails over the younger (prior tempore, potior iure: first in time, first in right), except that the grantor of the right is always postponed, although likely to be fully reinstated at the end of the term of the security right (if not executed). This priority among the grantees is the normal consequence of proprietary rights having an effect against all the world. The older interest holder may therefore ignore the younger. Any secured creditor may (in principle) execute subject to the other liens or similar interests, although subject to the rights of bona fide purchasers (not so likely in a forced sale). Bankruptcy laws may sometimes provide for a sale free and clear by the trustee (to realise overvalue) subject to the secured creditors being paid off according to their rank out of the proceeds (or being given alternative security): see s 363(b), (c) and (f) of the US Bankruptcy Code and s 15(2), (3) and (9) of the UK Insolvency Act (for administrations under the Act). Sometimes there may also be an implied right for the debtor to sell free and clear in the ordinary course of business as under a reservation of title or floating charge to protect the ordinary flow of his/her business. Although ‘first in time, first in right’ is the basic rule, there are exceptions: purchase money may have the highest priority in order to safeguard the ordinary flow of goods. More specific charges are also likely to prevail over more general ones: therefore, the later reservation of title is likely to prevail over an earlier charge over all the buyer’s present and future assets. In England this follows from the crystallisation requirement in respect of floating charges. Possessory liens may be advantaged over non-possessory liens, so that they may more readily entail their own execution right, even in bankruptcy of the debtor, and may therefore avoid the trustee’s cost, and will not be dependent on his/her action and timing. This is not so in Germany, where there is for the non-possessory charge (Sicherungsübereignung) in a bankruptcy of the counterparty only a right to a priority in the proceeds

46 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Thus, what we are concerned with is basically the operation of proprietary rights, but here only a limited one (a security interest in the underlying asset). Again, the situation is different in pure finance sales, where the buyer acquires ownership rights. Thus, upon a seller’s failure to tender the repurchase price in time, the buyer will be able to retain or repossess the asset, this time in full ownership. There will not be an execution sale and a return of overvalue. Simply, the finance sale becomes unconditional, while the party having received the funding keeps the sale price. If the buyer has possession, the seller reclaims the asset as if it were the bicycle in the shed of the bankrupt friend. There is full repossession amounting to appropriation of title. In the meantime, we enter the area of what more properly should be called equitable proprietary rights, defined in this book as contractually created user, enjoyment or income rights that may be maintained against all those who knew of them when acquiring the underlying assets. It allows for party autonomy and means that all subsequent owners who have knowledge or are assumed to have it (likely to be professionals only), must respect the residual rights to the assets of other interest holders, who may reclaim them on that basis. Party autonomy thus enters into the creation and operation of proprietary rights, but they can only be maintained against a group of insiders, who know or are supposed to know (for example, because of filing) of these interests. They are usually other professional creditors, notably funding providers like banks or major suppliers. The general public and the commercial flows are protected against these charges. That is the automatic result in equity in a common law sense, as explained above. Note again that were in civil law segregation would appear to follow automatically in bankruptcy (barring corporate reorganisation statutes), this may be less obvious in common law countries in respect of equitable proprietary rights. Ultimately there is also the possibility of set-off, especially relevant in particular in respect of contractual rights and their protection against non-payment or non-performance by a bankrupt counterparty. As we have seen in section 1.1.1 above, by statute these facilities are often limited to rights that are monetary, mature and in the same currency: see section 3.2 below. There may also have to be some connexity between both claims. But it is increasingly accepted that these restrictions may be overcome in netting agreements, which could therefore also cover repossession claims, therefore non-monetary claims, non-mature claims and claims in other currencies if incorporating the necessary valuation clauses: see section 3.2.4 below. When such facilities are recognised by the applicable bankruptcy laws, it may make many of the proprietary protections redundant, assuming that there are sufficient offsetting claims of all kinds. It took some time, but most bankruptcy regimes have become accommodating in this respect, as also demonstrated (Absonderung rather than Aussonderung), see n 26 above. Other countries such as the US accept rights to repossession and separate recovery, but make them subject to a short and temporary stay under s 362 of the Bankruptcy Code. It may also be different for statutory liens or (in France) privilèges, which are usually non-possessory and lead only to a preference in the bankruptcy liquidation proceeds. Contractual liens normally prevail over such statutory ones even if older, although some statutory liens, like tax liens, may sometimes also be given the status of a contractual security interest, especially in the US, as a consequence of which the older ones prevail over younger contractual liens. Statutory liens, especially general tax liens, may by statute also be given super priority status and then take priority also over all contractual liens and more specific statutory liens, which normally would have precedence. It may be added that in this area of status and ranking and the rights derived therefrom, the various legal systems are by no means always clear, even in respect of purely domestic proprietary and similar rights. Especially the conflicts between the reservation of title, particularly when allowed to shift to replacement goods and proceeds and floating charges or earlier security interests also comprising future assets of the debtor, may be substantial and have given rise to much litigation. It should also be considered that the set-off gives perforce the highest priority, while retention rights (see Vol 4, s 1.4.10) in practice may force the other creditors, even if secured, to pay off the retentor in order to be able to recover any excess value in the retained assets. The status of contractual enhancements of the set-off and retention right may again be much less certain and give rise to many questions.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 47 by the EU Settlement Finality and Collateral Directives and the 2005 amendments to the US Bankruptcy Code (section 553). Rather than in a bankruptcy reclaiming the asset as proprietary (for example, upon the end of the repo), it may indeed be easier to set off all mutual claims if there are many in the particular relationship, always assuming that a claim for assets may be included after a proper valuation. It avoids characterisation problems of repos and suggests that the risk can be handled contractually rather than proprietarily by reclaiming the underlying assets. In all these cases, bankruptcy protection or resistance is created for a financier by granting him/her full or more limited proprietary rights in the debtor’s assets or through set-off facilities. Separation or segregation facilities or priorities/preferences are not, however, only derived from proprietary and set-off rights. In the realm of separation outside the area of proprietary rights and set-off proper, in common law we have, for example, constructive trust facilities and the possibility of equitable liens or retention rights. They are often a sequel to unjust enrichment or restitution actions and not typical bankruptcy or default remedies: see also Volume 4, section 1.6.3. They may, however, also be important in bankruptcy situations, although when precisely they arise and how far they go (especially into commingled or replacement goods) is often less clear. In common law jurisdictions, the notion of tracing is closely related, as we have seen, and means exactly to reach replacement goods, of special importance in floating charges. It was shown that common law jurisdictions are basically pragmatic, especially in equity, although neither necessarily generous nor even fully clear outside the areas of trusts, conditional and temporary ownership rights, and floating charges; civil law is more restrained. A key point is that common law jurisdictions will allow proprietary relief, thus returning assets in appropriate cases, even in a bankruptcy of the counterparty, while civil law in such matters at best gives a claim for damages, which will be merely a competing claim in a bankruptcy of the debtor. Yet even in civil law, a retrieval concept increasingly surfaces where moneys have been improperly handled or misappropriated by asset managers and broking agents or are threatened by their bankruptcy. It shows a true need, also accepted where proprietary rights are increasingly allowed to shift into replacement goods and proceeds and a beginning of tracing becomes clear. In the law of obligations this type of relief earlier led everywhere to increased possibilities of specific performance. This was discussed at greater length in Volume 4 and summarised in its section 1.10.2. At least in civil law, the notion of separation beyond the realm of proprietary rights, set-off or unjust enrichment may be connected with pooling, joint or common ownership, and legal personality notions, as in the case of the bankrupt estate itself. Indeed, this estate may be considered owned by the joint creditors as such separated from the person of the bankrupt or his trustee. In this manner, the community of property between spouses and civil partners is in the main also considered separated from their own, as is the deceased’s estate from the estates of executors and of the heirs before distribution. Commercial partnership types commonly lead to similar forms of separation of assets between the partnership and individual partners, leading to a separation effect in a personal bankruptcy of one of the partners whose bankruptcy trustee would not then be able to hold on to any partnership property in possession of the partner concerned. Although there seems not to be a clear guiding principle, it is apparent that mere communality of property is not enough to lead to separation in this sense. There are other instances where separation is at work, for example in the case of charitable collections, when the moneys so collected cannot even in civil law be considered to belong to the (bankrupt) estate of the collector or donee. Here again, notions of unjust enrichment creep in, leading to what is in essence segregated property, introducing an inherent trust situation even in civil law: see also Volume 4, section 1.6.3. Indeed, it appears that there must be some special outside or policy reason why these properties obtain not only a separate asset status, but also a separate liability and profit and loss structure. In a more enlightened view, it leads into the notion of legal personality of the ensuing

48 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services assets or pools, which may be connected with the purpose that they mean to serve and is then a dynamic concept. In agency and guardian relationships, the management and treatment of client assets and moneys, as well as the handling of assets of minors or incapacitated persons, have also created a need for stronger protections of the principals or beneficiaries through separation notions, especially important if the assets are officially in the name of the agent or guardian, which is normally the case. Again, this is a problem habitually resolved in common law jurisdictions through constructive trust notions, much more difficult to achieve in civil law. See for the case of indirect agency more particularly Volume 3, section 3.1.6. In civil law, there may as a consequence also be problems for client accounts even if expressly so designated, but still in the name of the organiser of the account. Even if there is separation in principle in such cases, there may still be practical problems when the assets remain or become irreversibly commingled with the assets of the holders, managers or trustees, or creators of these separated properties. It is a question of fungibility and is then also a problem in common law (cf in the case of proceeds especially section 9-315 UCC in the US). Note, on the other hand, that sufficiently separated client assets and accounts may give rise to pooling if there are various beneficiaries, but also note that in such cases, this pooling is not itself the cause of separation, but rather, the result of it. Similar problems arise when assets are used in the manufacturing of replacement goods, when separation in principle may be joined by interests of others in the products if their assets are also used in the manufacturing process. When is there pooling and when will the holder be designated as owner? It follows from the foregoing that the extent to which separation/segregation or priority rights can be privately arranged or follows beyond full ownership structures and secured transactions is not always clear. It has already been mentioned that in executions or bankruptcies there may also be mere priority rights, which do not denote a proprietary interest proper, and do not therefore, give a repossession right, but all the same give a preference in execution sales or bankruptcy situations and concerns the distribution of the proceeds. They exist especially for some special types of creditors, such as the tax man in respect of late taxes, employees in respect of overdue wages, professionals sometimes in respect of certain professional fees, repairers in respect of the property repaired and maintained, etc. They tend to be statutory. Modern bankruptcy laws may limit these preferences for government claims as the German Insolvency Act of 1999 has done for tax liens. Although these preferences are thus often statutory, they may, as in the case of the German Sicherungsübereignung, also result from case law introducing here for Germany a type of nonpossessory security in movable property, even allowing for floating charges in bankruptcy, but not as a self-help remedy, as we have seen. These preferences may also arise more indirectly like those that result from set-offs and forms of contractual netting, as mentioned above. These have become greatly more important in modern financial transactions and are now key risk management tools in repo and swap transactions, particularly for commercial banks, as already mentioned: see further sections 3.2.5 and 4.2.5 below. Here again, we could note an important form of privatisation of recourse even in bankruptcies, which parallels repossession and other segregation rights. As we have seen, case law tends to recognise new or better liens or similar priority rights or preferences from time to time, and may in the process also rearrange the priorities and adjust repossession rights.41 The key here is 41 See for the German Sicherungsübereignung, s 1.4.2 below. See for Dutch case law extending preferences n 67 below. See for the principles of priority n 40 above. See further, CG Paulus, ‘Verbindungslinien zwischen Insolvenzrecht und Privatautonomie’ in Insolvenzrecht in Wissenschaft und Praxis, Festschrift für Wilhelm Uhlenbruck zum 70. Geburtstag (Cologne, 2000) 33. On the other hand, in England, the operation of private

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 49 to understand that this remains a fluid and dynamic process, and there may be a strong public policy element. One of the consequences is that, if this is ultimately policy, parties are not free to opt into or out of these structures at will. The reason is again the effect on third parties. Where they have the option, it might undermine, however, the very concept of separation at the same time, like in civil law in the creation of client accounts. Another consequence is that these structures may not reflect core notions that could easily be adopted in the modern lex mercatoria. It being policy, there may not be an overriding or general principle. Finally, it should also be considered that creditors may voluntarily postpone themselves; for example, lenders conceding subordinated loans. This is truly a question of party autonomy, not therefore limited, as it benefits and does not seek to prejudice other creditors. It is very common and is normally not contentious, although the ranking of these postponed creditors among themselves may still be an issue and the legal nature of subordination may still present problems.42 Subordination may be complete or springing (or inchoate), which means that junior creditors will still receive payments as long as certain events do not happen. In the practical operation there may also be some differences: it is normal in a contractual subordination that the junior does not receive anything as long as the senior creditors are not satisfied, but it is also possible that the junior creditor receives payments normally but sets them aside for another class of (senior) creditors. In this connection, there may even be a trust structure or subordination trust, which confers on the senior creditors a beneficial ownership right in the sums of money so set aside. More importantly, postponement may also result from the operation of the applicable law. This is again particularly relevant in bankruptcy and may arise in respect of creditors who have taken an active part in the management of a bankrupt company, such as directors/sole shareholders, and provided loans. It is an instance of lifting the corporate veil or of equitable subordination,43 also relevant for loans of unlimited partners. In modern finance sales as true conditional or temporary sales under which the financiers may take other than pure credit risks and buy (outright or through options) certain forms of temporary or conditional co-ownership or partnership rights in an asset instead (thus, providing the party needing financing with the required liquidity through payment of a purchase price), the concept of security and issues of equality of creditors may become altogether irrelevant. As explained before, these financiers may not have creditor status proper, but rather, ownership status for which they pay. However, it may still have to be considered whether, and to what extent, they postpone themselves in this manner to secured creditors in the same asset or to ordinary creditors of their counterparties in respect of their repossession rights in the asset.44 receivers under floating charges was outlawed in 2002, but largely in order not to interfere with reorganisation proceedings, see n 205 in fine below. This does not affect the operation of modern netting clauses, which now mostly do not suffer from stay provisions: see ss 362 and 553 US Bankruptcy Codes, last amended in this area in 2005. 42 It is probably best construed as a third-party benefit agreed with the debtor, the third parties being here the creditors that stand to benefit except in situations where there is an agreement to the effect between all existing creditors of a debtor. Notably in bond issues that is not normally the situation. It cannot be so in respect of unknown future (senior) creditors either. In the case of a bond issue, the undertaking between the debtor and junior (subordinated) creditors arises from the participation in the issue or the acquisition of subordinated bonds in the secondary market. The subordination must probably be seen as irrevocable by the debtor, even before the senior creditors have accepted the benefit. They may in fact never explicitly accept before a bankruptcy of the debtor, but their acceptance may be implied from the moment the benefit is given. It is commonly assumed that this acceptance does not lapse through a default under the original loan agreement, or in the case of its invalidity or rescission after the funds have been supplied. It would amount to a lifting of the subordination when the funds become so returnable. 43 cf s 510 US Bankruptcy Code. 44 See text at n 286 below.

50 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services

1.1.11. Party Autonomy and the Contractualisation or Unbundling of Proprietary Rights for Funding Purposes. The Better Protection of Bona Fide Purchasers and the Lesser Protection of Bona Fide Creditors and the Issue and Requirements of Financial Stability As we have seen, in finance sales, conditional or temporary transfers may give reclaiming rights in the relevant assets, and their recognition in law is an important matter. It is clear that in modern financing the position of conditional or temporary owner of the debtor’s assets is often preferred by the financier to the position of secured creditor. It is not uncommon in this connection to refer to the unbundling of the ownership right (or of the attached risks in an economic sense) in manners agreed between the parties. In this sense, one could also refer to the contractualisation of the ownership structure. Again, this poses the question of party autonomy in proprietary and bankruptcy matters, of the opening up of the system of proprietary rights, and of protection of bona fide third parties or purchasers in the ordinary course of business of commoditised products, as we have already seen. The true question then is how far choices can be left to the parties, and therefore to party autonomy, and how far the effect on third parties may reach. The result is likely to be a stronger position in enforcement proceedings against the counterparty, and especially against the latter’s other creditors in its bankruptcy, therefore at their expense. It has already been said (and cannot be repeated often enough) that bankruptcy protection and priority are primarily likely to be a question of the applicable objective law itself as a matter of public policy, rather than settled by contract, and therefore by party autonomy. Yet parties can opt for proprietary protection in the form of secured transactions, and increasingly also in the form of finance sales while financial structuring will test the borderlines or limits in this connection all the time; this is an important activity for transaction lawyers. It was identified ultimately as a question of better risk management, the reason why regulators often favour this development also, especially in respect of banks, clear notably in connection with set-off and netting facilities, as mentioned before. To the extent that contracting parties are allowed by the objective law or market practice more freely to create new proprietary rights in their assets or expand the old ones—either through conditional sales and proprietary options leading to appropriation or through (expanded) security interests with an execution sale and return of overvalue upon default or create newer or broader preferences notably in netting agreements, —the effect of any new structures in this regard on third parties, including other creditors, must still be evaluated. Again, there may here be public order restrictions or concerns, to be balanced therefore against the need for greater risk management control. To repeat, in this book (as explained in Volume 4 and earlier in Volume 1, section 1.1.6), party autonomy is increasingly seen as having a place in the unbundling (that is, creation) of more limited proprietary rights, exactly because of the need for better risk management, particularly in finance, and liquidity or indeed segregation of assets in a bankruptcy. Contractual user, enjoyment, and income rights may thus acquire effect against third parties who knew of them (or when professionals were supposed to know of them) before they acquired the underlying assets. This appears to be an important trend, also promoting the tradability or liquidity in the underlying assets (see Volume 4, section 1.1.3). This is likely to happen first in the professional sphere, especially in international finance. Property law in movable assets was here presented as dynamic and increasingly like a risk management tool, at least among professionals. This was identified as a vital facility in a modern system of private law, and an aspect favoured in the transnational modern lex mercatoria when properly understood. The numerus clausus idea of proprietary rights is then abandoned, balanced, however, by a better protection of bona fide purchasers in respect of

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 51 all assets (not only chattels, therefore) or, in the case of assets that commonly trade, all p urchasers in the ordinary course of business. It also assumes a robust regime concerning transactional finality: see for its foundations and underpinning section 1.1.4 above and also sections 3.1.1 and 4.1.2 below. Priority rights are thus not cut off at their creation, but only at the level of their operation. As part of this, bona fide purchasers and purchasers in the ordinary course of business of commoditised products will be protected (there is for them no search duty and their bona fides is presumed), which in fact makes this more informal and dynamic approach to proprietary right possible. This was recognised as the typical realm of equitable proprietary rights in a common law sense. The ordinary commercial flows will thus be protected and may even defeat secured creditors or others with similar interests in finance sales. It was noted above that these distinctions allow a system of special priorities to be created and to operate between professional insiders while not affecting others. Ordinary buyers need not worry or enquire. The interests will not work in the assets they buy. In such an approach, filing systems are targeted only at professional insiders as potential creditors and have no relevance for other purchasers who have no search duty. It has already been noted in this connection that, while in the modern approaches the concept of the protection of bona fide purchasers tends to be extended all the time—exactly to protect against the proliferation of proprietary rights and preferences in the manner just explained in order to protect the ordinary commercial flows at the level of the consumer—the rights of competing unsecured creditors on the other hand tend to erode further, even if they are bona fide, which means unaware of adverse proprietary interests or hidden liens being created against them in the assets of their debtors. This is more particularly shown in the steadily reducing impact of the concept of the solvabilité apparente or ‘apparent ownership’, for example in France, where it used to be strong (see section 1.3.2 below), and provided for creditors the original protection against hidden charges or interests, especially against reservations of title.45 In more modern times, it also allows for the operation of netting agreements at the expense of (unsuspecting) common creditors. Even though the (extended) set-off itself is also an equitable facility in common law terms, and might therefore as such not work against bona fide outsiders, it does work against bona fide (common) creditors and curtails their recovery rights. There is unlikely to be a filing system that helps in providing transparency in this area. In fact, as we shall see, even the filing system under Article 9 UCC only provides for transparency in respect of certain security interests. Notably, there is no transparency in respect of possessory security interests and reservation of title in consumer goods. Equipment leases, tax liens and statutory preferences are other exceptions. The UCC filing system is therefore not a general debt register that provides an overall insight into everyone’s indebtedness. In any event, it was already noted that outsiders (ordinary people) do not have a search duty and filing of these interests does not operate against them. This is very unlikely a real estate registration system and should not be compared. As noted before, unbundling of the proprietary structure and of the connected risks is a technique with which common law countries are traditionally more familiar and comfortable than civil law as demonstrated by their allowing an unlimited variety of equitable proprietary interests

45 The exception is where (especially in civil law) creditors themselves take out security interests in chattels belonging to the debtor unaware of older interests. They may do so because they are here themselves considered bona fide purchasers (rather than creditors). On the other hand, even common and other creditors are everywhere protected against the debtor frittering away its assets to third parties or providing them with preferences. This is done under special laws against fraudulent or preferential transfers, as we have already seen for US law (called actio revocatoria or actio pauliana in civil law), but such transfers may commonly only be invalidated if done during short periods prior to any bankruptcy.

52 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services to operate in chattels, subject to a broad protection of bona fide purchasers of the legal interest or purchasers in the ordinary course of business.46 This is so for practical reasons. At the more theoretical level, it probably has to do with the fact that common law distinguishes much less clearly between contractual and proprietary rights than civil law and is in any event less intellectual and systematic. In parallel, we see a dramatic expansion of the set-off principle and its inherent preferences through netting agreements, increasingly recognised for their effects in domestic bankruptcy statutes. They protect contractual interests, and in repos have even become a standard alternative to proprietary protection amongst professionals, as we have seen. They may be highly effective if there are offsetting positions between a claimant and a bankrupt counterparty. Here, the netting in swaps also springs to mind: see section 3.2.5 below. As noted, public policy could still be an important bar to greater flexibility and openness in this connection, thus to better risk management facilities. There are here in fact four often conflicting considerations, the first three already mentioned several times before, the first two favouring in particular the ordinary commercial flows, and the last two concerning in particular the financial flows: (a) (b) (c) (d)

the protection of bona fide purchasers or purchasers in the ordinary course of business; the finality of transactions; the position of bona fide common creditors; and finally the stability of the financial system.

Indeed, in civil law, a more liberal approach to the creation of proprietary interests is often considered to lead to an undesirable wild growth of security and similar interests, in turn detrimental to unsuspecting purchasers (who are normally protected, however, if bona fide, as another conflicting public policy imperative, but in civil law so far only in respect of chattels) and to unsuspecting common creditors, although the latter always could expect very little in a bankruptcy of the debtor: see also section 1.1.1 above. This being the case, it was also demonstrated that public policy favours common creditors ever less (depositors being in first instance protected by compensation schemes) and increasingly yields to better risk management, and therefore, financial stability considerations, especially in set-off and netting facilities among banks. Again, for common creditors, the traditional standard secured interests always undermined their recourse and newer alternatives may not therefore make much difference to them and only tend to reshuffle the protections among those who normally receive them, therefore, among the same insiders who may then also benefit from equitable proprietary rights. This allows for greater party autonomy subject to a better protection of the ordinary commercial flows against the interests so created. These are the true reasons why bona fide common creditors are increasingly ignored in the debates on newer bankruptcy protections of modern financiers, although through modern filing systems, to the extent that they exist, they may obtain a warning, but not much more. It may be recalled in this connection also that statistically the common creditors never received much in bankruptcies, so that there was always little to protect. It has already been said also that the more traditional bankruptcy notion of creditors’ equality, often still considered fundamental, although more so in civil than in common law with its less structured and more flexible system of proprietary rights and claims, is under pressure. At the more fundamental level, it has been noted (in section 1.1.2 above and at the beginning of the previous section) that this notion of equality was in bankruptcy always less fundamental than it seemed, honoured mostly in the breach (through secured transactions and statutory preferences

46 See

for some remaining constraints Vol 4, s.1.1.3.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 53 of all kinds). To repeat, it is equitable, not equal distribution that is the key of modern bankruptcy liquidation (whilst it acquires further meaning in modern reorganisation proceedings), and this assumes priority and ranking or similar alternative protections, not therefore equality. Again, equality only exists per class, in truth only in the lowest classes. Each proprietarily protected counterparty is usually in a class of its own and higher. So are those who benefit from a set-off/ netting clause. Then there are the statutory preferences, as we have also seen, in the previous section. One could even say that as a result bankruptcy itself is becoming less of a threat to professional creditors. At least the modern facilities help them to manage their risks better. The question of financial stability is an issue not so far raised in this connection but it is closely connected. It is a key regulatory concern which has to do with systemic risk (as we shall see in Volume 6), but is not a primary consideration in the private law aspects of financial activity, although legal risk in the financial products may raise the financial stability issue and it may be a justification for the support of more protection especially for banks as professional creditors. That is also clear from the fact that so far, no serious concerns have been expressed in respect of the development of floating charges, leasing, repos and other finance sales, and receivable financing. To the extent they facilitate risk management, they have been generally applauded, not least by regulators. Even securitisations, which came under more public pressure after 2008, are recognised as essential risk management tools in banks. It is especially clear for netting agreements in swaps and repos (see sections 3.2.5 and 4.2.5 below). Although common creditors of all sorts are affected, potentially even more fundamentally by netting agreements, these are applauded by regulators for much the same reasons, as we have seen. Hence, their increasingly undisputed survival, even in a bankruptcy of the counterparty, even their exemption from stay provisions. In this manner, stability of the system is considered enhanced, and the regulatory concern then only concerns legal risk in a narrower sense, limited to the question whether these arrangements work under all circumstances. For the rest, only in the details of some of these products may there still be some further regulatory concern: see for the discussions concerning them the relevant sections of Part II below. As we shall see for swaps, the regulatory concern shifted to their trading and recording through central counterparties (CCPs): see also section 2.6.5 below, to manage risk better, not therefore, to curtail the facility to do so. In the proprietary area proper, more choice for financiers balanced by a better protection of the public at large (except common creditors) is then the answer, but with the present insight at least in continental Europe, the drive for European solutions may well reduce them. It has already been said that the 2008–09 Draft Common Frame of Reference (DCFR), as an academic model for an EU private law codification, was regressive. There is hardly any tilt towards a more fundamental reassessment, and wherever it exists it is modest. No fundamental comparative research was apparent. Earlier, in 1996, the European Bank for Reconstruction and Development (EBRD) issued a set of general principles of a Modern Secured Transactions Law, but they dealt only with the more traditional proprietary securities and execution rights that attach to monetary claims, therefore, only with those arising in the context of loan financing and sales-price protection. Nonetheless, they underlined the need for security to be able to be offered for present, past and future debt and to cover present and future assets, including intangible rights and changing pools of assets, with a possibility of shifting into proceeds and replacement goods with an effective execution facility, thus promoting floating charges. More importantly, as we have seen, the 2002 Collateral Directive of the EU took a broader view. Notably, it distinguished finance sales from secured transactions and also promoted netting facilities. Special complications arise in cross-border transactions, in Europe within and outside the EU. The question posed is foremost one of recognition and adaptation of foreign interests per country and of harmonisation or unification from that perspective, especially in bankruptcies

54 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services which remain more naturally national as expression of sovereign enforcement authority. While still limiting the concerns to securities in assets that move across borders, the creation of a single, uniform, European, non-possessory security right was even discouraged, as it could leave considerable differences in the manner in which it would be absorbed in each Member State.47 This view was reversed in the DCFR, but it was hardly aware of the more modern financial environment and had no conceptual contribution to make. It was an update of the German BGB and largely reflected the limited German academic discourse on the subject. It would in any event not solve the problems in a financial world that is much larger than the EU. The risk is that the alternatives of ownership-based funding or finance sales remain ignored, particularly the international repo, finance leases, and receivable financing instruments. Also, the indirect preferences resulting from the ever-widening set-off, retention and tracing possibilities are largely overlooked. So are floating charges and the clearing issues in derivative products. This being said, it might be useful as a start to agree the basic characteristics of the various modern security rights and ownership-based funding techniques, beginning with the reservation of title. Although the DCFR set the reservation of title apart and did no longer view it as an example of a more fundamental concept, if properly analysed it should have a meaning also for other conditional ownership-based funding structures, therefore for all finance sales, including repos and swaps and for trust-like structures and similar equitable interests. But the problems are not small, even for the most common sales-price protection device of the reservation of title. Is it in the specific sold asset only, or can it also shift into replacement goods and proceeds? Can it serve other debt? Is it an accessory right? Does it require execution upon default with the return of overvalue to the buyer, or may it lead to appropriation of the asset by the seller without any return of overvalue? Is it a conditional sale? If so, what are the disposition rights of the buyer; what is the position of the buyer in a bankruptcy of the seller; are bona fide purchasers of both seller and buyer protected (regardless of possession) or even purchasers in the ordinary course of business, etc? What are for system thinkers the systemic implications? Still, it would be possible to outline the basic issues in the operation of the various security and conditional or finance sales rights, at least in chattels and intangible assets. At this stage, this may be preferred to providing detailed uniform legal texts. This is further discussed in Part II.

1.1.12. Autonomous Transnational and Domestic Legal Developments In section 1.1.4 above, the subject of the transnationalisation of the law concerning the operation of financial products and facilities was introduced, in which connection the role of fundamental principle, custom or practice, general principle, and party autonomy as sources of this new law was noted. As we have seen, party autonomy is not traditionally associated with the creation of proprietary rights. Parties use them, for example, when they buy and sell assets or give them as security, but they cannot create others, and these rights were normally considered to derive their status from the objective law (usually statute but it could be case law or custom). That is understandable in principle as property rights have a direct effect on unrelated third parties, who must respect them regardless. Especially in bankruptcy, this has a more special consequence and importance. Parties with a proprietary right may retake the assets (subject to any stay provisions,

47 Professor Drobnig, in his contribution referred to in n 21 above, earlier rejected for the EU the UCC approach for secured transactions in movables as politically unfeasible.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 55 which are rare) or, in the case of security interest, proceed to execution with a priority for them in the proceeds. This is to the detriment of common competing creditors in particular and another reason why traditionally only the objective law could create this effect, even if, as we have seen, the protection of the common creditor is becoming an ever-lesser concern, easier to accept in view of the fact that they mostly receive nothing or very little anyway. That was always their risk. The more immediate issue is often the reshuffling of interests among creditors with some protection, therefore largely among professionals who funded the bankrupt. It was already said that in more modern times the deeper issue is risk management and the flexibility for the parties to take the initiative here. In this connection greater party autonomy in proprietary matters was submitted as the natural way forward, especially in international financings at the level of the new law merchant, or modern transnational lex mercatoria, supported by custom and balanced by better bona fide purchaser protection (or protection of the buyer in the ordinary course of business of commoditised products) in respect of all types of assets, as we have also seen, and a robust notion of finality.48 The result is that these newer facilities only operate between professional insiders who can more easily deal with the consequences. This was considered analogous to the operation of equitable proprietary rights in common law. In addition, the extension of the set-off principle through netting agreements creates indirect preferences, which achieve similar goals and are now also promoted as effective risk management tools in banks, especially in respect of their contractual exposures even though at the expense of common creditors. It was already said that public policy pursuing financial stability especially in banks increasingly supports it. Although squeezed out by codification thinking, custom, especially if transnational, therefore operating in the operation of the international marketplace and its financing, may be considered increasingly part of the objective law in this connection, and may come to support the intent of the parties in this respect while the more objective needs of protection of the ordinary course of business may be a further issue of public order also in the international marketplace. Again, the support for netting agreements and their extended preferences may be considered a matter of financial stability as such also a public policy issue. It follows that the objective law is not always statutory or interpreting case law, while the ensuing custom or public order requirements are gaining in status when transnationalised, which would make the resulting interest a transnational proprietary right and its limitations a question of transnational public policy or order. Party autonomy, especially in its modern corporate variant, may itself now more readily be seen as an autonomous transnational source of law (see Volume 1, section 1.4.9) helped by its objectivation, as was argued in Volume 3, sections 1.1.4 and 1.1.5. The transnational lex mercatoria or law merchant, which is based on these sources of law, shows examples of transnational proprietary products so arising (see Volume 1, section 3.2.2 and also the discussion in section 1.1.4 above). It has already been said that traditionally, negotiable instruments qualified, the modern Eurobond being a particular example. Indeed, the operation of the Eurobond market (see also Volume 6, section 2.1.2) produced a prime model of an autonomous transnational development,

48 It is here also of some academic interest that in countries not requiring delivery for ownership transfers in chattels, such as France, Belgium, Italy and England, proprietary rights (in chattels) are seemingly created by contract alone. The relevant contractual terms transferring property rights must nevertheless be respected by all without the added formality of delivery as a form of publication of the new relationship. To the extent that these are civil law countries, it is now well established that only recognised proprietary rights can be created in this way— they depend therefore for their recognition on the objective law—and that in any event even in these countries the full proprietary effect often still depends on some form of delivery, even if it is purely constructive: see further Vol 4, ss 1.2.1 and 1.2.2.

56 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services and also then had an overriding impact on domestic contract and proprietary laws, particularly in the following areas: (a) issuing, underwriting and trading practices; (b) the proprietary status of the document (the Eurobond), the manner and also the timing of transfer of ownership, which in CAD (cash against documents) or DVP (delivery versus payment) may well depend on payment, and the protections of bona fide purchasers; (c) the (dis)application of traditional private international law rules or the possibility of contractual choice of law in proprietary and protection questions; (d) the force of transnational practices or customary law, even in matters of ownership and its transfer, including the creation of security interests and especially repos in these instruments, and of the related proprietary status and extent of their protections; (e) the effect of this force on the connected modern book-entry and custody arrangements or substitutes and their segregated status (see Volume 4, Part III, and further section 4.1 below). The effect on third parties of new ownership-based financing structures developed in this manner at the transnational level is a crucial issue, especially in bankruptcy law, as we have seen, which remains domestic, incorporating, correcting or substituting any accepted transnationalised practices in this regard. As just mentioned, in negotiable instruments such as bills of exchange, Eurobonds, euro-commercial paper or certificates of deposit and similar promissory notes, and even in documents of title such as bills of lading or warehouse receipts, transnationalisation has always had an impact in proprietary matters. Finality was here achieved through the important notion of the protection of bona fide purchasers, the concept of independence or abstraction, and the notion of reliance (see for transactional and payment finality, further sections 3.1.1 and 4.1.2 below and note 18 above). Indeed, negotiable instruments and documents of title as well as this type of protection in terms of finality first developed in the old law merchant. For newer financial products, they depend on the new lex mercatoria to develop further, especially in finance. That is even true for negotiable stocks and shares, especially in modern book-entry systems and repo financing. The details still need working out, including for security interests in, and conditional transfers or finance sales of, these instruments, especially when operating in transnationalised property structures, such as oil rigs on the high seas: see also Volume 4, section 1.10.2 (under (w)) and note 19 above. It has already been noted that the recent emergence of book-entry systems for stocks and shares (see Volume 4, section 3.1.4 and further section 4.1 below) seems to de-emphasise ownership rights of the interest holders and even their transnational character. In Eurobonds, this may be leading to de-emphasising their transnationalised status and might rekindle interest in domestic laws through the application of private international law rules pointing to applicability of the law of the country in which the register or book-entry system is organised. It was pointed out that this is also the tenor of the 2002 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary: see Volume 4, section 3.2.2. It re-emphasises local differences, and may make trading in these instruments again dependent on a fortuitous domestic law that may be insufficient, or even totally unaware of the international dimension and requirements of book-entry systems in respect of international investments. It was submitted, therefore, that this is not a desirable development. The lack of practical interest in the ratification of the Hague Convention after an initial flurry of attention bears this out. As suggested above, party autonomy may more especially operate at the transnational level and may, like supporting custom, be more important and powerful in that context as an autonomous source of law and take over. This may lead directly to the creation of transnational proprietary interests, although progress in this direction may be more subtle. First, at least the transfers of

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 57 receivables internationally have sometimes been allowed to be governed by the parties’ choice of (a national) law. Although that would not allow them to create any interest they want, it at least gives them a choice among national systems and an option to select the most suitable for their purposes.49 It may then also be possible for them to choose the lex mercatoria. Article 4 of the 2002 Hague Convention just mentioned also sustains party autonomy in the choice of the applicable proprietary law (with some limitations). The missing link remains the better protection of bona fide purchasers or assignees, especially when assets other than chattels are involved. Quite apart from greater party autonomy, even in the civil law on this point, the objective local laws are not a given and the line is constantly being redrawn. To repeat, even in domestic civil law, new security-related interests may emerge in case law, as in Germany the Sicherungsübereignung did and earlier in the Netherlands the fiducia cum creditore, or fiduciary sale, as types of nonpossessory charges in chattels and receivables. They were in origin both conditional sales, as we have seen. In these countries there emerged subsequently also the proprietary expectancy or dingliche Anwartschaft for the suspended owner in conditional sales, especially articulated for the reservation of title. In any event, even domestic systems are increasingly faced with the need to accept unfamiliar foreign or international structures and consider the effect in their own systems, especially in bankruptcy situations. It is not merely a question of discovering the lex situs, which is the traditional approach, as we have seen, and is in any event complicated when the assets move or when they are intangible or mixed with services and technology delivered from elsewhere, often in a virtual manner. It has rather become a question of re-characterisation of the foreign interest in terms of the nearest equivalent, especially under the bankruptcy laws of the recognising country. This is so for the more traditional security interests, if foreign, attached to assets arriving from abroad. Even then, they may not always be assimilated, and may require more special treatment. They may even be eliminated: see also Volume 4, section 1.8.3. Nevertheless, this recognition facility may amount in itself to some opening up of the domestic proprietary systems and the situation is not different for transnationalised instruments although they should speak for themselves and require recognition unless public policy forbids it. It would, however, still raise the question of fitting in in the relevant local bankruptcy order. In the meantime, the Hague Trust Convention promotes the international recognition of domestic trust concepts in countries that do not normally accept them in their own laws: see Volume 4, section 1.8.4. This means some further opening up of the system, albeit through statutory (treaty) law, and still relies on conflicts of law rules leading to the application of a national law, but a choice of law by the settlor is also accepted here in respect of defining the interest. This also opens further perspectives for international financing practice, which often uses forms of trusts and shows that these issues are no longer purely ones of public order. Much more thought will have to be given to this subject, which, in civil law terminology, concerns the distinction between in rem and in personam, or between proprietary and obligatory (contractual) rights. It may well be in the process of being recast. It was noticed in this connection (in Volume 4, section 1.1.3) that all contractual user, enjoyment and income rights in international commerce and finance tend towards proprietary status, if only as a matter of promoting the liquidity of the underlying assets. Hence, the influx of equitable proprietary rights (or economic interests), in fact not only at the transnational level. The whole traditional system of proprietary rights and the way we perceive them may well be in a process of transformation, particularly in civil law, at least in the financial area: see also Volume 4, sections 1.3.8 and 1.10. It could still be intellectually satisfying though, even at that transnational level, to have a unitary system of secured, security-related and other property-based funding transactions

49 See

Vol 4, s 1.9.2.

58 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services and credit protections, whatever practitioners’ needs, thus eliminating even the finance sale in a unitary functional approach. Yet, such a restrictive and abstract approach does not operate successfully anywhere, even in the US, where the conditional sale, including the reservation of title, trust deeds creating security interests, and the assignment of receivables, including factoring for other than collection purposes, were, as we have seen, all brought together in one system of secured transactions in Article 9 UCC.50 But the unity imposed here proved artificial, and it became clear that notably the finance lease and the repurchase agreement hardly fit into this system. In fact (as we shall see below and as was noted above in section 1.1.1), a product or facility approach now more properly prevails in the US, and proprietary notions may play out quite differently in the various Articles of the UCC.51 This appears also increasingly to be the case in France as shown in its new Monetary and Financial Code (CMF): see further section 1.3 below. Finally, it was also noted in Volume 4, section 1.10.2 (w), that in respect of rigs on the high sea, for example, there is often not much more than some documentation that shows who has control. In such cases, the proprietary right goes back to the more primitive common law notion of physical possession, seisin or bailment. But it was also pointed out that when it comes to financing, these rigs may become subject to more sophisticated non-possessory charges, which are then likely to be of an equitable nature, and may even now be treated as such in transnational law.

1.1.13. Uncertainty in International Financial Dealings. The Idea and Technique of Transnationalisation in Asset-backed Funding As may be clear from the discussion so far, in view of the history and present-day practices, it is clear that major differences still exist between the various legal systems in the area of modern financial transactions, whatever the effect of international convergence discussed in section 1.1.5 above or of the transnationalisation discussed in the previous section. This is so mostly in the types of assets that can be used as security (be they movable or immovable property) and in the need for possession, notification or publication. Other issues are the identification (and perhaps physical transfer) of the assets covered, and the possibility of including future assets and of transfers in bulk, notably in floating charges, the shifting of the interest into replacement goods and proceeds with the preservation of the original rank, and the specification of protected debt and the inclusion of future advances. This also affects old-fashioned (physical) delivery requirements that can only be maintained in respect of identified, existing assets. It is then also likely to affect the formal disposition powers in the transferor.52 50 See ss 1-201(35), 1-201(37), 9-19(a)(1) and 9-109(d)(4) UCC; see also the text at n 242 below. See for arguments in favour of a much more open system in civil law countries, JH Dalhuisen, ‘European Private Law: Moving from a Closed to an Open System of Proprietary Rights’ (2001) 5 Edinburgh Law Review 1. See for proposals for a more fundamental modernisation of Dutch property law (concerning chattels and intangible assets), JH Dalhuisen, ‘Zekerheid in roerende zaken en rechten’ [Security in chattels and intangible assets] in Preadvies Vereeniging’ Handelsrecht (Deventer, 2003). 51 In the UCC in particular, it is clear that in proprietary matters, an approach per product is now favoured, leading a different attitude to proprietary rights and their transfer in Article 2 (sale of goods) where the emphasis, eg, remains on the goods being in existence to be part of a sale (s 2-105), which approach is entirely abandoned in Article 9 in respect of security interest in future assets (s 9-204), while Article 2A on finance leases, Article 4A on electronic payments and Article 8 on interests in security entitlements and their transfer maintain different approaches again, none of which are interconnected. 52 It has already been said in n 31 above that new Dutch security law, for example, remains generally restrictive and continues to put considerable emphasis on the identification of the asset and the specificity of the debt at the time of the creation of the charge, which also goes to the disposition power of the transferor.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 59 Differences arise particularly in respect of the newer non-possessory security interests in chattels and intangibles. As we have seen, at first, they tended to take the form of conditional or temporary sales and transfers, but largely came to be treated as non-possessory security interests. The German Sicherungsübereignung still shows some ambivalence here, especially outside a bankruptcy situation. A further issue is the shifting of these modern interests into replacement goods and proceeds in order for them to become truly floating charges in a common law (equity) sense. Similar uncertainties also developed in the treatment of modern finance sales such as the investment securities repos, finance lease and factoring. This was primarily identified above as a characterisation issue, as these problems arise especially when these sales are equated with and converted into secured transactions. This is done in the US under the unitary functional approach of Article 9 UCC as noted before. They may also be considered undesirable security substitutes, as such deprived of all proprietary effect in the Netherlands. This has also been briefly discussed above, and will be covered in greater detail below in section 1.2 for a number of countries. But even if the notions of conditional or finance sales were accepted everywhere— also in their proprietary effect—there remains the question of the precise legal position of either party under them: see more particularly section 2.1.3 below. Since there is less law in this area, perversely there may be fewer obstacles to reaching satisfactory solutions. This flexibility may allow at the same time for a more practice-oriented, transnationalised approach, superimposed on domestic laws, particularly in bankruptcies. It would indeed be based on an important measure of party autonomy in operations between professionals, subsequently supported by custom, which would be transnationalised reflecting the practices in the international marketplace. One could start with receivables or intangibles. As we know, the traditional approach to the applicable law in proprietary matters is the application of the domestic law of the location of the asset, therefore the lex situs in conflict of laws terms. It still emphasises the aspect of physicality, but again, we may be helped by the fact that at least intangible assets like receivables have no natural situs. If we have to choose, it was earlier said that the law of the place of the debtor is the more likely to apply, as that is the law under which collection will take place if not voluntary.53 However, for practical reasons, claims are often located at the place of the creditor, who would be the same under all of them. In bulk assignments of multiple receivables, that allows for one law (of the assignment) to apply to all transfers. This law might even be chosen, at least in Germany as we have seen, which would then allow for considerable freedom as to the legal form the assignment might take, for example in terms of security or conditional transfer, and its formalities. It could even be the modern lex mercatoria. Thus, if we assume the place of the creditor to have an important meaning here, it would be left to its law or to the chosen law to determine the nature and extent of the security interest, for example a floating charge in respect of all worldwide receivables for, say, a receivable creditor who needs funding in England. But the nature of this charge, which would thus acquire a status worldwide in terms of its formation, may still be an issue in terms of recognition in countries of the debtors, especially if going bankrupt under their own bankruptcy laws. In that case, bankruptcy courts would likely still look at nearest equivalents under their own law, as we have also seen.54 The law of the place of enforcement cannot therefore be simply ignored or opted out off and foreign security or similar interests will have to fit, although perhaps in (some) breach of any numerus clausus idea, as already noted. This law would then also deal with a broader concept of party autonomy in these matters, and perhaps also recognise that the limit is in the protection of the international

53 Among 54 See

commercial lawyers this is in fact the more common approach, as we saw in Vol 4, s 1.9.4. Vol 4, ss 1.8.2 and 1.9.4.

60 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services flows, and therefore, in the protection of bona fide assignees. This could give priority to the first collecting assignee if in good faith, assuming there were more assignees of the same receivable upon multiple assignments, which otherwise would rank in time. Indeed, under English law, foreign interests of this nature are always likely to be recognised and transformed into equitable interests, leaving bona fide purchasers or assignees of them protected, as we saw in Volume 4, section 1.8. If this much is accepted, the next step would be to consider a similar approach in respect of chattels by locating them similarly at the place of the owner, thus also centralising the legal regime in respect of them, regardless of location. First this should apply to those assets that normally travel, such as ships and aircraft, and therefore have no proper situs either, but there is truly no fundamental reason not to treat all similarly. In other words, if for practical reasons we locate receivables at the place of the owner, there is no good reason why that could not also apply to other movable property. Again, it does away with the physical connotation of property rights in the lex situs approach. It means that all movable assets are deemed located at the place of the owner, at least for these purposes. The lex situs idea is thus eclipsed, even though we still have some notion of location, but perhaps more importantly the law of the owner could even then only apply to the formation of security interests or other asset-backed funding structures in worldwide assets and would therefore still be subject in the place of enforcement for proper recognition, more especially in bankruptcy courts and a search for the nearest equivalent by these courts in that context (as the lex situs approach also requires). That would then also apply to finance sales and floating charges. In a last phase, one could see here full transnationalisation and delocalisation on the basis of (a) party autonomy working at the transnational level, (b) transnational commercial practice or custom, or (c) even transnational general principle, subject to the protection of bona fide purchasers and purchasers in the ordinary course of business of commoditised products as a public order requirement in international operations of this nature. Local bankruptcy courts would then be asked to recognise these transnationalised security interests as such, directly without any domestication, although again subject to protection of the flows and to transnationalised notions of finality and public order, if adverse. Thus, unless notions of public order (which may themselves be transnationalised) still militate against this, domestic bankruptcy courts would be expected increasingly to co-operate, as domestically they have also done in accepting hidden new preferences and charges, in Germany notably for the Sicherungsübereignung, and now elsewhere also in the extension of set-off preferences through contractual netting clauses. It becomes a question of practicalities in a globalising world. It has already been said that the bona fide common creditors may increasingly miss out, but, again, even domestically, they are subject to all kinds of hidden charges and preferences and statistically never received much. Furthermore, it is not true that they have a natural right to more. Equality was never the basic principle of bankruptcy–only equitable distribution in liquidation, which means ranking. To repeat, notions of apparent ownership or solvency that favoured these bona fide common creditors have increasingly been abandoned as untenable in a more modern environment that depends on credit and better risk management. Transnationalisation was earlier spotted in a broad range of instruments and market operations.55 In truth, whatever the aims of nineteenth-century nationalism in private law, it was already mentioned that unification through an autonomous process of transnationalisation, therefore through the force of practices and market custom in private law, especially in

55 Vol

1, ss 1.1.2 and 3.2.2.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 61 international professional dealings, was never entirely eradicated, including in civil law countries: see Volume 1, section 1.4.4. Above, examples were found in the law concerning bills of lading, negotiable instruments, especially Eurobonds, and Euromarket practices, including clearing and settlement, the law of international assignment, of set-off and netting, of letters of credit (UCP) and trade terms (Incoterms). Also relevant is the important and connected issue of (international) finality. It was said in section 1.1.4 above that we are here concerned with the key legal infrastructure of the international marketplace, which can hardly any longer be suitably covered by domestic laws of any kind. In Volume 4, section 1.10.2 it was posited that the way in which transnationalisation is likely to proceed is through the notion of physical possession subsequently expanded by notions of control, and later by (non-possessory) equitable proprietary rights. It could still be argued, however, that transnationalisation may lead to more uncertainty for participants, which is the usual argument against it especially where it unsettles property rights (as we saw in Volume 1, section 1.1.7). Nevertheless, it should be noted that the parties are normally professionals in specialised financing schemes who may be able to live with some uncertainty rather than with unsuitable alternatives and limitations, such as purely localised secured transactions and security interests, or comparable structures as in finance sales in international business dealings, or with a split up of their transactions along domestic lines in the international flows. It was pointed out in this connection that local laws can become quite dysfunctional, and their application disruptive in an international context. Risk is then increased. Transnationalisation would in any event add to their choice. It was mentioned above that in all of this, ultimately the notion of finality is much more important than the idea of certainty and may be enhanced in transnational law. As pointed out before, (a) bona fide purchaser protections, (b) abstract systems of transfer, and (c) reliance notions are here used transnationally better to support this type of finality, and it is submitted that transnational law is here at least as efficient as domestic laws are. Professionals often must take legal risks here, and are used to doing so. Their concern is then mainly for better risk management tools, and the law should not be a constraint unless there are clear policy reasons and it was already said that the mere survival of parochial system thinking is not one of them. Beyond transactional and payment finality, predictability is the issue rather than certainty of a lowly sort. Practical certainty in risk management is more important to them than systematic certainty at the intellectual level. It has already been said that in the professional sphere the discipline of participants is the ultimate test of certainty in the system, but it would undoubtedly be better if, for example, the position of bulk transfers or bulk assignments, the use of future (replacement) assets in finance schemes, the operation of floating charges and conditional sales were clarified at the transnational level, if not also domestically, assuming that in principle these structures would be allowed to play a full role if parties so wished, again subject to the protection of bona fide purchasers and in the commodity trade of all purchasers in the ordinary course of business. It can only be repeated that this must be considered a public policy requirement of the transnational legal order itself, which protects the international flows of goods, services, money and technology and their liquidity.

1.1.14. The Impact of the Applicable Domestic Bankruptcy Regimes in International Financial Transactions. The US Approach and the EU Bankruptcy Regulation It was shown above that national laws concerning financial products, foremost secured transactions including floating charges and finance sales, still differ considerably. These differences are

62 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services likely to be reflected in national bankruptcy laws. Transnationalisation may overcome them in principle, but it was already said that this does not automatically mean that local bankruptcy courts applying their laws will be accommodating of these transnational interests in a local liquidation or reorganisation, although transnational custom and practice should find a place in them and increasingly require it. This being said, local bankruptcy laws generally take a different attitude to foreign or new proprietary interests, may re-rank priorities, even purely domestically, impose stays, or in reorganisation proceedings, reallocate the interests. This might happen all the more if foreign interests are asserted in assets within the control of the bankruptcy court when (at least) the nearest equivalent in their domestic laws is commonly considered: see the discussion in the previous sections and also Volume 4, section 1.8.3. In this manner, newer transnationalised interests could also be considered or indeed be allowed to prevail more readily on the basis of transnational custom and practice if proper respect for international law is being shown. This phenomenon of adjustment may even play within countries that have different jurisdictions within them and different priority regimes but one bankruptcy law, like the US. Although, as we have seen, the UCC brought unity, at least in the area of contractual security interests in personal property, State law continues to prevail in principle in the area of secured transactions and other priority rights. Here the Bankruptcy Code, which is federal, developed some rules of its own for the various securities and other proprietary interests or liens and preferences arising under State law, which may thus differ, especially if arising outside the area of Article 9 and need fitting in. To this effect, in the US, these interests are essentially divided into three types: consensual, judicial, and statutory liens. They need first to support an allowed claim to retain their effect in a federal bankruptcy (section 506(d)). Execution of all of them may now be stayed pending reorganisation proceedings (section 362(a)(5)), when interest only continues to accrue to the extent that there is overvalue in the collateral (section 506(b)). The stay may be lifted (section 362(d)) if there is no overvalue (or equity) for the debtor in the property and if it is not necessary in an effective reorganisation or otherwise for cause, including the lack of adequate protection (as defined in section 361). The proper valuation methods have given rise to much debate and depend on the situation. The Bankruptcy Code is not specific, and the bankruptcy courts assume here their traditional role and latitude as courts of equity. Another immediate impact of bankruptcy on security interests results in the US from the facility to remove excess security to allow the collateral to be used for new financings if not otherwise available during the evaluation period. Again, there is the need for adequate protection, which may mean the offering of replacement security or even cash (section 364(d)). It again raises the valuation issue. In reorganisations, security interests may be converted and adjusted as part of the plan, although not taken away without the consent of the secured creditor (sections 1129 and 1325). However, in the so-called ‘cram down’, a delay in payment may be imposed as long as the present value of these payments is not less than the secured claim. As elsewhere, in the US, security interests may sometimes be avoided altogether as fraudulent transfers under the Bankruptcy Code (section 548). Although still expressed in the traditional common law language of hindering, delaying or defrauding common creditors, the purpose is to prevent the debtor from transferring valuable assets in exchange for less than adequate value if the transfer leaves insufficient assets to compensate honest creditors. The transfer may be to creditors or to third parties, and there must be fraudulent intent on the part of the debtor (although not necessarily on the part of the beneficiary). Security interests may also be avoided as preferential conveyances (section 547). In that case, they must be given to existing creditors (in respect of antecedent debt) and may (just like payments) be voided, even if given pursuant to an existing obligation. Since the new US Bankruptcy Code of 1978, it no longer matters whether there

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 63 is beneficiaries’ knowledge or connivance, and the avoidance now follows as a matter of strict liability. There is an exception for (security) transfers in situations where new value is given or where payments are made in the ordinary course of business. Liens may also be pushed down as unperfected liens pursuant to section 544 (the strong-arm statute), in fact explained as another way of avoiding them, or may be ignored on the basis that they are in exempt property (unless contractual: see section 522(f)). As already mentioned, in the US the federal Bankruptcy Code deals with the key policy issues concerning secured transactions and their ranking and also with the treatment in bankruptcy of the newer financial products such as swaps and repos. Specific amendments were introduced for the latter, especially to allow netting (see sections 556ff; for netting generally see section 3.2 below; for repo netting section 4.1.4 below; and for swap netting section 2.6.7 below). Rights under conditional sales do not prevent the assets being part of the estate under section 541 (subject to the possibility of their abandonment as burdensome assets under section 554). The stay provisions also apply to them unless lifted in which case the assets can be repossessed. Besides lien recognition, in the US the federal Bankruptcy Code also has its own system of priorities (section 506), which gives a high rank to administrative expenses. This includes the cost of preserving and managing the estate (under section 503(b)(1)(A)). The contribution of secured creditors is limited to the cost of the estate in preserving and liquidating their collateral (section 506(c)). On the US and earlier the German analogy, it would be normal eventually to expect a uniform bankruptcy law in the EU sooner than a uniform secured transactions law. If the German Bankruptcy Act introduced in 1999 proves sufficiently successful, it might serve as the most ready model. It deviates, however, in important aspects from the more common attitude to floating charges. Although it allows repossession of assets subject to a security interest in principle, in a bankruptcy it only gives a preference in the execution proceeds if and when collected by the bankruptcy trustee so that there is no self-help in insolvency and a low rank. It has also abolished many statutory liens, especially those in favour of the tax and social securities authorities. Whatever the model, uniform bankruptcy law may appear a better approach than that of bankruptcy recognition between Member States, since 2002 effected under an EU Regulation in EU countries other than Denmark.56 As such it is only concerned with the question of choice of jurisdiction and of domestic laws in the myriad of public and private law issues and conflict of laws situations that are likely to arise in domestic bankruptcies opened in one of the EU countries but with substantial trans-border aspects in other Member States. It concerns bankruptcies that mean to cover the activities and the assets of the debtor abroad (here especially in other EU countries). The EU now deals in a centralised conflicts of laws manner with the interests of creditors in these activities or in these assets and has been given competency to do so since then 1998 Treaty amendments, which do not cover unification. Under the Regulation, the foreign bankruptcy trustee’s position in a bankruptcy opened in an EU country is in principle accepted and automatically recognised in the other EU countries that become so involved, provided the bankruptcy

56 The EU efforts in this field have a long history and go back to 1968: see JH Dalhuisen, Dalhuisen on International Bankruptcy and Insolvency (New York, 1986) vol 1, 3–165 and originally took the form of a draft treaty. An ultimate draft was presented on 23 November 1995, and the final date for signature was put at 23 May 1996. Because of the failure of the UK to sign the project it lapsed, but was revived and resulted in the Bankruptcy Regulation 1346/2000, effective in 2002, only excluding Denmark. See also J Israel, European Cross-Border Insolvency Regulation (Antwerp, 2005), M Veder, Cross-Border Insolvency Proceedings and Security Rights (Deventer, 2004) and Dicey, Morris and Collins on the Conflict of Laws, 14th edn (London, 2006) 1526.

64 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services is opened in the place of the main interest of the debtor (COMI, Article 3(1)(4) not always easy to establish) and subject to the public policy exception. Secondary bankruptcies may be opened elsewhere. They are not extraterritorial, but support the main bankruptcy (if there is any) and only lead to liquidation. A key issue is that all creditors may participate, although these secondary bankruptcies or local asset pools are foremost important in respect of domestically secured creditors and their priorities in local assets. Indeed, security interests remain governed by the law of the underlying assets, which in the case of receivables is here defined as the law of the debtor (Article 2(g)). They are not subject to suspension rights of the main lex concursus, except if located in the country of the main bankruptcy, or, if located elsewhere, there is a secondary bankruptcy which imposes such a suspension. Under the Regulation, the basic tension arises here from the fact that a regulatory regime such as bankruptcy is still treated like a private law event under the traditional conflict of laws rules. The connection is then found in an enhanced public policy bar to recognition. Other countries may operate a unilateral recognition regime instead, based, as in the case of the US (under the new Chapter XV of its federal Bankruptcy Code 2005), Japan, Mexico and South Africa, on the UNCITRAL Model Law of 1997.57 The US Code distinguished between foreign main and non-main proceedings, comparable to primary and secondary bankruptcies. In the first case, the automatic stay and adequate protection clauses of sections 362 and 363 apply to assets located in the US, unless manifestly contrary to US public policy, not in non-main proceedings. Multiple proceedings in the US and abroad are co-ordinated, and under them any relief elsewhere must be taken into account in the proceedings in the US, as it must in respect of a foreign non-main proceeding in a foreign main proceeding. Again, if within the EU bankruptcies with debtor activities and assets in other EU Member States became more frequent, the private international law Regulation, as just described, is unlikely to be truly sufficient, as it can hardly satisfactorily cover all the different aspects of insolvency proceedings, including the treatment and ranking of the great variety of domestic security interests or other funding facilities such as finance sales. If such cross-border bankruptcies do not become more frequent, then even a private international law approach, whatever the merits of the present Regulation, seems hardly worth the considerable effort required and may only prove to add to the confusion. If, as here suggested, within the EU a uniform bankruptcy act may ultimately be the true answer, it is likely that harmonisation or approximation of the security interest laws of the various countries will only follow later. It was already observed before that it is not a precondition. As earlier in the US and Germany, it may well be that such a uniform bankruptcy law would create exactly the climate in which such approximation could properly take place. It would require the financing alternatives, which are ownership-based, such as conditional or finance sales and the different proprietary interests that are embedded in them, to be more carefully considered and the transnational aspects of newer financial products to be taken into account. For the time being, the domestic systems remain, however, the starting point for any discussion of the new proprietary structures in international finance and the legal regimes concerning them. There is no competency in the EU to harmonise them or any bankruptcy laws except as required by the operation of the internal market under Article 114 TFEU. That case is difficult to make at this juncture and might need treaty law between Member States. Domestic proprietary regimes concerned with asset backing of funding operations will therefore be considered first

57 See Look Chan Ho (ed), Cross-Border Insolvency: A Commentary on the UNCITRAL Model Law (London, 2006).

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 65 for a number of countries. Most important are the US, England, Germany and perhaps France. The Dutch approach is also of some interest, as it presents the latest effort to deal comprehensively with proprietary interests, including secured transactions, and it will therefore be discussed first, if only to show that this latest effort did not produce great new insights and may even be regressive. It is submitted that this is largely because it was unaware of the revolution in financial products and facilities that started to take place from the 1980s. The same affects the latest attempt in Europe in the DCFR, already mentioned and discussed in Volume 4, section 1.11. As we have seen, it strongly builds on the German approach, but is even then regressive, especially in the area of floating charges, finance sales, and the finality of transactions including payments. It is too tentative a proposal to merit much further attention.

1.1.15. Fintech and its Challenges and Possibilities. The Legal Consequences. A New World of Finance? At the end of section 1.1.1 it was already asked whether fintech might affect the newer approaches and fundamentally change finance, international finance and its products and services in particular. This discussion will be continued below for payments, securitisations, derivative trading in CCPs and custodial holdings of investment securities: see sections 3.1.10, 2.5.12, 3.6.12 and 4.1.8. It remains speculation, but newer developments cannot be ignored. It is indeed conceivable, although it cannot yet be predicted with certainty, that radical change is at hand, which could have a far-reaching effect particularly on all sorts of financial activity, for banks affecting not only their role in the payment system, but then also in the closely connected deposit-taking function. Risk management may also be fundamentally affected. It is by no means irrelevant for the legal profession either. Enhanced forms of standardisation, not in the least through smart contracts, may cut out much legal activity. If some middlemen or intermediaries are here to suffer, the legal profession would not necessarily be excluded, and could be substantially relegated to dispute resolution, which may itself be significantly reduced, as much can no longer be questioned once parties choose to participate in the newer facilities. They are whatever they are, unless perhaps the whole set-up can be questioned as abusive or fraudulent.

1.2. The Situation in the Netherlands 1.2.1. Introduction: The New Civil Code of 1992 The Dutch system of property law, including secured transactions, was recast in the new Dutch Civil Code of 1992 (CC), and is therefore, the latest of its kind in Europe. The Dutch Code undoubtedly presents an example of how things should not be done and is only in that sense significant. In particular, the transformation of the financial scene in the 1970s and 1980s with a score of newer products and risk management facilities and tools was not considered or properly understood. Even what was covered proved to be hardly coherent. In retrospect there were many policy mistakes. For the purposes of this discussion, these deficiencies concerned foremost (a) the definition of assets still centring on physical existence, individualisation and identification as objective criteria (Bestimmtheitsprinzip in German); (b) the problem with the inclusion of receivables; (c) the status of future assets including replacement assets; (d) the notion and treatment of classes of assets

66 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services (or assets in bulk) and their transfer (or assignment); (e) the possibility of floating charges and the issue of tracing; (f) the status and operation of conditional and temporary ownership rights and other forms of duality of ownership, especially in finance sales like repos and leases; (g) the notion of client assets and segregation; and (h) the asset status and possibility of a transfer of commercial contracts. There was simply too little knowledge of the modern world of commerce and finance (or an unwillingness to listen and find out until it was too late). Deficiencies of this nature also surfaced in Brazil in its new Code of 2002 which shows similar constraints and defects. In the EU, the Draft Common Frame of reference (DCFR) as a proposal for some EU codification suffered from similar problems, as we have seen in Volume 4, section 1.11. Only in France, and now perhaps also in Belgium under new codification proposals, is there some movement. The overall result was an inadequate response, which was fatally caught up in system thinking and proved wholly insufficient to deal satisfactorily with the legitimate requirements of modern commerce and finance and to move it forward in a responsive and reliable legal framework.58 A particular feature and central theme in the new Dutch CC were the creation of a special security right in movables and intangibles—the non-possessory pledge. It was meant to replace the earlier fiduciary transfer of movable tangible and intangible assets, which had been a case law product and started as a conditional sale, although it subsequently acquired most features of a secured transaction—not unexpected in a clear loan situation, as we saw in sections 1.1.7/8 above. This older fiduciary sale and transfer was comparable to a security interest and was often stronger than the comparable German Sicherungsübereignung and Sicherungszession, also a case law product, as they developed from similar origins and replied to similar needs.59 All created unpublished or hidden non-possessory proprietary interests in movables, ultimately more in the manner of a security interest than a conditional sale. There was, therefore, an execution sale upon default and a return of any overvalue to the debtor instead of appropriation of the asset by the creditor, although in a bankruptcy in Germany, unlike in the Netherlands, it degenerated in a mere preference, as we shall also see. New Dutch law did not continue this development, but introduced instead a statutory non-possessory pledge in chattels and receivables. This change from a conditional sale type of protection to a true security interest was fundamental in a structural sense, affecting more generally the status of finance sales at the same time (hardly retrieved by the retention of the concept of conditional sales, especially in reservations of title as sales price protection but notably not as security substitutes leaving finance sales notably in the lurch), although the government repeatedly attempted to appease opponents by suggesting that no substantial change was meant,60 which in the end had significant consequences for new case law, forced to re-adopt some of the old ways.61 The new pledge does not cover or transfer to replacement goods or proceeds, which was left to contractual elaboration, therefore a form of party autonomy, but how this can work in proprietary matters and how far it goes was not further considered.62 Like elsewhere, problems are here the shift into future assets with retention of the original rank. That concerns asset substitution and tracing, concepts largely unfamiliar to the new Code. For the charge to attach (at the original rank), these goods must be included and sufficiently 58 See JH Dalhuisen, ‘Wat is de toekomst voor het Nederlandse vermogensrecht in een globaliserende pereld en hoe moeten wij ons die toekomst voorstellen?’ [What is the future of the Netherlands law of property and obligations in a globalizing world and how must we imagine that future?] 2018(3) Nederlands Tijdschrift voor Handelsrecht. 59 See HR 6 March 1970 (Pluvier), NJ 433 (1970), and for Germany see the text at n 172 below. 60 See Parliamentary History, Introduction Statute Book III, 1197 (Dutch text). 61 See n 67 below. 62 See n 72 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 67 identifiable at that time. That has proved especially problematic for trade receivables, but also for other replacement assets. There is no general regime for the transfer of proprietary rights (including security interests) in replacement assets (with the retention of rank). Another particular limitation in this connection is that the new Code does not have a general regime for creating charges in a generality of assets. In earlier drafts, it appeared impossible to define the notion of asset class and the effort was abandoned. There is therefore no legal framework allowing for bulk transfers. It is then also difficult to create a meaningful floating charge, and careful drafting is necessary to approximate it to some extent and it may still not be meaningfully possible, see section 1.2.2 below. The legal practice in this regard has been given some greater freedom in Germany.63 The trust concept (‘bewind’) could also not be incorporated and this effort was also abandoned. The non-possessory pledge in tangible movable assets requires a notarial deed or registration with a registration office, the latter having become more common. This does not mean publication, and was therefore not introduced to warn subsequent lenders or the public but rather to establish the existence and time of the security right and thereby its rank.64 As a consequence, this non-possessory charge remains, for all practical purposes, hidden. For the assignment of receivables (and other claims) by way of security in this manner, therefore for the pledging of intangible assets, registration meant that the substantive requirement of notification to the debtor of each receivable, which became necessary in the new Code for the validity of all other assignments and was often equated with publicity, was lifted.65 However, the relationship out of which the debt arises must exist which means that technically a security interest can attach only after the emergence of the debtor. Besides individual registration, there is also a documentation requirement in respect of each transfer. It follows that, within a security assignment, lists of new debtor relationships must still be provided regularly, and in respect of the debts the security assignment only dates from the transfer of these lists to the assignee. It then also establishes the ranking.66

63 See ss 1.4.2 and 1.4.4 below. 64 See Art 3.237 CC for tangibles and Art 3.239 CC for intangibles. 65 See for the notification requirement in the case of assignments Art 3.94(1), which as a constitutive requirement for the assignment was new in Dutch law. It was curious as the notification requirement was introduced at a time French law made an exception to this approach in order to facilitate the supply of credit among professionals and Belgian law abandoned the requirement altogether: cf Art 1690 of their respective CCs as amended, in France by the so-called Loi Dailly of 2 January 1981, reinforced on 24 January 1984—see s 1.3.6 below—and now codified in Arts L 313-23 to L 313-35 Code Monétaire et Financier but altogether abandoned in the amendments of the Code Civil in 2016. 66 The registration requirement for the security assignment of receivables immediately raised severe logistical difficulties as it seemed to be a requirement in respect of each assigned receivable and naturally caused special problems for bulk security assignments of present and future claims. It gave rise to a string of Supreme Court decisions to remedy the shortcomings of the new law in which the Supreme Court bent over backwards to help as much as possible. At first there were computer lists of claims allowed which could be attached in simplified form, but it limited the claims to those on the list and did not allow for those who had not yet arisen, although the legal relationship out of which they could arise was already established, which under Dutch law allowed such prospective claims also be to be included in principle, even if the security could therefore not yet be enforced. It was eventually decided that it was sufficient for the document to contain the necessary details to determine (if necessary, even retroactively and with the help of the financial administration of the pledgor) which claims were included, assuming the required relationship was already in place: see further n 68 below. Reference was made to no change from earlier practice being intended by the new Code. The key is that absolutely future claims can still not be covered, but as soon as the relationship out of which they arise is known, they may be: Arts 3.239 and 3.94–97 CC were so explained. These relationships will then be added on a daily basis and the pledges of any future claims arising therefrom take their rank as of that date. Others may be able to acquire a pledge in such claims at the same time. Consequently, it has now become common for

68 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Naturally, as a practical matter, the security assignee cannot collect before notification to the debtors is given. Even though notification is not legally required for the validity of registered security assignments in receivables, without it, the assignor/pledgor still remains entitled to retain the proceeds, as confirmed in case law, albeit subject to a preferred claim of the assignee.67 In the meantime, Dutch law, through amendment of the Code of 1992 in 2004, has accepted in financial transactions the need for other types of assignments without notification (provided there is a notarial deed or registration68 which tracks the Dutch method of creating registered security interests in receivables). Dutch banks to sign a daily assignment on behalf of their borrowers/debtors (who have commonly given the banks a power of attorney to the effect) of all the latter’s receivables, HR Feb 1 2013 NJ 156 (2013), always assuming that the relationship out of which they arise exists, the priority relating back to that date. For physical movable assets, the situation is simpler but not necessarily satisfactory either. Future assets may be included but only when they enter into the estate of the debtor and the latter acquires the disposition right in the asset which assumes under Dutch law that it must physically exist and is individualised. Replacement assets are not included, see n 68 below, and there is no tracing except in the limited case of insurance proceeds and similar repair moneys when the rank is the highest, but it does not shift in replacement assets that are bought with these moneys. 67 See Art 3.246(1) CC for the collection right of the security assignee, which remained an issue under old law and led to the fiduciary assignment being preferred, now in its generality ineffective: see Art 3.84(3) CC. Under the old system of the fiduciary assignment, the assignee was the party entitled to the proceeds (even if s/he could not collect for lack of notification so that the assignor would normally do this), as the assignment was valid in all its aspects without notification. In this approach the assignee reclaimed the proceeds probably as a matter of unjust enrichment from the collecting assignor, although this might still have given trouble in a bankruptcy of the latter. Under the new law, the Dutch Supreme Court allows assignee/bank still to claim a preference in these collections, again on the basis that no change had been intended by the new Code, thus conceivably undermining the logic of the new system: see HR, 17 February 1996, Mulder v CLBN [1996] NJ 471. Although this case confirmed at the same time that the charge did not shift into the proceeds so collected (as the lower court had proposed on the basis of an analogous interpretation of Art 3.246(5) CC) and that payment extinguished the receivable and the security for which it served, there is here nevertheless a form of tracing of the interest. The priority has no statutory base and is of an undetermined rank. In later case law, it has on the whole been given a limited scope. It is clear that especially the cost of the bankruptcy administration takes precedence over it, but practically speaking, there may result a set-off between the claims the assignee bank has on the bankrupt assignor bank and what the latter owes the former, avoiding sharing in these costs. 68 The notification as a constitutive requirement for assignments in the new Dutch Civil Code was a departure from earlier law and hindered all bulk assignments, and therefore in particular, factoring of receivables and their securitisation. It was from the beginning criticised: see HLE Verhagen, ‘Het mededelingsvereiste by cessie’ [The notification requirement for assignments] in SCJJ Kortmann et al (eds), Onderneming en 5 Jaar Nieuw Burgerlijk Recht (Deventer, 1997) 163, and a serious policy mistake. In 2003 statutory proposals to modify the requirement were introduced to accommodate the financial practice. It allows all assignments (not therefore only for the purpose of security) without notification to be valid if registered in the manner of securities transfers of intangible assets. To this effect a new Art 3.94(3) and (4) became effective on 1 October 2004. Even then for the proceeds to belong to the assignee, notice to the existing debtors remained necessary. This notice may be given beforehand, but is still not effective before the debtor becomes known. As a consequence, the difference between a security or registered assignment and an outright assignment (subject to notification) is not as important as it may seem at first. It became more important after the decision referred to in n 67 above, which gave the assignee a preference in any collection by the assignor under these receivables. As the rights so assigned must exist or otherwise directly result from an already existing legal relationship (Art 239), as we have seen, there may still be a difference here between the registered security assignment and the outright or conditional assignment of claims which, pursuant to Art 3.84(2), may follow when they are sufficiently identifiable. They are sufficiently identifiable under Art 3.84(2) when the debtor is definitely known: see A Hartkamp, Compendium (Deventer, 2017) No 138. Subject to proper notification, this allows a full assignment, eg, of all claims against a certain debtor: see also Government Memorandum (MvA, PG Inv W 3, 1248). It would therefore appear that an outright or conditional assignment may be easier to achieve in at least some future claims. It may still mean that a registered security assignment may not be possible in others, see HR 17 February 2012, Dix v ING [2012] NJ 261. In this approach, the question is always ‘when does a claim come into existence?’ There may still not be full clarity on this point, but it determines whether, in a subsequent bankruptcy, the proceeds will benefit secured or general creditors.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 69

1.2.2. Security Substitutes and Floating Charges. The Reservation of Title It is not necessary to go into further detail on the Dutch law of the non-possessory pledge, except to say that this new type of security is more formal, restricted and circumscribed than its (fiduciary transfer) predecessor, which had no statutory base and developed through case law from 192969 in the nature of a conditional sale, but subsequently applied security law principles by analogy to the extent that made sense.70 It was already mentioned that in 1992, this type of fiducia was explicitly abolished and can no longer be used as a security substitute (Article 3.84(3) CC). The apparent reason for this was to preserve the closed nature of the Dutch proprietary system on which the fiduciary sale had seemingly intruded.71 But it was no less indicative of a search for greater formality and precision, which also emerged in the Dutch wariness of shifting liens and floating charges, or other forms of tracing.72 It has already been said that Dutch law It remains curious that in 2004 the earlier situation was not simply restored. Apparently, some importance is still attached to further formalities for assignments if no notification is given, now in terms of registration. The idea is that as delivery is a formal requirement for the transfer of ownership in chattels, some further formality must therefore also exist for the transfer of claims. It is less clear why this should be necessary and shows the narrowing impact of system thinking. It does not conform with practices elsewhere. In France in 2016, the notification requirement was abandoned (Art 1321 ff Cc), in Belgium in 1992 (Art 1690 Cc). There is a relaxation under the EU Collateral Directive, whose main provisions are incorporated in Dutch law in Arts 7.53 and 7.54 CC. They only apply to financial collateral agreements, often connected with margin accounts, under which the party being funded surrenders (temporarily or conditionally) control of financial assets. Securities may be on-sold if desired by the funding party and may be appropriated upon default if so, agreed in the original documentation. So may cash balances, the other asset class covered by the Directive. These assets may be present or future, and could amount to floating charges in future assets which may be transferred in bulk assuming enough control is surrendered. The collateral may be expressed in security interests or conditional and temporary sales, the repo being a main example of the latter. The creation of these facilities (even in cash balances) requires no formalities. See for the Directive and its objectives more particularly s 4.1.5 below. It is of interest in this connection that the Dutch chose to incorporate the Directive quite separately from the system of 1992 rather than understanding newer business trends and using the opportunity fundamentally to reform the present system. Again, this shows the debilitating effect of system thinking, which isolates or ignores all newer thought unless imposed from the outside and is even then likely to be narrowed in its application. 69 HR, 25 January 1929 [1929] NJ 616, and 21 June 1929 [1929] NJ 1096. Originally, the practice was based on the repurchase option as codified in the old Civil Code (Arts 1555ff) following the French contract de remerge (Arts 1659ff CC). See, for the different developments of the Roman law principle of C 4.54.2, which was also the basis for the further development of the non-possessory security in movables in France and particularly Germany: nan 113 and 158 below and accompanying text. For receivables, the fiduciary transfer was accepted following the decision of the Amsterdam Court of Appeal of 16 April 1931, W 12326 (1931): see also HR, 17 June 1960 [1962] NJ 60. An important advantage of it was that it gave the assignee the ability to collect, which had remained doubtful under a pledge of receivables (a doubt relieved in the new Code, which gives the pledgee this right explicitly: see Art 3.246 CC and n 67 above). 70 HR 3 Jan 1941, Heartwoods Bank v Los NJ 470 (1941). This analogy proved increasingly unsatisfactory, however: see HR, 13 March 1959 [1959] NJ 579, 6 March 1970 [1971] NJ 433, 7 March 1975 [1976] NJ 91, 3 October 1980 [1981] NJ 60, 18 September 1987 [1988] NJ 876 and 5 November 1993 [1994] NJ 258. 71 See Parliamentary History, Introduction Statute Book II, 1197 (Dutch text) and also W Sneijders (the draftsman of the present text of Art 3.84(3) CC), Minutes Meeting Vereeniging Anderlecht on 10 March 1989, 73 and (showing some greater flexibility, but also an overriding concern for unsecured creditors) on 27 April 1990, 65, but it does not appear that the limitation of the secured creditors’ rights was the primary concern originally; it was the numerus clauses, therefore systemic considerations, although there was later an implicit bias in the new Code to limit creditors’ preferences. 72 Although the shifting of proprietary rights to replacement goods is known in the new Code (see eg Art 5.16 CC), it is not a general principle, and does not apply in the case of the non-possessory pledge, although it covers, for example, insurance proceeds when the asset is lost, but not their reinvestment: see n 62 above. According to yet another fundamental case, in a reservation of title, it is considered lost if the asset in which the ownership

70 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services also continues to require that the assets set aside must be and remain sufficiently identifiable. It is, therefore, still not possible generally to create security in absolutely future assets, certainly not with a priority from the creation date.73 As already mentioned in the previous section, floating charges are, therefore, not easily created either. Unlike in Germany,74 purely contractual enhancements and extensions of the non-possessory security right appear limited in their effectiveness and miss support in more general provisions concerning the transfer of future assets, bulk transfers, asset substitution and tracing. Future replacement goods are therefore difficult to cover. Importantly, there is now also a bankruptcy law provision (Article 35(2)), which since 1992 requires that all assets that enter into the ownership of a debtor after its bankruptcy are part of the bankrupt estate, which then also covers absolutely and relatively future assets already promised to be given as security but only acquired by the debtor after the bankruptcy. It might be different, however, if they are conditionally transferred: see Volume 4, section 1.7.5. Yet it is a more restrictive approach than that adopted under common law in general and by the UCC in the US in particular: see Volume 4, section 1.7.8 and section 1.6 below. It would appear also more limited than a similar facility developed under German case law, as we shall see in section 1.4 below. Again, it is the result of narrowing system thinking that acquired a life of its own and is impervious to practical needs. The new Dutch Code also covers the reservation of title, formerly also a product of case law.75 Here, it still presumes and accepts a conditional sale, although the Code does not spell out how this presumption is to be rebutted, what the alternatives are, or how the proprietary status of each party must be characterised.76 It is clear, however, that the parties may opt for another construction and notably exclude or adapt the conditionality, although they will have to ask themselves was reserved loses its identity and independence: see HR, 27 November 1992 [1993] NJ 316. Only for commingled property or for property not submerging into another asset upon conversion are there special rules in Arts 5.14(2), 5.15 and 5.16 CC allowing a form of joint ownership. It seems, however, that in the meantime, the Dutch Supreme Court has become more favourably inclined to accepting replacement goods in this category, HR Aug. 14 2015, NJ 253 ((2016). According to the Dutch Government Explanatory Memorandum (MvA II, PG3, 744), the non-possessory pledge could always shift into replacement goods in the case of inventory if such was expressly agreed, provided the pledgee accepted in the loan conditions that the assets may still be sold by the pledgor in possession free and clear of the charge. The new law itself does not elaborate and the charge, even if so agreed, might still be lost when the asset loses its identity and independence. See for the transfer of future receivables, assuming they are identifiable, and the different approach in security or other registered assignments n 62 above in fine. Tracing is as such not part of Dutch law either, yet in case law it is not altogether unknown either: see n 61 above in fine. See for a case in which a faulty payment to a bankruptcy trustee was recovered on the basis of notions of unjust enrichment of the creditors (assuming that the payment was made after the bankruptcy was opened), HR, 5 September 1997 [1998] NJ 437; see also HCF Schoordijk, Onverschuldigde betaling aan de faillissementscurator [Mistaken payment to the bankruptcy trustee], final lecture, University of Amsterdam, 1997, cf further HCF Schoordijk, Ongegronde verrijking, zaaksvervanging [Tracing, constructive trust, unjust enrichment, conversion], Valedictory Address, Amsterdam, 1991. 73 The difficulty is purely related to the type of asset that is to be encumbered. It was already said that the secured claim does not have to exist at the moment the security interest was created, but priority will be awarded only from the time the relationship out of which the claim arose came into being, although this could be determined retroactively, see HR June 16 2000, NJ 733 (2000). No stringent requirements exist regarding the specificity with which the secured claim is to be covered in the security agreement, but mere description is not enough, although the relevant Art 3.231 CC has been interpreted so as to allow descriptions as ‘any and all claims’ (see Hartkamp, n 68, No 206), but part of the claims even if described in the contract may not suffice as a sufficient identification. 74 See for the more liberal German approach, the text at n 166 below. 75 Art 3.92 CC. 76 The Dutch Supreme Court in a decision of 3 June 2016 (Rabobank/Reuser), HR NJ 290(2016) elaborated and accepted the complementary nature of the right of seller and buyer, both being allotted a proprietary right, the one (seller) under a resolving condition, the other (the buyer) under a suspensive condition, see also AJJ Smelt,

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 71 whether by doing so they are not creating a non-possessory security interest in the process subject to the above-mentioned formalities and limitations, short of which the arrangement may have no proprietary and priority effect at all. The reservation of title, as the new Code perceives it, is not registered in any way. It remains therefore a(nother type of) hidden proprietary interest, is not considered accessory to a credit agreement (a point confirmed in newer case law, the accessory nature always being an indication that there is a security interest),77 does not (according to equally recent case law) automatically extend into replacement goods or proceeds either, and cannot be extended to cover other debt than the purchase price.78 There is no execution sale, but rather appropriation of the asset by the seller upon default.79 Since the sales agreement must be rescinded for the asset to be repossessed

‘Het voorwaardelijke eigendomsrecht’, WPNR 7149 (2017). An important unresolved issue was whether this split of the ownership right was limited to the reservation of title or also operated in related structures like the finance lease and repo, or at least in the more closely related hirepurchase. The German approach of introducing a new proprietary right (dingliche Antwartschaft, see s 1.4.3 below) as a proprietary expectancy was not followed, but the Dutch system of conditional ownership under Art 3. 84 (4) CC was further elaborated: see also the discussion in, s 2.1.5 below. These rights can be transferred by either buyer or seller as security for financing, which in the case of the buyer would mean that his/her financier can put the purchase price and acquire the entire property as his/her security. 77 See HR, 18 January 1994 [1994] RvdW 61 confirming that the fiducia was not an accessory right under the old law, which was (a fortiori) always assumed for the reservation of title: see Parliamentary History Book 3, 1241 (Dutch text); see for the accessory nature of true security interests the text at n 28 above. The lack of this accessory status for a reservation of title can be disadvantageous for a factor of receivables as assignee of the receivable. In doing so s/he may be deemed to have paid the seller for or on behalf of the purchaser so that the reservation lapses: Art 3.92 CC. See for the different French approach n 124 below. A subrogation, if following at all, might not help much either: see RD Vriesendorp, ‘Eigendomsvoorbehoud en overgang van de verzekerde vordering’ [Reservation of title and the transfer of the secured claim] 6133 (1994) Weekblad voor Privaatrecht Notariaat en Registratie, 293; the answer may be in structuring the factoring as a mere collection arrangement: see for factoring n 96 below. 78 See n 72 above for the shift into replacement goods and Art 3.92(2) for the impossibility of covering other debt. If the extension into replacement goods is agreed, the question arises what kind of interest is created. It cannot be an extended reservation of title, which under statutory law is limited to the sold asset. It is not a security interest either, which would be subject to its formalities, eg in terms of registration. It is likely therefore to be a conditional transfer. 79 The lack of the accessory nature of the proprietary interest and the appropriation right are distinctive features of conditional sales: see s 1.1.5 and n 28 above, and distinguish them from security rights or interests, which since late Roman law (C 8.34.3 forbidding the lex commissoria, that is the rescission and appropriation upon default), and early common law (strictly insisting on the right of redemption: see the text at n 203 below) require some sale and the return of any excess value to the debtor as his/her basic protection: see also Art 3.235 of the Dutch CC. This protection is often seen as an important argument to avoid substitute securities (besides the closed nature of the proprietary system and the protection of the common creditors). Yet the difference between situations in which the lex commissoria is allowed (as in the Netherlands notably upon a failed sales agreement, if so agreed: see n 80 below) and true secured transactions was never defined in Roman or medieval law. In fact, Baldus at C 7.72.6 suggested that the lex commissoria was in the nature of a pledge, but also that it could entail a conditional ownership right (pactum reservati dominii). In notarial deeds of those days, both were often negotiated at the same time. As Roman law did not consider the reclaiming right in bankruptcy, medieval law had no clear answer. According to writers like Straccha, in sales-price protection schemes, the reclaiming right obtained only as long as the goods were not physically delivered to the buyer. This narrower interpretation became accepted in Germany, France and England, but not in the Netherlands. The difference between a reservation of title and the lex commissoria is not great. The one is an express, the other mostly an implied condition, although even the lex commissoria may also be express. In that case, the difference is probably only in the nature of the condition. The reservation of title is usually seen as a suspensive condition of ownership for the buyer, the lex commissoria as a resolutive condition. Even then, the difference is slight: see the discussion in s 2.1.5 below. See for the situation in Germany, n 162 below. Generally, there was no great clarity in Roman law on the nature of conditions. In classical Roman law, the rescinding condition did not clearly figure, unlike the suspending condition or condicio, which was well known. The rescinding condition was, however, sometimes construed as a suspensive condition for the counterparty of which

72 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services by the seller, it appears that any instalments paid have to be returned to the buyer at the same time.80 A similar construction applies to the hire-purchase.81

1.2.3. Conditional and Temporary Ownership: The Lex Commissoria Dutch law goes much further, however, than merely presuming a conditional sale in the case of a reservation of title, and generally recognises conditional and temporary ownership rights where transfers are made conditional (Articles 3.38 and 3.84(4) CC). In fact, the conditionality of the transfer results here automatically from the conditionality of the contract. An important example is indeed the reservation of title, but also the lex commissoria expressa under which the condition may be introduced by contract to protect more generally against non-payment upon a sale—it could also be deemed implied: the lex commissoria tacita.82 In a sale, at least in the case approach there are remnants in D 18.3.1: see also JA Ankum, ‘De opschortende voorwaarde naar Romeins recht en volgens het Nederlandse Burgerlijk Wetboek’ [The suspensive condition in Roman law and in the Dutch Civil Code] in ME Franke et al, Historisch Vooruitzicht, BW-krant Jaarboek (Arnhem, 1994) 19; and R Zimmermann, The Law of Obligations: Roman Foundation of the Civilian Tradition (Juta, 1990/1992) 716. In Justinian law, the rescinding condition was known and thought to have operated retroactively with full proprietary or in rem effect: see D 6.1.41 and M Kaser, Römisches Privatrecht [Roman private law], 14th edn (Munich, 1986) 198, although contested by Windscheid: see n 168 below. See more extensively AH Scheltema, De goedenrechtelijke werking van de ontbindende voorwaarde [The proprietary effect of the resolving condition] (Dissertation, Leiden, 2003) 46, 124ff; see also Vol 4, s 1.7.3. See for France, n 116 below. 80 Rescission of a sales agreement upon default (contrary to annulment or nullity of the transaction: see Arts 3.53 and 6.203) now lacks in rem effect under new Dutch law (lex commissoria tacita): see Art 6.269 CC, except if specifically so provided by the parties, cf Art 3.84(4) CC (lex commissoria expressa), which proprietary effect is also implicit in the reservation of title, Art 3.92 CC, although in that case there is a suspensive rather than a resolutive condition in relation to the buyer as already mentioned in the previous footnote. Even in the express condition, the rescission is no longer retroactive under new Dutch law: Arts 3.38(2) and 6.22 CC, although parties must still put themselves as far as possible in a situation as if the contract had not arisen. This in principle gives rise to personal actions only, for example, for reimbursement of instalments already paid and the return of the goods, unless the parties intended in rem effect when title may still automatically revert, giving revindication rights to the seller, but always subject to the rights of bona fide purchasers for value who acquired the asset from the buyer in the meantime: Art 3.86 CC. One may, however, still deem the buyer to have a retention right in the goods until the instalments are repaid. The buyer could also negotiate a possessory pledge in the sales agreement for the recovery of any sums paid, but reasonable damages of the seller would have to be set off. The idea is that retroactivity should not undermine any disposition and management acts. In this connection, it is sometimes said that conditional ownership is no more than a bet on the future, as such to be distinguished from trusts and usufructs where there is an intent to organise the future. 81 See Art 7A.1576h CC, although as a consumer financing vehicle it is subject to considerable restrictions and in particular requires the financier to return any overvalue to the debtor in the case of the latter’s default: cf Art 7A.1576(t) CC. 82 Cf n 79 above. The most important example remains the express condition of payment in a sales agreement, therefore the lex commissoria expressa, reinforced in Arts 7.39ff CC (see also n 80 above, but Art 3.84(4)), is not limited thereto, and other express conditions result from reservations of title and may also be inserted into finance sales in order to give them in rem or proprietary effect and avoid any doubt and characterisation issues in this connection. It is a consequence of the Dutch causal system of property transfer: see Vol 4, s 1.4.6. It is therefore different from the German abstract system, in which the condition must be specially inserted or attributed to the real agreement or dingliche Einigung: see n 168 below. Even so, Art 3.84(4) does not elaborate on the relative rights of both parties to a conditional sale. See, for the comparison with the reservation of title, n 79 above. There is also a statutory right to reclaim the unpaid asset for a short period: Art 7.39 CC. It may be seen as a statutory expression of the lex commissoria expressa implying a similar conditional ownership structure during this period. The conditional ownership notion was not new in Dutch codified law and appeared already in the French Code Napoléon as adapted for the Kingdom of Holland, which was briefly in force in the Netherlands from 1809 to 1811 (Art 443) and was, through the author of an earlier Dutch codification (Book II, Title 2, Pt 1, Art 9 of Draft Van der Linden) probably directly derived from Pothier, Traité du droit de domaine de propriété, partie I, chapître premier, not followed in the French Code itself.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 73 of a reservation of title, it renders the acquisition of the ownership right subject to a suspensive or suspending condition (or condition precedent) of payment. In the case of the lex commissoria, non-payment is rather a resolutive or rescinding condition (or condition subsequent). This is the result of the Dutch causal system of property transfer. Dutch law also seems to understand (in principle) that, in a proprietary sense, the suspending condition is necessarily the complement of the resolving condition. In other words, when the seller has an ownership interest subject to a rescinding or resolving condition, the buyer will have an ownership interest subject to a suspending condition in the same asset, so that together they hold the full ownership right. What is not known, however, is what this duality in ownership truly means; how the owner under the condition subsequent and the owner under the condition precedent, in the same asset, relate to each other and to third parties.83 Do they both have in rem or proprietary rights and are they both able to protect and transfer their respective rights in the asset accordingly? Do the future interest, the reversionary interest or any remainder, as the case may be, have proprietary status? Logically it appears to follow as is, in principle, the case in common law,84 but would this work, particularly in the details in legal systems such as the Dutch, which in principle require delivery of possession as a precondition for the transfer of ownership rights? Could there be a form of assignment instead? Here again, the new Code is largely silent. Article 3.91 CC requires the transfer of physical possession of the asset, as in the case of a reservation of title, to create suspensive interests, but it does not say how the remaining interest of the one party and the expectancy of the other may subsequently be transferred in view of the Dutch requirement of delivery. It seems logical that for the owner under a resolutive condition without physical possession (therefore normally the seller in a reservation of title) the transfer of its interest is completed by notice to the holder (like a transfer longa manu: see Article 3.115(3) CC), while the owner under a suspensive condition with physical possession (the buyer in a reservation of title) transfers this possession.85

See for the notion of duality of ownership in the Netherlands in particular HCF Schoordijk, ‘De Eigendomsvoorbehoudclausule en het gewijzigde Ontwerp van wet (Boek 3 BW)’ [The reservation of title and the amended proposal of Book 3 Draft new CC] (1971) 5148–49 Weekblad voor Privaatrecht Notariaat en Registratie 457. See for the history PL Neve, Eigendom in Staat van Ontbinding [Ownership dissolved], Valedictory Address, University of Nijmegen, 1998. See for further comments NED Faber, ‘Levering van toekomstige goederen en overdracht onder opschortende voorwaarde’ [Delivery of future goods and transfer under a suspensive condition] in SCJJ Kortmann et al (eds), Onderneming en 5 jaar Nieuw Burgerlijk Recht (Deventer, 1997) 179; WJ Zwalve, ‘Temporary and Conditional Ownerships’ in GE van Maanen and AJ van der Walt (eds), Property Law on the Threshold of the 21st Century (Antwerp, 1996) 333. See more recently, extensively and fundamentally, Scheltema (n 79) who rejects the duality of ownership notion (p 344), accepted by most Dutch authors. S/he accepts, however, the proprietary nature of the expectancy (p 348). See, however, for the latest Dutch case law that now accepts it: n 76 above. See for the duality of ownership in French legal writing, at one stage commonly accepted in France: n 116 below. It is more unusual to find references to it in Germany, but it is not unknown: see n 168 below. 83 See for the apparent confusion this has created in the Netherlands, SCJJ Kortmann, ‘Eigendom onder voorwaarde’ [Conditional ownership] in Quod Licet Liber Amicorum Professor WM Kleyn (Deventer, 1992) 199ff. 84 The tendency in the Netherlands was towards recognition of the proprietary or in rem nature of the expectancy, see also n 76 in fine, at least in the case of the reservation of title: cf for a commentary Asser-Mijnssen-van Velten, Zakenrecht [The law of property], 12th edn (Zwolle, 1994), no 428 and further H Stolz, ‘Een Nederlands Anwartschaftsrecht’ [A Dutch Anwartschaftsrecht], WPNR 7085, 1008 (2015), who supported a broader application than that in the reservation of title, but did notably not deal with repos and finance leases. See for Germany, n 167 below, and for common law the text following n 196 below. But see again the Dutch Supreme Court in 2016, n 79 above, recognising the duality of the ownership instead. 85 Under the 2016 Supreme Court case (see n 79 above) it became clear that delivery of each proprietary right takes place in the manner as is normal for the type of asset. The transfer may also be for security purposes or could be a usufruct.

74 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services There is substantial clarification since a Supreme Court case of 2016 in regard to the conditional sale.86 What remains clear, however, is that new Dutch law disapproves of security substitutes and has attempted to draw a line between them and true security interests. It is obvious that it has not been successful because no real criteria are being given.87 There remain, however, the taste and history of an abhorrence of these substitutes in some quarters.88 What could these be? They must be the fiduciary transfer, but also similar types of conditional sales and ownership forms. Yet in explicitly disallowing the in rem effect of the former in Article 3.84(3) while accepting it for the latter in Article 3.84(4), the conditional sale also being effective in reservations of title and in a hire purchase, the new Code has introduced a potential contradiction. What is allowed and when, and what is not? In the crossfire, some of the most important modern financial products, such as the finance lease, the repurchase agreement and major types of factoring, have been caught, and their basis in new Dutch law is uncertain. The drafters of the new Code never considered them. Again, the Supreme Court had to come to the rescue.89 It decided that finance leases are transactions not affected by the prohibition of Article 3.84(3) CC. They are not secured transactions, even the leaseback, and have in principle proprietary effect, leaving the lessor with some ownership right. As long as obtaining mere finance or funding is not the sole objective of the arrangement, conditional transfers, even in finance, are apparently not outlawed. The link with loan financing was not made in this connection. Although the Supreme Court concluded that the lessor had a proprietary right, in finding thus it also had to consider the residual rights of the lessee. It ignored any claim to conditionality under Article 3.84(3) CC and found that the future interest of the lessee was purely in personam, therefore obligatory or contractual, even though the latter has physical possession. It suggests that the lessor is the full, and not a conditional, owner. This was unexpected as the reservation of title and hire-purchase, which are closely related, were already defined as conditional sales (by way of presumption), as we have seen in the previous section, and allowed as sales price protection devices. This conclusion cannot be correct, which is evident in the event of a bankruptcy of the lessor, when the lease is at risk of being nothing more than an executory contract subject to repudiation by the lessor’s trustee in bankruptcy, except if it were subject to rental protection under Article 7.1612 CC (old), which was written for other situations.90 There are voices that 86 See n 79 above. 87 Art 3.84(3) CC provides: ‘a juridical act which is intended to transfer property for purposes of security or which does not have the purpose of bringing the property into the patrimony of the acquirer, after transfer, does not constitute valid title for transfer of that property’: see for this translation PPC Haanappel and E Mackaay, New Netherlands Civil Code (Property, Obligations and Special Contracts) (Deventer, 1990) 49. Transfer into the patrimony of the acquirer has been explained as the property becoming subject to the recovery rights of the acquirer’s creditors, but the question is when that is the case: see also WH Heyman, ‘De reikwijdte van het fiducia verbod’ [The extent of the prohibition of the fiducia] 6119 (1994) Weekblad voor Privaatrecht Notariaat en Registratie, 6. What the ‘transfer for purposes of security’ is has remained equally obscure. W Snijders (the author of the present Art 3.84(3) CC), n 65 above, (1990) 81, 65, refers to the facility to recover by priority, admits that the resolutive condition of default in a sales agreement is not a security, but otherwise shows concern about the appropriation aspects and the avoidance of the protection of the security laws against it, without giving any criteria, however, for when a transaction must be considered a secured transaction. 88 It may be traced back to the original designer of the Code, Prof EM Meijers, who saw the fiducia in particular as an avoidance of the statutory requirements of security rights even though it had become generally accepted in case law and legal doctrine since 1929: see for references n 69 above and further the Parliamentary History of Book III CC, 317 (Dutch text). It was a dogmatic position extolling in particular the numerus clausus principle. 89 HR, 19 May 1995 [1996] NJB 119. 90 More recent case law appears to move away from considering these leases executory contracts subject to the rescission or repudiation option of the bankruptcy trustee under Art 26 Bankruptcy Act, see HR June11 2014,

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 75 would give the lessee at least the status of a pledgor (and therefore proprietary protection in that manner),91 but what needs to be considered is the duality of ownership itself and not the pledge analogy, which was tried but never considered fully satisfactory under the old Dutch law of fiduciary ownership.92 It is unlikely that the new Code’s treatment of temporary ownership rights as usufructs (rather than security interests) in Article 3.85 CC will prove any less artificial, except perhaps if there is a clearly fixed term, although, as elsewhere,93 there may often be doubt about the line between a term (of time) and a condition: see section 2.1.5 below. Another suggestion has been to accept the Supreme Court’s decision as meaning to qualify the sale/leaseback as a full title transfer to the lessor subject to the personal user right of the lessee, while leaving room for the conditional sale in a finance lease, but only if parties specifically so agree, specifically pursuant to Article 3.84(4) CC.94 Although not incompatible with the system of the new Code, it appears only to increase the confusion. One should say that such an agreement is implicit in all finance leases (as indeed in repurchase agreements and factoring arrangements going beyond mere collection) unless the contrary is agreed, as in the case of a clear loan structure.95 It remains to be seen whether the 2016 decision of the Supreme Court in matters of a conditional sale will start to make a difference.

NJ 407 (2014) (Berzona). Situations, even if merely contractual, created before the bankruptcy, must be respected in principle, only further action in respect of them may be affected (like payments, repairs, etc). It may also have a meaning for the cherry picking option in repos as long as any asset return is automatic. It might be seen as a further move towards the proprietary status of leases (and repos) or of user rights in underlying assets more generally to promote their liquidity and risk management, see more in particular Vol 4, s 1.3.2. 91 SCJJ Kortmann and JJ van Hees, ‘Van fudicia-fobie naar fiducia-filie’ [From fiducia-phobia to fiducia-philia] 6187 (1995) Weekblad voor Privaatrecht Notariaat en Registratie 455, see also JJ van Hees, Leasing (Dissertation, 1997) 63ff, supporting clearly the duality of ownership concept for Dutch law and starting to develop some rules concerning the right of either party. The consequence in bankruptcy appears to be that in a bankruptcy of the lessor, the lessee may hold on to the asset (p 200), assuming (supposedly) that there is no executory contract, see also the previous footnote. In a bankruptcy of the lessee, the lessor retrieves the asset (p 196), but it is argued that any overvalue belongs to the lessee’s estate (p 184). This appears to be counter to the characterisation of the lease as a conditional sale in which the entitlement of the buyer to the overvalue is an essential feature. 92 See for references n 70 above. The pledge analogy would, in any event, suggest that the lessee, not the lessor, was the real owner; exactly the opposite of what the Supreme Court held. It would give rise to the requirement of an execution sale, which the lessor certainly does not intend as it may cause greatly detrimental delays, and major complications in re-leasing the asset and in readjusting its funding. It would also require any overvalue to be paid to the defaulting party, which appears to be totally inappropriate and, in any event, against the idea of a conditional sale as already demonstrated by the reservation of title where modern Dutch law does not require a disposition or execution sale either. As suggested above in s 1.1.8, that would only be justified if there were an entirely different risk and reward structure, as there is in a loan situation. Therefore, only if the finance lease is structured as a loan agreement, or at least as an interest-related instrument, could there be the question of a secured transaction and of the attendant protections in terms of execution sale and a return of any overvalue. This is exceptional, as the Supreme Court rightly accepted, even though without formulating any criteria for secured credit. 93 See eg for France, n 129 below and accompanying text. See for the qualification of the term as a usufruct in new Dutch law, Art 3.85 CC. It should most certainly not apply to repos. 94 See JB Vegter, ‘Het fiduciaverbod bij een financiele sale’ [The prohibition of the fiducia and finance sales] 6190–91 (1995) Weekblad voor Privaatrecht Notariaat en Registratie. Although the appropriation right is acknowledged, some dispute has arisen as to whether overvalue must still be returned to the defaulting lessee: see for a strong defence of the appropriation right without the execution analogy requiring a return of the overvalue, AF Salomons, ‘Nogmaals sale en leaseback’ [Again the sale and leaseback] 6204 (1995) Weekblad voor Privaatrecht Notariaat en Registratie. This must be the correct approach short of creating a security interest. 95 The key issues in a finance lease are normally: (a) the relationship between the contemporaneous owner under the resolutive condition and the owner under the suspensive condition; (b) possibly the role of physical possession in that context; the effect on third parties acquiring the respective interests, with or without physical possession; and (c) the manner of transfer and protection of their respective present and future interests under the circumstances, as will be discussed more fully below: see s 2.4.2.

76 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Indeed, without recognition of a proprietary interest for both parties under the arrangement, there appears to be no proper balance, certainly in the case of a bankruptcy of either. No doubt we shall hear more on these issues in case law, also in connection with repurchase agreements and factoring. The status of these latter two funding techniques has not given rise to much fundamental legal thought in Dutch case law and legal doctrine so far, although their vulnerability under the new Dutch Code is well understood, for securities repos, however, mostly discussed in the context of the alternative and effectiveness of close-out netting.96 In line with what the Supreme Court held in connection with finance leasing, there need not be an illegal substitute security in repos and factoring either—at least if there were reasons to enter into repos or factoring other than the mere obtaining of loan financing—but the purchaser under the repo and the factor would become the true owners. Crucially, as in the case of finance leasing, it leaves, as it now stands, the conditionality and effect of the factoring and repurchase agreement in Dutch case law largely unexplained.

96 See, however, for factoring, the illuminating discussion by CA Knape, ‘Factoring’ 6141 (1994) Weekblad voor Privaatrecht Notariaat en Registratie; see also J Beuving, Factoring (Dissertation, 1996) and JH Dalhuisen, Assignment of Receivables in the World of Modern Finance, Dutch Report, International Academy of Comparative Law (AIDC), Bristol, 1998. Yet factoring, if construed as a conditional sale, may now offend against the prohibition of the fiducia in the new Code: see Art 3.84(3). Until the Supreme Court decides, its true nature is in doubt. The consequence, accepted in present Dutch factoring practices, is that the receivables are transferred as a pledge with notification to the debtor or otherwise as a registered pledge with the problem of collection by the assignee: see also n 60 above. It creates all kinds of other problems, such as the need for the assignor to continue to carry the receivables on his/her balance sheet, while any advance under the facility is likely to be considered a loan. Registration implies extra formalities, time loss and extra costs. The pledge approach also deviates from established European patterns of factoring. Factoring has not been identified by new Dutch law as a definite legal structure. Properly to determine its legal nature, it is primarily necessary to distinguish between the contractual and proprietary side. On the contractual side there are three possibilities: there may be administration and collection, a credit risk transfer, which means a guarantee by the factor, and/or a funding structure. If only one of these is present, it is probably better not to speak of factoring. It seems to require a cocktail of at least two of these possibilities, of which administration and collection is always one. For factoring proper there must also be a proprietary aspect, therefore, a transfer of the receivables to the factor. Again there are three possibilities here: an outright transfer, a conditional transfer, and a security transfer. In view of the many conditions that are often attached to the transfer of the receivables (they may have to be approved, may not be able to exceed in total a certain limit per debtor, may not be contested, may—in recourse financing—not be affected by an insolvency of the debtor), this transfer is therefore usually conditional as to the individual claims. The transfer of those claims that do not prove to comply is then avoided, and these claims are automatically returned to the assignor and belong to his/her estate in the case of a bankruptcy of the factor, although Beuving, at p73, requires an act of retransfer unless there is a clear condition under Art 3.84(4) CC. The most common form of factoring (the old-line factoring) has all three contractual features and a conditional sale of the receivables depending on approvals and credit lines: see further also the discussion in ss 2.3.3/4 below. As for investment securities repos, their status in Dutch law remains equally in doubt and was also not covered by the new Code. They have become more important because they are used by the ECB as a means to provide liquidity to banks. See for a rare Dutch legal discussion, WAK Rank, ‘Repos en Repowet’ [Repos and repo-statute] in SCJJ Kortmann et al (eds), Onderneming en Recht Part 13 (1998) 371. This author continues to qualify the repo (economically) as secured lending and considers the repo rate a form of interest. This is at the heart of the confusion and raises indeed the specter of a prohibition under Art 3.84(3) CC. See also JH Dalhuisen, ‘Conditional Sales and Modern Financial Products’ in A Hartkamp et al (eds), Towards a European Civil Code, 2nd edn (London, 1998) 525. In the Netherlands a statutory amendment was introduced in 1998 to clarify the position of the securities repo to exclude it from the reach of Art 3.84(3) CC, not as an exception or presumption, however, but rather as a question of mandatory interpretation: see Art 2 of the Law concerning the Supervision of Transactions in Investment Securities (Wet Toezicht Effectenverkeer). Its true nature was not considered any further. The danger of repos being characterised as usufructs under Art 3.85 CC was not considered, but must now also be deemed removed.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 77

1.2.4. Open or Closed System of Proprietary Rights The discussion concerning the conditional and temporary ownership rights goes to the heart of the proprietary system and the freedom of parties to create additional proprietary rights or to split the property rights according to their needs and claim (a measure of) third-party effect for the result. In particular in civil law, the key issue is the ability to transfer these conditional rights as proprietary rights to be respected by all, and, if necessary, to protect them as such against creditors of other interest holders in the same assets (always subject to the rights of bona fide purchasers of the asset for value in countries where they are so protected in the case of chattels). It is the question of party autonomy in the creation of proprietary rights and how that is to be handled and the general public protected. Dutch law, as a matter of policy, limits this freedom like any other legal system, but by having alone raised this policy to the status of dogma,97 it seems to lose all flexibility at the theoretical level even if it does not deny in principle the existence of conditional ownership rights. Its new Code uses an abstract concept of proprietary rights to force and control all development rather than seeing the present statutory system as a point of departure, leaving room for new proprietary rights to emerge in practice, while accepting these, at least to the extent that they evolve out of, or are closely connected to, the present system if not amplified by customary law. As we have seen, this becomes increasingly necessary under the influence of the globalisation and transnationalisation of the modern financial products.98 It is to be expected that at the practical level, Dutch law will eventually accept this need, and the 2016 Supreme Court case may well lead to substantial reconsideration of the operation of the finance sale in particular. This need to accept uncommon proprietary interests is, in fact, mostly well understood in respect of foreign assets arriving in a particular country, also in the Netherlands, subject to foreign charges. The recognition of foreign secured and other limited proprietary interests as acquired rights in goods that are moved after these rights were perfected elsewhere is unavoidable, as is the requirement to adapt and introduce them into the domestic system (regardless of the fact that local formalities are unlikely to have been fulfilled for their creation, and that they may in fact operate as a type of substitute security even if forbidden under Dutch law).99 The ratification of the 1985 Hague Convention on the Law Applicable to Trusts and their Recognition, allowing recognition of foreign trusts even over domestic assets, may open up the domestic closed system of proprietary rights further.

97 Art 3.81 CC; see also the text at n 71 above. See for arguments in favour of a more open system subject to a better bona fide purchaser protection, JH Dalhuisen, ‘European Private Law: Moving from a Closed to an Open System of Proprietary Rights’ (2001) 5 Edinburgh Law Review 1; see further also Vol 4, ss 1.3.8–1.3.9. See for proposals for a more fundamental modernisation of Dutch property law (concerning chattels and intangible assets), JH Dalhuisen, Zekerheid in roerende zaken en rechten [Security in chattels and intangible assets] Preadvies Vereeninging Handelsrecht (Deventer, 200). Note in this connection also W Snijders, ‘Ongeregeldheden in het privaatrecht’ 6607–08 (2005) Weekblad voor Privaatrecht Notariaat en Registratie, who relies on case law to move on. It may be doubted whether in such fundamental issues this is realistic. 98 See further JH Dalhuisen, Wat is vreemd recht? [What is foreign law?] Inaugural Address, Utrecht (Deventer, 1992) 20. 99 See also JH Dalhuisen, ‘International Aspects of Secured Transactions and Finance Sales Involving Moveable and Intangible Property’ in D Kokkini-Iatridou et al, Eenvormig en Vergelijkend Privaatrecht (Molengrafica, 1994) 405, 423. For an interesting case in which a German expectancy (Anwartschaft) of the acquisition of real estate in the former East Germany resulting from the registration of the sales agreement was thought capable of being the subject of an attachment under its Dutch owner in the Netherlands, see Court of Appeal Amsterdam, 9 July 1991 [1994] NJ 79, [1992] NIPR 418. Note that under German law other types of expectancies, notably those resulting from conditional transfers, are not accepted for real property: see s 925(2) BGB.

78 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services It is probable that the acceptance in principle of future, conditional or contingent interests in new Dutch law will increasingly lead to this result (Article 3.84(4) CC) and erode Article 3.84(3), the abolition of which has been suggested. One may see this as the direction of the latest cases. They may even approach the trust construction in splitting the economic from the legal interest for a particular time span or until certain conditions are fulfilled, while giving these interests proprietary status subject to bona fide purchaser protection, at least in chattels, and ultimately even the protection of the bona fide payee in receivables. This is a development which, when properly identified and understood, may also prove greatly beneficial to the approximation of common and civil law (see also Volume 4, section 1.3.8) and may meet a considerable practical need in civil law countries, a situation even now seemingly accepted in the German fiduziarische Treuhand.100 France introduced the trust in its Civil Code in 2007 and subsequently also allowed it to be used as a security interest (fiducie gage, see more particularly section 1.3.7 and note 90 below), but it is not otherwise considered an expansive concept. Another factor in the opening up of the closed domestic system may be the appearance of notions of good faith and reasonableness in proprietary matters, which may increasingly allow or amend revindication rights, require and impose the separation of pools of assets for the benefit of special classes of creditors or for other interested parties being given proprietary protection in this manner, create new security interests and especially preferences or statutory liens in cases where this is just and decide on ranking. In fact, in the Netherlands, Article 3.13(2) CC on the abuse of rights may provide a statutory reason for the return of assets on the basis of reasonableness, for example by a trustee in bankruptcy who acquired goods from a third party by mistake after the commencement of the proceedings.101 The preference under recent case law granted to the registered security assignee against the collecting assignor may in truth be another example of proprietary adjustments on the basis of fairness. The developments in this direction are necessarily timid but significant, and may follow the older German example, as will be discussed below.102 Increasingly, it may be expected that forms of tracing or constructive trust will also be accepted in Dutch law because it is often only fair that they should exist in order to prevent an unjust enrichment of a bankrupt’s estate. Greater awareness and impact of foreign practices may introduce an element of international convergence here. This may also revive the discussion on floating charges more generally, where, as we have seen, the 1992 codification has also been regressive. So far, it may be said in conclusion, that the case law of the Supreme Court has been facilitating in respect of the new Code and its facilities, but has not chosen to go new ways, for which there also does not seem much domestic demand; the pressure is now more likely to come from outside, through globalisation of the international flows for goods and services, and from international supply chains. Although the Dutch Supreme Court tried to make the vagaries of the new system more palatable, neither in the issue of the definition of what an asset is, the transfer of asset classes, the status of future assets, the status of replacement assets and issue of tracing, especially of security interests in replacement goods with the retention of rank, the concept of

100 Swiss law has similar facilities, but does not allow the fiducia to create non-possessory securities in movables: see Art 717 ZGB without the dividing line between securities and conditional sales being defined either. Like in Germany, Art 717(2) seems to leave considerable discretion to the judge in this connection. The Sicherungsübereigung as non-possessory security came to be accepted in Swiss case law praeter legem. It is sometimes considered in violation of Art 717: see D Zolb, Berner Kommentar zum schweizerischen Privatrecht, Band IV, 2 Abteilung, 5 Teilband, Die beschränkten dinglichen Rechte; Das Fahrnispfand, 1 Unterteilband, Systematischer Teil und Art 884–887 ZGB, 2nd edn (Bern, 1982) nos 568ff, and 719ff. 101 See n 72 above in fine. 102 See also n 67 above and further the text at n 187 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 79 segregation,103 and the operation of floating charges, there is fundamental rethinking. Perhaps only in the conditional ownership concept, important especially in the area of finance sales, is there greater and more fundamental movement since 2016. As we shall see, more recent French statutory law may have been more creative, and there may now also be some movement in Belgium, much less in Germany. Perhaps more generally it may be said that a system like the Dutch, that was not able to formulate the concept of the generality or classes of goods nor the trust and segregation concepts, is systematically in serious trouble, but it is as yet not generally so experienced in local banking activities in the Netherlands, which after 2008 became smaller and more domestic.

1.3. The Situation in France 1.3.1. Introduction: The Vente à Reméré and Lex Commissoria. Non-possessory Security Interests and the Modern Floating Charge Generally, in France, the situation in respect of asset-backed funding using movable property is legally hardly clearer than elsewhere on the European Continent, especially with respect to nonpossessory security in movable property and the status of conditional sales and ownership rights, their use in financing and their relationship to secured transactions. First, for security interests in movable assets there was in France like elsewhere since the nineteenth century the requirement of physical possession. There developed, however, also a fractured and incidental system of non-possessory security rights in certain movables which were called nantissements. They were based on a measure of publicity but with very different publication requirements depending on the nature of the asset.104 This system was amended (from 2006) with

103 For the client account of law firms that analogy with the client accounts of notaries was accepted, the latter being segregated by statute, see HR NJ 196 (2004), but there was no attempt at formulating a deeper principle. 104 The first non-possessory charge in chattels was the maritime lien created in 1874. The situation in France as regards non-possessory charges in movable property may briefly be summarised as follows. Goodwill may be pledged through the nantissement de fonds de commerce since a law of 1 March 1898, replaced in 1909 and later amended; cf also Art 2075 CC. Motion picture films may be mortgaged through a nantissement des films cinématographiques since a law of 22 February 1944. They require registration in a special register. Since a law of 18 January 1951, there was also a nantissement d’outillage et matériel d’équipement (machinery and accessories) registered in the local commercial courts, but available only to the seller or lender of money for the purchase of the materials (as a form of purchase money security) and not generally for other debt, present or future. If a notice plate is put on the equipment, the secured creditor may pursue his/her interest if the goods are sold to third parties (removal of the plate is a criminal offence). The security prevails over any earlier mortgage in immovables to which the secured assets become affixed. Since the law of 29 December 1934, there has been a further nantissement in favour of sellers of motor vehicles in the gage du vendeur de véhicules automobiles. See, for a rare discussion following a decision of the Court of Appeal, Versailles, of 20 September 1995, G Wicker and P Gaubil, ‘L’efficacité du gage automobile non inscrit’ [1997] Receuil Dalloz Chroniques A–1. There was a further attempt to fill the gap traditionally left in France in the field of non-possessory security in movables by the pledging of warrants symbolising certain movable goods such as the pledging of warehouse receipts (magasin général). This traditional warrant technique known since decrees of 22 and 23 March 1848, several times amended, was consequently extended by statute to cover other situations: the warrant agricole of 18 July 1898, later amended for farmers’ crops and equipment. The sold goods could be replaced by others under the security, but for security purposes the equipment must remain in the farmer’s possession. If the farm is leased, the owner who has a security for rent may oppose the warrant and must in any event be notified. The warrant is registered in the local courts. In the case of a fixture attached to mortgaged real estate, the dates of the respective registrations determine the relative priorities. Material, equipment and furniture of hotels could also

80 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services a more general floating charge facility, the details of which are still not fully settled.105 It is clear that the transfer may be in bulk, may include future assets, and may cover a collection facility instead of an execution sale for receivables. It might even allow appropriation although always subject to a return of overvalue. The fiducie-sûreté has offered further support since 2009.106 Thus, for non-possessory security, a floating charge is now possible. For physical movable assets there is a register of charges, but not for claims. It is not fully clear whether there is a search duty and how or how much bona fide purchasers are protected, but like in the case of the nonpossessory charges there appears to be no search duty for the public at large. The charge may not be in other people’s property. This concerns the disposition right, which apparently cannot be prospective, which may still create problems for future assets. As for conditional or temporary ownership rights and their use in finance sales, there is a type of repurchase agreement mentioned in the Code, the vente à reméré.107 It has a long history, was copied from the Corpus Iuris108 and is cast in terms of an option for the seller to repurchase the asset (for a period of five years maximum). Does it have an effect in rem, that is to say, can it be maintained and enforced against a counterparty even in the latter’s bankruptcy? Ghestin and Desche in their well-known book on French contract law, dwelt on this point at some length.109 They think probably not, although they also cite important authority to the contrary. It views the situation as one of conditional ownership of the buyer, which may be rescinded and under which the erstwhile seller has at least a conditional or suspended right, which s/he may alienate or give as security or in usufruct.110

be incorporated in warrants and given as security under a law of 8 August 1913, later amended, assuming the fonds de commerce has not already been pledged. Warrants are also possible for petroleum stocks under a law of 21 April 1932. Of these non-possessory security interests, the charge on the ongoing business (nantissement de fonds de commerce) was conceptually the most important. It may cover real property leases, industrial property rights, and the equipment of a business. But inventory and accounts were notably excluded and there was no possibility of creating a floating charge in them in this manner also because of the lack of certainty and identification of the underlying. See, for the situation regarding the pledging of receivables after the Loi Dailly of 1981, s.1.3.6 below and for the alternative of the fiducie-sûreté, n 105 below. See for the assignability of future receivables also Vol 4, s 1.5.6. In the case of these non-possessory security interests in chattels, a form of registration was usually provided but bona fide purchasers remained protected unless the interest was marked on the asset itself. It should be noted that in France the priority status of the security interests so created may be restructured in a bankruptcy of the debtor granting the interests. All secured interests may also be subject to some super priorities (privilèges) concerning wages of employees and the cost of the bankruptcy. 105 Ordonnance no 2006–346 du 23 mars 2006 relative aux sûretés; see also Rapport au Président de la République relative à l’ordonnance no 2006-346 du 23 mars 2006 relative aux Sûretés, JO no 71 of 24 March 2006. 106 Arts 2372-1–6 (mobilière) and Arts 2488-1–6 (immobilière) CC. This allows the setting apart of property with a trustee for the benefit of funding parties subject to the conditions of the arrangement. See for the earlier introduction of the fiducie in France in 2007, s 1.3.7 below. Appropriation upon default is possible as an alternative to security interests, still subject, however, to the return of any overvalue, although in the case of natural persons only: Art 2372-3 CC. This facility also allows for the transfer of future assets including receivables, as has the fiducie proper since 2007, see s 1.3.7 below. A transfer in bulk would also appear to be possible upon an adequate description of the underlying asset (class). 107 Arts 1659ff CC. It was copied in the Netherlands in the former CC (Arts 1555ff) but not retained in the new Dutch Civil Code: see n 69 above and for Germany n 163 below. 108 C.4.54.2 (pactum de retroemendo). It is formulated as a rescinding condition in Justinian law: see for this condition and its proprietary effect in Roman law n 79 above. If C 4.54.2 is not accorded proprietary effect, however, this is probably because there was only an option for the seller, no duty, and therefore, no automatic retransfer. Roman law never dealt with the effects in bankruptcy. 109 J Ghestin and B Desche, Traité des contrats, la vente (Paris, 1990) 635. 110 P Malaurie, Encyclopédie Dalloz, Droit civil V, Vente (elem const) no 776.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 81 Ghestin and Desche construed this repurchase option as a condition résolutoire of the sale, which, in France, at least in the case of default of a sales agreement, traditionally had proprietary or in rem effect (lex commissoria tacita) and led to an automatic return of title without further steps being taken. This is now considered exceptional in bankruptcy, however, the general principle being that conditions can no longer mature against a debtor upon the opening of bankruptcy proceedings. The French rule appears to be that if the goods are already with the buyer, they can only be deemed returned to the seller if the latter has started reclaiming proceedings before bankruptcy.111

1.3.2. The Impact of the Notion of the Solvabilité Apparente The true impediment in France to a return of the asset upon the rescission of the sale agreement after the bankruptcy of a non-paying buyer in France or under a repurchase facility (vente à reméré) appeared to be that, if the debtor is in possession, other creditors of the buyer may rely on the outward signs of his creditworthiness (solvabilité apparente by virtue of Article 2279 CC). As we shall see, it also threatened the reservation of title and repo. Traditionally, French law protected these creditors, especially if these signs were created by a seller having delivered goods to the buyer and having left him in possession, no matter his reversionary interest or any rescission of a sale and transfer with a revindication right upon default.112 The creditors may thus ignore the reversion rights of the seller. Strictly speaking, it does not rule out the proprietary effect of a condition, but it limits its effect in bankruptcy beyond the more modern rule that it cannot be invoked any longer after a bankruptcy, and provides an important further check on the proliferation of hidden security or revindication rights in France. It was similar to the English notion of reputed ownership, another example of protection of bona fide creditors: see also section 1.1.11 above. In England it was, however, applicable only in the personal bankruptcy of a debtor who engaged in commerce under its own name and it was not maintained in the Insolvency Acts of 1985 and 1986.113 111 See Art 117 French Bankruptcy Act (BA) 1985 and also G Ripert and R Roblot, 2 Droit Commercial, 16th edn (Paris, 2000), no 3158. A distinction is made (since the Bankruptcy Act of 1985) between a situation in which the sale was already rescinded before the bankruptcy and in which rescission was petitioned or intended, but not yet granted. In that case, a revindication is still possible, but only if the rescission was for reasons other than default of payment of the purchase price. This was because of Art 47 of the 1985 French Bankruptcy Act, which after bankruptcy generally suspended all actions for the rescission of contracts based on lack of payment of a sum of money. See in France for the lex commissoria tacita, Arts 1184, 1610 and 1654 CC, and for the lex commissoria expressa Art 1656 CC. 112 In France, this principle has been operative in the indicated manner since Cour de Cass, 24 June 1845, D 1.309 (1845); see in Belgium for a similar attitude, Cour de Cass (Belge), 9 February 1933 [1933] I Pas, 103, confirmed as recently as Cour de Cass 22 September 1994 [1994–95] RW 1264 (note Dirix). The amendments to the French BA since 1980 (see n 119 below) here make a full exception for the reservation of title; cf also Art 101 of the new Belgian Bankruptcy Act of 8 August 1997. French law allows the transfer of future assets, also for security purposes (see Art 1130 CC), but is restrictive as regards future claims, and requires that at the moment of the assignments all conditions for their emergence are fulfilled. This has been established case law since 1854: see Cour de Cass, 31 January 1854, D 2.179 (1855). 113 See s 283 Insolvency Act 1986 and n 204 below. See for the concept also Ryall v Rolle, (1749) 1 Atk 165 and Re Sharpe [1980] 1 All ER 198. It dates back to 1603 and was last repeated in s 38(c) of the Bankruptcy Act of 1914. It did not apply to corporate bankruptcy, which was covered by the winding-up provisions of the Companies Act, and it was never accepted in the US, but hidden proprietary interests are sometimes still vulnerable in the US, especially in the context of the creation of security interests under Art 9 UCC: see n 204 below. The concept is now also under pressure, however, in France, especially in connection with the modern reservation of title: see s 1.3.5 and n 123 below.

82 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Whatever its true nature, according to case law, the French repurchase option leads to a return of the asset without any further formality upon the option being exercised and there is no need for an act of retransfer.114 This suggests itself some in rem effect and its effectiveness in a bankruptcy of the buyer barring the effects of the solvabilité apparente and the impossibility to exercise the option after bankruptcy. The option is traditionally clearly distinguished from a security interest except where a security is suggested by the facts surrounding the option. This is considered the case only when the original sales price was much lower than the reasonable value of the assets while they remained in the possession of the seller who paid an artificial rent similar to the prevailing interest rate. If this type of transaction is frequent between the same parties, its character as a scam (secured) transaction may be further enhanced with the consequence of nullity.115 The distinctions between a security interest and repurchase option are thus not always sharp under French law, and it is clear that the repurchase option may sometimes be seen as a security interest with in rem effect (giving the buyer a non-possessory interest in the asset, which must be released upon repayment of the purchase price or otherwise executed). Whether the conversion into a security is desirable or not, it at least suggests that there may be little fundamental objection to accepting in rem effect in a situation where the option operates in the nature of a true condition. It is further accepted that the option itself may be sold and transferred to third parties, except where it is prohibited under the original sales agreement. Thus, there are many facets under the vente à reméré. However, French law, as well as French authors, remain unclear or divided whether the result is a mere personal right of the seller to retake the asset upon the exercise of the option (as indeed suggested by the original passage in the Justininan Codex, which did not, however, deal with the effect in bankruptcy) or whether there may be some third-party effect and a stronger position for the seller in the bankruptcy of the counterparty, as appears to be suggested by the qualification of the option as a condition résolutoire under French law and by the instant return of the title upon the option being exercised, that is, without any act of retransfer or other formality.116

1.3.3. The Reservation of Title The nature of the reservation of title in France (pactum reservati dominii) may provide further clarification of the possible qualification of repurchase agreements (or finance sales) as conditional sales. It was always valid in principle in France, which logically follows from the mere facility to postpone the transfer of title if the parties so agree until the moment of payment.117

114 Cour de Cass, 24 October 1950 [1950] Bull civil 1, 155. 115 Cour de Cass, 21 March 1938, D 2.57 (1938), earlier 11 March 1879, D 1.401 (1879). 116 See for the concept of conditional ownership and its history in civil law also n 79 above. It has long been known in French law: see RJ Pothier (1699–1772), Traité du droit de domaine de propriété, pt I, Chapitre premier, although not elaborating on the concept. It did not find its way into the Code civil, but it was accepted in French legal writing: see eg C Demolombe, Cours de Code Napoleon, Tôme IX (1854) 489. M Planiol and G Ripert, Traité pratique de droit civil français, Tôme III. Les biens (Paris, 1926) nos 231–32 recognised in this connection for the first time the duality in conditional ownership and the complementary nature of the ownership under a resolving and suspending condition. See more recently also H and L Mazeaud and F Chabas, Leçons de droit civil, Tôme II, 2nd vol, Biens: Droit de propriété et ses démembrements (Paris, 1998) no 1395, p 176; so also G Marty and P Raynaud, Droit Civil, Les Biens (Paris, 1980) no 46, p 52; but see also Scheltema, n 79, 164, noting that the duality of ownership approach is in retreat in France. See for the modern repo and reservation of title in France, n 108, and nn 135ff below plus accompanying text. 117 See Art 1584 CC.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 83 Whether or not the reservation of title could benefit from an exception to the rule that conditions could not mature after bankruptcy (at least if notice of revindication was given before the opening of insolvency proceedings), it was also faced with the doctrine of the appearance of creditworthiness of the buyer, the notion of the solvabilité apparente, as we have seen and it was for this reason not considered effective in a French bankruptcy118 until the amendment of the French Bankruptcy Act of 1967 in 1980, later reinforced in the French Bankruptcy Act of 1985.119 Since the Ordonnance no 2006-346 of 23 March 2006, the reservation of title is covered by Articles 2367–2372 of the French Civil Code. On the basis of this statutory law, the reservation of title is now mostly considered a conditional sale,120 also accepted in a bankruptcy of the buyer and leading to appropriation by the seller regardless of the maturing of the condition after bankruptcy and the notion of reputed ownership with its protection of the appearance of creditworthiness.121 The Cour de Cassation sees it, however, as an accessory right to the debt,122 confirmed in Article 2367 CC. As we have seen in section 1.1.4 above, this points into the direction of a security interest, which is somewhat incongruous and not commonly the view elsewhere in Western Europe.123 This accessory nature of the reservation of title is of special importance in factoring when payment of the seller by the factor would normally extinguish the reservation of title and vest full title in the buyer.124 In fact, it seems that the security analogy is increasingly pursued for the reservation of title in France, although it is clear that there is no execution sale while full title automatically reverts to the seller upon default, the sales agreement having lapsed. This remains indicative of a conditional sale resulting in in rem effect of the condition, now also supported in a bankruptcy of the buyer. Yet so far, in France, there seems to be no clear opinion in favour of this conditionality leading to a split-ownership right between seller and buyer as present and future owners.125 Rather, in a reservation of title, the condition is mostly seen either as rescinding or suspending, and not as creating complementary forms of ownership for the seller and the buyer at the same time. Instead, there is much inconclusive thought, focusing mainly on the retroactivity of the title transfer to the seller, or on any retransfer to the buyer and the liability for the risk of the loss 118 See Cour de Cass, 21 July 1897, DP 1.269 (1898) and 28 March/22 October 1934, D 1.151 (1934). 119 See Arts 59 and 65 of the French BA 1967 as amended in 1980, superseded by Arts 115 and 121 of the French BA 1985: see also Ripert and Roblot (n 111) 3155, 3159ff. The reservation of title was further reinforced by the 1994 amendments to the French BA (Art 59 of Loi 94-475 of 10 June), now L 624-16 C de Com, cf also Art 2369 Cc. 120 This still allows for several different qualifications. Is the contract conditional or rather its legal consequences or the obligations that follow from it as well as the resulting transfer of the title, and in either approach is the contract or the resulting obligations and title transfer suspended or subject to later rescission? See also Ghestin and Desche (n 109) 588ff. It is equally possible to see the reservation of title as achieving no more than a delayed transfer (see n 126 below and accompanying text), which appears also to be the prevailing view in England (see s 1.5.3 below), and might be typical for countries in which title transfers upon the mere conclusion of a sale agreement, therefore without the additional requirement of delivery. 121 Earlier, the Cour de Cassation had consistently held that the reservation was valid but lacked effectiveness in bankruptcy for the reasons stated in a line of cases started on 21 July 1897, DP.1.269 (1898). 122 Cour de Cass, 15 March 1988, Bull Civ IV, 106 (1988). 123 See for the Netherlands n 77 above, for Germany n 165 below and for England the text at n 235 below. In the meantime, the French Cour de Cassation now also holds that overvalue must be returned to the buyer upon his/her default (Cour de Cass, 5 March 1996, Bull IV, no 72 (1996)) without, however, the need for an execution sale. This is now confirmed in Art 2371 CC. 124 The effect in France is that a factor having paid the seller retains the benefit of the reservation of title at the same time, which is unlikely in systems like the Dutch that do not accept the accessory nature of the reservation of title and must therefore structure their factoring schemes in which reservations of title play an important role more in the manner of collection arrangements: see n 77 above. 125 See, however, also the approach to conditionality more generally of the writers cited in n 116 above.

84 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services of the asset.126 The extended reservation of title or reservation of title that transfers into (future) replacement assets (or receivables) is considered.127 As mentioned above,128 the reservation of title is sometimes seen as no more than effecting a delayed transfer avoiding the problem of retroactivity, but it is agreed that parties may be able to define it in their contract as a conditional sale.129

1.3.4. The Modern Repurchase Agreement or Pension Livrée In the modern French repurchase agreement or repo of investment securities, the return of the assets (mostly fungible investment securities) is also automatic in principle upon the mere repayment of the advance. It then appears to imply a right as well as a duty of the seller to repurchase. This is called the pension livrée and was reinforced by statute at the end of 1993 for repos in the professional sphere,130 but neither its legal nature and the aspect of its conditionality, nor the 126 See for an overview, see Ghestin and Desche (n 109) fnn 588ff. See for the risk of the loss of the asset pending full payment, Cour de Cassation, 20 November 1979 (1980) 33 Revue Trimestrielle de Droit Commercial 43, Note D von Breitenstein, in which case the Cour de Cassation ultimately appeared to opt for a delayed title transfer approach (like the amendments of 1980). The view is that there is no transfer of title pending payment, nor a retransfer if payment does not follow. The contract itself is rescinded upon default so that nothing subsists except that physical possession remains to be reclaimed by the seller, if necessary, through a proprietary action. This approach strengthened the seller’s position as owner in an intervening bankruptcy of the buyer before 1980. A further consequence of this approach was that pending payment the seller remained liable as owner for the risk of loss of the asset. Earlier case law had considered the reservation of title a suspensive condition of the contract rather than of the title transfer: see the original case of the Cour de Cassation, 21 July 1897, DP 1.272 (1898), withholding effectiveness to both the contract and the title transfer until payment, which was strange in view of the implementation of the sale agreement. If, on the other hand, upon default the transfer had been considered rescinded, either alone or together with the sales agreement, there would have been a title transfer to the buyer and a retransfer would have become necessary which, even though automatic, would have weakened the position of the seller in a bankruptcy of the buyer before 1980. The buyer would in that case have carried the risk of loss unless otherwise agreed. 127 More recent French law may preserve revindication rights in converted or commingled property as a matter of inventory rotation assuming the same sort and quality, Cour de Cass. March 5 2002, Bull.civ.IV, no 48 and Nov. 13. 2002, no 00-10284. French law also accepts the shift into proceeds (real subrogation): Cour de Cass, 8 March 1988, Bull IV, no 99 (1988) 20 June 1989, D Jur 431 (1989) and 15 December 1992, Bull IV no 412 (1992) at least of the moneys are sufficiently set aside. It does not eliminate the problem with fungible property if more than simply replacement stock but rather the result of fundamental change in the underlying assets in a production chain. A kind of floating charge has been considered in the literature, see 4 Ripert- Roblot, Traite des Droits des Affaires, Effets de Commerce et Entreprise en Difficulte, 666 (2018); S Torck, Essai d’une theorie generale des droits reels sur les choses fongibles (these Paris II (2001). For the reservation of title, it is established that a mere alteration in the underlying asset does not prevent its reclamation, Cour de Cass. March 6 1990, Bull civ. IV, no 73, but if the asset is completely reworked, the identity may be lost and the burden of proof is on the creditor, see 4 Ripert- Roblot supra, 686. Resale to a bona fide purchaser extinguishes the right but there may still be a claim on the proceeds, Cour de Cass. Jan 15 1991 Bull. civ. IV no 31. 128 See n 126 above. 129 See Malaurie (n 110) fnn 766ff and Ghestin and Desche (n 109) no 600. Following Art 1179(1) CC, in France it was thought that only where the transfer of title is conditional, and not merely delayed, is it retroactive to the moment of the sale, unless the parties agreed otherwise: see for this possibility Cour de Cass, 21 July 1958 [1958] II JCP 10843. In the approach of a delayed title transfer, the buyer may have no proprietary rights whatever: see for this conclusion Ghestin and Desche (n 109) no 603. On the other hand, in view of the 1958 precedent, it appears possible for the parties to declare the reservation of title to be a conditional sale rather than a delayed transfer, implying the retroactivity and probably also certain proprietary protections for the buyer at the same time. 130 Arts 12ff of Loi 93-1444 of 31 December 1995: see also S Moury and S Nalbantian, ‘Repurchase Transactions in the Cross-border Arena’ [1995] International Finance Law Review 15. Also relevant is Art 47 of Loi 83-1 of

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 85 consequences of a bankruptcy of the financier/buyer were clearly covered in terms of proprietary or personal rights especially in respect of fungible or commingled assets. The new law specified that the transaction is one of sale or assignment and that the financier/buyer may keep the investment securities (provided they have been delivered to him) if the original seller does not repay the price (and the original seller may keep the sales price if the financier/buyer does not return the investment securities). Thus, the problems with the solvabilité apparente and the impossibility to exercise the right after bankruptcy appear to be overcome in principle. It suggests that in the financier/buyer’s bankruptcy, the seller of the investment securities may revindicate the assets by merely tendering payment of the repurchase price on the appointed date, a point which is especially relevant if the investment securities have increased in value. That would be a true indication of the conditionality of the sale and of any in rem effect. Yet Article L 432-15 CMF talks of retrocession, which may still suggest that there is never automaticity in the retransfer of title upon payment of the repurchase price but that an act of retransfer is still necessary, unlike in the vente à remère. In that event, in a bankruptcy of the buyer/financier, the complication of the French Bankruptcy Act in that it does not generally allow the bankrupt still to act, would still have to be considered while it may then also be questioned whether the exception for defaulted sales would apply in this type of financial transaction, especially since the buyer is in possession.131 Yet another aspect to consider here is the impact of the fungible nature of most of the securities used in the repurchase transaction and of these securities often being held by third parties/depositories. The first circumstance could weaken the seller’s position, but the latter could strengthen it, as the assets, although fungible and only returnable as the same number of the same sort, may still be sufficiently identifiable and separate. The statute does not go into these aspects and the question of an in rem right of the original seller against the buyer does not seem to have clearly arisen in the mind of the legislator. Yet this cannot be the end of the story, as the system of the law would give both seller and buyer an option to default without impunity if the price of the investment securities had respectively dropped or risen, so that there would be a premium on default following from the right of a trustee of a bankrupt buyer to repudiate contracts if merely executory and not resulting in proprietary rights. Personal rights to damages would supplement this system and restrain this so-called ‘cherrypicking’, but personal actions for damages are unlikely to be of great benefit against a bankrupt financier and his trustee. As in the case of finance leases discussed previously with reference to the Netherlands,132 it appears that a proper balance between the two parties can only be established by accepting an in rem repossession right of the seller, at least if the investment securities were not fungible or if they were held by independent depositories who would hold others of the same sort in substitution. 3 January 1983 (originally introduced as Art 47 bis to this law amended through Loi 92-868 of 10 July 1992) covering default by either party and allowing them in a cash against documents (CAD) sale of investment securities not to perform if the other party did not do so. This would apply to each individual leg of a repurchase agreement, but would not cover the retransfer obligation resulting from the prior sale. More incidental provisions could be found in Art 31(c) of Loi 87-416 of 17 June 1987, now Art L 432-6CMF relating to securities lending and Art 52 of Loi 96-597 of 2 July 1996 relating to derivative transactions. They explicitly accept the finance sale for investment securities located in France provided the transaction is governed by a local, national or international framework agreement and one of the parties is in the business of rendering investment services. In stock lending transactions the transferee obtains (full) title to the (conditionally) transferred assets only in the event of default of the transferor. What the proprietary situation is in the meantime is unclear. 131 As mentioned in n 111 above, Art 117 of the French BA 1985 offers for rescinded sales agreements upon default an exception to this general principle of French bankruptcy law (Art 47), but only if the goods are not yet in the possession of the buyer or if the recovery action is initiated before bankruptcy. 132 See the text following n 89 above.

86 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Because of the uncertainty concerning this repossession right in a bankruptcy of the buyer and the proprietary status of the repo, the more common solution at present in France (as elsewhere) is to provide an extended set-off or netting right in standard repurchase agreements,133 reducing the retransfer obligation to money on the basis of market rates, while including in the set-off all other repurchase transactions outstanding between the parties, and considering them matured so as to arrive at one total net amount either owed by or to the bankrupt. No less than the in rem status of the conditional sale in bankruptcy, in France this netting facility remained uncertain in its effect, however, as it creates an expanded indirect preference. A special bankruptcy provision now exists also in France supporting this netting: see Article L 431-7 CMF 2000 following an earlier law of 1993 (No 93-1444). This was also needed in the US and done in the Bankruptcy Code amendment of 1990, further amended in 2005, and in the German Insolvency Act of 1994, effective 1999, as already mentioned and will be discussed more extensively below.134 It means, however, that if there are not enough counterbalancing transactions between the parties, the netting may not be to sufficient avail.

1.3.5. Finance Sales, Fiduciary Transfers, and the Implementation of the EU Collateral Directive It was shown that in modern writings there is no great inclination to see the conditionality of ownership as a broader concept in France. This is borne out by the discussion of the reservation of title, of the repurchase option (vente à reméré), and of the pension livrée legislation. The subject is not commonly raised in the context of the finance lease either, whatever the legal qualification of the reservation of title, which may be considered the closest related structure.135 It affects the subject of finance sales more generally. Although, the conditional sale structure may be used more specifically to create a transfer of ownership in the nature of a fiduciary transfer136 in the

133 In France, the relevant master agreement is the one prepared by the French Banking Association (AFB) since 1987 and referred to as the Conditions Générales pour les Opérations d’Echange de Devises ou de Conditions d’Intérêts, providing for contractual close-out netting: see also EJ Nalbantian, ‘France Sorts Out Netting Uncertainty’ [1994] International Financial Law Review 34. 134 See text at n 182 and ss 2.1.1 and 4.2.4 below. 135 See, however, for a more modern reconsideration of title transfers for funding purposes, FM Cabrillac and C Mouly, Les suretés (Paris, 1997) nos 527ff. In France, the finance lease was regulated by Loi 66-455 of 2 July 1966 on the credit-bail, now in Arts L313-7 to L313-11 CMF, which is inconclusive in the proprietary aspects. Some see leasing as a financing method without defining it further in terms of secured transaction or conditional sale while emphasising the sui generis nature of the arrangement instead: see P Cordier, ‘Note under Cour de Cass, 9 Jan 1990’ [1990] Gazette du Palais 127. Others seem to accept a security interest: G Marty, P Raynaud and P Jestaz, Les sûretés, la publicité foncière, 2nd edn (Paris, 1987) 335. There are also those who see a mere rental agreement: El Mokhtar Bey, Note [1987] JCP 20865, although later underlining the hybrid character of the lease in terms of sale, rental and option: see ‘Des conséquences de la jurisprudence de la chambre mixte de la cour de cassation du 25 novembre 1990 sur la symbiotique du crédit-bail’ [1992] Gazette du Palais 568; see also D KokkiniIatridou, ‘Enkele juridische aspecten van de financiele leasing (credit-bail) in Frankrijk’ [Some legal aspects of finance leasing (credit-bail) in France] in Kokkini-Iatridou et al (n 99) 55, 77. 136 The facility follows from Art 1584 CC. Recent Belgian case law, in the meantime, rejected the fiduciary transfer, that is all transfers of ownership meant to produce a security interest: see Cour de Cass (Belge), 17 October 1996 [1995–96] RW 1395 (Note ME Storme). Reservation of title is believed not to be affected because the security of the return of title upon default is deemed inherent in any sales transaction. A similar attitude may be taken towards Belgian finance leasing, which resembles in many respects the reservation of title: Cour de Cass (Belge), 27 November 1981 [1981–82] RW 2141. See for remedial legislation but only for clearing systems, including the operations in Euroclear, Vol 4, n 582. A decision of 2010 left open the possibility of conversion into an ordinary

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 87 former Dutch sense or Sicherungsübereignung in the German sense subject therefore to its lapse in the case of repayment of the sales price, its use is uncommon in the case of chattels or movable physical assets. This is due to the same impediments which affected the reservation of title in bankruptcy before 1980 (and which may also affect the repurchase agreement) in terms of (a) the impossibility (normally) for conditions to mature after the opening of the proceedings and (b) the apparent solvency theory. Moreover, the Cour de Cassation has insisted that appropriation of the underlying assets in bankruptcy is unlawful under this type of transfer,137 much as in Germany and earlier in the Netherlands, and has not led to a transformation of this kind of sale into a general non-possessory security interest either. It was not much of an issue in the discussion and coverage of the vente à reméré,138 and (as yet) the reservation of title, as we have seen. French law appears less averse, however, to the conditional transfer of receivables, probably because in its system it required until 2016 notification to the debtor, which was considered sufficient publicity. In any event, the theory of the solvabilité apparente or reputed ownership would not endanger its effectiveness as it typically relates to chattels only. French law dispenses in this connection also with the formalities attached to pledging receivables, which is traditionally also possible for receivables but requires an official document or the registration of an informal document, except if this charge (gage) is in the commercial sphere.139 The conditional transfer of receivables as an alternative also allows for better treatment in bankruptcy as the buyer/assignee may claim his ownership right, which avoids any dispute about the right to collect any proceeds (which in France remains disputed when receivables were merely pledged). No other security holders are ahead. Yet again, the nature of the transfer of receivables in this manner was not much explored any further in France, at least not in terms of a conditional transfer with a duality of ownership. Dispensing with the requirement of notification for professional financial transactions (in the Loi Dailly since 1980, see the next section) and introducing the fiducie for movable assets as proposed first through a new Article 2062 CC (in various drafts since 1990) and ultimately achieved through a more elaborate amendment of the CC in 2007, further supplemented by the fiducie-sûreté in 2009 (see section 1.3.7 below) could in practice eliminate the differences with the fiduciary transfer in movables, and in any event reinforce the conditional sale concept, while party autonomy would come in, allowing greater choices to be made by the parties. Another development is the implementation in France of the EU Collateral Directive 2002/47/EC (see more particularly section 1.1.9 above), CMF, Article L 211. The facility is limited to financial assets in terms of bank balances, balances in collective investment schemes, interest and currency swaps, credit derivatives, futures, and some options. The charge may shift from one class to another. Enforcement does not require court intervention and, depending on the contractual terms, may include collection and appropriation by the creditor.

security interest to the extent existing in the relevant assets and subject to its formalities: see Cour de Cass (Belge), December 3 2010, Bank Fin 2011, no 2, 120–27. For receivables, it may in particular limit the collection facility and still require an execution sale, which is cumbersome for that type of asset. 137 French law in Art 2078 CC specifically rules out any arrangement to the contrary and the fiduciary sale has been so caught: Cour de Cass, 24 May 1933 [1934] Revue critique de droit international privé 142. It is also wary of scam transactions: see text at n 115 above. 138 See, however, the text at n 107 above. 139 See Art 2074 CC as compared to Arts 91 and 109 of the Code de Comm. The Cour de Cassation has allowed the fiduciary assignment ever since its early case of 19 August 1849, D 1.273 (1849), confirmed on 16 January 1923, D 1.177 (1923). This may now have been largely superseded by the facility available since 2009 under the fiducie-sûreté in France: see n 105 above and s 1.3.7 below. See for the different Belgian attitude, n 136 above.

88 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services

1.3.6. Assignments of Monetary Claims in Finance Schemes, Loi Dailly, Securitisation or Titrisation (Fonds Communs de Créances) Assignments for asset backed funding in France may need some further attention. As elsewhere problems are in the need for individualisation, identification, notification of debtors, and documentation as requirements or formalities of these transfers which therefore have particular problems with present and future monetary claims in bulk. Especially the requirement of Article 1690 Cc of notification to each debtor as a precondition for the validity of each assignment was detrimental.140 In all this, since 1980 there operates the special and simplified assignment facility under the Loi Dailly in respect of certain financial instruments)dispensing with notification (but having its own limitations alongside the traditional civil assignment. The notification requirement (but not the individual documentation requirement) was abandoned in 2016 (Article 1321ff Cc), but it is of special interest to consider the issue of bulk assignments including future claims, and what these are.141 The issue is also important in securitisations and floating charges. The true meaning and impact of the assignability of future claims in bulk remains an important issue also in French law. For securitisation met with similar problems, new legislation was introduced from 1988 onwards for a special form of asset securitisation (titrisation) through the creation or facilitation of fonds communs de créances (FCCs), now contained in Articles L 214-43 to L 214-49 CMF.

140 It has a long history, see Vol 4, s 1.5.2. 141 The Loi Dailly of 2 January 1981 (Loi 81-1) was reinforced on 24 January 1984, and is now incorporated in Arts L 313-23–L 313-35 CMF. It was available only to French licensed credit institutions or similar EU institutions as assignees and not therefore to, for example, US banks without a branch in France. In France, the assignment of receivables under it still requires an official document (bordereau) to incorporate these receivables which are then transferred to a credit institution. It underlines the fact that no special facility was provided to include future receivables in the nature of a floating charge. Their transfer remains unfeasible because of the lack of proper identification, unless the contract out of which they arose was in existence: see also Vol 4, s 1.5.6. Here the new floating charge legislation of 2005 and the fiducie-sûreté of 2009 (see n 105 above and n 146 below) may provide relief as may the new legislation concerning securitization (titrisation), see below. Belgian law (Art 1690 CC) since 1994, doing away altogether with the notification as a constitutive requirement for assignments, does not have this restrictive requirement any longer, but also does not provide for a general facility to cover future receivables. As long as they are determined or determinable, they might, however, be assignable in Belgium. Earlier, the discounting of bills of exchange had often been used in France to raise money on claims, but required these bills to be drawn and accepted in order to be so used, which is cumbersome and costly. Another much used way was for financier and creditor to agree a contractual subrogation pursuant to Art 1249 CC. Under it, the financier pays the receivable to the creditor and substitutes himself as the new creditor under the receivable, which s/he must expressly receive at the same time together with all rights, causes of action, priorities and mortgages supporting the receivable. This approach remained common in France, especially in factoring of receivables—see Lamy Droit du financement, Affacturage (Paris 1996) 1344, 1347, but was not effective in respect of future claims and was in any event individualised per claim and dependent on actual payment of the face amount, which creates problems with the discounts normally applied for collection, maturity and the taking over of credit risk. See for older literature on factoring in France, C Gavalda and J Stoufflet, ‘Le contrat dit de “factoring”’ [1966] La Semaine Juridique, Doctrine 2044, and later also C Gavalda, ‘Perspectives et réalités juridiques de la convention dite d’affacturage’ [1989] Semaine Juridique 534; El M Bey, ‘Les tiers dans la complexion de l’affacturage’ [1994] Revue de Jurisprudence de Droit des Affaires 207. To facilitate securitisations (titrisation), a special law was passed in 1988 (Loi 88-1201 of 23 December 1988, amended by Loi 93-6 of 4 January 1993, Loi 93-1444 of 29 December 1993, Loi 96-597 of 2 July 1996 and Loi 98-546 of 2 July 1998) supported by Decree 89-158 of 9 March 1989 (amended by Decree 93-589 of 27 March 1993, Decree 97-919 of 6 October 1997 and Decree 98-1015 of 6 November 1998) on the so-called fonds communs de créances (FCCs), now in Arts L 213-43–L 214-49 CMF: see the next section.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 89 It originally allowed banks and insurance companies, but since 1998 anyone, to transfer, by way of a special type of assignment, loans or receivables to these fonds, which issue a kind of negotiable participation in which the institutional investor may invest (see for securitisation technique itself section 2.5 below). Securitisation was originally meant as a balance sheet tailoring device following the Basel agreements on capital adequacy (see Volume 6, section 2.5 below), but these schemes may now be used more generally. The funds are pools or forms of co-ownership and do not have legal personality. This means that the co-owners have a direct interest in the pool, which has a management company as sole representative. This company may not engage in other activities and must be approved by the regulators. As for the formalities, the law of 1988, as amended, borrows the bordereau approach of the Loi Dailly.142 The document incorporates the assigned debts and indicates the assignee/FCC. It is delivered by the originator to the management company of the scheme. There is no need for notification to the debtors. These FCCs may now cover any kind of receivables, present or future. The inclusion of future receivables is an important departure, also shown in the new legislation concerning the floating charge and fiducie,143 and might ultimately mean a broadening of the present regime under the Cc altogether, although it may still be limited to those arising out of existing contracts. The transfer as a class would also appear to be possible. FCCs may borrow (even through subordinated loans, which subordination is here introduced by statute) to enhance their credit or to cover their temporary liquidity needs. However, the type of investor who may invest in these FCCs is limited and individuals remain notably excluded. As in the case of the modern legislation on the pension livrée, there is no attempt at characterisation of the transfer of the loans/receivables to the FCCs as outright, conditional or security transfers. The assignment of future receivables may still become vulnerable in a bankruptcy of the originator if payable after the bankruptcy has been opened, resulting only in an unsecured claim on the originator, even if the debtor is subsequently notified. The end result is that in France, bulk assignments for factoring and securitisation purposes may be achieved in different ways, through outright assignments subject to notification or recognition, through subrogation, through conditional or security assignments subject to notification, through a transfer under the Loi Dailly (Articles L 313-23–L 313-35 CMF—see the previous section) and, especially in securitisations, through a transfer to an FCC (Articles L 214-43– L 214-49 CMF). In the latter two cases the transfer is by way of the transfer of a bordereau without notification to the debtors. Future receivables arising out of existing contracts may generally be included.

1.3.7. The Introduction of the Trust or Fiducie in France In section 1.3.5 the introduction by statute of the notion of fiducia or fiducie in France was mentioned.144 In fact, it was shown that fiducial transfers had never completely disappeared145

142 See n 141 above. 143 See n 105 above. 144 See for the introduction of an earlier fiducie proposal, Projet Loi No 2583 of 20 February 1992. Reservations, mainly of the tax authorities, impeded progress. See on the subject of the fiducia cum creditore in present French law P Remy, ‘National Report for France’ in DJ Hayton, SCJJ Kortmann and HLE Verhagen (eds), Principles of European Trust Law (Deventer, 1999) 131, 137. 145 See also PG Lepaulle, Traité théorique et pratiques des trusts en droit interne, en droit fiscal et en droit international (Paris, 1932) and C Witz, La fiducie en droit privé français (Paris, 1981).

90 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services and continued to operate especially as conditional sales of receivables, but the types of ownership rights that it created remained largely obscure. Formal reintroduction of a trust-like structure was achieved by special statute of 19 February 2007,146 which overcame earlier objections of the tax authorities, and introduced the present Articles 2011–2031 of the Civil Code, as well as some amendments to the tax code and the French money laundering laws (in the CMF). One key feature is the limited time frame: the maximum lifespan of this kind of trust is only 33 years: Article 2018(2) CC. There is segregation or ring-fencing of the trust assets (only confirmed in Article 12 of the Act dealing with accounting matters), although creditors of the trust assets may still have a claim on the settlor if they prove to be insufficient. Protection is offered against any sale of the assets to third parties that know of the arrangements (Article 2023 CC). There is no tracing foreseen in the new provisions. In 2016 a register was introduced.147 The new facility can be seen as a new statutory proprietary right or ius in re aliena, which can also be structured as a security interest. The idea of the numerus clausus of proprietary rights and the impact of party autonomy in their creation is thus not fundamentally challenged. Article 2011 of the French CC now states simply that the fiducie is the operation by which one or several constituents transfer goods, rights or investment securities, or a package of goods, rights or investment securities, to one or more fiduciaries who, by holding these assets separate from their own patrimony, manage them for a pre-established purpose in the interest of one or more beneficiaries. It is interesting that the corporation is considered the closest analogy, although private persons cannot create the fiducie, and the fiduciaire or trustee must also be a company—in fact a type of financial service body, mainly a bank or insurance company (Article 2015). The settlor must be subject to French corporation tax (Article 2014), and also remains primarily liable for the tax burden of the trust. Both the settlor and trustee must be resident in the EU or in a country with a tax treaty with France. The arrangement cannot be used to confer a gift and must have some business purpose. Its operation is in fact confined to the commercial and financial world and it can notably not be used for estate planning. Attention has been given in the literature to what a fiducie of this type might achieve. Especially the temporary transfers of investment securities (presumably in the nature of finance sales) and the transfer of business receivables as security have been mentioned in this connection.148 146 Loi no 2007-211 of 19 February 2007; see for a comment P Matthews, ‘The French Fiducie: And Now for Something Completely Different?’ (2007) 22 Trust Law International 1. The law was preceded by a report of the French Confédération Nationale des Avocats of November 2003, called Reflexion sur la Fiducie, and may also have been stimulated by earlier calls from the European Parliament asking for harmonisation also in this area (November 2001). See on the calls for private law unification in the EU more particularly Vol 1, s 1.4.20. The idea was that the settlor would not be put in a better position tax-wise and full transparency was therefore demanded. In France, in the meantime, the First President of the Cour de Cassation observed that the common law and its trust concept had been shown to be much better adapted to business life: Les Echos, 26 June 2006. 147 Decree no 2016-567 of May 10 2016. 148 See Professor Remy cited in n 144 above. In 2009 a fiducie gage was specially introduced, see Arts 2372-1-6 (mobiliere) and Arts 2488-1-6 (immobiliere) CC. This allows the setting aside of property with a trustee for funding purposes subject to the conditions of the arrangement. Appropriation upon default is possible as an alternative to security interests, still subject, however, to the return of any overvalue but only in the case of natural persons, Art 2372-3. This facility also allows for the transfer of future assets including receivables (as did the fiducie proper since 2007). A transfer in bulk would also appear possible upon an adequate description of the underlying asset class.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 91 Upon the revival of the project in the French Senate in 2004,149 the emphasis was on retirement funds, saving schemes, custodial arrangements, funds for cleaning contaminated land, and only ultimately on structures for putting together a bundle of assets as security for which, as we have already seen, at least in respect of receivables, the facility had never died in France. In 2009, a specific facility of fiducie-sûreté was added,150 to provide further clarity as to the use of the fiducie in the context of asset-backed funding. Along similar lines (but not as part of the same facility), in 2010 it was further made possible that an entrepreneur could set assets aside from his/her own for professional activity without the need to create a legal entity.151 It confirmed that the new facility was especially positioned as a tool for financiers and is then in line with the renewal (but product-related ad hoc) legislation in the field of assignments, repos and securitisations, already described in the previous sections. It remains to be seen to what use it will be put in practice. Although the idea seems to have been that no new in rem right was created, this would appear less than perceptive, but the proprietary rights of both settlor and trustee and how they can be managed and transferred have not received much attention in the new legislative structure nor the manner and nature of that transfer.152 The legal provisions are in fact also largely empty regarding the operation of the fiducie and how its function is to be established and its purposes realised. As so often (also in common law), the dual proprietary and split-ownership-rights structure of conditional and temporary transfers is in fact hidden behind the facility itself, although it may still have a meaning outside it. It is clear, however, that the trust assets are not only separated from those of the trustee, but also from those of the settler, at least in principle and his creditors do not have a right in the trust assets. There are therefore also no prior creditors to worry about. This is a great advantage over the normal pledge or similar security interest. Notably, the facility does not carry as far as the constructive or resulting trust in common law countries or into ideas of tracing and appears indeed confined to formal structures. This again is in line with the thought that a new proprietary right was created and no new concept of property law introduced. It must be noted in this regard that the action for unjust enrichment is not proprietary in France and does not give relief in a bankruptcy of the enriched person. French law thus misses the flexibility that equity brought in common law countries in terms of segregation, especially important in respect of client assets. There is also no special emphasis on the protection of the ordinary business against these types of undisclosed interests. The comparison with the common law trust concepts is therefore only of limited relevance. Especially, the whole concept of party autonomy in the creation of proprietary rights remains underdeveloped and has not caught the attention of French academia. France so far has signed, but not yet ratified, the 1985 Hague Convention on the Law Applicable to Trusts and their Recognition: see Volume 4, section 1.6.7. This would introduce a two-tier system for the operation of trusts (local and foreign) in France, which may not now be considered feasible. As we have seen, the Hague Convention is limited to more formal trust structures.

149 By Philippe Marini; see for the list of possible uses, French Senate, Séance of 17 October 2006. 150 See n 105 above. 151 Law No 2010-658, 10 June 2010. 152 See also A Arsac, The fiduciary property: nature and regime, Thesis Pantheon-Sorbonne 2013.

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1.3.8. Open or Closed System of Proprietary Rights French law also adheres to the notion that proprietary rights cannot be created freely by the parties to a transaction. However, it is often thought that there may be greater flexibility under its system where ownership in chattels transfers through the will of the parties immediately under a sales agreement and not through another more objective act, such as delivery of possession, as under Dutch and German law.153 Parties are thus able to create conditional sales and transfers,154 but their power freely to create proprietary interests is now no less considered limited,155 although their freedom in this respect was originally fully upheld in proprietary matters.156 More modern French doctrine relies for third-party effect on a measure of publicity (which may include physical possession in the case of tangible assets and notification to the debtors in the case of receivables) or on public policy.157 This conforms to the situation elsewhere in civil law but French law may still imply some greater flexibility, which may well go beyond, for example, the more recent official Dutch position.158 More important is undoubtedly the French approach to the various new financial products in assignment, reservation of title, repos, securitisations, floating charges and trust structures. Here a product approach undermines any systematic consideration and a pragmatic attitude to proprietary rights has become evident. This may be on a scale unique in civil law and is an important departure whose final effect on the French law of property remains, however, still insufficiently studied.

1.4. The Situation in Germany 1.4.1. Introduction: The Development of the Reservation of Title and Conditional Transfers; Floating Charges In Germany, the section of the Civil Code (BGB) dealing with conditional or temporary transfers,159 as distinguished from secured transactions, has given rise to some contemplation but the concept has never been central to BGB thinking. If one may follow the comments in the Münchener Kommentar,160 the reservation of title is normally considered a

153 See U Drobnig, ‘Transfer of Property’ in Hartkamp et al (n 96) 345ff. 154 Art 1584 CC. The corresponding Art 1138 CC still uses the old concept of delivery, and fixes it at the moment of the conclusion of the sales agreement, but it is generally accepted that parties may postpone the transfer as they wish. 155 See Ghestin and Desche (n 109) fnn 542 and 612. 156 Cour de Cass, 13 February 1834, s 1.205 (1834). 157 Ghestin and Desche (n 109) no 612 and A Weill, Les Biens (Paris, 1974) no 10. 158 See F Terre and P Simler, Droit civil, les biens (Paris, 1998) no 41; see for the modern, more restrictive approach, text at n 99 above. 159 S 161 BGB. Note also s 158 BGB, which allows title automatically to pass or revert upon the fulfilment of a condition, but that must be a condition of the transfer itself (of the so-called dingliche Einigung or real contract or dinglicher Vertrag (see Vol 4, s 1.4.6), and not of the underlying contract, which itself can also be conditional but—in the so-called abstract German system of title transfer (see more particularly n 163 below)—that has no effect on the title transfer, except if, as in the reservation of title, it is deemed also to affect the act of transfer itself. This contrasts with the Dutch causal system: cf n 82 above and Vol 4, s 1.4.6. 160 Münchener Kommentar zum Bürgerlichen Gesetzbuch, Band 1, Allgemeiner Teil (ss 1–240) by FJ Säcker (1993); Band 3, Schuldrecht, Besonderer Teil, 1 Halbband (ss 433–651k), esp Rdn 42ff, by HP Westermann (1988); and Band 4, Sachenrecht (ss 854–1296) by F Quack (1986).

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 93 conditional sale,161 borne out by the reference to it in the BGB. At least this is so in the case of doubt,162 although as in the Netherlands it is not immediately clear what the alternative would be. It should be noted from the outset that, unlike in the Netherlands, in Germany the concept of the conditional transfer is caught up in the abstract system of title transfer: see Volume 4, section 1.4.6. Under it, the sales agreement and the subsequent transfer of title are in principle independent of each other. A conditional sale therefore does not result in a conditional transfer unless it is indicative of the intention also to transfer title conditionally as is presumed to be the case in a reservation of title (only). The Sicherungsübereignung or non-possessory security transfer for chattels is a case law development and started out as a conditional sale and transfer but developed more in the direction of a security interest. It is commonly distinguished from the Sicherungszession, which entails a similar facility for receivables. It may be expressly organised as a conditional sale and transfer although this is now uncommon.163 In the reservation of title, there is certainly no similar execution upon default, but rather appropriation, giving rise to a reclaiming right for the seller in the bankruptcy of the buyer if the trustee does not want to retain the contract (and offers payment guarantees). The return of title is in that case sanctioned by the Bankruptcy Act164 and

161 This is the common English expression, but it should be understood that the sale itself is not conditional, only the title transfer pursuant to it is. 162 Section 449 BGB. Any conditionality of the title transfer in a sale is in Germany normally explained as in a reservation of title. The alternative is not obvious. One could construe an immediate transfer to the buyer subject to a resolutive condition, as the lex commissoria probably does in the Netherlands: see nn 80 and 84 above. In Germany, reference is made in this connection to Bedingungszusammenhang. It seems to be a German variation on the exceptio non-adimpleti contractus (see also Vol 4, s 1.4.10), which itself would not lead to a return of title, certainly in an abstract system of title transfer. It results in another form of proprietary sales protection not subject to re-characterisation in bankruptcy, but, as in the Netherlands, the difference from the reservation of title is not great. The lex commissoria tacita as an implied resolutive condition upon non-payment seems to be unknown in Germany. At issue here is sales credit protection, not funding proper. 163 Before the entering into force of the BGB in 1900, when received Roman law still prevailed in Germany, but after the introduction of the new Federal Bankruptcy Act of 1877, its original s 14 eliminated the proprietary effect (and thereby the in rem and priority status) of both the (Roman law) pledge if delivered constituto possessorio (ie, without physical possession) and the (Roman law) non-possessory hypothec in movables, and therefore, of all securities in movables without actual possession of the security holder or his/her agent. This conformed to the trend under the European codifications of the early nineteenth century: see s 1.1.7 above. To regain the necessary flexibility, German law then started to use the Roman law repurchase option of C 4.54.2 to create the Sicherungsübereignung (under which the repurchase became an obligation and not merely an option): see also text at n 69 above for the situation in the Netherlands, and at n 109 and text at n 138 above for the situation in France, in which latter country the development was more hesitant and the conditional sale of Art 1584 CC provided another method, as Art 3.84(4) CC now does in the Netherlands. The subsequent German development of the Sicherungsübereignung did, however, move away from the concept of conditional ownership, and it is now mostly treated as an ordinary ownership transfer. Thus, for tangible movables, the transfer takes place pursuant to ss 929ff, especially s 930, which deals with the transfer constituto possessorio, even though in bankruptcy it is not now considered to result in more than a preference in the execution sale: see text at n 177 below. For receivables, the rules concerning the assignment apply, which in Germany do not require any notification to the debtor: see s 398 BGB. See, for the continuing possibility of the conditional ownership construction in the case of a Sicherungsübereignung, M Wolf, Sachenrecht (Munich, 1993) 299, 310, but it has become uncommon except perhaps in true repurchase agreements. cf, however, text at n 189 below for limiting considerations, especially in connection with the appropriation right. 164 Generally, in Germany, contractual rescission clauses requiring the return of the sold assets upon default are denied validity in bankruptcy: see s 26 of the Bankruptcy Act 1877 and now ss 103–05 of the Insolvency Act 1999. The old Act introduced here a uniform law for all of Germany before the introduction of the all-German Civil Code in 1900. This approach did not apply if the goods had not yet reached the point of delivery to the transferee: see s 44 of the old Bankruptcy Act, not retained in the new Insolvency Act of 1999. In that case they were likely to

94 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services automatic and does not require a formal retransfer of the title. This automatic return is therefore not considered impeded by the lack of authority of the bankrupt debtor or the intervention of his trustee. The reservation of title is not accessory to the claim for the purchase price unless it is otherwise agreed. It means that the benefit must be separately transferred if it is not altogether deemed extinguished when the seller is paid off upon an assignment of his claim. The assignor is considered to be under an obligation to transfer the benefit of reservation of title to the assignee, again unless the parties agreed otherwise.165 It depends therefore how it is done. If so agreed, the right of the seller under a reservation of title may be reinforced by the shift of the proprietary right into the manufactured end-products and into the proceeds upon a sale if previously authorised. This is done through what is called a verlängerter Eigentumsvorbehalt clause, which may take various forms, although in a subsequent bankruptcy it may weaken the reservation of title to a mere preference upon conversion of the good in the nature of a Sicherungsübereignung.166 An erweiterter Eigentumsvorbehalt extends the protection of the reservation of title to other debts of the buyer to the seller and may be combined with the (horizontal) verlängerter Eigentumsvorbehalt. Again, in a bankruptcy of the buyer, it only results in an Absonderungsrecht or mere preference in any execution proceeds upon default, much in the way of the modern German form of the non-possessory pledge, the so-called Sicherungsübereignung (section 51 Bankruptcy Act 1999), as we shall see below. The Aussonderung or retrieval right in the bankruptcy of a buyer is limited to the sold asset not being paid for in a timely manner (see also the next section for these concepts). It is therefore lost in the other situations. be after-acquired. This after-acquired property was not considered part of the estate in a German bankruptcy: see s 1 of the Bankruptcy Act 1877, not retained in the new Act either. Reservation of title as a condition is exceptionally valid in a German bankruptcy: see Insolvency Act 1999, s 107(1). The condition as expressed in the sale agreement is commonly deemed implied in the transfer of title itself, therefore in the real agreement or dingliche Einigung: see also n 159 above. It leads to a revindication (Aussonderungsrecht) against the bankrupt estate (see s 43 of the Bankruptcy Act 1877, now s 47 of the Insolvency Act 1999) if the bankruptcy trustee does not elect to continue the contract and give guarantees for payment under s 17 of the Bankruptcy Act 1877, now s 103 of the Insolvency Act 1999: see also BGH, 1 July 1970, 54 BGHZ 214, at 218. 165 BGH, 5 May 1971, BGHZ 56, 123 (1971). See for the situation in the Netherlands and France, nn 77 and 124 above and for England the text at n 235 below and for the US n 28 above and 279 below. 166 See also text at n 173 below. These facilities are first the so-called Verarbeitungsklausel, leading to joint ownership of processed, assembled or mixed goods, title to which, under s 950 BGB, is normally acquired by the manufacturer except where otherwise agreed, as indeed it normally is in the Verarbeitungsklausel: see BGH, 28 June 1954, BGHZ 14, 117 (1954), although appropriation is not then thought possible upon default, and the owners only have a priority right or preference in the proceeds upon an execution sale. Then there is the Vorausabtretungsklausel leading to an advance assignment of the proceeds of any (future authorised) resale and allowing collection by the original seller, which is common where the original buyer needs to sell the goods in his/her ordinary business. Together they are normally referred to as the vertical verlängerter Eigentumsvorbehalt. There is also a horizontal verlängerter Eigentumsvorbehalt, sometimes called a Kontokorrentvorbehalt, created through a so-called Saldoklausel, which creates a general reservation of title to all goods passing between seller and buyer and valid until all outstanding debt is paid. It also leads to a priority right in execution sales only and not to appropriation or execution rights: see BGH [1971] NJW 799. There could even be a Konzernklausel or Konzernvorbehalt under which all transactions with an entire group of companies could be subject to reservations of title until all outstanding debt was paid. To avoid excess security and excessive inroads into the room for manœuvre for the buyer, German case law tested these arrangements in the light of its requirement of good morals (gute Sitten): see also n 187 below and accompanying text. They are forbidden since 1 January 1999.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 95 In the meantime, the right of the buyer, pending full payment of the price, has been clearly qualified as proprietary in case law.167 It has led to a more extensive study of this type of contingent property right or proprietary expectancy, also called a dingliche Anwartschaft, and the resulting duality of the title under the circumstances.168 The discussions on this subject are sometimes 167 The German Supreme Court originally only gave the buyer a personal right in the asset in which the seller had reserved title. This right could be transferred through assignment pursuant to the normal rules of ss 398 and 413 BGB: see RG, 4 April 1933, RGZ 140, 223 (1933). Even if the physical possession was transferred to the buyer pursuant to s 929 BGB, the result would not have been different, except for the bona fide purchaser pursuant to s 932 BGB. Since 1956, the German Supreme Court has taken a different view and has held that the expectancy of the buyer is an in rem right. It allows its transfer without the consent of the original seller under the reservation of title as and in the manner of a proprietary right: see BGH, 22 February 1956, BGHZ 20, 88 (1956) and it is now well established that a buyer may transfer this interest to a third party, even as security: see Westermann (n 160) 148. As such it can be part of a Sicherungsübereignung: see for this facility the text below. Thus, the third-party transferee no longer receives from a person without the right to dispose and need therefore not rely on his/her bona fides and possession of the asset under s 932 BGB. Dingliche Einigung (see n 164 above) and Übergabe (delivery) of the expectancy are necessary pursuant to s 929 BGB, the latter not being a problem where the transferor has actual possession. Naturally, acquisition of the full title, therefore of any right in excess of the expectancy will still depend for its full effect on the bona fides and the actual control of the acquirer under the general rule of ss 932ff BGB, even if s/he buys in the ordinary course of business. 168 L Raiser, Dingliche Anwartschaften (Tübingen, 1961); see further H Forkel, Grundfragen der Lehre vom privatrechtlichen Anwartschaftsrecht (Berlin, 1962). Also in Germany, there are some voices which would give the seller under a reservation of title only a security interest: see eg U Huebner, ‘Zur dogmatischen Einordnung der Rechtsposition des Vorbehaltskäufers’ [1980] Neue Juristische Wochenschrift 729, 735, which is not extended, however, to the right of the buyer under a Sicherungsübereignung: see for this facility text following n 174 below. The idea of a duality of ownership resulting from the conditional title could be one further step in the discussion of the Anwartschaft. The discussion on this point is often fierce, as implementation of the concept of duality affects the basic characteristics of German civil law with its sharp and fundamental separation of the law of obligations and law of property as demonstrated by the concept of abstraction. It is important that in Germany proprietary rights in principle operate independently of their underlying (contractual) cause or origin, like a sales contract. In this system, the sale agreement must be considered separate from the title transfer itself, which requires a further (implicit) agreement (dingliche Einigung or dinglicher Vertrag) and is not affected by the underlying intent of the parties, unless also made part of the dingliche Einigung or transfer itself: see for this principle of abstraction Drobnig (n 153) 357. Another complication derives from the fact that German law allows the valid on-sale of the asset and title transfer by the buyer to a third party even if the latter knew of the limited purposes for which or under which the asset was originally sold to the buyer: see RG, 4 April 1919, RGZ 95, 244 (1919); see further Vol 4, s 1.4.6. An important impediment to the duality of ownership is further the closed nature of the proprietary system and the impossibility of parties freely to create rights that can be maintained against third parties. They cannot create iura extra commercium: see text at n 189 below. This is strictly speaking an issue separate from the abstraction principle and more fundamental to all civil law. Again, under German law, it is not normal for the conditionality of the contract transferring proprietary rights to have an impact on the title, although there are exceptions, notably in the reservation of title, as we have seen, when the conditionality in the contract is also deemed to affect the title transfer itself, but it is not thought to be capable of easy expansion into finance sales. It is clear, however, that the title transfer can be conditional, but that is then determined at the time of the dingliche Einigung itself, and not through the underlying sale agreement. In this vein, s 158 BGB allows title automatically to pass or revert upon fulfilment of a condition, but only if it is part of the Einigung. This concept of abstraction is of great importance to German law. It is in sharp (theoretical) contrast, for example, to Dutch law, which accepts the proprietary impact of contractual conditions as a matter of principle: see Art 3.84(4) CC and text at n 83 above. That is the causal system. As we have seen in Vol 4, s 1.4.7, the notion of abstraction is by no means a universal civil law principle and only a matter of policy. See for the discussion of these aspects in connection with conditional ownership rights in Germany, J Rinnewitz, Zur dogmatischen Struktur des Anwartschaftsrechts aus dem Eigentumsvorbehalt (Dissertation, Göttingen, 1989), dealing with the proprietary complementary nature of the interests of both parties to a conditional title and the duality of legal possession that necessarily follows the duality of ownership. Here we also see the idea that the Anwartschaft is a limited concept (a sui generis proprietary right) that nevertheless may arise in other types of conditional ownership, and therefore,

96 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services thought somewhat metaphysical, and there is still some resistance to the idea,169 but the concept would appear to be real enough and firmly established.170 The floating charge has no base in statutory or case law and must be gathered together on the basis of contractual clauses. The situation compares closely to the verlängerter and erweiterter Eigentumsvorbehalt situation. There are in this connection the so-called Raumsicherungsvertrag, not only in a reservation of title. As a minimum, both parties to a conditional sale have a proprietary expectancy, therefore, also the seller in a reservation of title: that is the expectancy again to become the full owner if the buyer does not pay. Staudiger/Wiegand, Kommentar zum Bürgerlichen Gesetzbuch mit Einführungsgesetz und Nebengesetzen, s 929, no 34, p 173 appears to be the most receptive, and sees the duality as the simplest solution but considers it inconsistent with the indivisible nature of the ownership concept under German law, so that only a (new) limited proprietary right results. It may seem to be semantics: see, for discussion, Forkel, above, referring to older opinion that accepted the duality, and further AH Scheltema, De goederenrechtelijke werking van de ontbindende voorwaarde [The proprietary effect of the resolving condition] (Deventer, 2003) 213. German doctrine, even to the extent that it is favourable to the idea, seems to remain generally puzzled about how to treat the consequences and the proprietary flexibility that would seem to follow. See for doubts on the terminology, D Medicus, Bürgerliches Recht, 18th edn (Cologne, 1999) no 456. In fact, denying proprietary effect to the resolving condition (of the seller but not the suspensive one of the buyer), accepted in Justinian law (see n 79 above) started in Germany with Windscheid: see Windscheid-Kipp, 1 Lehrbuch des Pandektenrechts, 8th edn (1900) s 91, who contested the more current interpretation of Justinian law on this point. Indeed, it seemed a more normal consequence of the abstraction principle, which does not favour the conditionality of a sale unless incorporated in the dingliche Einigung. As we have seen, Dutch law now follows in the case of a rescission of the contract for reason of default, except if there is a special clause inserted to the effect: see n 82 above. 169 Wolf (n 163) Rdns 504ff and 547b accepts the in rem expectancy for the buyer under a reservation of title, but notably denies the in rem right for the lessee under a finance lease if not clearly expressed in the contract, even if the lease is very similar to the reservation except that mostly the lessee has the option rather than the automatic right to acquire full ownership upon payment of the last lease instalment. See for the repo and finance lease situation more particularly below. 170 The subject tends to be more fully explored in connection with s 161 BGB, which discusses the suspensive and rescinding conditions in the General Part of the BGB: see Säcker (n 160) 1362, who supports the need for transferability of the expectancy for commercial reasons, but cf also M Wolf, Bürgerliches Gesetzbuch, Band 1, Allgemeiner Teil (Stuttgart, 1987) 1241, who does not dwell on the point in connection with s 161 BGB, which is often limited to the reservation of title but has a broader reach. German law is clear that conditions are not retroactive (ss 158 and 159 BGB) and only take in rem effect as at the date of their fulfilment, although personal actions may lie to undo the other effects if necessary. Again, only if the condition went to the dingliche Einigung itself, as probably in the reservation of title, would the situation be different. There have been many attempts at defining the essence of the dingliche Anwartschaft. Recurring themes are the degree of certainty in the expectancy of acquiring a full right; the specificity of this right; the absence of the need for any further formalities in acquiring the full right when the condition matures; and the possibility of disposing of the asset or Anwartschaftsrecht in it without the other party’s consent. W Marotzke, Das Anwartschaftsrecht (Berlin, 1977) 7, 13, starts with the power to dispose of the asset. In his/her view, the expectant party cannot dispose of the underlying asset but only of the dingliche Anwartschaftsrecht in it: see also J v Staudiger, Kommentar zum BGB (Berlin, 1995) ss 164–240, 271. It suggests that the expectancy is a limited proprietary right. The right itself exists when there is such certainty about the expectancy that it only depends on the expectant himself or on time for his/her full proprietary right to mature. L Raiser, Dingliche Anwartschaften (Tübingen, 1961) 3–4, sees it as arising if most acts or formalities concerning the transfer have been performed, but only some or a last one are still missing, such as payment in a reservation of title. Rinnewitz (n 168) 60 seems to combine both views and believes that the Anwartschaftsrecht exists when sufficient steps to the creation of the full proprietary right have been taken for its structure and the interest holder to be known and in existence (konkretisiert) and the acquisition of the full right may with sufficient probability be expected. In a similar vein is C Liebl, Die dinglichen Anwartschaftrechte und ihre Behandlung in Konkurs (Frankfurt am Main, 1990) 7, 71. The situation in a bankruptcy is particularly important as the dingliche Anwartschaft is only relevant if the expectancy in the underlying assets can mature in a bankruptcy of the counterparty and gives rise to a revindication action (Ausssonderungsrecht) of the expecting party once the condition is fulfilled, even if this occurs after bankruptcy. The Germans use here the term Konkurs or Insolvenzfestigheit or bankruptcy resistance. It is the true test of the existence of a proprietary right. It is clear that in the case of a reservation of title, there is no problem,

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 97 which allows for bulk transfers of assets within a certain space, the Verarbeitungsklausel, which allows their conversion into other products in which the charge is then contractually extended, and the Vorausabtretungsklausel, which allows for an anticipated assignment of all future claims from sales of the assets. Section 91 of the German Bankruptcy Act of 1999 may interfere with the transfer of future or replacement assets in this connection. It would appear (at least in the case of receivables) to apply only to assets that remain absolutely future at the time of the intervening bankruptcy of the transferee/debtor.171 As in the Netherlands, a conditional transfer in respect of future assets may protect the financier better: see Volume 4, section 1.4.5. In either case there would only be an Absonderungsrecht in a bankruptcy of the debtor.

1.4.2. Sicherungsübereignung and the Conditional Sale In Germany, besides the reservation of title (and lex commissoria or Bedingungszusammenhang), the other main non-possessory proprietary protection right in tangibles is the Sicherungsübereignung. As mentioned in the previous section, it started very much in the nature of a conditional transfer operating under case law since 1890.172 It became the major (non-possessory) loan protection device in chattels and may shift into replacement goods and proceeds if so agreed. In the form of the Sicherungszession it may cover intangible assets, present or future. It was surprisingly not covered in the Civil Code of 1900. As a consequence, its nature and effects were not coherently considered at legislative level and it remains a device praeter legem based on customary law.173 It is still not a true security right, although later case law clearly moved in that direction, and subsequent transfers of this nature in respect of the same asset are possible, which then rank according to time.174 The financier is still

see the case law referred to in n 167 above and s 107(1) of the German Insolvency Act 1999. This could still be considered exceptional and emphasis could be put instead on the bankrupt’s lack of disposition rights and therefore inability to shift assets out of his/her estate. Nevertheless, if no more acts are required of the bankrupt counterparty or his/her trustee to make the other party the full owner, it can be convincingly argued that the conditional ownership right of the non-bankrupt party is always effective against the bankrupt estate when the condition matures, even if this is after the bankruptcy itself. It can also be said that in that case ownership passes to the non-bankrupt party by the force of law. Actual possession and use are not the determining factors here. Even if the assets are with the bankrupt, they can still be validly reclaimed by the non-bankrupt party on the basis of his/her matured ownership right. Section 103 of the German Insolvency Act containing the facility for the trustee to repudiate executory contracts is not relevant and s 161 BGB does not appear to have relevance either where it refers to the interaction of a bankruptcy trustee and implies that neither party in a conditional sale (thus also not the seller under a reservation of title) has fully performed. 171 See K Larenz, Schuldrecht, Allgemeiner Teil (Munich, 1987) s 34 III. The difference with chattels may be that in their case delivery is necessary, which may not be deemed completed through an anticipated constitutum possessorium; see also Vol 4, s 1.4.5. In Germany an assignment does not require any other formal steps. 172 RG, 2 June 1890; RGZ 2, 173 (1890): see also n 178 below. 173 The drafters of the BGB considered outlawing the transfer of title constituto possessorio (therefore the transfer which left physical possession with the seller or an agent, while transferring only the legal or constructive possession to the buyer) if this mode of transfer was intended to create a substitute security. This attempt did not succeed as under the abstraction principle the underlying intent is not considered directly relevant in the German law of title transfer: see for the German discussion at the time, B Mugdan, Die gesammten Materialien zum BGB [All the materials concerning the BGB] I Sachenrecht [Property law] (Berlin, 1899) 626. 174 This is an important exception to the rule that no one may dispose twice of the same property, subject of course to the rights of bona fide purchasers of movable tangible assets and concerns any overvalue. The second buyer need not be bona fide under the circumstances: see Quack (n 160) 787. Another, probably better way of looking at this problem, is to recognise the proprietary expectancy of the seller (dingliche Anwartschaft) and his/her right to dispose of it even to (second) purchasers who are aware of the (first) fiduciary transfer.

98 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services considered the transferee, however, and technically advances the purchase price to the transferor rather than extending a loan to him, and the assets will be repurchased by the buyer on an agreed date against the original price plus an agreed interest rate. That clearly implies a conditional sale supporting a loan structure which, as suggested in section 1.1.6 above, would indeed lead one to expect a conversion of the title transfer into a secured transaction. That is what has largely happened in Germany, even if technically there remain some features of a conditional sale. In this structure, normally the transferor will retain the assets for his/her own use and the delivery to the transferee will be constituto possessorio, that is constructive only. It seems frequently to be the case, however, that the transferor transfers title unconditionally to the buyer/financier who, in that case, has only a personal duty to retransfer title upon repayment of the loan. Thus, there is no conditional sale or security proper, and the position of the seller in a bankruptcy of the transferee/financier would be weak, and s/he would have no automatic repossession right. As s/he has the money, this will be a disadvantage only if the assets are increasing in value. As in the case of equipment or even inventory, this is seldom the case, this structure may in practice prove adequate for the parties. If there is a proper conditional sale, the Sicherungsübereignung would result in the transferor of the assets retaining an in rem right to retrieve his assets (or dingliche Anwartschaft) upon fulfilling his duty to offer repayment of the advance (plus interest) on the due date, which right would then also effective in the event of a bankruptcy of the financier and would then result in a so-called Aussonderungsrecht for him.175 However, in a Sicherungsübereignung the transferee/financier is no longer considered to have an appropriation right proper upon default of the transferor, and must conduct an execution sale with a return of overvalue. S/he has in a bankruptcy of the transferor only a preference in the sales proceeds of the assets, whatever was agreed, therefore only an Absonderungsrecht. In this respect, the ownership right of the transferee/financier has become weak and is in that sense debased.176 Thus, compared to the seller under a reservation of title, who has, in German terminology, an Aussonderungsrecht from which the seller under a Sicherungsübereignung also benefits if s/he can offer their payment amount, the buyer under a Sicherungsübereignung has at least in the bankruptcy of the seller a mere Absonderungsrecht that is a preferential right to the sales proceeds of the asset.177 In a bankruptcy of the seller, s/he is therefore dependent in timing on the bankruptcy 175 RG, 23 December 1899, RGZ 45, 80 (1899). References are often also made to RG, 20 March 1919, RGZ 79, 121 (1912); RG, 10 October 1917, RGZ 91, 12 (1917); and RG, 5 November 1918, RGZ 94, 305 (1918). 176 RG, 14 October 1927, RGZ 118, 209 (1927) and 9 April 1929, RGZ 124, 73 (1929). The term fiduciary transfer is here sometimes used (as was more common in the Netherlands), but unlike under the pre-Justinian Roman law of the fiducia, the financier cannot rely on his/her ownership rights and ignore the bankruptcy of his/her counterparty. The thought appears to be that in a bankruptcy of the seller his/her repayment obligation becomes due, while the ownership interest of the buyer lapses and is converted into a priority right: see also s 27(2) of the German Reorganisation Act [Vergleichsordnung] of 1935, now superseded. It is also said that the financier has a claim for repayment and should not therefore have ownership of the asset as well (Problem der doppelten Befriedigung). The true reason is probably the status of the residual proprietary interest of the bankrupt seller. The resulting mere preference for the financier is in line with the situation prevailing under the received Roman law before 1900, under which the hypothec as a non-possessory security resulted only in a preference and not in a revindication right at the same time: see WJ Zwalve, Hoofdstukken uit de geschiedenis van het Europese privaatrecht, 1 Inleiding en Zakenrecht [Chapters from the history of the European private law, 1 Introduction and Property Law] (Groningen, 1993), 342, 394. It is also in line with the general modern German approach that in bankruptcy all security interests, whether possessory or not, lose their repossession and separate execution facilities in bankruptcy: see s 51 Insolvency Act 1999. 177 See respectively ss 43 and 48 of the old German Bankruptcy Act, now ss 47 and 50 of the Insolvency Act 1999. In Germany, Aussonderung is based on a full proprietary right in assets, that is ownership or any other proprietary right entitling the beneficiary to possession. As already mentioned, reservation of title is supposed to give the seller

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 99 trustee who is in charge of the asset and of his/her disposition, and the buyer has no repossession and execution right. The buyer’s right is mostly considered accessory to the advance, unless otherwise expressly agreed. This is also indicative of a lesser right than full ownership, in particular of a security right, which suggests that the ownership reverts automatically to the seller upon repayment.178 It implies that the seller remains the true owner and that the asset still belongs to his/her estate, just like any owner who has conceded a security interest in them. It explains the seller’s Aussonderungsrecht in a bankruptcy of the buyer. Duality of ownership, unlike in reservations of title, would not therefore seem to be the issue in the Sicherungsübereignung as it developed. However, the conditional assignment or Sicherungszession of receivables allows for collection by the financier and amortisation of the advance in the manner of an owner, as if therefore a full assignment to the buyer had taken place, although any excess collection must be returned.179 Most importantly, the buyer/financier in a Sicherungsübereignung or Sicherungszession may also legally on-sell or assign the assets. It may subject him/her to any claims for damages by the original owner, although they would not affect the title of purchasers/assignees. S/he thus appears to have full disposition rights and the conditional ownership rights (if any) of the seller do not figure here.

an Aussonderungsrecht, assuming it is also part of the Einigung. It leads to a self-help remedy. Absonderung is typical for non-possessory security interests and signifies that the asset still belongs to the debtor’s estate, even though the creditor has a proprietary security interest in it. It means that there must be an execution sale, and the secured creditor only has a preference in the proceeds. The trustee here takes the initiative in the sale if the interests are non-possessory (also therefore in the case of real estate mortgages). It applies also to the possessory pledge, and only if the trustee is not entitled to take action does the right to repossession and separate execution remain unaffected: see ss 50 and 173 of the German Insolvency Act 1999. Statutory liens are treated similarly but the liens of the tax and social security authorities have since 1999 no longer been effective in a German bankruptcy, while the lien for the workforce is substituted by a state-funded guarantee. The distinction between Aussonderung and Absonderung is typical for German bankruptcy law (and not outside it). Most other countries make a distinction between self-help and non-self-help remedies in the case of secured transactions or statutory liens. If there is self-help, the secured creditor may in essence ignore a bankruptcy of the debtor as self-help means a right to repossession upon default. That is in most countries normal for possessory as well as non-possessory security interests. Non-self-help remedies only give a preference in the proceeds of an execution, conducted by the trustee in the case of a bankruptcy of the debtor. It means that the creditor is dependent on the trustee in the timing, and must also share in the expenses of the bankruptcy (unless there is also a set-off possibility). In many countries in the French tradition, statutory liens are also in that category and do not lead to self-help. They are called privilèges rather than secured interests. In reorganisation-oriented bankruptcy statutes like those of the US and now also of Germany and France, even self-help remedies are mostly subject to a stay provision pending the decision on reorganisation or liquidation. It does not, however, make them mere privileges, and the stay is only a temporary measure and may be lifted in certain circumstances, especially when the asset is not needed in the reorganisation or depreciates fast. 178 BGH, 23 September 1981 [1981] NJW 275. There is criticism of this approach, and it has been suggested that even though the property retransfers automatically to the seller upon payment, this does not imply the automatic transfer of the buyer’s rights with the assignment of his/her repayment claim, although this may be agreed: see Quack (n 160) 778. The alternative to the accessory nature of the Sicherungsübereignung is to consider repayment a rescinding condition of the title transfer to the buyer, which was the Dutch approach before the new Code abolished the fiduciary transfer (see HR, 3 October 1980 [1981] NJ 60) and the fiduciary transfer to the financier was never considered accessory: see n 79 above. The German general banking conditions do not use the automaticity, but allow the banks to remain owners until they retransfer the title. The accessory nature of the Sicherungsübereigung is thus abrogated by agreement. One of the dangers was that in a bankruptcy of the bank the original seller loses his/her in rem status as a consequence and only retains a personal right to retrieval, but this is countered by case law. 179 The German Supreme Court (BGH) accepts that the fiduciary assignment may be chosen merely to avoid the notification that would be required if the same receivables had been pledged: see BGH, 23 September 1981, cited in n 178 above, and for a similar attitude in France, s 1.3.6 above in fine.

100 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services As a consequence, bona fides of the purchaser is not required in order to obtain full title, nor is the transfer of physical possession (which the buyer/financier could not have provided).180 Both of those would be indispensable for the protection of the transferee if s/he had acquired the asset from an unauthorised person under the German exception to the nemo dat rule (section 932 BGB). The proper method of delivery by the buyer/financier is here longa manu by mere agreement without notice even to the original seller of the interest on the basis of sections 870 and 931 BGB, although it is also conceivable that German law opts for the assignment route instead. From this perspective, it is the buyer/financier who is considered to have full title, although, as we have just seen, from other perspectives it is the seller/borrower. Thus, there must be some duality in the ownership structure if the Sicherungsübereignung is not to be reduced to a mere secured transaction. Yet the hybrid nature of the title remains here largely unexplored, contrary to the situation in the reservation of title, probably because the conditional sale analogy has mostly been lost in the Sicherungsübereignung, which in practice operates in Germany as the principal non-possessory security interest in personal property.

1.4.3. Finance Sales Perhaps a more general statement should be made at this juncture. The development of the reservation of title and much more so of the Sicherungsübereignung in Germany shows that German law leaves some latitude to the parties in this area. Except for the security interests covered by statute which, besides the statutory liens, are mainly the real-estate mortgage, the possessory pledge, and the reservation of title (although the latter only in its most elementary form), there was no preconceived framework or mandatory form for new financial products in Germany. They may in essence be freely created, although of course within the German framework of proprietary rights as a, in principle, closed system. Thus, the characterisation issue cannot be avoided, and courts will intervene in case of doubt. They will interpret the parties’ intentions and define their basic proprietary and other protections, but there is in all this in Germany probably still some greater flexibility than in many other civil law countries, as also shown in the development of the Anwartschaft. It is shown no less in the unstructured development of the Sicherungsübereignung and related floating charge. It may also be shown in the liberal set-off facilities for repos. Besides the existing proprietary system, the concept of good morals or gute Sitten indicates the outside limit of the modern financial products and their status in law (see the next section). As was pointed out in the previous section, German law also allows in principle the true conditional sale and transfer. It all appears to depend on the parties’ intention in respect of the real agreement and how they structure their deals. There are no functional bars, even though there may be objections to the right of a finance lessee or repo seller being characterised as a dingliche Anwartschaft. It depends on the structure of the lease and type of repo. A mere option for the lessee to acquire full ownership upon payment of the last instalment might not be sufficient support for such a characterisation. The finance lease is therefore normally considered in its contractual aspects only. In true conditional sales, on the other hand, the protection of the sellers/fundraisers through execution sales and repayment of overvalue would not to be one of the concerns. Appropriation of the asset could follow except perhaps if there is a clear loan structure when the need for an execution sale and return of the overvalue is often deemed implied in the contract or when, as in the case of a Sicherungsübereignung, there may only be an Absonderungsrecht in bankruptcy, as we have seen in the previous section, even if it may still be 180 Cf for conditional ownership the discussion n 170 above and in n 176 for the resulting preference in Germany.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 101 structured as a true conditional sale with an appropriation facility also effective in bankruptcy (Aussonderung).181 The repurchase agreement or repo for investment securities was the subject of new legislation in Germany in 1994: see section 340b of the Commercial Code and section 104 of the new Insolvency Act of the same year, effective only in 1999, but brought forward in this aspect in 1994. Proprietary aspects are virtually ignored. As elsewhere, the practice has been to balance the contractual ‘cherry-picking’ approach in the bankruptcy of either party (which in the case of market-related securities under section 18 of the old German Bankruptcy Act was already converted into an automatic termination) with a contractual netting facility. The validity of this netting facility is now endorsed by the new German Insolvency Act (see section 104 for Fixgeschäfte and Finanztermingeschäfte). As just mentioned, in Germany, finance leasing is normally also only considered in its contractual aspects. That is not to say that proprietary aspects do not exist in leases and repos, even if in Germany the intent of the parties determines the existence of a conditional transfer and title. But the problem remains what this means, the essence remains whether this intent also transfers to the proprietary agreement although this is not much discussed in connection with finance leasing and the repo business.182 Also in factoring of receivables there may be a characterisation risk. To avoid it, the transfer of the receivables is often structured in Germany as being complete and 181 See nn 162, 168 and 171 above plus accompanying text. See for the good morals concern n 186 below and accompanying text. 182 See for the proprietary aspects also the references to Wolf in nn 163 and 170 above. See, however, for the lack of an extensive discussion of the Anwartschaft notion in connection with conditional ownership in Germany n 167 in fine and n 169 above, and this crucial notion does not much figure in the discussion of the finance lease and repurchase agreement either. In the repurchase agreement of investment securities, the fungible nature of the securities may be a further hindrance to the recognition of the proprietary status for the seller, but s/he may be able to rely on the general German facility to shift ownership rights into replacement goods if contractually agreed (the anticipatory dingliche Einigung). For the finance lease, the key would have to be the automatic shift of title to the lessee upon payment of the last instalment or at least the in rem option to acquire full ownership at that time without the payment of further consideration. Without such clauses the lease is purely contractual everywhere, but in Germany probably also if there is only an option. See for a discussion of the repurchase agreement of investment securities in Germany, J Krumnow, W Sprissler, Y Bellavite-Höverman, M Kemmer and H Steinbruecker, Rechnungslegung der Kreditinstitute (Stuttgart, 1994) 75ff. Discussions of the tax complications seem more common than those of the legal complications: see A Lohner, Echte Pensionsgeschäfte, ihre ertragsteuerliche Behandlung und ihr Einsatz als Sachverhaltgestaltungen im Rahmen der Steurerplanung (Frankfurt am Main, 1992); see also J Wagenmann, Wertpapierpensionsgeschäfte: das Überlegene Refinanzierungsinstrument, Pfaffenweiler (Munich, 1991) 52–72 and further G Waschbusch, ‘Die Rechnungslegung der Kreditinstitute bei Pensionsgeschäfte. Zur Rechtslage nach Section 340b HGB’ (1993) 3 Betriebsberater 172–79. The key tax problem is often identified in the legal nature of the transfer and its finality or in the contractual re-characterisation of this product, which leads to a return of similar assets but not necessarily the same. In fact, the interest for the repo buyer is mostly in the use of the underlying assets, and this type of reward substitutes for the notion of interest. That is why also in Germany the notion of security is often considered less apt and liquidity is rightly perceived as the objective of the repo seller: see eg HD Bennat, ‘Wertpapierpensionsgeschäfte in Steuerlicher Sicht’ (1969) 50 Wertpapier-Mitteilungen 1434. For repos, a kind of trust relationship or Treuhandverhältnis is sometimes suggested, but often considered not to be the parties’ intention, or otherwise a rental agreement, but the idea seems mostly to be that the return obligation is only contractual and has no proprietary underpinning. There is then no Aus- or Absonderungrecht for the repo seller in a bankruptcy of the repo buyer either. In relation to the Bundesbank, the practice developed that banks would open a so-called ‘disposition account’ and transfer securities into that account or withdraw them from it. This was often called some kind of ‘general pledge’, but the precise legal characterisation remained unclear and untested as central banks are unlikely to go bankrupt. The term ‘pensionsgeschäft’, which is now common, may be regarded as somewhat peculiar; see for this term also Monatsbericht der deutschen Bundesbank (November 1965) 3ff. See for the netting aspects in repos in Germany after the changes of 1994, U Bosch and

102 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services unconditional. It is then an outright sale. In that case, the duality of ownership is not an issue, but in other forms of factoring (see section 2.3 below) it may be, even if these are purely domestic. Here, tax legislation is likely to have an impact on the structures as well.

1.4.4. Curbing Excess: Open or Closed System of Proprietary Rights. Gute Sitten and Newer Charges To summarise, the situation for the more commonly discussed reservation of title and Sicherungsübereignung: in both cases, it is the seller/transferor in need of sales-price protection or funding who mostly appears to have the upper hand in a proprietary sense. The difference is that in the Sicherungsübereignung, the transferee is not perceived to have much of a title for the time being,183 whilst the transferor still has physical possession and is likely to transform the assets. The opposite is the case for the seller under a reservation of title, who has no physical possession—the buyer being in charge of the assets and their possible transformation—but is deemed to retain ownership. Under German law both transferees have an in rem right in the bankruptcy of their counterparty. In a reservation of title in Germany, the buyer has an in rem expectation (dingliche Anwartschaft). This appears now less likely for the buyer/financier under a Sicherungsübereignung,184 probably because his/her expectation of becoming unconditional owner is less realistic than in the case of the buyer under a reservation of title, and it is certainly not the intention. If the Sicherungsübereignung were structured as a true conditional sale to the transferee/financier, the transferor could still have an Anwartschaftsrecht. Even if it is not so structured, s/he may still resell the goods as owner. On the other hand, if there is no conditional sale structure considered to be in place, in a bankruptcy of the transferor, the financier’s property right is habitually converted into a mere preference in the proceeds of the asset (Absonderungsrecht) as we have seen. This was different under old Dutch law, where the buyer/transferee was thought to have a security right with a self-help facility, at least to the extent that made sense, while the conditional sale concept was also increasingly ignored.185 This re-characterisation was logical in a situation where, economically speaking, there was loan financing and an interest rate agreed. S Hodges, ‘German Legislation on Netting of Derivatives’ [1995] Butterworths Journal of International Banking and Financial Law 304. See for finance leasing and the various theories on its (contractual) nature PW Heermann, ‘Grundprobleme beim Finanzierungsleasing beweglicher Güter in Deutschland und den Vereinigten Staaten von Amerika’ [1993] Zeitschrift für rechtsvergleichende Rechtswissenschaft (ZVglRW) 362ff. highlighting the problem of the particularly tripartite nature of many of these arrangements; others see a credit agreement, which was also the approach of s 3(2)(1) of the Consumer Credit Act (Verbraucherkreditgesetz or VerbrKG of 1 January 1991), now incorporated in the BGB. The BGH traditionally qualifies the finance lease as a rental agreement, BGHZ 71, 189, only more recently with some emphasis on the financial nature of the arrangement, BGHZ 95, 39, not seen, however, as a fundamental shift; see F von Westphalen, ‘Leasing als “sonstige Finanzierungshilfe” gemäss 1(2) VerbrKG’ [1991] Zeitschrift fur Wirtschaftsrecht und Insolvenzpraxis 639, 640, and SM Martinek, Modere Vertragstypen, Band I: Leasing und Factoring (Munich, 1991) 72. The former author explicitly maintains the BGH interpretation against the newer definition of the VerbrKG. The latter argues for a sui generis approach (at 86) with emphasis both on the financial and users’ aspects. Others see a contract of a mixed nature with aspects of a credit-giving role and of a purchasing agent role for the lessor with payment of interest and a commission by the lessee: see CW Canaris, Interessenlage, Grundprinzipien und Rechtsnatur des Finanzierungsleasing (Berlin, 1990) 450ff. 183 Cf n 176 above. 184 The possibility of the seller having an expectancy (Anwartschaft) which may be subject to the recovery rights of his/her creditors has, however, been suggested: see Quack (n 160) 781. 185 See text at n 70 above.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 103 The Sicherungsübereignung is of great importance in Germany, particularly for the bulk transfer of present and future tangible assets and in the form of the Sicherungszession for receivables, normally contractually supplemented by a similar right in proceeds. As such, it may achieve a floating charge on future cash flows.186 In terms of priority, an earlier reservation of title prevails over it as the seller in a Sicherungsübereignung (being the buyer under a reservation of title) does not have sufficient title to include the asset and is not transferring actual possession to the fiduciary buyer. This superiority of the earlier reservation of title extends to any contractual shift into converted products and sales proceeds unless the clauses to this effect were agreed later than the conflicting Sicherungsübereignung, provided that the extended reservation of title does not result in excessive security, which would be considered against good morals (gute Sitten). This concept is traditionally less restrictive for reservation of title than for a conflicting Sicherungsübereignung, which could be invalid for the same reasons.187 It is the German way of curbing charges, which in the case of a Sicherungsübereignung give a preference, in principle, as at the moment of the original agreement, even if it involves future debt and assets. Others, like the Dutch and the French, as we have seen, continue to insist on a greater measure of individualisation of the debt and the assets here, or require, in respect of the assignment of future claims for funding purposes, that the contract out of which they arise already exists. In any event, they limit more generally the possibility of the charge shifting into manufactured replacement goods and sales proceeds. French law also protects the appearance of creditworthiness, thus guarding against secret charges and revindication rights, in particular, and does not allow charges to mature after bankruptcy.188 In the US, there is a possibility of avoiding early perfection at the expense of others on the basis of good faith, and equitable subordination under the Bankruptcy Code (section 510) (as we shall see in section 1.6 below). In Germany, as just mentioned, the impact of the gute Sitten may exceptionally limit the reach of the Sicherungsübereignung. It could conceivably also limit any right of the parties to create a real conditional transfer instead, especially in order to obtain an appropriation right in bankruptcy to circumvent creating a mere preference only and also to gain any overvalue, but there does not seem to be much focus on this point.189 Although in principle, the intent of the parties dominates, it finds in the proprietary consequences limits in the concept 186 See text at n 166 above. The requirement of specificity nevertheless remains an impediment as it is necessary to force the bulk transfer in the established patterns of individual transfers, which is more particularly problematic for future tangibles and receivables. The requirement of specificity is only (partly) overcome by the use of special constructions like the Raumsicherungsvertrag for tangible movable assets and the Globalzession for intangibles. For tangibles it allows them to be described with reference to a certain place or room (Raum). Receivables may be sufficiently described with reference to certain debtors. For the transfer of future goods, the facility of the anticipated constitutum possessorium through a representative was created: see RG, 11 June 1920, RGZ 99, 208 (1920). The assignment of future receivables was much facilitated as notification is not a constitutive requirement under German law and the claim itself need only be identifiable when it emerges: see BGH, 25 October 1952, BGHZ 7, 365 (1952), while the relationship out of which it arises need not exist (as Dutch law, eg, normally still requires: see n 65 in fine above). As in the case of an extended reservation of title, see n 166 above, the Verarbeitungsklausel and the Vorausabtretungsklausel will attempt to cover situations of conversion of the assets in manufactured goods and of resale. 187 BGH, 30 April 1959, BGHZ 30, 149 (1959), pursuant to s 138(1) BGB: see earlier also RG, 9 April 1932, RGZ 136, 247 (1932). It may disallow the bank’s older priority if the client would be forced to disclose it to his/her suppliers who may refuse to deal with him/her if their own extended reservation of title would be in danger. It may also be seen as an instance in which the specific assignment of the future sale proceeds (upon the condition of which the supplier is willing to allow the resale of his/her goods) prevails over any earlier general assignment of any present and future goods and receivables arising out of their on-sale. As a matter of policy, it is clear that suppliers receive here an extra protection at the expense of the bank in order not to interrupt the ordinary course of business. 188 See for the Netherlands text at n 77 above and for France s 1.3.2 above. 189 See also Quack (n 160).

104 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services of abstraction, as we have seen, but also in gute Sitten. The modern repurchase agreement in respect of investment securities could be characterised as an example of a conditional sale and appropriation facility in a bankruptcy of the seller, but may have been similarly constrained. Finally, the German approach to the limitation of proprietary rights generally needs to be considered. The granting of in rem rights (or an Anwartschaft) to the buyer under a reservation of title, the construction of the Sicherungsübereignung praeter legem and its development in case law, the extension of the priority into converted assets and proceeds by mere contractual enhancement of the reservation of title or Sicherungsübereignung, the possibility in principle of true conditional ownership with a dual ownership structure, and the modern German approach to the trust or Treuhand,190 all suggest some flexibility.191 Even if parties may not directly change the possibilities here, it is accepted that customary law may do so.192 Yet, for conditional sales the split-ownership right and the resulting duality in ownership remains largely unexplored and the relative rights of both parties unanalysed. Another important aspect of the modern devices, particularly the Sicherungsübereignung, is the application of the test of good morals (gute Sitten) to the use of the device and the determination of its rank when conflicts arise.193 This also underlines the flexible public policy approach to third-party effect. It may be an important application of the principle of good faith in proprietary matters. We have seen in Volume 4, section 1.11 that in these matters the DCFR, although steeped in the German tradition of movable property law, is regressive. Rather than using the temporary and conditional ownership right as a fundamental building block, it prefers the creation of some narrowly defined new property rights for reservations of title. The finance lease is merely contractual and the repo a security interest, while also rejecting the notion of constructive trust/segregation, and the concept of future commercial/cashflows as an asset class dependent on mere description. It must be assumed that this is the present state of German discourse in these matters, all sustained by a rigid and uncritical attitude towards the numerous clausus of proprietary rights. It seems to be barely understood. This lack of flexibility bodes ill for the DCFR prospects in this area.

1.5. The Situation in the UK 1.5.1. Introduction: Differences from Civil Law There are a number of important aspects in which the common law is traditionally different from the continental civil law in the area of asset-backed funding. In the US, through Article 9 of the UCC, as we shall see in section 1.6 below, some limited convergence with the continental 190 See the text at n 101 above. 191 To this list may be added the in rem effect of a contractual prohibition of an assignment regardless of s 137 BGB: see BGH, 14 October 1963, BGHZ 40, 156 (1963), the BGH concluding that the prohibition was an innate part of the claim and not an addition or separate element thereof, which would have been ineffective under s 139 BGB. 192 Case law will express this, see also Säcker (n 160) 1363, who notes that s 161 BGB does not decisively indicate that conditional ownership entails a split ownership right. In Germany the underlying agreement is always considered unconditional, but the consequences and transfers may not be: see BGH, 9 July 1975, BGHZ 64, 395 (1975). It goes back to the German principle of abstraction and the concept of dingliche Einigung and: see also n 168 above. As mentioned in n 82 above, Dutch law does not follow this approach and sees the conditionality of the underlying agreement as the cause of the conditionality of the ownership: Art 3.38 together with Art 3.84(4) CC. 193 See n 187 above.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 105 European method of conceptualisation and system thinking may have taken place in the area of secured transactions in chattels and intangible assets. If so, it was a development which left English law unaffected and led, even in the US, to different results as compared to civil law: (a) The essence is that common law—and this is also true in the US, possibly even more so there—is used to the notion of future interests, not only in land, but also in chattels, such interests having proprietary protection and being transferable as property rights. Reverters and remainders are the traditional by-products, as such also transferable. (b) Furthermore, in England, the traditional mortgage, which may still be created in chattels as well, as a non-possessory interest, entails a transfer of ownership subject to a duty of the transferor to repay the purchase price at a certain date. Upon such repayment, the ownership right automatically reverts but especially in respect of land with a right of redemption for her/him to do so later if s/he cannot repay in time. (c) The old common law mortgage is not therefore a typical security interest, but remains structured like a conditional sale with proprietary effect, resulting in an (in rem) reversion right for the seller or mortgagor. In the US, it is not unusual either to see a trust construction emerge under which trustees will hold the property for a certain purpose, in this case until the return of the money. The owner may even convert himself into a trustee for this purpose. Reference is often made in such situations to an equitable mortgage. Again, the result is some split ownership and not a security interest proper. The difference is that the equitable mortgagee or beneficiary is not protected against bona fide purchasers of the property by the legal owner/trustee. (d) English law is generally relaxed about the possibility of appropriation of full title upon default, which the conditional sale approach entails. This may give the ultimate owner a windfall if the asset increases in value, but s/he is also releasing his/her defaulting counterparty if there is a shortfall. That is the other side of the conditional sale. (e) In the case of default, there is therefore no fundamental emphasis on an execution or supervised sale with a return of the overvalue, even under the equitable charges (see below) which are otherwise much more in the nature of a (non-possessory) pledge as true security interests. However, the courts will strictly enforce and favour the redemption right even for chattel mortgages, although for an uncertain period. This equity of redemption is not implied in other types of conditional sales, like reservation of title and hire-purchases and finance sales. (f) English law further makes a fundamental distinction between: (i) loan credit, (ii) sales credit, and (iii) finance sales.

In this connection, English law distinguishes sharply between loan agreements and late payment agreements. The former commonly give rise to mortgage arrangements or secured transactions, the latter to protection through retention or reservation of title, or hire-purchase arrangements. Again, the traditional mortgage was set up as a type of conditional transfer subject to the equity of redemption; and the reservation of title and the hire-purchase were set up as delayed or other types of conditional title transfers without this equity. (g) In this regard, English law is fairly flexible and relaxed about the way parties go about their affairs, and it readily accepts that they may make alternative or substitute arrangements to avoid what they consider to be the undesirable legal consequences or side-effects of any of them. As a consequence, if a conditional sale of chattels is preferred to raise money instead of

106 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services taking out a loan on the security of the same assets (even if only to avoid registration), then the law will not normally go behind the parties’ intent and will not consider their structure illegal per se or a sham. If there is a mortgage to secure a loan, the equity of redemption cannot be circumvented, however, probably again because there is normally a clear loan structure. (h) In connection with secured transactions proper, common law jurisdiction in equity, at least in England, requires neither a great deal of identification of the assets nor specification of the debt they secure. A reasonable description in the agreement will suffice. It is not averse either to these charges shifting into manufactured goods and proceeds. In fact, it normally assumes that they do, at least in all equitable charges except where otherwise agreed, an approach which is backed by the equitable notion of tracing. (i) This is probably the most fundamental difference with the civil law approach and the essence of a floating charge. It is less likely that this liberal attitude also applies at law, therefore to mortgages as borne out by bills of sale (which for private persons are registered chattel mortgages—see below), or whether it also applies to conditional sales, such as reservation of title, without additional arrangements being made in the contract to the effect, which may themselves amount to the creation of (further) bills of sale, security interests, or to equitable charges. (j) Even in respect of chattels and intangibles, non-possessory securities, including the chattel mortgage and the floating charge, are, under English law, subject to a wide-ranging system of registration. Yet this system is fractured, and different types of registrations may mean different things and may have different consequences. Notably, registration is not required for finance sales. Scottish law has different features and remains in essence based on received Roman law (ius commune). Even though it has accepted the floating charge by statute since 1961, and the reservation of title through case law, the former is less common than in England, and the latter is explicitly not a security interest. Except where there is statutory law, Scottish law remains generally opposed to non-possessory security interest in chattels,194 an attitude mostly respected by the House of Lords, now the Supreme Court, which is also the supreme appeal body for Scotland.195

1.5.2. Basic Features of Conditional or Split-ownership Interests. Equitable and Floating Charges. An Open System of Proprietary Rights in Equity? It may be useful briefly to expand on the above-mentioned features of the approach in common law jurisdictions, especially as it operates in England. First the question of conditional or future interests and their operation arises, therefore the issue of their proprietary effect, even if these interests are merely contingent. Common law has long accepted them as proprietary, provided that, if contingent, they do not go on too long together, hence the application of the

194 Cf Voet, Commentarius ad Pandectas, 20.1.12, although not followed by the Dutch Supreme Court at the time: see HR, 13 November 1737, in C van Bynkershoek, IV Observationes Timultariae (Haarlem, 1962) [189–85]. The House of Lords in North Western Bank v Poynter [1895] AC 56, no 3051; [1895] All ER 754 allowed a certain relaxation if the pledgee returned the goods to the pledgor for certain limited purposes. 195 See in particular Armour and Others v Thyssen Edelstahlwerke AG [1990] All ER 481.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 107 law against perpetuities.196 The main principles of the law of conditional or future interests were first developed in respect of land. Besides the fee simple, the life interests, and the estates for years or leaseholds, there thus arose conditional or future interests such as reversionary interests or remainders, either vested or contingent depending on the conditions attached. Subsequently, these notions were mostly also made applicable to chattels even though then only in equity, at least so it is mainly assumed. At law, their protection was largely based on the exercise of power in or over the asset under the law of bailment, but in equity there are in parallel more limited proprietary interests in terms of a user, enjoyment or income right that may be (more) freely created and can be non-possessory, although their third-party effect is limited, as bona fide purchasers of these assets from the title holder are protected, as we have seen. In England, these future interests in chattels are now often hidden in trust arrangements, as the law is more specific in this area. Therefore, the subject of future interests in chattels receives less attention as such. This may be different in the US, where, on the other hand, when used for financing, these structures are now covered by Article 9 UCC for movable assets. The approach to split, conditional or future interests in this manner, supported by a variety of actions, highlights an underlying concern with user, income, enjoyment, and possession or retention rights and their duration in common law. In it, better rights rather than absolute rights are the basis for proprietary protection. At law, especially physical possession (mostly in bailment)197 was always strongly protected, often more than ownership. It meant that even if there were underlying split-ownership rights, the actual possessor was always in a strong position. Although the real (split) owners were not powerless, they were at a relative disadvantage and only had a right to immediate repossession at the end of the bailment period or if its terms were breached. This contrasted on the whole with the Roman or civil law system of more abstract absolute rights in the property—rights maintainable against all the world in terms of ownership, of which legal possession became the appearance, and holdership the physical expression: see for these concepts more particularly Volume 4, section 1.2.2. In civil law, physical holdership, legal possession, and ownership are thus interconnected and allow for increasing levels of protection for the interest holder. Limited proprietary rights, such as usufructs and secured interests, are, in this system, seen as derivatives of the ownership right, are similarly protected, and eventually submerge again in it when the entitlement lapses. The importance of legal possession (besides its own type of protection) in civil law is in this regard the possibility of acquiring ownership (or the more limited proprietary rights) on the basis of it through acquisitive prescription. It shows the principal (theoretical) differences between the common and civil law of property, and especially the different function of possession, even though a better proprietary protection of mere physical holdership against third parties through possessory actions has also been advocated in civil law and became more accepted in Germany.198 It may mark a return to the more Germanic or Saxon physical concepts of possession, abandoned

196 See for England, the still classic treatise of FH Lawson, Introduction to the Law of Property (Oxford, 1958) 65ff and 134ff, revised in a second edition by Bernard Rudden. Cf also S Worthington, Proprietary Interests in Commercial Transactions (Oxford, 1996). 197 See Vol 4, s 1.3.2 and also n 279 below. 198 See HCF Schoordijk, ‘Enige opmerkingen over de bescherming van bezitters en houders’ (1984) [Some observations on the protection of legal possessors and holders] in HCF Schoordijk, Verspreid Werk [Assorted Works] (Deventer, 1991) 447. It means that only someone who is a holder pursuant to a contractual right may still defend this right as his/her asset or property right vis-à-vis third parties. The new Dutch Civil Code does not generally go this far but does exceptionally award the retentor—that is the person who may retain the property for cause, eg because s/he has not been paid for the repairs—this position: see Art 3.295 CC and also Vol 4, s 1.4.10.

108 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services on the Continent since the return to Roman law thinking in this area, but still at the heart of the common law where there is no such concept as absolute title199 and where possession or bailment is a proprietary right in itself. In any event, protection of holdership through tort actions is now largely accepted, also in civil law, and a holder is therefore no longer fully dependent on the owner/possessor for its protection.200 It remains true, however, that the common law of property operates a much more fractured system of proprietary rights and does not think systematically on the subject, although notions of proprietary or third-party effect, ownership and possession, their protection and transferability, and priorities in the assets or proceeds in an execution or bankruptcy, which are substantially elaborated in civil law, are no less known in common law. Yet, thinking in terms of a system of proprietary rights, and especially of a closed system, is alien to traditional common law thinking. Although at law it admits only two proprietary rights in chattels: ownership and possession (or bailment). There are also the equitable rights, including those of trust beneficiaries, and the trust deed can cut the ownership and users’ right in almost any way the settlor wants (except as curtailed in the statutes against perpetuities). Thus, in common law jurisdictions, ownership in respect of chattels and intangible assets can be split almost at will either under conditional or temporary forms of ownership or through trusts, subject always to the rights of bona fide purchasers of the legal title only: see more particularly Volume 4, section 1.3.1. This sets much of the scene for the discussion. The traditional common law mortgage fits into this scenario in a particular manner. It was already said that it is a transfer of ownership, therefore a transfer of title, and does not create a security interest in the transferee of either immovable or movable (including intangible) property, who will have advanced a sum of money against this transfer. This sum is likely to be related to the value of the asset, such as a purchase price, and is therefore likely to represent this value in full. The sale is conditional, however, and the asset automatically re-conveys to the transferor upon repayment of the advance and the agreed interest.201 The transferor therefore retains a conditional or future interest in the asset. This interest is, in principle, transferable, for which common law does not even require transfer of possession.202 As already mentioned, the conditional ownership right of the transferor or mortgagor is reinforced by its right of redemption. This gives the latter the possibility of reclaiming the asset in equity upon offering full payment even after the term for repayment has expired, and is not itself limited in time, at least for chattels, and will be granted as long as it is fair and equitable to 199 See Lord Diplock in Ocean Estates Ltd v Pinder [1969] 2 AC 19. 200 The difference is that, in civil law (unlike in common law), such an action can only be brought against a tortfeasor, and not against any third parties who in the meantime have obtained the asset from the latter (assuming that this person is not protected as a bona fide purchaser). In the event of the bankruptcy of the tortfeasor, the physical holder without proprietary protection has a weak position in civil law and may have to rely on the owner to re-establish his/her holdership. The possessor in common law may be better off, although it should be remembered that in the case of chattels, common law allows no true revindication right. At least in England, the courts may exercise discretion so that the wrongful possessor usually has an option to pay damages rather than return the asset, specific performance not being a right. In England this discretion to order specific relief was eventually vested in the courts in s 78 of the Common Law Procedure Act 1854, now superseded by s 3(2) of the Torts (Interference with Goods) Act 1977: see further Vol 4, s 1.3.4. 201 Interestingly, the common law mortgage was compared to the repurchase facility under Justininan Roman Law (C.4.54.2; see also nn 69, 110 and 163 above and accompanying text) in the 1749 case of Ryall v Rolle (1749) 1 Atk 165, and notably not to the Roman hypothec, which was not considered to give a similar property interest to the transferee. 202 See s 17 of the Sale of Goods Act 1979. It may also be construed as a sale of the equity of redemption: see text below and Thomas v Searles [1891] 2 QB 408. It may even be considered a second sale of the original full interest by a seller still in possession. In this latter case, the buyer’s protection depends on his/her bona fides: see s 24 of the Sale of Goods Act.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 109 do so. In normal circumstances the courts are greatly in favour of this right. In this approach, there is no execution sale or repayment of any overvalue, although the transferee may cut the redemption possibility short to avoid undesirable uncertainty by conducting a sale upon court order under any contractual power of sale or by asking the court for foreclosure (of the equity of redemption),203 which results in a judicial appropriation204 with a release of the debtor for any undervalue. The other feature of the old common law mortgage is that it never depended on actual possession either. One of the key elements of the mortgage was therefore that the transferor remained in physical possession, although without power to dispose. This distinguished it from the pledge of chattels, which is possessory, and relates it to equitable charges,205 notably 203 Foreclosure allows title to vest in the transferee (or mortgagee) unconditionally. In both these cases of a judicial sale or a foreclosure, the surplus is appropriated by the transferee, which is the reason the courts may seek to delay them to allow for the redemption to take place and may give only a provisional authorisation (a decree nisi) setting a further redemption period for the mortgagor. On the other hand, if the mortgagee takes this route, the mortgagor is released from his/her debt should there be undervalue: see RM Goode, Commercial Law, 3rd edn (London, 2004) 641. In a private sale conducted under a contractual power of sale, the mortgagee may, however, be bound to return any overvalue to subsequent and lower-ranking mortgagees or to the mortgagor; alternatively s/he may, in the case of land, appoint a receiver to exploit the property using the income to pay off the mortgage: see Lawson (n 196) 162. 204 The transferee lacking possession was vulnerable to charges of reputed ownership of the transferor and could thereby be deprived of his/her appropriation rights in bankruptcy, a typical bankruptcy concept in personal bankruptcy, now abandoned (since the Insolvency Act of 1986, s 283) in England and never adopted in the US: see n 113 above and accompanying text. For corporate bankruptcy, theories of reputed ownership had already been abandoned in earlier case law: see In re Crumlin Viaduct Works Co Ltd [1879] II Ch 755. It opened the way for non-possessory charges in company assets. See for the concept of reputed ownership Ryall v Rolle (1749) 1 Atk 165, and Re Sharpe [1980] 1 All ER 198. The concept was last repeated in s 38(c) of the Bankruptcy Act 1914. The concept is also well known in France, as we have seen, although now also under pressure in that country, especially in connection with the modern reservation of title: see n 128 above. The legal suspicion of secret interests went back to Twyne’s Case (1601) 76 ER 809, in which a debtor sold all his/her goods to one of his/her creditors, but retained possession. In this case, the Star Chamber accepted that this sale was not bona fide, but was meant to defraud the other creditors. It is the origin of the law against fraudulent conveyances and reputed ownership in common law, which subsequently became statutory; see further Lord Mansfield in Wilson v Day [1759] 2 Burr 827. Floating charges, even in respect of the whole business, later became possible regardless, but left the overvalue to the debtor. They are not therefore true sales or general assignments. The Statute of Frauds of 1677 had tried to curb non-possessory interests in tangible assets by requiring a document in writing. In this connection, constructive delivery is possible, however, in respect of assets under third parties such as custodians or bailees, but the transfer in those cases requires the consent of the holder. This is attornment: see Farina v Home (1846) 153 ER 1124, retained in s 29(4) of the Sale of Goods Act in the UK, even if delivery is no longer required for the transfer of chattels. In the US, where it is (unless parties have agreed to dispense with it), the old English case law remains relevant. On the other hand, in the US, the reputed ownership notion was not retained, but the question of ostensible ownership remained an issue and hidden proprietary interests are sometimes still vulnerable, especially in the context of the creation of security interests under Art 9 UCC. Retrieval rights upon default in sales are, however, discouraged probably for these reasons: see Vol 4, s 1.4.7. Modern filing requirements for non-possessory security interests, especially under Art 9 UCC, have alleviated the problem in respect of such interests, but the other side of this filing is that non-filed proprietary interests in chattels may become subordinated, creating a windfall for any secured creditor under Art 9. See, for this problem and the impact of filing, Vol 4, s 1.7.7. 205 Equitable charges arise in this connection when a person promises to set aside certain goods for a particular purpose, including the satisfaction of debt, when a trust structure or at least sufficient separation may be deemed to have arisen. They are normally non-possessory. A particular asset may thus be designated to the discharge of the indebtedness, the debt being set off against the sale proceeds of the asset. The sale may result from the debtor’s voluntary act, the execution of the contract if including a power of sale, or from a court order made upon the request of the chargee. Again, the commonest and most all-embracing is the floating charge, which may cover a whole business, including real estate usually created by a contract called a debenture. Their importance is mainly derived from their shift to replacement goods and proceeds, so that money may be advanced on the security of future cash flow. Since Holroyd v Marshall [1862] 10 HL Cas 191, these charges are also recognised in equity in other future assets. See for the equitable mortgage n 209 below.

110 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services floating charges in personal (movable) property, which, like the pledge, are otherwise much more in the nature of a true security interest206 with an implied power of sale upon default, subject to the return of any overvalue. Under common law, exceptionally, the pledge as a possessory instrument could also be created through mere constructive possession, usually through the use of a third-party bailee.207 All the same, the conditional or finance sales remain also possible in England for chattels and may be possessory or non-possessory, depending on the will of the parties. Again, for personal property they are equitable and often operate behind a (constructive) trust structure, not unlike a floating charge. It is of interest in this connection that under the Statute of Frauds of 1677, abolished in England in 1954, transfer of (constructive) possession was one way of creating a sale by way of a mortgage. The non-possessory mortgage is, however, more likely to be created by deed or, especially for chattels, by ‘some other note or memorandum’. Since 1854 for chattels, this has required registration (at the Royal Courts of Justice in London) as a bill of sale under the Bills of Sale Act unless it is given by corporations.208 In fact, the Act covers any document giving someone other

The technique has generally been upheld in case law since the end of the nineteenth century: see Salomon v A Salomon & Co Ltd [1897] AC 22; Government Stock v Manila Rail Co [1897] AC 81; Re Yorkshire Woolcombers Association Ltd [1903] 2 Ch 284 and Illingworth v Houldsworth [1904] AC 355. Their weakness is that these nonpossessory floating charges do not crystallise into a fixed charge until default, and it is only at that time that they derive their rank, which is therefore low and may induce the chargee bank or financier to solicit fixed charges on individual assets, for example, real estate, within the floating charge. The promise to set aside creates the charge. It implies that the chargee bank or financier does not receive control of the assets. Should it do so, the charge would be fixed; see National Westminster Bank plc v Spectrum Plus Ltd [2005] 2 AC 680 and UKHL 41. Sufficient control is the difference between fixed and floating charges, which may not always be easy to determine. Control of the chargee leaves the chargor with less freedom to dispose of the asset. In this connection, a contractual requirement of consent of the chargee to a disposal by the chargor may imply sufficient control of the chargee. This may be sufficient also in receivable financing or securitisations, and a contractual prohibition of any further assignments without the chargee’s consent may thus create a fixed charge in them. The holder of a floating charge must consider competition from other creditors who may always be superior. Employee claims may be in that category, so may be the liquidation expenses since the Companies Act 2006, while under the Enterprise Act 2002 a certain part of the proceeds may accrue to unsecured creditors. At the same time tax preferences were removed, especially in respect of unpaid corporation tax, real estate rates, and VAT. It is to be noted that the Law Commission in its 2002 Consultation Paper No 164 on Registration of Security Interests: Company Charges and Property Other than Land, proposed an advance filing system along the lines of Art 9 UCC. See for the US system s 1.6.1 below and for a critique Vol 4, s 1.7.7. The main importance was in the ranking of floating charges, which was proposed to relate back to the date of filing. Consequently, the distinction between fixed and floating charges would disappear in the aspect of priority while the notion of crystallisation would have become irrelevant. This was not implemented. It was already noted that floating charges in England normally allowed the chargee, usually a bank, to appoint an administrator or receiver to conduct its own type of private liquidation outside bankruptcy upon an event of default. This was not considered an insolvency procedure as it involved only one creditor. Although not against the traditional principle of repossession in bankruptcy and separate recovery, this became quite disruptive when under newer legislation for corporate reorganisations secured creditors could also become involved. The Enterprise Act of 2002 (in force since 2003) superseded among other things the earlier ‘administration’ that gave secured creditors veto power and abolished this contractual private execution facility. The administrator appointed under the new reorganisation procedure must restructure the company, deal with the rights of all creditors in that context, see Sch B1 para 3, and is an officer of the court. 206 The pledge, mostly in the form of a pawn, is for small debts regulated under the Pawnbrokers Acts 1872–1960, and otherwise follows common law principles. It remains relevant in respect of investment securities of the physical type. 207 Dublin City Distillery v Doherty [1914] AC 823. This mere transfer constituto possessorio was particularly curtailed under continental European law (see the text at n 29 above), but not in England. 208 The original Act was of 1854–66, repealed and replaced by the Act of 1878 as amended in 1882, 1890, 1891. The effect of the Act has been severely to limit the use of the chattel mortgage as a non-possessory instrument

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 111 than the owner (except if corporate) a legal or equitable right to the goods, entitling that person to seize or take possession of the goods in certain circumstances. The term ‘chattel mortgage’ as distinguished from a ‘bill of sale’ is now normally reserved for mortgages created in personal property in the corporate sphere by (constructive) delivery or for mortgages in registered chattels, such as ships and aircraft. An important consequence of the 1854 Act and its successors was that the transfer of chattels into a non-possessory mortgage in the personal non-corporate sphere no longer takes place as an ordinary sale of goods under the Sale of Goods Act, but through a registered document (a bill of sale) under the Bills of Sale Act. This does not affect its character as a conditional sale and transfer,209 but it is relevant, as the mortgagee under the Bills of Sale Act does not have the protection for the bona fide purchaser of section 24 of the Sale of Goods Act. On the other hand, it means that the mortgagee is protected against later mortgagees of the same asset even if they are bona fide. Again, appropriation or forfeiture upon default is a normal feature of the common law mortgage, which only became mitigated by the equitable right of redemption, as equity was said to abhor forfeiture. It should be repeated that in this respect common law did not have anything like the basic civil law principle of an execution sale, a supervised sale with a return of any excess value in these circumstances. That approach was only introduced into several US States by statute, and it subsequently also became one of the main features of Article 9 UCC.210 In civil law, on the

in the personal sphere. It had become a facility mainly solicited by all kinds of moneylenders, and obtained a bad reputation until the Moneylenders Act of 1900, amended in 1927, and now largely repealed. The Act made money lending other than through recognised banks subject to an annual licence and imposed strict conditions on money-lending contracts. The combined effect of both Acts (together with s 4 of the amendment to the Bills of Sale Act of 1882, which imposed the requirement of specificity of the assets being set aside) was virtually to end floating charges in the private sphere. Combined with the reputed ownership doctrine (see nn 113 and 204 above), they also discouraged reservations of title. This led to greater emphasis on other types of conditional sales, especially on hire-purchase, which under the Hire Purchase Act 1965 is virtually implied in all conditional sales if used to raise finance in the private sphere, such as any lease with an automatic right or option to acquire the full ownership of the asset after all instalments are paid. This latter Act in particular remedied the vulnerable position of the original transferor under a conditional sale of movables because of the protection of bona fide purchasers from the transferee under s 9 of the Factors Act and s 25(2) of the Sale of Goods Act by defining the transferee as a hirer rather than an owner, which leaves bona fide purchasers from him/her unprotected. They must return the goods to the transferor if the assets revert to the latter under the conditions set or pay damages: see also Wickham Holdings Ltd v Brooke House Motors Ltd [1967] 1 All ER 117. This rule does not apply in the motor trade, and does not necessarily deprive the hire-purchase of its nature as a conditional sale for other purposes. 209 It was mentioned above that the trust may also be used to create what is in essence an equitable mortgage under which the mortgagor may transform himself into a trustee and hold the asset for the benefit of the person or institution giving the advance. In England, this is the normal way of achieving a mortgage in future goods or interests or of creating a second mortgage in the same asset, and is in fact mortgaging a beneficial interest: the equity of redemption. The result is a weak right subject to the protection of bona fide purchasers of the goods when actually obtained by the mortgagor: see Joseph v Lyons (1884) 15 QBD 280. In England the equitable character of this mortgage does not prevent it from being a bill of sale subject to registration (this registration does not itself deprive any bona fide purchaser from his/her protections, as there is no search duty). This type of equitable mortgage is still common in the US for real estate, and in England remains a different way of achieving a similar result besides the creation of a mortgage often for 999 years as an estate in land and the charge by way of a legal mortgage under the Law of Property Act 1925. In the US, the trustee conducts a sale upon default, but the right of redemption (in those states that retain it instead of requiring a public execution sale) is reinstituted upon any sale so conducted. It is another way of splitting the ownership with a similar objective, and notably does not create a security interest proper. 210 See for the civil law approach in the Netherlands, Arts 3.248ff CC, in France, Art 2078 (first paragraph) CC and in Germany, ss 1234ff BGB. See for the situation in the US, SA Riesenfeld, Creditors’ Remedies and Debtors’ Protection, 3rd edn (St Paul, MN, 1979) 149.

112 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services other hand, the mortgagee has only a limited proprietary right. It is always subject to an execution sale and there is never any appropriation.211 In England, a similar attitude prevails for the pledge and for equitable charges, which are all in the nature of security interests (and not therefore conditional sales) although, as in Roman law,212 the execution sale need not be judicially conducted or supervised. Any excess value is returned to the debtor. This does not strictly apply to the mortgage (which is subject to the equity of redemption), or to any other type of conditional or finance sale,213 and even the pledge and the equitable charges may be superseded by other arrangements in this regard in the contract. As already mentioned, in the case of the traditional common law mortgage, the trade-off in England is that although the mortgagee may retain the overvalue, s/he surrenders any claim for undervalue if s/he chooses appropriation (unless otherwise agreed). This is still likely to be so for all conditional or finance sales in England.214

1.5.3. The Distinction between Conditional Sales and Secured Transactions in English Law. Publication Requirements and their Meaning The above leads to a discussion of the distinction between conditional sales and security interests under English law, especially in respect of movable property. Professor Goode, in his well-known book on English commercial law, sees a fundamental difference between loan and sales credit.215 211 Under late Roman law, appropriation (and a clause to the effect in the contract) was strictly forbidden following a decree of the Emperor Constantine, repeated in C 8.34.3: see also n 79 above. It remains the underlying attitude in civil law, although the clause (or lex commissoria) is effective in the case of a failed sale agreement in some countries, notably in the Netherlands, at least as long as entered into by the parties as a contractual condition, and is then also operative in the bankruptcy of the defaulting buyer leading to revindication rights. Other civil law countries do not go that far, however: see for the situation in France, Art 2078 (second para) CC and n 118 above, in Germany s 1229 BGB and n 164 above. 212 In Roman law, the principle of a supervised sale with the return of any excess value (superfluum) to the creditor only gradually developed, and in this respect, Roman law is closer to common law than to modern civil law. Originally, appropriation seems to have been the normal practice, at least under the possessory pledge or pignus unless there was a clause to the contrary (pactum de vendendo). Under Justinian law, such a clause was always deemed implicit, D 13.7.4, whilst a redemption right after the normal repayment period and sale could also be agreed, even allowing the debtor to retrieve the asset from the buyer at the latter’s purchase price: see D 13.7.13 and also M Kaser, Römisches Privatrecht [Roman private law], 14th edn (Munich, 1986) ss 31 and 146; see further F de Zulueta, The Institutes of Gaius (Oxford, 1953) pt II, 75. Yet, it left room for alternative arrangements short of the (later) forbidden appropriation: see n 194 above. In the non-possessory security or in the earlier non-possessory fiduciary transfers, the situation may have been different as the creditor did not acquire possession so that appropriation would have been more difficult. Special sales provisions in the underlying agreement were then all the more appropriate and necessary. 213 The question when any other type of conditional sale is created in chattels rather than a mortgage was the subject of the early case of Beckett v Towers Assets Co [1891] 1 QB 1. One of the key elements appears to be that in the mortgage there is a duty to redeem for the mortgagee rather than some option to repurchase for the mortgagor under the conditions stated. Although the result may be the same upon the exercise of the option, the parties’ intention decides whether there is a registrable mortgage (bill of sale) or any other type of conditional sale. A similar borderline issue to be decided on the basis of intent may arise between the pledge when subject to constructive delivery only, and the (non-possessory) chattel mortgage as a bill of sale which requires registration: see Sewell v Burdick (1884) 10 AC 74. In fact, possession itself does not necessarily signify a pledge either, but could also be part of a chattel mortgage or an equitable charge. Again, it is the intention that is decisive, and it is not possible to be a pledgee, mortgagee and chargee at the same time: see Goode (n 203) 666. 214 See n 203 above. 215 See Goode (n 203) 578, 618.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 113 That English law makes this distinction is probably pragmatic and also eases the problems connected with the difference between charges and sales protection. It has been defined in a line of cases starting with Re George Inglefield Ltd216 and ending for the time being with the Court of Appeal’s decision in Welsh Development Agency Ltd v Export Finance Co (Exfinco).217 In this perception, a loan is a payment of money to a borrower upon terms that the sum advanced together with the agreed interest will be repaid, mostly at a date certain. It may be supported by security in the debtor’s assets. Bank loans and bank real-estate mortgages, but also overdrafts, credit card and similar arrangements, fall into this category of loan credit. Credit sales, on the other hand, involve payment deferment, which may take the form of a simple contractual concession, or it may be part of bigger schemes such as instalment sales or hire-purchases. Reservation of title arrangements are also likely to be in this class. There is normally no agreed interest rate structure, and therefore no loan proper. However, there may be a form of proprietary protection, as in the case of a reservation of title. The English courts have always considered both types of credit (loan and sales) as essentially different. Thus, legislation concerning lending (and usury) has never been applied to deferred payment arrangements, instalment sales, hire-purchases and reservation of title or other forms of purchase money arrangements and sales credit. This is also true for the application of the Bills of Sale Act 1854 and its successors. The natural progression from here is to conclude that only true loans can give rise to secured transactions proper with disposition duties and the return of overvalue to the debtor or to mortgage arrangements as conditional sales with the equity of redemption as the basic protection for lenders. These safeguards for the debtor do not apply to credit sales arrangements such as reservation of title, which are also conditional, or to deferred sales, as there is no loan credit. The next step is to accept that all conditional sales of assets for funding purposes (such as repurchase agreements and the sale-leaseback) do not have these safeguards for the conditional seller either, even those used to raise funding (as long as they do not have a loan structure, as no agreed interest rate is being applied to the original sale proceeds given to the conditional seller). Finance sales of this nature have other types of rewards, risks and attractions for the parties. They are not considered to be secured loans and do not give the person receiving the funding the normal secured loan benefits in terms of a return of any overvalue or an equity of redemption upon default. Rather, they lead to appropriation of full title by the conditional buyer, who is entitled to the overvalue as part of the deal if the price cannot be provided in time. Thus, deferred payment clauses may lead to property-based protection for the seller of the goods in deferred and conditional transfers of which hire-purchase and reservation of title could be considered prime examples. They do not normally lead to special protection for the defaulting debtor in terms of an execution sale and return of overvalue (or of redemption). Upon rescission of the underlying agreement because of default, the debtor would only have a personal action for the return of any instalment payments (after deduction of any claims for damages). The same applies to repurchase agreements and other types of conditional sales used to raise funding. Only in the mortgage, which, as explained above, developed in England as a conditional sale, is there a case for giving some special protection to the debtor, the reason being that there is normally a loan structure. It may then be more readily (and rightly) equated with and treated as

216 Re George Inglefield Ltd [1933] Ch 1. 217 Welsh Development Agency Ltd v Export Finance Co (Exfinco) BCC 270 (1992); see also F Oditah, ‘Financing Trade Credit; Welsh Development Agency v Exfinco’ [1992] Journal of Business Law 541.

114 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services a security or charge than the reservation of title,218 in which context the equity of redemption is appropriate. The differences in the treatment of the resulting protection, in terms of security or ownership-based devices, does not prevent parties making use of ownership-based (instead of security-based) funding, even in situations which may have greater similarity with the granting of a loan. It may in particular be used to avoid the limitations imposed on security-based funding, either by law or by contract. Thus, when under a floating charge, receivables may not be allowed to be pledged any further, they may still be sold subject to a reversion when a sufficient amount is collected under them by the financier/buyer of the receivables. It is the essence of factoring, which at least in such cases, is more properly considered a conditional sale. The law in England is not normally inclined to go behind the preference of the parties in this regard and re-characterise their arrangement. More generally, it will not deem a secured transaction, chattel mortgage, or similar secured arrangement to have been created instead, even if the clear intention may have been merely to avoid contractual restrictions or even registration under the Bills of Sale or Companies Acts.219 The choice is usually considered a matter of business judgment, at least when operating between professional parties, to be respected by the courts. Nothing else should be put in its place,220 although even then there are limits and mere shams are avoided.221 It follows that English law will commonly accept that selling property to raise funds, even if subject to a repurchasing right or duty, is in essence different from raising a loan on the security of the same assets. In the first case, there are likely to be fewer protections. Again, there is appropriation upon default without a possibility of redemption or other safeguards in terms of an execution sale and return of any overvalue to the seller. It results in another agreed balance of benefits, risks and costs, and the contract may elaborate on them without any dangers of re-characterisation of the structure as a secured loan situation. Only when there is an agreed interest reward (and not all types of other fees) besides the return of the principal is there by law also a return of any overvalue or an equity of redemption. In England, in the case of a foreclosure of this equity of redemption, the debtor is released if the assets have been reduced in market value in the meantime. It is the parties’ choice and financier’s risk. In more recent English case law, however, there is some evidence that for property-based protection not leading to the presumption of secured lending, or to a (registrable) bill of sale, or a company charge, the emphasis would have to be on the seller not retaining any proprietary interest in the property in terms of a reversion or any liability for the risks attached to owning the asset. In particular, the buyer would have to be able to sell on the goods and retain the profits for himself, even if the assets are not fungible. A similar approach is taken in the US.222 Thus, any automatic return of the (replacement) assets or of the payments received thereon (as in the case of shares or bonds) or any restrictions concerning on-sales would have to be separately agreed and construed. This would be necessary to avoid the sales being considered mere arrangements

218 See for the question when a reservation of title might be considered a charge, the text at n 234 below. 219 This is quite established law: see Olds Discount Co Ltd v John Playfair Ltd [1938] 3 All ER 275 and Chaw Yoong Hong v Choong Fah Rubber Manufactory [1962] AC 209. Discounting of bills of exchange is also not considered loan financing in England: see IRC v Rowntree and Co Ltd [1948] 1 All ER 482. See for the avoidance of registration duties, Re Watson (1890) 25 QBD 27 and Polsky v S&A Services [1951] 1 All ER 185, 1062. In England, the finance lease is not considered a conditional sale if there is no automatic transfer of title upon full performance of the lease agreement or an option to the effect at that time (without the payment of further consideration) and is then merely a bailment. In fact, if there is an automatic transfer, the finance lease is qualified as a conditional sale rather than a lease and if there is an option as a hire-purchase: see Goode (n 203) 721. 220 See Welsh Development Agency v Exfinco (n 217). 221 See Re George Inglefield Ltd (n 216). 222 See s 1.6.2 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 115 to curtail the equity of redemption or retain the overvalue, which would in truth suggest a chattel mortgage or charge.223 However, to look merely at the arrangements concerning the assets and their return does not appear to be in accordance with English law as it stands.224 The whole of the transaction needs to be considered. In this regard, it is fully accepted in England that a sale is not always a mercantile transaction but may be purely financial (as in the case of futures). Any reference to substance may mean a substance of a different sort.225 Funds can thus be raised by way of a sale of the underlying assets without borrowing proper. But a reverter plus an agreed interest rate structure as compensation is likely to be indicative of a loan agreement. The arrangement may then be viewed as a (registrable) mortgage or equitable charge, subject to the formalities concerning their creation and the protections of the debtor in terms of the equity of redemption or repayment of the overvalue.226 If, however, there is an agreed interest rate structure, it is submitted that a loan may be presumed (see section 1.1.6 above) and if a security exists, even if clad in the form of a conditional sale, it is then likely to be recharacterised as a mortgage or equitable charge subject to its formalities and protections. Finance leases, repurchase agreements and factoring of receivables are therefore not normally secured lending for lack of such an agreed interest rate structure. They are sales of assets, albeit conditional.227 Moreover, English law is not likely to deem an interest rate structure if one has not been clearly agreed. Importantly, other types of fees or charges are not automatically equated with it. 223 This was often considered the message from Re George Inglefield Ltd (n 216). 224 See for earlier case law, Alderson v White (1858) 2 De G & J 97, confirming that conditionality of ownership does not always imply a security interest or charge, even in the case of a mortgage: see for the sale and repurchase (option) also Manchester, Sheffield and Lincolnshire Railway Co v North Central Wagon Co (1888) 13 App Cas 554, and for the sale and repurchase duty, Lloyds & Scottish Finance Ltd v Cyril Lord Carpet Sales Ltd (1979) 129 NLJ 366. 225 Clough Mill Ltd v Martin [1985] 1 WLR 111. See earlier the House of Lords in McEntire v Crossley Brothers Ltd [1895] AC 457 in which, with regard to the whole agreement, it was decided that a leasing transaction was a sale and not a registrable charge under the Bill of Sales Act 1854. The use of the term ‘security’ is in this context not decisive, see Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142. 226 Automobile Association (Canterbury) Inc v Australasian Secured Deposits Ltd [1973] 1 NZLR 417. 227 See for a further discussion, Goode (n 203) 605ff and n 240 below. As far as the repurchase agreement of investment securities is concerned, also in England retrieval problems are in practice minimised through contractual netting clauses, the status of which in a bankruptcy of the buyer remained as elsewhere (see for Germany n 182 above and for the US the text at n 251 below) in some doubt however, as netting is accepted only if it does not give better rights under s 323(2) of the Insolvency Act 1986 or for company liquidation under Insolvency Rule 4.90 (1986); see further s 3.2 below and Carreras Rothman Ltd v Freeman Matthews Treasure Ltd [1985] 1 All ER 155 and also R Derham, ‘Set-off and Netting in the Liquidation of a Counterparty’ [1991] Journal of Business Law 463, 541, and further the paper of the British Bankers Association (BBA) of 13 August 1993 (Circular 93/56) on the validity of bilateral close-out and netting under English law. See also the guidance notice of the City of London Law Panel on Netting of Counterparty Exposure of 19 November 1993 (BBA Circular 93(82)), and further J Walter, ‘Close Out Netting in English Law: Comfort at Last’ [1995] Butterworths Journal of International Banking and Finance Law, 167ff. Lord Hoffmann retraced the set-off concept and the ipso facto (or automatic) nature of the set-off in bankruptcy in Stein v Blake [1995] 2 WLR 710; see also his earlier judgment in MS Fashions Ltd v BCCI [1993] Ch 425, and emphasised that in bankruptcy, the set-off does not require the trustee or creditor to invoke or exercise it. Proof by the creditor is not necessary. Cross-claims therefore are extinct as at the date of bankruptcy and there is by law only a net balance either way. Any supporting charges disappear at the same time as the bankruptcy set-off provides its own form of security. This type of set-off also includes future claims, claims certain or contingent, liquidated or not, payable or not. When future or contingent claims have become quantifiable since the bankruptcy, the amounts will be treated as having been due at the bankruptcy date, otherwise they are evaluated under rule 4.86 of the UK Insolvency Rules if the claim is against the bankrupt debtor. Contingent counterclaims on creditors are not so brought forward and are therefore outside the set-off. The result of the automatic set-off in these terms is that liquidators cannot cherrypick and keep claims outside a bankruptcy set-off.

116 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Finally, it may be of interest to look at the various types of registration and their impact in England. There are many registers,228 registration does not always mean the same thing, and each type may attract its own priority regime. Only in respect of bills of sale does non-registration lead to absolute nullity, even inter partes. In the other cases, the effect of registration, like that of the company (floating) charge,229 is mainly on the effectiveness of any subsequent outright sale or on the priorities, but as between various mortgagees and chargees registration may not even create the presumption of the absence of their bona fides.230

1.5.4. Reservation of Title It is also necessary to give some more attention to the modern development of the reservation of title in England. It was technically always possible as a delayed title transfer under section 19 of the Sale of Goods Act 1979, and under section 17 of its predecessor of 1893, in a system which in essence transfers title upon consent of the parties, but it was substantially introduced by case law in 1976.231 In this connection reference is now normally made to Romalpa clauses. As elsewhere, the defining line between charges has also been raised in this connection.232 It now seems well established that once title passes under an extended reservation of title to the buyer, who then re-transfers replacement rights in them to the seller, for example upon conversion of the asset into manufactured goods or upon a sale into the proceeds, this may result in an equitable charge, which as such needs registration in the Companies Register.233 Any agreed extension of the protection into proceeds is likely to be considered a registrable charge, also if interest in the proceeds is meant to end only when all outstanding debts have been paid or if the proceeds are insufficient to pay the claims and a claim for the balance remains.234 It is clear that such charges are not necessarily supporting loans but normally relate to sales credit, which introduces an element of confusion. 228 Goode (n 203) 649, refers to 11 different registers for different types of consensual mortgages and charges. The bills of sale register, the companies register, and the land register are the most important. See for the 2002 Law Commission proposals (Consultation Paper 164) n 200 above. They cover both floating charges and bills of sale. 229 See s 298 of the Companies Act 1986. 230 See also text following n 209 above. 231 Aluminium Industrie Vaassen BV v Romalpa Aluminium Ltd [1976] 2 All ER 552. Arguments against the effect of the reservation of title on the basis of reputed ownership of the buyer in possession subsided and are even less relevant in England after deletion of the concept in the Insolvency Act of 1986: see nn 112, 113 and 204 above. 232 Almost from the beginning, the Romalpa case gave rise to controversy as it also covered converted assets and proceeds. This requires specific stipulation, and is not considered automatic: see Borden (UK) Ltd v Scottish Timber [1979] 3 All ER 961, and would for its effectiveness have required registration under the Companies Act (s 395) if intended to attach to a multitude of unspecified goods so that it may become a floating charge, while this would also seem to be necessary if the (extended) reservation of title is meant to cover debt other than the sales credit: see the Irish case of Re Interview Ltd [1973] IR 382, except (probably) if it concerns identified assets in which title is reserved even in respect of sister-company debt. Any right to pursue the protection into the balances of the buyer’s accounts (upon a sale by him/her of the assets) is also problematic, but here the buyer is usually considered an agent or bailee of the seller, at least as long as s/he is under a duty to separate the proceeds and accepts a fiduciary duty in connection with their distribution; see also Chase Manhattan Bank v Israel British Bank [1979] 3 All ER 1025, although it has now also been held that this fiduciary relationship may itself be indicative of a charge: see Tatung (UK) Ltd v Galex Telesure Ltd (1989) 5 BCC 325, confirmed in Compaq Computer Ltd v The Abercorn Group Ltd (1991) BCC 484. If registration is required it will in principle be necessary in respect of each individual sale: see Independent Automatic Sales v Knowles & Foster [1962] 1 WLR 974. 233 See Clough Mill Ltd v Martin (n 225). 234 See n 229 above.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 117 The potentially accessory nature of the interest, with the automatic shift of the protection to any succeeding owner of the claim it supports and the automatic release of the asset upon payment of the sale price, does not appear to play a similar fundamental role in common law as it does in civil law in this connection. It is not commonly seen as an essential element or an indication of a security interest as distinguished from a conditional sale. In more recent case law, it may have played a role, however, in assuming a security interest if the accessory nature of the right was contractually introduced.235 Indeed it may also be so in the civil law of conditional sales and their operation then depends on the nature of the condition but such a contractually agreed accessory right may still not automatically render the arrangement a secured transaction. In common law, a more distinctive element appears to be the automatic shift of the protection of a security or at least of an equitable charge236 into replacement goods and proceeds. It does not normally happen in property-based funding where there seems to be a requirement of greater specificity of the asset and of the debt it supports, as there still is in the English chattel mortgage.237

1.5.5. Finance Sales The English approach is not always fully clear on where the modern finance sales such as repos, finance leases and receivable factoring can be placed. The simple fact is that English law does not aspire to a single coherent narrative in these matters. So far much has been said on conditional or finance sales, but only a little on the subject of repos and finance leases.238 235 See Compaq Computer Ltd v The Abercorn Group Ltd (n 232). See for the situation in the Netherlands, France and Germany respectively nn 79, 130 and 165 above. Instead of automaticity, common law appears to think more in terms of the creditor being able to transfer his/her security with his/her underlying advance or claim if, and only if, so agreed between the parties: see Goode (n 203) 642 and also n 28 above. 236 Equitable charges carry through to products and proceeds as a consequence of the equitable principle of tracing under which the chargee becomes the trustee for the chargor subject to the bona fide purchaser protection of the acquirer of the constructive trustee. If these replacement assets are subsequently commingled there is likely to be a form of co-ownership. The charge may be floating as to the replacement goods, but can be fixed as to the proceeds if kept separate: see Goode (n 203) 618 and 696ff. 237 See n 203 above for the chattel mortgage in the personal sphere. It raises principally the question of the inclusion of future assets. As at law for its effectiveness the mortgage required transfer of ownership and the pledge transfer of possession, there was obviously a problem with security in future assets or after-acquired property as a mere agreement to create these instruments was not sufficient to give effect to their operation and the emergence of the property in the hands of the mortgagor or chargor did not automatically extend the mortgage or charge to this property as some new disposition appeared necessary. Only equity could achieve the desired result as long as consideration had been paid and was not merely promised: Rogers v Challis (1859) 27 Beav. 175. For the validity of these charges, it is not necessary for the property to be exactly described as long as it is identifiable, and they may cover classes of assets: Re Kelcey [1899] 2 Ch 530 and Syrett v Egerton [1957] 3 All ER 331. These equitable charges are not dependent on transfer of ownership or possession either. They cannot attach, however, before the asset is acquired by the chargor but the attachment is then automatic: Holroyd v Marshal (1862) 10 HL Cas 191. In this connection, property (or income) accruing under existing contracts is considered present: see G&E Earle Ltd v Hemsworth RDC (1928) 140 LT 69. On the other hand, a security cannot attach before the related advance is made and attachment will cease when the advance plus interest is paid off. Here again the notion of accessory right comes in. Whether or not the priority relates back to the original agreement or each advance thereunder is an important, albeit moot, point under English law: see Goode (n 203) 635 and is in the case of floating charges dependent on crystallisation into a fixed charge, usually upon a default, see n 205 above. Existing requirements of the mortgage and the pledge in terms of ownership and possession were not so diluted, although the notion of constructive possession was helpful in the case of the pledge even at law: see n 207 above. Thus, the Bill of Sales Act 1854 requires specificity (1882 Amendment, s 4) and conditional transfers of ownership as under a reservation of title are equally limited; anything more would create at best a registrable charge: see text at n 233 above. 238 See respectively nn 224 and 219 above.

118 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services How they fit in English law, as outlined above, is hardly ever discussed in any detail, English law by its very nature not being preoccupied with system thinking.239 It would appear, however, that the conditionality of the ownership in these finance sales would not present a basic problem under English law, and that there is no great threat that finance sales could be equated with secured transactions as a consequence. It is equity, but what the effects are in a bankruptcy of either party remains little discussed. At least in repos there is reliance on contractual close-out 239 As far as the finance lease and repo are concerned, there are no leading treatises and these structures are more likely to be discussed from an accounting and a tax perspective: see for finance leasing D Wainman, Leasing (London, 1991), who sees leasing as a contract of bailment, therefore recognising at least the protections of possession and use by the lessee, but the legal aspects are further largely ignored. In English law, a distinction is often made between hire contracts, hire-purchases and conditional sales. A conditional sale in this narrower sense is then usually confined to reservation of title, therefore to sales credit protection under which title is often thought to remain with the seller until the purchase price has been paid. In this approach, it differs from the hire-purchase in that the hire-purchaser has an option and not an obligation to buy: see Helby v Matthews [1895] AC 471. A finance lease is then more properly seen as a bailment under which the lessee has the enjoyment and use of the asset but is distinguished from the conditional sale and the hire-purchase in that the lessee has neither option nor obligation to purchase the goods, but must return them to the lessor when the bailment ends: see also Goode (n 203) 721. The limited nature of the lessee’s rights may derive from the wish to avoid a hire-purchase situation to which all kinds of mandatory rules would apply for the protection of the hirer. It is not possible to discuss at length here the concept of possession in common law—see more particularly Vol 4, s 1.3.2, and s. 1.5.2 above, but it implies the protection of the holder/user of assets, who has a much more independent position than the holder under civil law and can defend it, if necessary even in a bankruptcy of the possessor. In fact, it is the bailor who may have real difficulty in retrieving the asset in a bankruptcy of the bailee. As a consequence, in a bankruptcy of both the bailor and bailee, the creditors of the bailee may prove stronger than the creditors of the bailor. It is not ownership that is necessarily decisive here as would be the civil law attitude. Thus, there is a form of proprietary protection (in civil law terms) for the bailee. Even under a reservation of title, the position of the seller in a bankruptcy of the buyer in possession may for these reasons remain unclear, although it has been suggested that exceptionally full title here revests automatically in the seller who retains a reclaiming right: see Goode (n 203) 391; see also Vol 4, n 110, and for the US before the UCC n 278 below, but see also G Lightman and G Moss, The Law of Receivers of Companies (London, 1986) 140, who observe that even upon a reservation of title, once the seller has parted with possession, s/he normally has no satisfactory statutory remedy if the buyer becomes insolvent and defaults. Goode (n 203) 390, while suggesting that, exceptionally in the case of the sale of goods upon rescission of the contract for reasons of default, the title re-vests in the seller (although not retrospectively), accepts that the effect in bankruptcy of the buyer in possession remains unclear. As between the bailee and a stranger, possession is considered title, and this is not then a limited interest but absolute and complete: see The Winkfield [1900–03] All ER 346. It is therefore said that both bailor and bailee have title at the same time: the title of the bailor is indefeasible, but difficult to defend against third parties; the title of the bailee is relative, but may be defended by an action of the bailee. Again, it suggests a strong position of the bailee even in his/her bankruptcy unless under the terms of the bailment it comes to an end upon insolvency. It is considered an original right and action and not a sub-right; it is only reduced by the bailee’s duties towards the bailor, which are mainly contractual. When it comes to the return of the property, more generally, the courts assume considerable discretion in the case of chattels as it is seen as a form of specific relief normally giving the (wrongful) possessor the option to pay damages instead. True revindication rights exist under common law only in the case of real estate. Hire purchasers, lessees, pledgees and possessors under a conditional title transfer are all bailees in this sense and in a strong position, especially since possession was voluntarily transferred by the owner. Again, it should be emphasised that common law does not maintain a coordinated or integrated concept of title and possession or ownership and bailment. They stand side by side and cannot easily be reduced to each other as in the civil law approach. It creates problems in a bankruptcy of a bailee, and this may also affect repos which then become dependent on a netting mechanism between parties who have mutual repos positions as may be the case between the major banks, see s 4.2.5 below. See for factoring of receivables, FR Salinger et al, Salinger on Factoring: The Law and Practice of Invoice Financing, 3rd edn (London, 1999), who emphasise the practical aspects of factoring. See for a legal analysis of receivables financing more generally, F Oditah, Legal Aspects of Receivables Financing (London, 1995). Under English law, factoring implies a sale of the receivables to the factor, subject to certain defined classes of receivables being returned under certain circumstances: see Goode (n 203) 746. Whether this return is automatic also in a bankruptcy of the factor remains undiscussed. See further the discussion in s 2.3.2 below.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 119 netting under standard repo documentation, which in England is the Global Master Repurchase Agreement. It may well be that lending of investment securities is different here and that the proprietary issues are more likely to surface in that context: see also the discussion in section 4.2 below. In all these finance sales a proprietary or at least possessory element in the structure seems to be assumed, which tends to be protected. It appears that if the arrangement is only contractual there is no finance lease, repo or factoring proper.240 As the duality of ownership is no great common law problem, it may be that no greater fundamental discussion is required, but also in English law it leaves the relationship between both parties (and their creditors, especially in bankruptcy) in some doubt. In the case of chattels, the law of bailment is also relevant and likely to provide further guidance, but also complicates (as mentioned in note 239 above). United States law also shows that there remain uncertainties here: see especially section 2.1.3 below.

1.6. The Situation in the US 1.6.1. Introduction: Article 9 UCC and its Unitary Functional Approach In the US, Article 9 UCC, which is with minor adjustments accepted in all States, operates a unitary system of security interests in chattels and intangible assets. Unlike in England,241 there is no fundamental difference between loan and sales credit and the UCC notably converts reservations of title, conditional sales, trust deeds substituting securities, and assignments of receivables (other than for collection purposes) into security interests and treats them all the same: see sections 1-201(35) and 9-109(a) UCC (originally 9-102(1)(a) and (2), which expressed the principle more clearly).242 It means that all arrangements backed up by tangible assets ‘supporting payment or the performance of an obligation’ create security interests. In principle, this is also the case with finance leases and repos, whilst the backing up by intangible claims always assumes such a purpose (usually funding) unless true sales are intended, which is relevant especially in securitisations and receivable financing for which there are now some special provisions in sections 9-318 and 9-607/8. This means that in this unitary functional approach all these arrangements are subject to the formalities of Article 9, especially in terms of documentation and filing to achieve their perfection, which establishes the priority, as distinguished from mere attachment, which creates the immediate effect (assuming there is a sufficient interest of the debtor in the assets given as security): sections 9-201 and 9-203. The key notion of perfection usually depends on both proper attachment and filing (although there is no such filing requirement in respect of possessory security, non-possessory security in consumer goods, and incidental assignments of receivables. In these cases, the perfection is automatic upon attachment: see sections 9-309 and 9-310 UCC). Otherwise, attachment without proper perfection will result in a low priority (just above the common creditors), although still according to time within this class of secured creditors. 240 See for a fuller description of factoring in this connection s 2.3 below. 241 See n 217 above. 242 The idea is that parties may agree whatever they like, but if their relationship may be characterised as a secured transaction, the pertinent sections of Article 9 will apply: see further also s 9-202 (new and old), which shows a similar indifference as to whether title is put in the secured party or in the debtor under the scheme. In this respect Article 9 appears mandatory: see also s 9-601.

120 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services The conversion of conditional sales, including reservations of title, into security interests deviates from the common law approach in England, as we have seen. It results from the professed unitary approach of Article 9 UCC in which a security interest means any interest in personal property or fixtures which secures payment or performance of an obligation.243 Substance prevails here over form and all contractual creditor protection involving personal property is covered regardless of the type of indebtedness, such as loan or sales credit, or other types of funding by way of conditional sale or assignment. One important aspect of this is the already mentioned application of the attachment and perfection regime to all. In addition, section 9-601 protects this approach by compulsorily requiring (generally) disposal of the affected assets in the case of default and the turning over of any surplus proceeds to the debtor, although there is now greater flexibility but only in the case of intangible monetary claims when used in securitisations or receivable financing (sections 9-607/8) when proper sales are intended. Another dominant feature of the secured transaction regime of Article 9 UCC is the advance filing facility.244 Under the filing requirement, an early finance statement can be filed against a debtor. The security will relate back to that date, even if the loan is given later, and its ranking or perfection will date from the original filing date: see sections 9-308(a) and 9-322. It was done to give negotiating parties time without fear of an intervening other filing. The debtor can withdraw the filing at any time before attachment. No less important in this connection is that all the debtor has or shall have (except future consumables: see section 9-204(b)) may be given as security (see section 9-204(a)), even in respect of later debt (see section 9-204 (c)). Again, the priority will date back to the date of the filing, even though since 1999 the clause cannot be too generic in the description of the included assets. This is the basic ethos of Article 9. It naturally gives money lenders a strong position, even if in modern times there are certain consumer protections through the Federal Trade Commission Unfair Credit Practices Regulations: 16 CFR sections 444.1(i) and 444.2. They concern especially wage assignments or non-possessory security interests in household goods (which are narrowly defined) other than purchase money security interests. For professionals in particular, much depends on the description of the collateral in the securities agreement and on its type. There are here no strict identification requirements (section 9-203(b)(3)(A), cf section 2-105 for the sale of goods, which is stricter (insisting on existence and identification, which may still have some relevance in this connection in the case of finance sales, although section 9-108 accepts any description as specific if it reasonably identifies what is described).245 As to types of assets, the UCC distinguishes primarily between equipment, inventory and accounts (or receivables). An important aspect of this distinction is that floating charges in inventory and accounts are presumed in the filing (finance statement) of security interests in these types of assets but not in equipment. There are further differences between these various classes of assets in the perfection method (sections 9-308ff), in the priorities (sections 9-324ff), in the manner of enforcement (sections 9-607 and 9-608), and in the disposition upon a default (section 9-609). In fact, one of the principles of the UCC remains that everything can be varied by agreement (see section 1-302) except as otherwise provided by the Code. That also applies to Article 9, but as

243 See s 1-201(a)(35). 244 See for a critique of the US filing requirement, Vol 4, s 1.7.8, n 385 and for English proposals to follow this approach n 205 above. 245 See for third-party rights in assets left with the debtor, Vol 4, s 1.7.7, n 384

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 121 just mentioned, notably priority rights of third parties cannot be challenged (see section 9-317) and the disposition provisions upon default cannot be varied either (except as to manner if not manifestly unreasonable: section 9-603) but there is more leeway in the case of a sale of receivables or bank loans. The obligation of good faith and reasonable care of section 1-304 also stands, but is subject to interpretation (see below). Special debtor protection statutes must of course also be respected, especially relevant for consumer debtors Article 9 has as a key policy the facility to include future assets to cover future advances with the priority relating back to the filing of the relevant financing statement (section 9-204). It is still subject to the requirement of section 9-203 of ownership or sufficient control, which may be assumed unless better interests exist, relevant especially in respect of replacement assets, and is accompanied by the facility of the security interest liberally shifting into replacement and commingled assets and into proceeds (sections 9-315 and 9-336). Since 1972 in most States, this now happens even without a special clause to the effect in the agreement (section 9-315(a)) in respect of inventory and receivables, as we have seen. The result is an accommodating stance in respect of floating liens or charges in which regard the UCC was truly revolutionary, certainly from a comparative law point of view. It is balanced by a strong protection for buyers of the secured assets. They are protected even if they are aware of the charge assuming that the goods are sold in the ordinary course of the debtor’s business. They must therefore come out of inventory (section 9-320(a)), but the buyer remains unprotected if s/he knew of any resale restrictions in the security agreement (see section 1-201(9), which maintains a good faith requirement in this aspect only. The bona fide consumer buyer of consumables is more specifically protected under section 9-320(b). The good faith requirement is here purely subjective (the ‘empty head, pure heart’ test). The protection of bona fide buyers under section 9-320 does not seem to depend on actual possession of the goods, but does not apply to pledgees or chargees (even though they are also purchasers under section 1-201(29) but not buyers under sections 9-320 and 9-323). Bona fide security holders with possession are protected against older perfected interests only in the case of chattel paper (which under section 9-102(a)(11) means documented secured claims or lease income, used as collateral) and negotiable (or semi-negotiable) instruments: see section 9-330. As regards the priorities, sections 9-102(a)(52), 9-317, 9-322, 9-323 and 9-324 give the ranking for attached and perfected security interests respectively. The first are vulnerable especially to older statutory (especially tax) and all perfected liens. It was already said that they rank just above the unsecured creditors (see sections 9-102(a)(52), 9-317 and 9-323, but are in a bankruptcy even pushed down to that level by the statutory lien of the trustee under the so-called strongarm statute of section 544 of the Bankruptcy Code. For perfected security interests, the essence is first in time (of filing or perfection, whichever is first), first in right (section 9-322(d)) except for purchase money security and some other special situations. That is also the rule for attached security interests amongst each other. The emphasis on filing rather than on perfection in this connection allows for the advance filing facility and the relation back of the priority to that date for filed security interests. By including a proper after-acquired property clause, it eliminates the need for further security agreements (which would still relate back to their date of filing) or filings. Although none can perfect before attachment (section 9-308 (9-303 old)), which itself normally requires a document, the existence of the collateral, a sufficient right or control of the debtor therein, and the giving of value (section 9-203), this does not undermine the ranking in the case of filing (assuming it properly mentions the collateral). Filing may thus also be relevant in respect of securities that are ordinarily perfected through delivery of possession and allows in that case for the relation back.

122 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services Few security interests only perfect by taking possession. Examples are security interests in money or instruments.246 Another question is whether the secured creditors take subject to unknown third-party rights in this type of collateral. Above it was said that they do not have the bona fide buyer protection, but, except in the case of pure bailment and equipment leases, the creditor secured on these assets may ignore such interests unknown to him; that is the ordinary rule in respect of equitable interests or the risk of third parties that leave their assets in the possession of others. The debtor only needs to have a sufficient interest (section 9-203(b) (2)), whilst after-acquired property may be specifically included or results automatically in floating charges, as we have seen. It should be noted in this connection that filing of a security interest itself does not guarantee anything: it does not mean that the collateral exists or that there are no hidden proprietary rights in it (such as bailors’ and equipment lessors’ rights). The filing statement itself may be incomplete. In any event bona fide purchasers or purchasers in the ordinary course of business do not need to worry about any filings, have no investigation or search duty and may ignore the charge. In fact, the filing guarantees nothing and is only meant to warn subsequent lenders, who would in any event make their own investigation of the debtor’s financial commitments as a matter of due diligence.247 It is a relatively expensive warning system, which in many countries is found to be unnecessary and was not originally foreseen in Article 9 either. Its main merit is establishing the date, and therefore (normally) the rank of the security interest but this could also have been achieved through a (non-public) registration system at a fraction of the cost. It is clear that this type of filing system only serves to make the life of banks a little easier. It was the price for their support of Article 9 when it was first proposed. It may also help main suppliers and all other professionals who may have a search duty but again does not affect the general public in respect of commoditised products. It has already been mentioned that the provisions of all security agreements under Article 9 are subject to good faith requirements (section 1-304) and may not become unduly oppressive in themselves or in their enforcement. This is similar to the gute Sitten effect of German law: see section 1.4.4 above. The good faith adjustment under the UCC has been used, especially to subordinate priorities created by filing creditors aware of competing unperfected interests and gaining an advantage in the race for perfection.248 This subordination facility sometimes assumed by the 246 An important instance where perfection rather than filing remains relevant is also in the priority over judicial lien creditors under s 9-317(a)(2) (s 9-301(1)(b) old). This was changed in the 1999 Revision effective in 2001. It is also relevant for the lien of the bankruptcy trustee under s 544 of the Bankruptcy Code. Even though federal, it will not affect the all-important federal tax lien under ss 6321ff of the Federal Tax Lien Statute (FTLS), which is generally interpreted as a judicial lien but has its own federal regime and definition of security interests that is considered to take precedence over the s 544 lien. It adopts in this connection much of the attachment language of s 9-203(1)(a) old (now 9-203(b)) as a condition for priority (see s 6323(h)(1) FTLS). 247 See for a broader discussion of this aspect of publicity, Vol 4, ss 1.7.7–1.7.8. 248 See for Germany n 187 above. See in the US for a rare case, General Ins Co v Lowry, 412 F Supp 12 (1976), in which a lawyer charged with the delivery of shares to perfect a security interest in them for a third party retained them while later creating his/her own security interest in these shares through perfection based on his/her possession. We are interested here in equitable relief in narrowly defined circumstances. The impact of good faith notions in this area remains contested. It has long been held that ‘in commercial transactions it does not in the end promote justice to seek strained interpretations in aid of those who do not protect themselves’: see Judge Learned Hand in James Baird Co v Gimbel Bros, Inc, 64 F 2d 344, 46 (1933); see also Judge Easterbrook in Kham & Nate’s Shoes No 2 v First Bank of Whiting, 908 F 2d 1351 (1990), denying any ‘general duty of kindness’ in lender/borrower relationships or, one must assume, between secured lenders inter se. Article 9 tends to be neutral in these matters, but in the interpretation of the UCC it cannot be avoided that its good faith notion is tested. Section 9-401(2) (old) presented a statutory example allowing a wrong filing made in good faith to be upheld against anyone who has knowledge of it. In view of the simplified filing requirements, this provision was deleted in the 1999 Revision.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 123 courts has been criticised. In bankruptcy, section 510 of the US Bankruptcy Code supports the principle of equitable subordination, but this is usually limited to special situations, for example where sole shareholders are managing their company and claim back their loans ahead of other creditors. On the other hand, the Bankruptcy Code may affect perfected security interests more fundamentally, especially through the stay provision, the possibility of immediate removal of excess collateral, the precedence of the estate over unperfected liens, and the cram down in a reorganisation: see also section 1.1.4 above.

1.6.2. The Unitary Functional Approach and Finance Sales: Problem Areas in Article 9 UCC It follows from the US unitary functional approach that conditional and similar contractually created ownership interests or finance sales are automatically converted into secured interests at least if supporting payment or the performance of an obligation, which is a matter of interpretation. One of the consequences is that if the interest is not filed, it will be reduced in rank to just above that of the common creditors and in bankruptcy to their level as an attached but unperfected security interest, as we have seen. Other consequences are that upon default a disposition with a return of overvalue to the debtor must (in principle) follow. Moreover, in the latter’s bankruptcy, there will be a stay while the security interest may be further curtailed and overvalue removed. In practice, however, it will still be necessary to decide whether a conditional interest of this sort is meant to ‘secure payment or performance’ or has a different purpose, even if in assignments of receivables funding is commonly assumed. In the version of 1999, section 9-318 tried to bring some clarity by making clear that a sale means that no legal or equitable interest is maintained, but it does not say when this is so, in other words ‘when is a sale a sale’? Borderline issues arise in the functional approach, notwithstanding its search for economic realities. Lines must still be drawn, although this is mostly left to case law and therefore to the facts of each case. Apparently, no great need has arisen to test the borderlines except for leasing,249 where a new Article 2A was eventually introduced into the UCC to make some distinctions. However, the legal status of investment securities repos has attracted attention. There seems to be a fairly general consensus that they are not affected by Article 9 and they are not usually treated in that manner. This is significant, as it shows not only that the functional approach of Article 9 in its generality proved untenable but also that it is not necessarily all-embracing in practice, especially not in respect of repos. The issue of a sale or a secured transaction has also arisen in securitisations where an income stream is used to raise new funding. If the buyer/financier (usually a special purpose vehicle or SPV, created to function as assignee) is guaranteed a certain return by the seller, with a possible return of non-performing assets, a danger exists that the sale will not be considered complete and the transaction will be re-characterised as a loan arrangement secured by the income stream: see for this danger more in particular section 2.5.7 below. There may also be issues in receivable financing. To elaborate, in leasing the transaction may be characterised as a sale under Article 2, therefore as ‘the passing of title from the seller to the buyer for a price’; as an equipment lease under Article 2A, therefore as ‘the right to possession and use of goods for a term in return for

249 The difference between finance leases and security interests is considered one of the most frequently litigated issues under the entire UCC: see J White and R Summers, Uniform Commercial Code, 4th edn (St Paul, MN, 1996) 719.

124 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services consideration’; or still as a security interest in the above terms.250 It could also be considered a common law lease or simply a contractual arrangement. Terminology is not decisive and there is nothing in the word ‘lease’ itself to determine the characterisation issue. Although a conditional sale or defeasible title may no longer be an option, and while there may not be a leasehold or a term of years nor any other (equitable) rights in personal property or a trusts structure either, there will still be a bailment. Equally, a repurchase agreement, especially of investment securities, may be defined as a sale, a loan or, depending on the arrangement, as a secured transaction, although as already observed, the latter characterisation now appears less common.251 It could also be considered a mere contractual arrangement, but that would not explain the disposition rights of the repo buyer. A similar qualification problem affects receivable financing or factoring in the US, which may be a sale or a secured loan, even if not merely for collection purposes, which the Code itself excludes from Article 9.252 250 See respectively ss 2-106(1), 2A-103 and 9-109(a)(5). Article 2A dates from 1987 and is now introduced in most States. The terminology remains confusing. Article 2A distinguishes between consumer leases, which are mere rental agreements, and finance leases, which are equipment leases for much longer periods in which the lessee normally negotiates with the supplier directly and receives collateral rights under this agreement even though ultimately concluded with a lessor/financier. The line with Article 9 leases/secured transactions remains thin. In this book the term ‘finance lease’ is used as a more generic term for all leases that include a financing element, whether or not subsequently characterised as a secured transaction or a conditional sale under applicable law. 251 See Cohen v Army Moral Support Fund (In re Bevill, Breslett and Schulman Asset Management Corp) 67 BR 557 (1986) and In the matter of Bevill, Breslett and Schulman Asset Management Corporation and SS Cohen v The Savings Building and Loan Co, USCA 3rd Cir, 896 Fed Rep 2d, 54 (1990). In these cases intention was considered decisive as to whether there was a security agreement or a sale and repurchase: see also Jonas v Farmers Bros Co (In re Comark) 145 BR 47, 53 (9th Cir, 1992), but the fungibility of the underlying assets was believed to have an undermining effect on proprietary claims, although it seems that if the assets are with a depository who will provide replacement goods, the fungibility issue may be less urgent. All now translates into entitlements, which could be shared or conditional. See for the new model for transfer and pledging of such securities and the priorities of owners and pledgees in them, Art 8 UCC 1994 Revision: Vol 4, s 3.1.4 and also s 4.1.3 below. However, case law may sometimes still be construed to be more generally adverse to true repurchase agreements: see LombardWall Inc v Columbus Bank & Trust Co, No 82-B-11556 Bankr. SDNY 16 Sept 1982; cf also In re Lombard-Wall 23 BR 165 (1982), which characterised repos as secured loans and led to the 1984 Bankruptcy Code amendments, see n 266 below. See more recently still the US Supreme Court in Nebraska Dept of Revenue v Loewenstein 115 SCt 557 (1994), holding the same, but expressly limiting this finding to taxation matters. It did not mean to interpret ‘the Securities Exchange Act of 1934, the Bankruptcy Code or any other body of law’. It is often thought that the 1982, 1984, 1990 and 2005 amendments to the Bankruptcy Code especially dealing with repos in government and other securities (ss 101(47), 741(7), 101(49), 555 and 559–62) and exempting the netting of these transactions from the stay provisions now indicate a different approach to repos whilst taking them outside Art 9 UCC. It is generally agreed in the US that the characterisation of repos as a secured transaction would be disastrous. It would lead to dispositions upon default and perhaps even to filing needs at the time of creation in view of the fungible nature of investment securities, and therefore the tenuous nature of the possession by the financier. There would also be the danger of a stay and adjustment of the security: see MA Spielman, ‘Whole Loan Repurchase Agreement’ (1994) 4 Commercial Law Journal 476 and JL Schroeder, ‘Repo Madness: The Characterisation of Repurchase Agreements under the Bankruptcy Code and the UCC’ (1996) 46 Syracuse Law Review 999. However, where the repo price is clearly expressed in terms of the original purchase price plus an agreed interest rate, the repurchase seems to be re-characterised as a secured loan, also in the US. It is submitted that that is correct and certainly in line with the approach of this book. 252 Section 9-109(d)(5). See G Gilmore, Security Interests in Personal Property (Boston, MA, 1965) ss 2.2–2.5 and 11.6–11.7, describing the philosophy behind the new rules concerning assignment of accounts in Article 9. Floating liens in them had historically met with much resistance culminating in the decision of the US Supreme Court in Benedict v Ratner 268 US 353 (1925) in which the court struck down the assignment of present and future receivables as a fraudulent conveyance in view of the unfettered dominion and control of the assignor over the collateral and proceeds. The result was simply the imposition of more expensive formalities on the ongoing

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 125 Except for mere collection or a single assignment, section 9-109(a)(3) no longer makes any distinction and covers all assignments of accounts for whatever purpose, funding is therefore always assumed, although the consequences in the filing requirement (section 9-309(2)) and the disposition regime (section 9-607(c)) are alleviated. Filing is necessary only if a significant part of the debt portfolio is sold. Upon default, the assignee/ financier has the choice of collecting or of selling the portfolio to a collection agent. If there was a security agreement, overvalue must be returned, but if there was an outright sale of receivables to the financier, overvalue is returned only when the agreement so provides. As already mentioned, the use of SPVs in securitisation may also have to be considered in this context, as may the effect of any ring-fencing and credit enhancement agreements, which are not normally considered by Article 9 either: see also section 2.5.1 below.253 Where there is a finance sale rather than a secured transaction, it is likely to be conditional so that not all interests are transferred, and there may still not be a sale in the sense of section 9-318. It is nevertheless an example of the typical common law tolerance towards splitting the ownership in ways that the parties desire. But, as in other common law countries, in the US it still poses the questions of: (a) the type of proprietary interest of either party and its protection as well as that of those who acquire rights in the assets from either of them, problem areas not explicitly considered in Article 2 UCC,254 and (b) the borderline with secured transactions. financing of accounts (and inventory), leading to daily remittances of all receivables and collections received even though they were immediately returned to the debtor to keep him/her funded. Many State laws tried to overcome the inconvenience: see also the Official Comment on s 9-205 UCC (new and old). It is still the situation in many European countries. Art 9 UCC effectively repealed Benedict by introducing s 9-204 (new and old). But Article 9 goes further and brings all assignments of receivables within its reach, as will be discussed shortly below. 253 The guaranteeing of a certain income level by the seller independent from the yield of the underlying financial assets constituting the income stream must be considered a serious danger to securitisation and may convert the sale of the investment stream to the SPV into a secured loan. This is different from guaranteeing the existence of the income stream itself. It is submitted that also in the US this danger is the greatest if a certain interest income is guaranteed in this manner: see the early case of Home Bond Co v McChesney 239 US 568 (1916) and also Gilmore (n 252) 47ff. Others refer to an economic return, which may have to be measured, however, in similar terms: see PV Pantaleo, HS Edelman, FL Feldkamp, J Kravitt, W McNeill, TE Plank, KP Morrison, SL Schwarcz, P Shupack and B Zaretsky, ‘Rethinking the Role of Recourse in the Sale of Financial Assets’ (1996) 52 The Business Lawyer 159. A similar danger may exist in factoring and securitisations where any overvalue beyond a certain agreed amount of collections must be returned, especially when that amount is the sale price plus an agreed interest rate on it: see In re Grand Union Co 219 F 353 (1914), but the return of uncollectable receivables at their face value was not sufficient to convert the sale into a secured loan: Chase & Baker Co v National Trust & Credit Co 215 F 633 (1914). This is still good law after the emergence of the UCC, and shows that not all forms of receivables factoring are secured transactions, but modern case law suggests that the level of risk that remains with the seller is the determining factor and not so much the guaranteeing of a certain collection plus interest: see Major’s Furniture Mart Inc v Castle Credit Corp 602 F 2d 538 (1979). This leads to unnecessary uncertainty and has rightly been criticised: see Pantaleo et al, above, where courts require that the risk of loss of the asset must be with the buyer, as in Re Executive Growth Investment Inc 40 BR 417 (1984). In a bankruptcy of the seller, the buyer (SPV) may then find that it is only a secured creditor whose collection rights may be stayed under s 362 of the US Bankruptcy Code while the seller may retain any current collections under s 363 and the security may even be diluted under s 364 (in the latter two cases always subject to adequate protection of the buyer, however). This is always assuming that the buyer has properly filed the security interest. Without it s/he may have at best a position just above the unsecured creditors but below all others as his/her interest is attached but not perfected: see s 9-322(a)(3) (9-312(5)(b) old) UCC. 254 In this connection, it should be noted that Art 9 UCC made the equitable interests or charges statutory and therefore also the inherent protection of bona fide purchasers against these interests if undisclosed, which required

126 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services It is clear that there may still be conditional sales or perhaps even reservations of title which may not be secured transactions under the Code, such as where the conditions are not financial at all. Yet not all financial conditions would make the conditional sale a secured transaction either. It all depends on the facts,255 in which the intention of the parties may also figure.256 Article 9 especially in its latest 1999 version has a tendency to buckle under its own sophistication, but there is conceptual confusion all the same. The uncertainty it leaves under its unitary functional approach in respect of major financial instruments like leases and repos was signalled as one aspect. No less curious in this respect is the treatment of assignments of accounts or receivables. To repeat, all these assignments are covered by Article 9, whatever their purpose (unless collection or if it concerns a single assignment). Thus, an outright assignment of claims (rather than a security assignment) of the type covered by Article 9 is also governed by it, as we have seen. It is said in the Official Comment to section 9-109(a)(3) that a sale of accounts is often so conducted that the distinction between a security transfer and a sale is blurred. Exceptions are made in some instances only when there is clearly no financing motive, as in the case of a collection agreement, or when the assignment is part of the sale of a business, or when a payment right is assigned to someone who will perform the major obligation under the contract, or when the assignment is meant as payment for a pre-existing debt: section 9-109(d)(7). In the case of other assignments of receivables (or accounts) covered by Article 9, the difference from a security assignment may, however, also still be recognised, especially in the assignment of bank loans as part of securitisations, a term not used in the UCC. As noted, in such cases there need be no disposition and return of overvalue under sections 9-607 and 9-608 if the assignment does not secure indebtedness. Still, the collection rights are determined by perfection through filing (except if they are incidental when perfection may be automatic: section 9-309(2)) and not on the basis of the bona fides of the collecting assignee, which is otherwise the more normal rule in the US: see Volume 4, section 1.5.9. Notice to the debtor is not a requirement for the validity of the assignment (or the attachment of the transfer), and the assignment of receivables becomes immediately effective in respect of third parties, even in States that otherwise require notice to the debtor. It follows from section 9-201 UCC. To introduce some uniform rules here is undoubtedly useful—and especially the abolition of the notice requirement for the validity of the assignments in some States promotes bulk assignments greatly—but to bring all assignments of receivables under Article 9 in this manner is an unusual departure; the ordinary sale of chattels could never be so treated. It brings all forms of receivable financing or factoring within the ambit of Article 9 (assuming they cover account receivable, chattel or realty paper, which are financial obligations insured by security interests in personal or real property) unless again it can be demonstrated that there was no financial motive at all in the terms of section 9-109(d)(5) (as in pure collections). Other areas where Article 9 in its elaboration may become problematic concern the very refined system of collateral distinctions, the coverage of the security interests, the identification requirements in the security agreement and (to a lesser extent) finance statement, and the meaning the reformulation of the approach to the nemo dat rule, a subject beyond the scope of this Volume: see, however, Vol 4, ss 1.4.8–1.4.9. It has led to a liberal approach which allows bona fide purchasers in sales between consumers the full protection and even non-bona fide purchasers of all goods except farm products if they are sold in the ordinary course of business of the party requiring the funding: see s 9-320 UCC. As under the old equity approach, the free flow of assets is thus normally not to be hindered by security interests of this nature. 255 See for the emphasis on the facts of the case in particular in connection with leases: ss 1-201(a)(35) and 1-203. 256 See White and Summers (n 249) 725 and the Official Comment to s 9-109. The original text of s 1-201(a)(35) (1-201(37) old) cryptically stated that ‘whether a lease is intended as security is to be determined by the facts of each case’.

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 127 of filing and the details thereof. As to the collateral distinctions for chattels, in section 9-102(44) a distinction is made between consumer goods, farm products, inventory, and equipment, and for intangibles in sections 9-102 and 9-102(2)(42) between chattel paper (which embodies secured claims or lease payments), instruments, accounts, and general intangibles. Other classes are documents and, in the 1999 Revisions, also commercial tort claims, deposit accounts, and letters of credit benefits. Different treatment may arise especially in the area of perfection and priority of a security interest in these different types of collateral, which, as is the case everywhere else, however, always comes down to possessory and non-possessory security. The distinctions in this connection may seem overly elaborate, while overlap and the attendant confusion cannot always be avoided. As regards the coverage of the security interests, they may under section 9-203(1)(c) include all collateral in which the debtor has rights. These rights may be only contractual, conditional or temporary. While it is clear that mere possession of the collateral by the debtor is not sufficient, anything more in terms of disposition rights could be given as security. It suggests a protection for any lien creditor in respect of any type of value in the debtor’s possession, at least if the lien creditor is unaware of the earlier interests of others (is therefore a bona fide purchaser regardless of possession). It is a benefit of apparent or ostensible ownership no longer given to unsecured creditors, or perhaps even statutory or judicial lien creditors, under State law.257 It creates problems particularly in the case of agents or brokers who need secured financing and have assets of others in their control or in the case of assets held by a debtor pursuant to a voidable title. As just mentioned, other problems arise in the identification requirement under section 9-108 for security agreements and finance statements, for which different requirements obtain; cf also sections 9-502, 9-503 and 9-504. They tend to undermine the ideal of section 9-204 aiming at a situation in which all present and future assets may be given for all present and future debt upon a reasonable description of either. In the security agreement, the identification requirement has given rise to problems where omnibus clauses are used which may become too generic, while in addition the collateral description must also be ‘an adequate reflection of the parties’ intention’. In the finance statement, the concern appears now to be less with generic description and more with adequate warning of unsuspecting prospective creditors. The terminology of Article 9 need not strictly speaking be used in these documents, but courts still seem to use descriptive requirements to limit the security granted and leave more room for new secured or old unsecured creditors. Overreaching of secured creditors is countered in this way. Finally, it was already said that the finance statement and its filing themselves guarantee nothing in terms of the existence of the security, the collateral or the rights of the debtor therein, while the security may in any event be undermined by later bona fide purchasers or buyers of the asset. They give a warning to bona fide unsuspecting creditors, but small suppliers and other potential creditors are unlikely to check up on their counterparty on a daily basis. In any event it should be clear that there is no general debt register. Unsecured funding and purchase price protections in consumer goods are not recorded. This also applies to equipment leases. Neither are tax liens and set-off and netting preferences. The organisation of the various filing systems per state, and the confusion that may arise about where to file or where to look with the probabilities of name changes, reorganisations or movement of debtors, makes the direct and indirect costs of filing and searches relatively high. The present system does not eliminate uncertainty and requires creditors to make their own enquiries into the collateral status and liabilities of the debtor. In the case of an advance filing, no security 257 See also n 204 above and the earlier references in nn 112 and 113 above.

128 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services interest at all may result. The finance statement gives at most some warning. It clouds the title in the collateral for five years and any later filer must assume an inferior status: even if the security does not include after-acquired property, any subsequent filing in respect of the same type of collateral will establish priority (not perfection) as at the original filing date. It was already said that the true significance of filing is in the registration of the moment at which the priority arises for non-possessory security interests but that may be better and more cheaply achieved through an official stamping of the security agreement. Again, a filing system was not originally contemplated for non-possessory security interests, but only came in under pressure from the financial services industry. In truth, filing achieves a great deal less than may appear on the surface and would be desirable for it to be truly meaningful. Outside the US this filing system is nevertheless often admired.

1.6.3. Proprietary Characterisations An analysis of the US case law would be appropriate at this point to determine how the different financial interests in chattels may be distinguished in the light of Article 9 UCC, but with the exception of the cases already referred to in the footnotes, and the history related in section 2.1.3 below, it is beyond the scope of this book. The essence is that Code and its implementing case law do not always achieve clarity. The investment securities repos were already mentioned. For the finance lease, the Code gives some indication of what facts may be considered to determine when a lease falls under Article 9, but it becomes so convoluted that clear guidance remained elusive, also in that area. However, if the lessee has a future proprietary interest in the asset, such as when the lease is for its useful life, or when the lessee acquires full title at the end without further valuable consideration (see sections 1-201(a)(35) and 1-203), the structure is likely to qualify as a secured loan agreement under section 9-109.258 Otherwise it may be considered some kind of operational lease, a more special type of which—the equipment lease—was later covered by the UCC in a new Article 2A, disconnected therefore from Article 9, in which also a direct relationship was created between lessee and supplier. If the lease is covered by Article 9 UCC, it means that the law will treat the lessee as the immediate owner subject to a security interest of the lessor, with the need for a disposition of the asset upon default by the lessee under the lease and a return of any overvalue. It is a potentially dangerous and often costly process for the lessor, who might be much better off organising a replacement lease, unless a clear loan with an interest rate structure was always intended, when this consequence would more naturally follow.259 At the other end of the spectrum are 258 Filing a finance statement may itself be indicative of parties considering their lease a secured transaction so that even preventive filing under s 9-505 is dangerous: see Mann Inv Co v Columbia Nitrogen Corp, 325 SE 2d 612 (1984). 259 It should be noted here that the execution sale concept is now fully embraced by the UCC but was not as such part of the common law tradition—see also n 210 above and accompanying text—although it became more common in the US. The UCC in ss 9-610ff requires advance notice of any default action by the lessor and a commercially reasonable disposition of the asset followed by a handing over of any overvalue, provided that the lease is considered a secured transaction in the first place, which will also require the filing of a financial statement as a way of perfecting the security and of protecting the lease against adverse third-party interests, such as those of purchasers and lien creditors or the bankruptcy trustee of the lessee: see ss 9-309, 9-310 and 9-310 together with respectively ss 9-320 and 9-323, 9-317(a)(2) and 9-102(a)(52). In the case of a lease under Article 2A, there is no filing or disposition duty. The disposition requirement itself is in any event always interpreted in a flexible manner and could in the case of a finance lease be another lease arrangement, possibly one under Article 2A. This was done on purpose and is a consequence of the interest of the

Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services 129 the shorter-term leases, at least shorter than for the economic life of the assets. If the lessee may terminate the arrangement at any time, there cannot be a finance lease at all. Pure rentals result, which are merely contractual arrangements, but they are also possible in situations without a funding perspective. For consumers they are often called consumer leases. They will not be further considered in this context. The true area covered by Article 2A is the space between the rental agreement and secured transaction under Article 9. Most leases need therefore first to be properly characterised. It does not appear that equipment leases are merely operational leases in a European sense, these being no more than contractual arrangements and coming close to rental agreements. The equipment lease is a funding technique in which the emphasis is mainly on the lessee receiving the collateral rights against the supplier of the equipment (even though officially ordered by the lessor): see section 2A-103(1)(g). It also suggests that the lessee must pay the rental whatever the circumstances. The lessor becomes here passive (a mere financier). Once there is an equipment lease, the lessee has more than purely contractual rights however, although it is not fully clear whether s/he also has a proprietary status. Probably, the type of ownership created in a true equipment lease under Article 2A should not be seen as split between lessor and lessee in the manner of a conditional sale.260 Any future interest of the lessee in the title may be construed as an indication of a secured transaction, as just mentioned,261 certainly if the conditions are financial. The new Article 2A did not elaborate on any duality in ownership, the transferability or possibility of attachment of the interests of either party, although in section 2A-103(1) it qualifies the lessor’s interest as ‘residual’. It suggests some remaining interest, perhaps especially in a bankruptcy of the lessee, but is otherwise mainly reflective of the lessee’s consuming powers in the asset. The position of the lessee itself is stronger than contractual262 and follows from his protection in two different ways: sections 2A-301 and 2A-307(2) allow the lessee to take and retain the lease asset in principle free of any charges or other interests of third parties as his fair expectation. On the other hand, it is also clear that the lessor may still sell full title to others (but always subject to the lessee’s interest) and has a proprietary reclaiming right in the case of default of the lessee. However, in the latter’s bankruptcy, this appropriation by the lessor seems to yield to the right of the bankruptcy trustee of the lessee to make an election to continue or reject the contract as long as it may still be considered executory.263 lessor being outside the scope of Article 9. It means that whatever interest s/he still has in the asset amounts to a hidden proprietary interest, which nevertheless may be asserted against all other later interest holders (as if it had been published). 260 Cf also JB Vegter, ‘The Distinction between True Leases and Secured Transactions under the Uniform Commercial Code’ in D Kokkini et al, Eenvormig en Vergelijkend Privaatrecht (Molengrafica, 1994) 163, 182, who also goes briefly into the different proprietary concepts and property forms on which the UCC focuses and the protection of the dual ownership of lessor and lessee. See further the Official Comment, ULA Vol 1B, 775, which makes clear that the distinction between the lease as a conditional sale and the equipment lease was borrowed from the old Uniform Conditional Sales Act. 261 SL Harris, ‘The Interface between Articles 2A and 9’ (1989) 22 Uniform Commercial Code Law Journal 99ff suggests that leases are only secured transactions if structured as conditional sales. See for the traditional definition of a lease, Undercofler v Whiteway Neon Ad Inc 152 SE Ed 616, 618 (1966) in which it was said that a lease is a contract by which one owning the property grants to another the right to possess, use and enjoy it for a specified period of time in exchange for periodic payment of a stipulated price, referred to as rent. 262 See also comment in n 261 above. 263 If merely a contract, the trustee of a bankrupt lessee has the right to assume or reject the lease as an executory contract under s 365 of the Bankruptcy Code. Characterisation of the equipment lease as an executory contract means that the lessor does not have an automatic appropriation right in a bankruptcy of the lessee. Conversely in a bankruptcy of the lessor, the lessee has no automatic right to retain the goods either, but is subject to the election by the lessor’s bankruptcy trustee either to assume or reject the lease contract.

130 Volume 5: Secured Transactions, Finance Sales and Other Financial Products and Services It would also be subject to a stay of all unilateral action (subject to any relief from it under the special provisions of section 362 of the Bankruptcy Code) while under section 365(e) an early termination clause would not be effective. The equipment lease is usually treated in this way, even though the lessor may have fully performed. It is a further indication that the arrangement under Article 2A is not a conditional sale, but it must remain uncertain whether it is purely contractual. A special proprietary right for both parties has been advocated.264 Again, like in England, bailment protection is also conceivable for the lessee.265 Although other types of conditional sales of movables and intangibles may also emerge outside Article 9, the true distinctive criteria may be even less clear. It is somewhat surprising that in a jurisdiction as large and sophisticated as the US, these issues remain little discussed. In any event, to say that in the financial sphere all is in principle under Article 9 and that therefore the issue of characterisation does not normally arise is avoiding the issue. In the US, policy adjustments are often left to the Bankruptcy Code as a federal statute, so this Code also needs to be considered. Sections 555ff of the Bankruptcy Code are particularly relevant here for repurchase agreements and the concept of netting, and now seem to have taken the repo (indirectly) outside the ambit of Article 9, at least in bankruptcy.266 The regime for factoring, on the other hand, remains in principle fully incorporated in Article 9, which covers all sales of accounts, as we saw (unless for collection purposes only). Finance leasing, repos and factoring will be further discussed below in sections 2.4, 4.2 and 2.3 respectively. Securitisation and the recharacterisation issue will be dealt with in section 2.5.8.

In the meantime, the concept of executory contract, that is a contract not fully performed by either party, and therefore subject to the trustee’s right of assumption or rejection, has been criticised as a determination often arrived at after the fact: see National Bankruptcy Review Commission, set up by Congress in 1994 with Professor Elizabeth Warren of Harvard University as general reporter. The proposal was to make all contracts subject to this election possibility: see the Commission’s Report of 20 October 1997, a proposal that did not find favour in the 2005 amendments to the Bankruptcy Code. 264 Cf also J Dolan, ‘The UCC Framework’ (1979) 59 Boston University Law Review 828. 265 Although other characterisations may also apply, see s 2.4.2 below, the proprietary consequences may be left even more uncertain. The general rules of bailment as (physical) possession could additionally become applicable: see also nn 197 and 240 and text at n 250 above and n 278 below for the situation in England and earlier in the US. 266 S 559 of the Bankruptcy Code, which in the case of repurchase agreements disallows the trustee’s option to terminate the contracts in certain circumstances, does not go for appropriation instead, probably because of the fungible nature of the investment securities which may affect and undermine the proprietary reclaiming right. It rather adopts a netting approach to all outstanding positions between the same parties, which principle was extended to regular interest rate and foreign exchange swaps by a further amendment of the Code in 1990 (s 560). This suggests a contractual attitude also to repos and avoids in any event any reference to a conditional sale, probably to avoid complications under Article 9 UCC.

Part II Financial Products and Funding Techniques. Private, Regulatory and International Aspects 2.1. Finance Sales as Distinguished from Secured Transactions: The Recharacterisation Issue and Risk 2.1.1. Introduction Part I of this Volume was a long, but as far as this author can see a necessary introduction to present-day financial practices and legal approaches concerning funding transactions and risk management tools and facilities. Some of them, such as unsecured loans, deposits, futures, options and swaps, are purely contractual. So are guarantees. Others, such as mortgages, pledges or non-possessory security interests in chattels or floating charges, wherever allowed to operate, and finance sales, have an important proprietary element and are expressions of asset-backed funding. Especially repos and finance leases may depend on further characterisation as either contractual or proprietary or some mixture. In terms of risk management, in contractual situations much may depend on set-off and netting facilities or otherwise on the removal of loans from balance sheets in securitisations. In proprietary protections, the response is repossession of the assets followed by either an execution sale and set-off of the claim against the proceeds, or otherwise by an appropriation of the assets upon default of the counterparty. In this part, several of these products and techniques will be more extensively discussed, and there will be further elaboration in particular on floating charges, receivable financing, and finance leases. It will be followed by asset securitisation and the operation of derivatives. For presentational reasons, set-off and netting will be discussed in the context of payments, and repos more in particular in the context of the operation of investment securities entitlements and custodial systems. As we have seen, asset-backed funding is particularly important in respect of modern commercial banking activity to manage risk in financing operations. Legally, it foremost concerns secured transactions (including floating charges) and finance sales and the distinction between them. It was submitted that this distinction is fundamental and that awareness of it contributes substantially to our understanding of modern financial products and the way they legally arise and operate. This concerns largely their proprietary effect and status in a bankruptcy of the party needing funding. It is then substantially a segregation issue. Most people are aware of secured transactions. In the traditional view, in the case of default or upon a bankruptcy of the debtor, they lead to repossession with a duty to conduct an execution sale and return the overvalue to the debtor. The finance sale as an alternative is much less known and understood. As we have seen, it is a sale with a repurchase facility, the essence of which is that if the seller does not tender the

132 Volume 5: Financial Products and Funding Techniques repurchase price on the appointed date, the repurchase right will lapse267 and the buyer/financier will become the full owner of the sold assets and obtain any overvalue. It was pointed out that there is here a different risk, cost, and reward structure and a true alternative. Secured transactions and finance sales are not economically the same as is sometimes maintained, which gives rise to an important recharacterisation issue—that is the legal conversion of finance sales into security interests. This is in fact also the essence of the so-called (US) unitary functional approach, an undesirable development—it was submitted—that deprives finance of useful alternatives: see section 1.6.1 above, and can be explained mainly for historical reasons, the earlier wild growth of all kind of asset backed funding structures under state law. It is crucial in this connection, however, to understand that not all funding is lending, and that there are other ways in which financing can be provided. This is also key in sharia financing where repos, finance leases, and the factoring or sale of trade receivables are most important secular alternatives as we shall see more in particular below in section 2.1.7. Undoubtedly others will develop. We are stuck with the competition between different types of asset-backed funding and must define the legal difference.268 In line with what is largely believed to be the English practice (see sections 1.1.8 and 1.5.3 above), this book advocates269 that the true nature of a security interest is that it supports and is accessory to a loan agreement of which an agreed interest rate structure is the true indication. If there is no interest rate structure, there is no loan, and there will be no security for a loan either. The funding transaction will then have another character and another legal characterisation, which is likely to be a conditional or temporary sale (and transfer). That is indeed the legal nature of the finance sale. 267 In this conditional sale/repurchase structure, the nature of the repurchase could still vary, however, giving rise to important further preliminary characterisation issues. There could be: (a) a retrieval right or (call) option for the seller, through repayment or tender of a pre-agreed price at a certain date, a facility already known in Roman law in the pactum de retroemendo (of C.4.54.2) and retained in French law as the vente à réméré (Art 1659 CC); see also nn 79, 108 and 165; (b) a right and duty of the seller to repay the agreed price on the appointed date to the buyer (or at least tender the repayment price), conceivably leading to an automatic return of the asset, as we may see in the modern repurchase agreement—the automaticity here is one of the most important issues to be considered, and may produce an in rem or proprietary interest in the asset for the former owner/re-purchaser, as no further act of co-operation is necessary or expected from the other (possibly bankrupt) party; or (c) a right or (put) option for the buyer to return the asset for a predetermined price on an appointed date, a technique which the Germans call an uncharacteristic, unauthentic, or untrue (unecht) repurchase agreement. Whether on the European continent the repurchase option under (b) had proprietary effect originally may be doubted, but it acquired it later in the ius commune, when the repurchase right was increasingly characterised as a resolving condition: see Scheltema, n 168, at 46, 124ff. Indeed, history shows that the contractual arrangements in this respect and the courts’ sanction of the conditional sale started with the first possibility (the pactum de retroemendo), but tended to proceed to the second (the modern repurchase agreement). This is also apparent in the Sicherungsübereignung (for chattels) and Sicherungszession (for receivables) in Germany and in the former fiduciary sale in the Netherlands: see ss 1.4.1 and 1.2.3 above. Both developed as conditional sales of chattels and receivables to raise financing. Subsequently, they acquired significant features of a secured transaction, as already mentioned, but not all repurchase agreements necessarily did so, especially not if there was no lending proper, signified by an agreed interest rate structure. 268 It may be of interest that the EBRD Model Law on Secured Transactions did not provide any particular insights into this distinction. According to the Comment on Art 1, the Model Law does not mean to affect any other financing technique besides secured lending, although the expression ‘security for a debt’ in Art 1 may suggest that the security may also be given for sales credit, which is borne out by the fact that reservation of title, following the UCC, is covered but treated as a security interest (Article 9). Also in the latter case there is therefore a need for an execution sale upon default with the return of any overvalue (Art 24(1)) while the charge is accessory to the debt (Art 18(1)). 269 See JH Dalhuisen, ‘Conditional Sales and Modern Financial Products’ in A Hartkamp et al (eds), Towards a European Civil Code, 2nd edn (London, 1998) 525. See also ss 1.1.8 and 1.5.3 above.

Volume 5: Financial Products and Funding Techniques 133 It has already been shown that the concept of the finance sale remains underdeveloped in many countries, especially those of the civil law variety, but, as we have also seen in section 1.6.1 above, it suffered even under Article 9 UCC in the US because of its unitary functional approach which converts all conditional or temporary transfers of movable assets for funding purposes into secured transactions (subject to its formalities and filing requirements). However, it obscured reality and did not clarify these issues as it sought to do at least not for professional financial dealings.270 Whatever the insights and motives at the time, it was not long before it became clear, even in the US, that finance leases could not be so treated. Case law meant to clarify, but ultimately some new home was created for at least some of these finance leases in Article 2A UCC covering equipment. Indirectly, investment securities repos became exempted from the problems with Article 9 UCC through amendment of the federal Bankruptcy Code, which promoted netting if the formalities were not followed, and factoring received special treatment even within Article 9 in which pure collection agreements were exempted from its reach while for other forms of factoring of receivables some amended regime was developed from the beginning. In the case of default, and depending on the contract terms, it allowed the factor to continue to collect for himself instead of conducting a disposition and sale of the receivable portfolio. In such cases, there would not be a return of overvalue to the party requiring the financing (being the assignor of the receivables) either, unless otherwise agreed. So, even the US practice shows that if there is no interest agreed, there may not be a loan agreement, and, if there is no loan agreement, there result difficulties with the security analogy if there was some kind of transfer. On the other hand, when there is an interest rate structure, it may be more safely assumed that there is a loan, and any proprietary interests under it should rightly be considered a security interest. Its creation and execution are then subject to the applicable formalities and safeguards for the creation and execution of all security interests, including the filing requirement to maintain rank, even though purchasers in the ordinary course of business may ignore the filing and have no investigation duty. The requirement of an interest rate structure is a clear one. It must be specifically agreed and cannot easily be deemed implied (except where there is a pure sham). A formal attitude must be taken. In repos, there will be a fee or other reward structure as part of the agreed repurchase price, but that is, unless expressly so stated, not interest, and is likely to be indicative of another service or financial product being provided. In such cases, there are, as we have seen, likely to result temporary or conditional transfers of proprietary rights in the assets of the party requiring funding. This is the situation not only in repos, but also in finance leases and ‘limited recourse’ factoring. Thus, in these modern finance sales, there is a proprietary element, even though the precise right (or expectancy) might still be difficult to define in many legal systems. Yet it is clear that characterisation as a purely contractual structure on the one hand271 or as a secured transaction on the other, is unlikely to reflect reality sufficiently. What is more likely to follow is a conditional ownership with some split proprietary structure in the manner discussed below. 270 In this respect, it must be admitted that the UCC was not written only for professionals, but from its newer coverage of payment systems, letters of credit, investment securities and even secured transactions, it is clear that it tends more and more towards professional dealings: see also n 1 above. However that may be, it was not the protection of the smaller or weaker party that reduced all alternative funding facilities, in which assets of the party seeking financing were used to secured transactions, but rather the fact that finance sales had presented too much legal diversity between the different States of the Union earlier: see s 2.1.3 below. But the result of the new approach was more litigation, in particular about the line between secured transactions and finance leases based on cumbersome definitions in the UCC in this respect: see more particularly ss 1.6.3 above and 2.4.3 below. 271 If it were to be executory there may then also be the possibility of repudiation by the bankruptcy trustee, see for newer case law on this point in the Netherlands (Berzona), n 90 above.

134 Volume 5: Financial Products and Funding Techniques It was shown before that conditionality of the sale and transfer may also support sales credit, as in the case of a reservation of title and a hire-purchase when there is no funding proper but rather a purchase money protection arrangement. Indeed, in the reservation of title, the conditionality of the transfer is most apparent and also (albeit slowly) better understood in civil law. It may also affect the hire-purchase, which is closely related. In fact, the German BGB and new Dutch Civil Code expressly refer to this conditionality for the reservations of title, but, as we have seen, they do not define what conditional ownership is and how it works. Rather the consequence of split ownership may be viewed with unease as it is believed to offend the notion of a closed system or numerus clausus of proprietary rights, although German law accepted here at least a proprietary expectancy (dingliche Anwartschaft): see section 1.4.3 above (in the DCFR identified as a new proprietary right, the conditionality of the reservation of title having been abandoned). Dutch case law since 2016 goes more clearly in the direction of a duality in ownership. Whatever the approach, it is clear that there may also be conditional sales and forms of ownership when there is funding proper, usually based on a sale of assets made conditional upon the buyer returning the sales price in due course and paying a fee for this kind of facility, whether or not discounted in the repurchase price. Indeed, that is the basic structure of a repo. In a finance lease, on the other hand, the condition is the full payment of the instalments, which will also include a fee element (characterised as purely contractual in the DCFR). As we shall see in factoring, it may be the approval of the receivables and their collectability. Any claims or receivables in excess of an agreed total of collections may also be returnable, although especially in that case the borderline with a secured loan may become thinner. It was shown that one may note the proprietary element best in common law jurisdictions, which in equity do not assume a closed system of proprietary rights and are traditionally comfortable with split-ownership rights and equitable proprietary interests, while (at law) the party in possession may have additional bailment protection. These equitable rights are by their very nature subject to the protection of bona fide purchasers, which covers transferees who are unaware of contractually created beneficial ownership rights (in terms of user, enjoyment or income rights), at least in trusts, conditional or temporary ownership structures, and floating charges concerning chattels and intangible assets (although it may not defeat the bailment of any user). On the other hand, as we have seen, it may still be that finance sales, at least in some of their manifestations, such as repos and finance leases, are considered no more than purely contractual arrangements (the former characterised as a security interest in the DCFR as is the sale and lease back, the other finance leases being purely contractual unless ownership passes at the end when they are treated as a reservation of title). In countries that still use the contractual characterisation, as may be the case particularly among some civil law countries, investment security repos and finance leases in particular may then become subject to the cherry-picking option of the bankruptcy trustee of either party. This means that the bankruptcy trustee of whatever party it concerns may have the right to reject the contract if that is advantageous to the bankrupt estate. In repos, the obvious danger is that the bankruptcy trustee will not tender the repurchase price if the underlying securities have gone down, but will try to retrieve them against the agreed repurchase price if they have gone up. This is clearly undesirable. As we have seen, netting of the contractual position has proven to be the answer between parties who regularly engage in this business between each other, and the alternative protection may then be found in a bilateral netting agreement under which all mutual rights and obligations in terms of payment, repayment and delivery of securities are netted out. This has become the preferred protection technique and risk management facility in this connection, as such exceedingly important, but it assumes a sufficient number of mutual claims.

Volume 5: Financial Products and Funding Techniques 135 The absence of proprietary protection may thus be countered both in civil and common law by close-out netting clauses or agreements—now part of standard repo (and swap) master agreements (see section 3.2.5 below). The result is that proprietary protection is substituted for a preference through an extended set-off or netting of claims that are then characterised as or accepted to be merely contractual. This may be particularly effective in bankruptcy, but again only if there are sufficient opposite transactions between the same parties. The other requirement is that all claims to assets can be converted into money, whatever the currency and maturity, normally on the basis of prevailing market prices. Indeed, this relief does not have much meaning in repurchase agreements unless the re-transfer obligation of the investment securities can be reduced to money. That tends to be the aim of netting agreements that introduce by contract formulae to that effect if an event of default (as defined) occurs: see for the repos (and swap) netting or master agreements in this connection, sections 4.2.4ff and 3.2.5 below, although the acceptability of the dramatic extension of the set-off principle in this manner may still be in some doubt for policy reasons, except where it has been sanctioned by statutory amendment: see further section 4.2.4 below, and also the EU Settlement Finality and Collateral Directives—Volume 4, sections 3.1.3 and 3.2.4 and section 4.1.5 below.

2.1.2. The Practical Differences between Security and Ownership-based Funding. The Recharacterisation Issue Revisited To highlight the differences between secured transactions and finance sales, it is useful to take the reservation of title as the most obvious and best-known example, less contentious at the same time even in civil law, at least in countries like Germany and the Netherlands. Of course, there is credit being given by the seller, the sales credit or purchase money—in German, the Lieferantenkredit—resulting from the payment deferment clause. But credit is not always the same as a loan and leads, in the view posited in this book, only to a (secured) loan situation if there is at the same time an agreed interest rate (structure). Normally that is not the case in sales, and there is only a concessionary late or postponed payment granted as a competitive incentive for which the reservation of title serves as protection. That is not to say that there is no cost to the seller, but that is not usually translated into or recovered through an agreed interest rate structure. Therefore, as long as there is no such interest rate structure, there is no loan, and if there is no loan there is no security either, and the reservation of title is then legally a true conditional or deferred transfer of title. If there were an agreed interest rate, however—and this is by no means impossible—any reservation of title would convert into a security interest. Thus, the new Dutch Civil Code,272 following German law,273 appears to be correct in assuming that a reservation of title in a sale normally creates a conditional sale and not a security interest. Although it does not say when this assumption is rebutted, it clearly can be, and it is when, in the view of this book, the reservation of title supports a loan rather than a sales credit, normally therefore when interest is specifically agreed and charged. It is also rebutted when parties clearly agree otherwise. The idea that because there must be a cost to the seller, interest is somehow discounted in the sale price so that there is always agreed interest and therefore a loan with a supporting 272 Art 3.92 CC. See also text at n 75 above. 273 S 449 BGB.

136 Volume 5: Financial Products and Funding Techniques accessory security interest, confuses everything. The sales and repurchase price is normally set by competitive conditions and is unlikely to allow for an extra charge or component in respect of loss of theoretical interest by the seller in the case of sales credit. If it does allow for a surcharge, it is again set by competitive conditions, which are unlikely to have anything to do with the real interest rate. To repeat, the idea that since there is some cost, this must imply some interest is likely to lack any basis in fact. The seller does not normally have the room unilaterally to impose a mark-up of this sort. His selling point (at least in consumer sales) will often be that s/he is not doing so. The buyer would not want to hear of any other proposition and rather go elsewhere. This may be even clearer in the repurchase agreement of investment securities. The seller, in order to raise funds, probably to finance the acquisition of the securities in question, will immediately sell them for a certain period (until s/he wants to resell the securities to third parties). At the end of the agreed period, s/he will refund the sales price and pay the repo rate. It will include a fee element. This is not an interest rate. The whole point is that this fee element, which is in truth a market-dictated fee for this type of service or funding, is likely to be lower. On the other hand, the amount of funding received may be higher than when a loan against the security of the same assets was agreed, as this amount is likely to be the full market value of the underlying asset. In other words, there is a true alternative here. As the cost of this type of funding may be lower, it makes the repo more attractive to the repo seller than taking out a loan with the relevant investment securities given as a pledge to support the credit. This is one reason why the repo facility is chosen, another important element being the greater speed with which this type of facility can be arranged. Other advantages of ownershipbased financing through repos for the repo seller, and therefore for the party requiring funding, are the lack of formalities, the use of existing settlement systems for the transfer of investment securities to execute the transactions, the ease and speed that follow from this, and of course the 100 per cent financing. The repo buyer or financier is protected in the case of the repo seller defaulting in his/her obligation to tender the purchase price on the appointed date. In a true repurchase, characterised as a conditional sale, the repo buyer, upon the failure of the repo seller to tender the repurchase price, will appropriate the full title in the assets and retain any overvalue; that is the trade-off for him/her. It was already noted that the situation may be different in practice when the proprietary nature of repos remains in doubt or even where it is not accepted in principle. This may in particular figure when the underlying assets are fungible, as already mentioned several times before. This may be especially the case in the repo-ing of investment securities: see further section 4.2 below. In such cases the relevant assets may not as such easily be reclaimed or traced for lack of specificity and identification, although a beneficial proprietary interest in equity would not be inappropriate. However, as we have already seen, the situation may be substantially retrieved through netting facilities under which the mutual obligations of the parties are set off. This is only to reconfirm that, from a legal perspective, it is still a mistake to see all funding as loan financing and all credit as a loan, a mistake nevertheless very common among lawyers. A similar situation may present itself in the finance lease. Here the fee may be higher than the interest rate might have been because there may be other benefits to the lessee besides 100 per cent financing. These benefits could be off-balance-sheet financing and better tax treatment. It again underscores the fact that the charge of the lessor is market dictated for this type of service and not related to the prevailing interest rate. That rate will only be a benchmark for the lessee to determine his/her extra cost, and for the lessor his/her extra profit, in providing this kind of service rather than a secured loan.

Volume 5: Financial Products and Funding Techniques 137 It confirms the fundamental point: the risk and reward structure is likely to be different under a conditional or finance sale as compared to a secured loan. Thus ownership-based and security-based funding are different fundraising techniques with different cost, risk and reward structures. This is clear enough if there was an outright sale of assets to raise cash rather than entering into a loan arrangement. Everyone would accept that these funding techniques are in no way comparable or related. By making the sale subject to a repurchase duty on the one hand, and by securing the loan on the same assets on the other, these two funding possibilities start to look similar, but they are not the same. English law is fully aware of this, as we have seen. In French law, there are still remnants of this recognition,274 as there are in the Dutch reservation of title, but in Germany, since its Civil Code of 1900 (BGB), this perception has receded into the background (except again for the reservation of title, where, however, it led to the abandonment of the duality in favour of an expectation as a new proprietary right, but limited to the reservation of title), as it subsequently did in other parts of the European Continent. That is also borne out in the Draft Common Frame of Reference (DCFR), which declared the reservation of title a special proprietary interest following German case law and no longer a conditional sale, while in the US the UCC has also tried to ignore the difference, as we have seen,275 thus deleting a true asset-backed funding alternative. It was submitted, however, that the distinction remains fundamental and of the greatest importance also in the US, as became clear in finance leasing and in repo financing.

2.1.3. Legal Differences between Security- and Ownership-based Funding. The Operation of Split-ownership Rights in England and the US It is clear that the details of ownership-based funding and of the conditional sale and transfer inherent in it have remained largely unexplored in modern civil law. In conditional finance sales, the position of either party in a dual ownership structure at one stage received much more attention in the US, but only before the introduction of the UCC. It may be useful to recall this history before further analysing the situation in civil law countries in particular. As already mentioned several times, largely because of the greatly different attitudes of the courts in prior case law, the UCC adopted its unitary functional approach in which all funding supported by movable assets was converted into a secured transaction. This attitude is critiqued throughout this book, and even in the US required important later exceptions, especially for equipment leases and repos as already mentioned. The older US, pre-UCC, case law remains revealing, however, and will be researched and summarised in this section. There is no European equivalent, even for the reservation of title, but the issues are nevertheless often similar. It has already been said that in civil law, the legal nature of conditional and split-ownership rights remains largely unexplored as it goes against the grain of the numerus clausus or closed system of proprietary rights, although earlier it had received serious attention, especially in the older French and Dutch legal literature. Nowadays, this question is not much pursued, although new case law in the Netherlands since 2016 has reopened the discussion.276 274 See for English law, n 216 above and accompanying text. Note for France the concern, however, about scam secured transactions by using conditional sales: see text at n 115 above and Cour de Cass, 21 March 1938, D 2.57 (1938) and earlier 11 March 1879, D 1.401 (1879). 275 See also nn 201, 217, 107, 75, 162 and 248 above and accompanying text. 276 See Scheltema, n 168 above, 203.

138 Volume 5: Financial Products and Funding Techniques In the US, in older case law, the legal differences from secured transactions in practice largely concerned the necessary formalities such as documentation and publication,277 the effect of a tender of repayment on the title in the underlying assets, the appropriation right or execution duty and the entitlement to any overvalue or liability for undervalue,278 the qualification of 277 In the US before the UCC, no formalities were imposed on the formation of the contract of conditional sale, even under the Statute of Frauds (which required a document for all contracts to be performed in a period over one year) as long as the goods were delivered to the buyer (in lieu of the requirement that some money was given in credit sales of goods to make the bargain binding) and it concerned then chattels that could be paid for within the year: see Barbour Plumbing, Heating & Electric Co v Ewing 16 Ala App 280 (1917). This mostly left room for some kind of reservation of title. However, in many States a filing requirement was introduced, which also became the system of the Uniform Conditional Sales Act (s 6, except for railway equipment and other rolling stock that had no permanent place of being). This was often believed necessary to guard against the buyer’s apparent ownership whilst the burden of filing on the buyer was deemed slight and the benefit to the public great. It should be repeated in this connection that the theory of apparent ownership was otherwise not commonly taken over from the English practice. The filing was done by the seller at the place the goods were first held after delivery. It obviously made it difficult for subsequent buyers to know where to look. In other States, the reservation of title became treated as a chattel mortgage and was then sometimes registrable as such under applicable chattel mortgage statutes. Where such filing was required, a written document normally became necessary, but as between the parties the contract continued to be perfectly valid without it. Even without filing, the reservation of title was also held perfectly valid against earlier security interest holders in the buyer’s property under after-acquired property clauses. It was in fact the reason for the popularity of conditional sales: see Babbitt & Co v Carr 53 Fla 480 (1907). 278 See for details in particular the text at nn 210 and 211 above, and for the appropriation right giving way to the bankruptcy trustee’s option under executory contracts, the text at n 263 above and s 4.1.1 below. The execution sale may allow the buyer to acquire the goods free and clear of older charges: see s 9-618 (9-504(4) old) UCC in the US. In civil law countries, this might still depend on the buyer’s bona fide acquisition under the normal rules, which in the case of an execution sale might give rise to extra investigation duties, but there may be the exception of the auction sale, particularly in Germany. In the US before the UCC, the basic rule in conditional sales was that, upon full performance by the buyer, title would automatically pass to the latter and no further acts of transfer would be necessary. One sees here the payment protection nature of many of these sales, which were therefore not in the nature of repos, under which the seller would be the party who had to perform in tendering the repurchase price. Where it was the buyer who had to perform, the nature of his/her tender and its effect were obvious issues, especially in an intervening bankruptcy of the seller who still had conditional title, although s/he was (mostly) no longer in possession. It was agreed that in such cases the buyer was in sole control of the transfer and could achieve it at any time, even by paying the seller before the maturity of the debt; if interest had been agreed it needed to be added in full: Cushion v Jewel 7 Hun 525 (1876). The tender of the price had the effect of absolutely vesting title in the buyer: Day v Basset 102 Mass 445 (1869), even if the tender took place after default on the maturity date: Hatch v Lamas 65 NHS 1 (1888). A third party who had acquired an interest in the goods from the buyer could also make the tender: Scott v Farnam, 55 Wash 336 (1909). A return of possession would not automatically release the buyer from the contract, at least if there was a secured transaction rather than a conditional sale: Finlay v Ludden & B Southern Music House 105 Ga 264 (1898). Furthermore, the seller had an option to demand the return of the asset if the buyer’s conduct in respect of it became unsatisfactory: Hydraulic Press Manufacturing Co v Whetstone 63 Kan 704 (1901). In the case of default of payment of the purchase price, the seller normally had the option to go for (a) recovery of the price, (b) repossession of the asset or execution of a deemed security interest therein, or (c) damages, or perhaps for a combination of these options. All were subject to limitations and the combination more so, but were mostly considered mutually exclusive. It meant that retaking the asset constituted an election by the seller not to sue for the purchase price: Hanson v Dayton 153 Fed 258 (1907). It excluded a suit for damages at the same time, although the seller might have been able to keep any payments already made as a reward for use of the asset by the buyer, compensation for depreciation in its value, or as a normal penalty upon default: Pfeiffer v Norman 22 ND 168 (1911). It followed that if the seller only demanded the price, the title transfer to the buyer became absolute, therefore even before a collection judgment. Repossession, on the other hand, was seen as an act of implementation of the contract, and might excuse performance by the buyer who still might have had a redemption right, however: Fairbanks v Malloy 16 Ill App 277 (1885). Yet there was much uncertainty as to both the right of the buyer to demand a return of its payments and its redemption right. It was conceded that the latter right did not exist at common law for conditional sales: Franklin Motor Car Co v Hamilton 113 Me 63 (1915).

Volume 5: Financial Products and Funding Techniques 139 the interests and the accessory right issues,279 and the continuing protection of any security supporting a receivable in the case of factoring.280 Then there were the right to capital gains in or the income out of the assets, the risk of loss of the assets and the liability for the harm they The Uniform Conditional Sales Act in s 24 allowed the retaking of the asset even after an action for recovery of the price. If the asset was repossessed, however, the buyer was only liable to the seller upon a resale of the asset for a lower price. Any overvalue on a resale was also for the original buyer. The buyer had a redemption right for 10 days (s 19), after which a resale had to follow if a buyer had already paid more than 50 per cent of the price. If it had been less, the buyer still had an option to demand such a resale (s 20) with the same consequences as to under- or over-value. The right to take repossession was a proprietary right of the seller in replevin, also available in the case of leases: Ferguson v Lauterstein 160 Pa 427 (1894), therefore also good against the buyer’s trustee in bankruptcy: Bryant v Swofford Bros Dry Goods 214 US 279 (1909) and clearly distinguished from the action to obtain possession with a view to a disposition under a secured transaction: Tufts v Stone 70 Miss 54 (1892). Indeed, s 16 of the Uniform Conditional Sales Act allowed appropriation by the seller under a conditional sale proper as long as it could be done without breaching the peace. The conditional seller was also protected against earlier mortgagees of the buyer with after-acquired property protection, one of the traditional advantages of this type of sale: Frank v Denver & RGR Co 23 Fed 123 (1885). As for damages, these were in particular claimable if the buyer retained and used the asset upon default. The measure of damages was then the reasonable value of this use: Barton v Mulvane 59 Kan 313 (1898). Where the replevin action could be combined with a demand for the price, the proper measure of damages was deemed the interest on the purchase price: Winton Motor Carriage Co v Blomberg 84 Wash 451 (1915). If the property had remained unsold by the buyer, the measure of damages was the purchase price plus interest, unless the total exceeded the value of the property at the time of the on-sale plus interest until the date of trial: Hall v Nix 156 Ala 423 (1908). 279 See more particularly the discussion at nn 28, 79, 123, 165 and 235 above. It shows that in Europe only in France (and probably Belgium) is the conditional interest of a seller in a reservation of title believed accessory to the seller’s claim for payment and transfers with it. It is an indication of the right of the seller being seen as a security interest rather as an ownership right. It is well known that the UCC in the US now characterises the reservation of title as a security interest subject to a duty of disposition in the case of the buyer’s default while overvalue accrues to the latter. Again, French law seems to go the same way, although so far, no execution sale is necessary. In the US before the UCC, the accessory nature of the conditional ownership right was not a big issue, but it was not considered to exist except where intended. An assignment by the seller of his/her right to the purchase price therefore did not automatically include an assignment of his/her conditional ownership right: Burch v Pedigo 113 Ga 1157 (1901). In the US before the UCC, the qualification issue was not straightforward, however. The conditional sale was mostly defined as a conveyance of personal property, which reserved title in the seller until certain conditions were met, usually payment of the purchase price. It was then seen as protecting sellers’ credit. The Uniform Conditional Sales Act 1918 also included in its s 1 bailment or leasing of goods, therefore alternative funding techniques under which a bailee or lessee paid total compensation substantially equivalent to the value of the asset upon which s/ he had the right or option to become absolute owner. These structures were then also seen as conditional sales. Repurchase agreements were not covered, but there was some case law which accepted a seller’s option to repay money and demand a re-conveyance of the property: Beck v Blue 42 Ala 32 (1868), which was apparently not uncommon in the slave trade (!), where the buyer might be given a similar option to reclaim the money after deduction of an amount for hire and return the asset: Reese v Beck 24 Ala 651 (1854). Although the Uniform Conditional Sales Act also referred to bailments, conditional sales giving possession to the buyer were often seen as creating more than a buyer’s bailment, as a bailment itself always implies a return of the asset after the objectives have been met: see Krause v Com 93 Pa 418 (1880). See for bailments in this connection in England, nn 198 and 239 above plus accompanying text. It might have been more appropriate in a repo situation, not normally the objective of these sales, however. Most importantly for this study, even in the US the conditional sale was sometimes defined as a sale in which the vesting of title in the buyer was subject to a condition precedent, the condition being full performance—Re Columbus Buggy Co 143 Fed 859 (1906) and Dunlop v Mercer 156 Fed 545 (1907)—although depending on the type of condition vesting in the buyer, it could also be subject to a condition subsequent and the re-vesting in the seller to a condition precedent: Re Lutz 197 Fed 492 (1912). The name and form the parties gave to their contract was irrelevant and their intent decisive: Adler v Ammerman Furniture Co 100 Conn 223 (1924), but a mere conditional transfer of possession only might not have been enough to create a conditional sale as title could not be substituted for it: Maxson v Ashland Iron Works

140 Volume 5: Financial Products and Funding Techniques could cause to others.281 The entirely different situation under conditional sales (as compared to secured transactions) was particularly illustrated in the proprietary protections of each party’s interest:282 in the disposition rights in the goods and of their interests in them, including 85 Ore 345 (1917). The term ‘security’ could be indicative of another type of deal. Thus, courts intervened in the characterisation issue if only to determine the true intent, in which connection the circumstances of the case were also taken into account: Whitsett v Carney 124 SW 443 (1910). In this connection it was established that inclusion of a power of sale for the buyer did not make the conditional sale a chattel mortgage or lien per se as it did not in itself divest the seller of his/her title: Call v Seymour 40 Ohio St 670 (1884), but a duty to pay overvalue to the buyer could be indicative of a secured transaction: Knowles Loom Work v Knowles 6 Penn (Del) 185 (1906). Especially a conditional sale without an adequate price could be considered a pledge: Murray v Butte-Monitor Tunnel Min Co 41 Mont 449 (1910). A present absolute sale to a buyer who mortgaged the goods back to the seller did not result in a conditional sale, however. There was only a security interest (even though the mortgage itself was originally a conditional sale): Chicago R Equipment Co v Merchant’s Nat Bank 136 US 268 (1890). No fundamental test was developed to distinguish clearly between conditional sales and security interests, but certain criteria emerged. There was an assumption of a security interest where there was a sale with a return of overvalue or recovery of a purchase price whilst the interest in the title was also retained. This indicated a mere debt protected by a security interest as there was no reliance on a conditional sale: Young v Phillips 202 Mich 480 (1918). Thus, a conditional sale and an action to recover the price were not truly compatible, and if there was emphasis on payment of the price rather than on reclaiming of the goods instead, a secured transaction might be assumed. Other borderline issues arose between conditional and absolute sales, intent normally being decisive: Blackford v Neaves 23 Ariz 501 (1922). In the former case, the Uniform Conditional Sales Act 1918 was applicable in States that had adopted it and in the latter case the Sale of Goods Act of the relevant State or otherwise the common law of sale of goods: Ivers & P Piano Co v Allen 101 Me 218 (1906). There could be a difference in the protection of bona fide purchasers of the buyer. Again, intention if it could be established decided the issue in principle: Blackford v Neaves above. In case of doubt the courts were inclined to assume an absolute sale, this being the more normal situation: Sears, R & Co v Higbee 225 Ill App 197 (1922). Instalment payments could, however, be indicative of a conditional sale: Perkins v Metter 126 Cal 100 (1899) and any statement on an invoice that goods were sold was not held conclusive: HB Claflin Co v Porter 34 Atl 259 (1895). It was possible for the seller to retain the possession of the assets under a conditional sale. This could raise Statute of Frauds problems, however, if there was no document: see n 277 above. Most importantly, a nonpossessory chattel mortgage was then sometimes implied. It was also possible that there would be no more than an executory contract to sell the asset but no sale: Davis v Giddings 30 Neb 209 (1890). There could be such danger even if the goods had been delivered to the buyer who had not received an interest in the title: State ex rel MalinYates Co v Justice of the Peace Ct 51 Mont 133 (1915) when a bona fide purchaser from the buyer could not obtain title either: Harkness v Russell & Co 118 US 663 (1886). 280 It may be argued that in a conditional sale of a receivable any security interest supporting the claim itself is transferred to the new owner and supports his/her collection activity, whilst this is not automatically the case for a pledgee if the secured receivable is merely pledged. Opinion is divided on the subject. See for the ancillary nature of security interests more generally, n 28 above. 281 In a conditional sale, the capital gain or capital depreciation may be for the party who eventually obtains the full ownership, which will depend on the fulfilment (or non-fulfilment as the case may be) of the condition and subsequent appropriation, while in the case of a security interest the capital gain or loss remains in principle with the owner, even if only expressed in terms of overvalue to be returned or undervalue in an execution sale. Income may be considered to accrue to the owner, who in the case of a conditional sale is probably the person likely to become the ultimate full owner (although under repurchase agreements of investment securities, assets paying interest or dividends during the repurchase period are normally not included to avoid any dispute or complication in this regard), and not to the security holder. It may also be that the income is truly for the party that holds the physical possession (the buyer in a repo) at the time it is accrued or is paid out (which need not be the same). The risk of the loss of the asset for reasons of force majeure may, under a conditional sale, also be carried by the person who has the actual possession of the asset. This person may also bear the maintenance and insurance cost and any third-party liability for harm caused by the asset. In the case of a security interest, actual possession may have a similar effect but may not render the security holder liable for the loss of the asset due to force majeure. However, in all these cases, contractual arrangements to the contrary may be made, except where product liability statutes contain mandatory liability provisions. Voting rights on pledged shares normally remain with the pledgor (see Art 3.247 Dutch CC) whilst the financier may acquire them in a conditional sale to him.

Volume 5: Financial Products and Funding Techniques 141 the protection of bona fide buyers;283 the possibility and right to (subsequently) encumber the various interests in the asset;284 and in the inclusion of future assets and the shifting of the interest into replacement goods.285 Then there was the difference in the entitlement to the asset in The foregoing meant that, barring contractual provisions to the contrary, the person receiving funding through a conditional sale or benefiting from a payment deferment is likely to have the benefits and carry the burdens of the asset, which is by no means always so for the holder of a security interest, although the security agreement may approximate this situation. If the asset is a receivable, the collection facility and proceeds will normally be with the party providing the funding, although this can only be so upon notification to the debtor in the case of a security interest. Another difference with the collection by a conditional or fiduciary assignee is that the latter, unlike the pledgee of receivables, does not need to return any overvalue (except where his/her rights are equated with those of a pledgee). In the US before the UCC, case law elaborated extensively on the benefits and burdens of assets subject to a conditional sale and how they were distributed between seller and buyer. Of course, they could be redistributed in the contract itself, but if this had not happened, the question was what followed from the conditional sale itself. As the buyer was normally in physical possession of the goods, it followed also in the US that s/he was entitled to their enjoyment, which carried with it also a prima facie responsibility for their burdens. Thus, the risk of loss and destruction without fault of either party shifted eventually from the original owner to the person with physical possession and that became the majority view: Phillips v Hollenburg Music Co 82 Ark 9 (1907), confirmed in s 27 of the Uniform Conditional Sales Act 1918. But when the goods were still with the carrier, the seller retained the risk, except where under the contract the risk had already passed to the buyer as in a free-on-board (FOB) sale. In so far as third-party liability was concerned, the seller was not normally thought liable for the negligence of the buyer in the use of the property: Coonse v Bechold 71 Ind App 663 (1919). This corresponds with the idea that the physical holder had the risk of the assets and therefore the duty to insure and collect the insurance payments. Property that remained in the possession of the seller or with an agent at the request of the buyer was at his/her risk. The right to the capital gain was nevertheless likely to accrue to the ultimate absolute title-holder, unless otherwise agreed. It follows that income tax would be for the buyer, capital gains tax for the ultimate owner. Property tax would appear to have been for the buyer’s account: State v White Furniture Co 206 Ala 575 (1921), at least after the delivery of possession was completed. 282 At least in civil law countries other than Germany, the pledgor as owner may have to defend the rights of the pledgee against third parties who may have divested him. The pledgee may not have the possessory action himself, except in Germany and under common law (like a bailee under a bailment). Conditional owners even if not in physical possession may in this respect have a stronger right, certainly where the in rem effect of their expectancy or Anwartschaft is accepted. 283 As regards disposition rights, the pledgee normally has none (except in an execution sale, while in England there may be a sub-pledgee of the possession of the pledgee), but the conditional owners are likely to be able to dispose of their interests even if only an expectancy or option: see also text following nn 80 and 84 above and further nn 162 and 175 above plus accompanying text. It raises the question of delivery of possession in systems such as the German and Dutch (and for a pledge also the French), which require it for title transfer. For the conditional owner not holding the asset, the transfer of his/her conditional proprietary right may then be through the mere conclusion of the contract (in Germany, either as an assignment under s 870 or through a sale and delivery longa manu under s 931 BGB without notice or in the Netherlands with notice), while the asset itself remains in the control of the other party. For the latter, the transfer of his/her proprietary interest will be completed through the physical delivery of the asset or constituto possessorio if the asset remains in his/her control. In countries like Germany and the Netherlands, both the owner under a resolutive condition and the one under a suspensive condition may thus be able to transfer their respective interests in the title. The bona fide purchaser from the conditional owner who acquires physical possession of the asset may thereby even acquire full title, thus title free of any condition. In these countries, such uncluttered title cannot be obtained from a conditional owner without physical possession of the goods and the rule does not operate in respect of other assets. Generally, to a purchaser aware of the conditionality, full title can only be transferred by both conditional owners together, except perhaps in some common law countries when disposal is in the nature of the asset or it is disposed of in the ordinary course of business when the bona fides of the acquirer may even become irrelevant. This is the realm of defeasible equitable titles, which raises the issue who has or retains legal title, as we shall see. Also, the inability to dispose of full title might not prevent a financier with conditional title from collecting receivables and using the proceeds for set-off against the purchase price repayment obligation by way of amortisation. Only Dutch law requires the physical transfer of the asset for the creation of suspensive ownership (Art 3.91), particularly relevant for reservations of title. In the US before the broad acceptance of the UCC, the possibility for each party to transfer its conditional ownership interest, for the holder to transfer the assets themselves, and for bona fide purchasers to claim full title (either as successor of the legal owner or upon repudiation of all unknown equitable interests in the property),

142 Volume 5: Financial Products and Funding Techniques the case of a bankrupt financier in possession: the repurchase option might have been merely in personam, but the repurchase duty and the tendering of the repurchase price could conceivably give proprietary protection and reclamation rights. Any pledge of a bankrupt financier would, gave rise to much case law. In so far as the protection of bona fide purchasers was concerned, the filing requirement in some States also proved relevant and the rules of bailment or physical possession were also important. Although the fact that the seller reserved ownership meant for many that the buyer could not have a proprietary right (see Re Lyon Fed Cas No 8, 644 (1872)), it was always clear that the buyer could unilaterally make himself the owner and it was therefore also accepted that the relationship between seller and buyer was not one of merely creditor and debtor (see Holt Manufacturing Co v Jaussand 132 Wash 667 (1925)), certainly if the seller did not rely on his/her action to recover the purchase price but rather on his/her proprietary protection as a conditional seller only, but it was also clear that upon a conditional sale, the position of the seller was no longer one of absolute unbridled ownership either. The seller had a lesser interest which s/he could nevertheless sell. Also, the buyer had some interest in the property. When in possession, some saw him/her as a bailee: Rodgers v Rachman 109 Cal 552 (1895), but it was often thought to be more than that: see State v Automobile 122 Me 280 (1925) as a true bailment is temporary in nature. It was sometimes believed that a defeasible title had indeed vested in the buyer: Peter Water Wheel Co v Oregon Iron & Steel Co 87, Or 248 (1918). Others thought it to be an equitable interest like future interests: Carolina Co v Unaka Sporings Lumber Co 130 Tenn 354 (1914), whilst the buyer was to all intents and purposes believed the (legal?) owner in Kentucky Wagon Manufacturing Co v Blanton-Curtis Mercantile Co 8 Ala App 669 (1913), although it was probably never legal ownership; see also Blackwell v Walker Bros below. His/her title was thought to exist in principle, however, to be ripened by payment into an absolute title in Newhall v Kingsbury 131 Mass 445 (1881), which the seller could not stop: Brian v HA Born Packers’ Supply Co 203 Ill App 262 (1917). It was clear, however, that the buyer was not allowed to divest him/herself of his/her interest, either through agreement with the seller or through surrender, merely in order to defraud his/her creditors: Horn v Georgia Fertilizer & Oil Co 18 Ga App 35 (1916). A simple return of the property to relieve him/her from the payment burden was also not accepted: Appleton v Norwalk Library Corp 53 Conn 4 (1885). Thus each party had apparently a sufficient interest in the property at least to be able to defend it independently of the other, could sell and defend it, and had a negligence action against third parties for damage to or destruction of the property, the seller probably on the basis of his/her general ownership right (legal title) and the buyer on the basis of a special ownership right (equitable title): Smith v Gufford 36 Fla 481 (1895). Naturally an action of the one was a bar to that of the other: Louisville & NR Co v Mack 2 Tenn CCA 194 (1911). They did not need to join and the seller needed no permission of the buyer nor did s/he need possession. A settlement by the buyer did not necessarily bind the seller either, but an action in trespass could only be brought by the seller after default by the buyer: Fields v Williams 91 Ala 502 (1890). As for the transfer of each party’s interest, it indeed came to be accepted that both the seller and the buyer could transfer their interest without the consent or involvement of the other party, even if this did not transfer full title in the chattels. See for the interest of the seller, Burrier v Cunningham Piano Co 135 Md 135 (1919), and the Uniform Conditional Sales Act was believed to support it: Van Marel v Watson 235 Pac 144 (1925). The form in which the seller (not in possession) could do this was through assignment, as the seller’s right to retake the property was characterised as a chose in action. The assignment was not subject to any formalities in terms of documentation or notification to the conditional buyer in possession: Swann Davis Co v Stanton 7 Ga App 688 (1910). It was necessary to specify the interest transferred; just writing over the contract document that it was assigned was not sufficient. It was also possible to transfer a security interest in the seller’s remainder: Thayer v Yakima Tire Service Co 116 Wash 299 (1921), but there was a question whether in that case the lienee acquired only a collection right for the purchase price or also a security interest in the chattel when it returned to the seller upon default of the buyer: Bank of California v Danamiller 125 Wash 225 (1923). The assignment of the purchase price itself did not include an assignment of the conditional title except if so intended: see for this ancillary issue n 279 above. An assignment of the conditional interest itself divested the seller of all his/her rights in the assets. A subsequent second sale of his/her interest, even if accompanied by delivery of the asset to the new assignee, was ineffective even if the latter was bona fide: Newell Bros v Hanson 97 Vt 297 (1924). The bona fide purchaser of the interest of the seller if still qualified as the legal interest could ignore all interests of the buyer if qualified as equitable but (if in possession) not his/her bailment, it being a proprietary interest at law. A transfer of the buyer’s interest in the asset was also possible, and upon the physical delivery of the asset, the full title of the bona fide purchaser might be protected, even if legal title remained with the seller, the usual exception to the nemo dat rule in sales of goods. There could also have been an implied licence of the seller authorising the buyer to do so in the ordinary course of his/her business, which would have protected all purchasers. But the purchaser of the interest of the conditional buyer could not otherwise repudiate the legal title in the original seller or his/her successor in interest.

Volume 5: Financial Products and Funding Techniques 143 on the other hand, certainly disappear upon repayment of the loan by the debtor, which gave him a reclaiming right in the asset. Finally, there were also to be considered the effect of an attachment levied on the interests of either party to a conditional sale by creditors of either,286 It was thus sometimes held that delivery of physical possession to the buyer in a conditional sale gave him/her indicia of ownership, but in the majority view this was not truly the case as no title was thought to have passed and possession was no more than prima facie evidence of it: see Blackwell v Walker Bros 5 Fed 419 (1880). There was as a consequence no sufficient entrusting of the asset to the buyer allowing him/her to at least transfer good title to bona fide purchasers. But these purchasers as well as bona fide creditors of the buyer were nevertheless protected in some States: see Beatrice Creamery Co v Sylvester 65 Colo 569 (1919). This was then done on the basis of bailment in the purchaser. Where there was a filing requirement, it gave the seller a much better position. On the other hand, its omission tended further to protect the rights of third parties including purchasers and creditors of the buyer, at least if unaware of the seller’s interest. The Uniform Conditional Sales Act 1918 (s 3) followed this line. All the same, whatever the buyer had in terms of conditional title or future equitable right was normally deemed transferable without consent of the other party: Re Pittsburgh Industrial Iron Works, 179 Fed 151 (1910) and it is clear that it could give the bona fide purchaser of such an interest an even better position than his/her predecessor if s/he also acquired physical possession. That would be particularly relevant if there were multiple equitable interests of others in the property. But it is still important to understand that in those cases the purchaser of the interest would rely on the bailment rather than on his/her underlying (equitable) right to hold on to the property, which seemed to decide the issue when there were multiple equitable claims, assuming that the purchaser of the interest was unaware of them when s/he acquired his/her own interest. As in the case of the seller, the buyer could also sub-encumber his/her interest either by granting his/her bank a security interest in his/her conditional title or by selling on the interest in a further conditional sale of his/her own, but case law remained divided as some continued to argue that the buyer had no right in the title at all, but the better view was probably that the sub-vendee acquired a right in the property subject to that of the original seller: Clinton v Ross 108 Ark 442 (1912). The seller’s title could thus be weakened by the actions of the buyer but remained protected against after-acquired property clauses in earlier mortgages or security interests granted by the buyer to his/her creditors. It was one of the main attractions of the conditional sale and one of the main reasons for its popularity, as mentioned above: see Hanesley v Council 147 Ga 27 (1917). This also applied to purchasers in an execution sale conducted against the buyer who could only buy subject to the seller’s interest even if bona fide. On the other hand, where goods were sold by the buyer in the ordinary course of his/her business, the purchaser acquired full title even if s/he was aware of the interests of the original seller. This was a major departure reflected also in the Uniform Conditional Sales Act 1918 (s 9) and was retained in the UCC. 284 A pledgee normally has no right to repledge his/her interest: see also Art 3.242 Dutch CC. It is only the owner who can do so, although there was authority to the contrary in Roman law and the ius commune (C 8.23) and common law in England also accepted the possibility, thus viewing the pledgee’s interest as a right independent of the claim it insured: see in England Donald v Suckling (1866) LR 1 QB 585 subject always to a contractual clause to the contrary when the goods could still be (conditionally) sold however: see n 217 above. See in the US before the UCC, n 278 above. An interesting complication is whether an encumbrance of his/her interest by one of the parties in a conditional ownership also affects the other. Under civil law, where the bona fide pledgee taking possession is often protected, s/he would thus take more than the pledgor may have or can give. This is less likely to be the result under common law, which adopts a more rigorous interpretation of the nemo dat rule, certainly outside the law of sales. 285 See for common law in England, nn 236 and 237 above and accompanying text. In the US under pre-UCC law, the property conditionally sold had to be specific but could be described generally. The description could be so general as to render the conditional sale invalid, but parol evidence was allowed to describe the property: Thomas Furniture Co v T&C Furniture Co 120 Ga 879 (1909). Under the Uniform Conditional Sales Act 1918, a reasonable identification was sufficient: cf also the present s 9-108 UCC. It should be remembered here that a document was not normally necessary for a conditional sale: see n 277 above. Future assets could be included provided they could also be sufficiently identified (Benner v Puffer 114 Mass 376 (1874)), but especially in this context the description could be too general. The general rules of goods not in esse were thought applicable and they were at law more restrictive than in equity—and conditional sales were transactions at law (even though where they resulted in future interests in chattels, these were equitable). The inclusion of after-acquired property in the conditional sale was subject to similar specificity requirements, although this inclusion was sometimes explained as creating a security interest in the nature of a floating charge. Such an after-acquired property clause could not affect goods that the seller received under conditional sales. A substitution of property was possible in a conditional sale if specifically so agreed, as in a herd of cows: Paris v Vail 18 Vt 277 (1846). Sometimes new property was automatically included as in the case of accession

144 Volume 5: Financial Products and Funding Techniques or the inclusion of either party’s interest in a bankruptcy of the other and his/her bankrupt estate.287 This raised the issue of the ranking of each party’s interests in the priority ladder of the other’s bankruptcy and their relationship to security holders in the same asset. Thus, a reservation of title (even calf in cattle) or repair (like new tyres on a car). On the other hand, the conditional right in the property could also be lost, eg, if it was affixed to real estate: see s 7 of the Uniform Conditional Sales Act 1918. The conditional sale could also be used to support other debt: Union Machinery & Supply Co v Thompson 98 Wash 119 (1917), but this had to be agreed and was not automatic: Smith v Long Cigar & Grocery Co 21 Ga App 730 (1917). If another debt was to be covered, normally payments were used to extinguish that debt first and the payment of the purchase price, which was the true condition of the title transfer, would then be deemed to take place last: Faist v Waldo 57 Ark 270 (1893). Finally, the rights of the seller could shift into proceeds and authorisation did not appear necessary and no general clause to the effect was required in the conditional sale contract. It was not considered a fraud on other creditors: Prentiss Tool & Supply Co v Schirmer 136 NY 305 (1892). However, where the buyer was authorised to sell the property, this could defeat the shift into proceeds: Re Howland 109 Fed 869 (1901). Where there had been commingling, such proceeds as could be identified to the original conditional sale were reclaimable. If this was not possible, the seller’s right was lost, which could already be so if the good was irretrievably commingled with others, notably the buyer’s own: Re Agnew 178 Fed 478 (1909). 286 Exceptionally, German law has a specific statutory rule in the case of reservations of title: see s 771 Code of Civil Procedure, and allows the conditional buyer’s creditors to attach the latter’s rights. The conditional seller may object, to protect his/her title against a judicial sale and allege unjust attachment. Under German case law, the buyer may similarly object to an attachment of the assets by the seller’s creditors. Where the attachment does not itself result in a charge, which is the situation in most West European countries, although not in Germany, and in most States of the US, the measure is a mere order to preserve or execute the asset. As in the case of a conditional sale the attachment does not cover full title but only each conditional owner’s limited disposition right and interest in the asset, it might not be very valuable and hardly result in a worthwhile sale, especially in countries where an execution sale is not free and clear of all charges in it: see also n 276 above. In pre-UCC law in the US, it was clear that the seller’s and buyer’s rights in the chattels conditionally sold were both subject to the recovery rights of their creditors, but this did not apply to more than each party to the conditional sale had, although case law remained divided on whether in the case of the buyer, even if in possession, there was a leviable interest. It depended on one’s view of the nature of his/her interest. Where it was considered merely equitable it was sometimes deemed not sufficiently vested to be attachable: Goodell v Fairbrother 12 RI 233 (1878). Yet there was also case law to the contrary: Savall v Wauful 16 NY Supp 219 (1890). Another possibility was to give creditors of the buyer the right to tender the purchase price in order to obtain a leviable interest in this manner: Frank v Batten 1 NY Supp 705 (1888). In any event, creditors of a buyer in possession would normally attempt to attach the whole property, in which case the seller had to defend himself. As a general proposition, the seller’s interest was good against the creditors of the buyer, although in recording States this was subject to his/her proper filing, and in the case of failure to do so, the bona fide creditors of the buyer were likely to prevail. Otherwise, creditors of the buyer could not interfere with the seller’s right on penalty of wrongful attachment and an execution sale would not improve their rights or the title of the buyer in such a sale. Damages would be payable if the seller were wrongfully thwarted in regaining physical possession. Yet the attachment was meaningful if it preserved the asset until the maturity date, the payment of the last instalment and the acquisition of absolute title by the buyer. 287 In a bankruptcy of a seller under a reservation of title, the trustee prevails over a buyer under a reservation of title if the latter does not pay. Only if the contract is still executory, ie, it is not fulfilled in whole or in part by either party, is there a choice for the trustee either to continue or terminate the contract, cf eg, s 365 of the US Bankruptcy Code and ss 103 and 107 of the German Insolvency Act 1999. In leasing, the contract is often considered executory even though the lessor has delivered the asset, hence the election right rather than the appropriation in the case of a bankruptcy of the lessee: see also the text at n 265 above. In the US, this appears also to be the case in repos. It is important to realise that without the characterisation of the underlying contract as executory, with the implied option to terminate the agreement in a bankruptcy of a financier or buyer of the assets, the bankruptcy trustee may have to wait until the repayment or repayment option date before s/he can reclaim the purchase price (upon offering the return of the assets), which is in fact no different from a repayment of a secured loan. In a bankruptcy of the conditional vendor, on the other hand, the claim of the financier for the repurchase price will mature immediately so that s/he may be able to appropriate a full ownership right if there is no payment in full by the trustee. In Germany in a Sicherungsübereignung, the original owner always has an in rem reclaiming right: see text at n 175 above. It is in fact an in rem option.

Volume 5: Financial Products and Funding Techniques 145 could in theory give the highest priority to the seller in a bankruptcy of the buyer. Full title could then be returned to him, but s/he could be subject to later security interests created by the buyer in the asset. In connection with this, conditional owners might not be competing creditors in the other’s bankruptcy at all and may have had more the status of co-owners or partners who take subject to the security interest of all others, even if later, although they may sometimes have had a facility to resist their creation if they became aware of it. It was likely to affect their revindication right also.288

2.1.4. Practical Issues and Relevance Comparative and historical research of this nature is useful as it demonstrates many of the substantive issues and differences between the ownership positions of parties under a conditional/finance sale or payment deferment scheme and in a security transaction. It identifies the issues between the conditional owners in the same asset in any resulting split-ownership situation. In particular it highlights the difference in the overall risk the parties are taking under the various schemes of funding or in sales credit and in the protection they may expect.

In the US in pre-UCC law, as at 1910, the trustee in bankruptcy was given the position of a lien creditor. It meant that the rights of conditional sellers who failed to record or file their interests became inferior to the rights of a trustee in bankruptcy of the buyer. Where there was no need to file, the right of the conditional seller remained superior, however, to the rights of the buyer’s trustee. The trustee could of course always pay off the seller in order to acquire full title. As we have seen, a conditional seller was no less protected against bona fide purchasers from the buyer, except again if s/he had failed to record his/her interest in States that required it. There was likely to be an exception if the seller had given the buyer a right to on-sell the asset when bona fides of purchasers may also have been irrelevant: see n 285 above in fine. Where the right of the conditional seller was only considered executory, the buyer’s trustee in bankruptcy might have had an election to continue or terminate the contract. Repudiation might have allowed the trustee to retain the asset subject to a competing claim for damages, but the more normal solution was to accept the seller’s replevin action, except where there had only been an agreement to sell but the buyer was in that case unlikely to have been in possession. In the case of a bankruptcy of the seller, his/her right was also likely to pass to his/her trustee who would have had to respect the buyer’s right to acquire full title upon payment. The trustee could not appropriate the asset before there was a default of the buyer. Where the seller still had custody of the assets, it appears that the buyer, even in a bankruptcy of the seller, was still entitled to them by offering the purchase price on the due date. s/he could then re-levy (or repossess) the asset. Thus, in such cases this right was considered proprietary and superior to the rights of the creditors and the trustee of the seller. Note that prior filing is not likely to affect the bona fides of the purchasers as there is normally no search duty in respect of charges in movable assets. 288 If it is true that the bona fide pledgee or chargee is protected against the conditionality of the ownership, as is the case for chattels in many civil law countries under the general rules of the protection of bona fides (subject to the requirements of proper consideration and actual possession)—see also n 284 above—it follows that the conditional owner without possession it postponed even if himself bona fide and unaware of any adverse interests created in the property by the other owner in the meantime. Any contractual prohibition concerning the alienability of the asset would not affect him, even if s/he knew of it: see also s 9-01 (9-311 old) UCC. Again, it is a general principle in civil law, at least in respect of chattels which cannot be tied down: see for the different civil law attitude in the case of a contractual prohibition of an assignment and for the UCC response, Vol 4, s 1.5.3. The result is that conditional owners may not be able to disown pledges given by the other party to the conditional sale, at least if the latter has transferred actual possession of the asset to the pledgee, as both cannot be protected at the same time. If the charge is non-possessory, even if registered or published, the situation may well be different and these (later) interests may rank lower than that of the conditional owner not in possession who will have the older right and therefore probably the better title except in systems in which published non-possessory interests have the rank of possessory interests, whilst the interest holder is at least bona fide in respect of the existence of any earlier proprietary interests.

146 Volume 5: Financial Products and Funding Techniques If we limit ourselves for the moment to the appropriation aspect, this may be essential to the party parting with the asset and is particularly indicative of the difference in risk between finance sales and secured transactions (which risk is not limited to the risk of loss of the asset and the liability for any damage caused by it). Especially in an inflationary climate, the seller of an asset under a reservation of title will not be interested in an execution sale and the return of any (inflated) overvalue to the defaulting buyer. In the case of a default, s/he would want to resell the asset whenever a good opportunity arose and preserve his/her store of value until such time. S/he would also want to avoid the extra risk of the delays necessarily attached to an execution sale. Even if technically s/he might be able to deduct any damages from this overvalue, they will have to be judicially assessed, which is costly and time-consuming. The alternative is to agree commercial interest with the buyer from the beginning, the rate of which in times of inflation would have to be high, a protection which s/he may be unlikely to get. Should the seller nevertheless obtain it, it was already said that it would be logical in such cases for the reservation of title to be considered a security interest, with any overvalue accruing to the buyer upon an execution sale. That would then be the bargain; in any event the seller cannot expect interest and overvalue at the same time. In an environment like that of the US, not used to high inflation, it may not have occurred to the drafters of the UCC that there is a fundamental issue here. In France, where the reservation of title is evolving into a security interest, it is less understandable. In the context of the Model Law of the EBRD, targeted at potentially higher-inflation countries, the re-characterisation of the reservation of title into a security interest was even more difficult to explain. Similarly, in a finance lease, the lessor will not normally be interested in an execution sale upon the default of the lessee. Again, it will be time-consuming and costly, while the often valuable asset, such as a ship or aircraft, remains unused; any cashing in of proceeds upon an execution sale may also substantially disrupt funding patterns. Instead, the lessor will normally want to re-lease the asset immediately, if necessary, through an operational lease. Or, if the asset was tailor made for the lessee, s/he may wish to make other arrangements but certainly not conduct an execution sale, which may yield very little and destroy everything. In exchange for this facility and the protection appropriation gives, the rent under the lease could be lower than the financing cost of an equivalent loan, although it naturally depends on the totality of the arrangement and on market conditions. In fact, as has already been mentioned, because of extra services, the amount payable under a finance lease is often higher than the interest would be if the asset were acquired directly by the lessee funded by a loan secured on it. Again, it is a different arrangement. Also, in other areas, banks may be willing to take risks under ownership-based funding for other types of rewards; that is their business and choice; it is not for the law to intervene and adjust risk in professional dealings. The conditional sales concept allows great flexibility and variety. That is its attraction and justification, at least among professionals. It may be noted in this connection that in hire-purchases, which resemble reservations of title very closely, an execution sale instead of appropriation is often required by statute to protect consumers who are the usual beneficiaries of this type of facility, but not professionals. Indeed, if modern US law is confining in a mandatory manner since the introduction of the unitary functional UCC approach, part of it (besides the confusion in older case law) may derive from a concern with abuse—especially of the appropriation facility upon default in respect of consumers—much as the appropriation under the earlier lex commissoria was discouraged in Roman law and in the ius commune. Important remnants are still left in civil law, especially in the case of security interests, although not necessarily when it comes to reclaiming an asset upon default under a sales agreement (at least if there is a reservation of title clause to the effect in the agreement).289 The concerns are likely to be 289 See s 1.1.8 above.

Volume 5: Financial Products and Funding Techniques 147 about proportionality of reward in the sense that the non-defaulting party gets more than s/he bargained for through an appropriation windfall. There may also be concerns about the rights of other creditors of the defaulter. If justified, these concerns can mostly be redressed, however, through in personam or obligatory actions including unjust enrichment. It was already said that normally, cashing in the overvalue will be justified as a lower reward structure was balancing this benefit or protection. At least in the professional sphere, there does not seem to be any fundamental policy against letting participants make their own arrangements in this respect, therefore also not in the appropriation or execution sale and overvalue aspects. In any event, it is hard to see why a (professional) defaulting party should always be entitled to the overvalue and why it should not be allowed to bargain this value away in advance in conditional ownership arrangements for other benefits. In modern financial schemes, there may be a combination of all kinds of options or repurchase rights and duties, which all raise the question of their in rem or proprietary effect. In fact, an option, which normally confers a contractual claiming right, may easily be clothed in a conditional ownership right, which the party may or may not elect to exercise, thus translating the option into an in rem claiming right. Another aspect is that in a conditional sale, the risk-sharing arrangement may be such that the financier, who does not qualify for the status of creditor proper, is as a consequence taken out of the priority ladder of the debtor. This presents a risk and may mean that the financier may end up with an ownership interest in the asset subject to all security interests granted by his counterparty (in possession) to bona fide creditors in the meantime, and to which s/he did not object if only because s/he was not aware of their creation. As observed before, on the European Continent, where the US functional approach is not adopted, these issues remain largely undiscussed although in France there has been some important case law attempting to distinguish the repurchase option agreement from the secured transaction, and they now operate in principle side by side.290 In Germany, the common Sicherungsübereignung started as a conditional transfer, as we have seen, but has now abandoned many of its features and has, at least in bankruptcy, become more like a preferential right in the sales proceeds of the assets (Absonderungsrecht).291 In the Netherlands, under its old law, this structure had acquired the status of a security interest (Aussonderungsrecht), as one would expect at least when supporting a loan agreement.292 In the above, we have seen that new Dutch statutory law, even though accepting conditional ownership rights (Article 3.84(4) CC), attempts to abolish the in rem effect of all conditional transfers used for funding purposes (not for sales credit), sees them as inadmissible security substitutes (Article 3.84(3)), but failed to define what such substitutes are. It did not introduce a functional or other workable criterion, nor is there a conversion into a secured transaction but only invalidity of proprietary effect. The rights so granted are then only deemed contractual, which has increased the confusion. Still, outside the area of funding, Dutch law accepts conditional ownership forms, although surprisingly it converts temporary ownership into a usufruct (Article 3.85 CC), probably another mistake. It remains to be seen how case law will ultimately react in the financial area; the indications so far go in the direction of renewed support for the conditional sales concept in non-loan situations, although the precise consequences for both parties still remain unclear.293 290 See n 115 above and accompanying text. 291 See n 177 above and accompanying text. 292 See n 175 above. 293 See respectively text at nn 181, 115 and 87ff above. See for the latest case law, n 76 above. For an early discussion of ownership-based financing, see also U Drobnig, ‘Uncitral Report, Part Two, International payments’ in VIII Yearbook of the United Nations Commission on International Trade Law (UNCITRAL) (1977), who pleads for the functional approach, therefore conversion into secured transactions.

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2.1.5. Nature, Use and Transfers of Conditional and Temporary Ownership Rights. The Difference between Them Where true conditional or finance sales are used to raise financing, ownership in assets so used is conditionally transferred. The conditions may vary, but are (at least in civil law countries’ typology) legally essentially of two types. They may either be suspensive conditions, also called conditions precedent or suspending conditions, or they may be resolutive or resolving conditions, also called conditions subsequent or rescinding conditions. In a conditional transfer, some form of ownership remains with the seller until a certain event occurs, for example payment of the sale price, when the buyer becomes full owner.294 This results in a delayed transfer and is often considered the essence of the reservation of title. Title may also be considered transferred immediately, but made subject to a resolutive condition, such as nonpayment. The reservation of title can also be expressed in this manner, but it seems less common. All sales may even be deemed to be subject to an implicit resolutive condition of proper payment, thus becoming subject to an implicit conditionality of the ownership they transfer. In civil law as we have seen, this facility is referred to as the lex commissoria tacita, and suggests that title reverts to the seller as of right upon non-payment. This concept already of Roman law origin, later weakened in civil law countries in many ways, was always less fundamental to common law. Dutch law before 1992 gave full proprietary effect to this implied condition, and would automatically allow title to return to the seller upon default, even in a bankruptcy of the buyer in possession. It no longer has such proprietary effect in the Netherlands unless expressly agreed in the sales agreement, then called the lex commissoria expressa, see Article 3.84(4) CC, which remains effective in a subsequent bankruptcy of the buyer.295 In Germany an explicit condition, if intended to undo the proprietary transfer agreement (Einigung), may also still be effective in bankruptcy. The lex commissoria tacita still operates in a proprietary sense in France, but its effect is also curtailed in bankruptcy, as we have seen in section 1.3.2 above. Whether a condition of ownership transfer is qualified as resolving or suspending may not matter greatly as a resolving condition, negatively expressed, becomes a suspending condition and vice versa. Nevertheless, it is sometimes said that a suspending condition means to express that the creation of an intended legal consequence is made dependent on an uncertain event, 294 Duality of ownership in conditional transfers is often supported in civil law countries, at least in principle: see nn 116 and 82 above (France and the Netherlands), but is less common in Germany where the expectancy (Anwartschaft) is characterised instead as a proprietary right (outside the system): see n 168 above. This may be in the realm of semantics, but cf more recently Scheltema (n 168) 46, 124ff, who also rejects duality and opts for an independent limited proprietary right. This denies the balance and economic realities innate in finance sales. There was no great clarity in Roman law on the nature of conditions. In classical Roman law, the rescinding condition did not clearly figure unlike the suspending condition or condicio, which was well known. The rescinding condition was, however, sometimes construed as a suspensive condition for the counterparty of which approach there are remnants in D 18.3.1; see JA Ankum, ‘De opschortende voorwaarde naar Romeins recht en volgens het Nederlandse Burgerlijk Wetboek’ [The suspensive condition in Roman law and in the Dutch Civil Code] in Historisch Vooruitzicht, BW-krant Jaarboek (Arnhem, 1994) 19; see also n 79 above. But even then, a sale could be made conditional on payment (lex commissoria) or on a better bid within a time certain (in diem addictio); transfer restrictions could be construed as rescinding conditions whilst gifts could also be conditional. In Justinian law, the rescinding condition was more directly known and thought to have operated retroactively with proprietary or in rem effect (see D 6.1.41 and M Kaser, Römisches Privatrecht [Roman private law], 14th edn (Munich, 1986) 198), although contested by Windscheid: see n 168 above. It remains doubtful, however, whether more generally there was a proprietary consequence, and that property was automatically returned upon the fulfilment of the rescinding condition. This became the trend, however, in the ius commune: see more extensively Scheltema, above n 168, 50, 58, 75, 129ff. 295 See for the situation in the Netherlands the text at n 82 above and in France the text at n 111 above.

Volume 5: Financial Products and Funding Techniques 149 while in a rescinding condition the continuation of the legal consequence is made so dependent. It must be assumed that the contract stipulating the condition is not itself affected thereby, and that the condition only concerns the consequences that arise from it including, importantly, in a sale the proprietary transfers that result (at least in systems where property is transferred by agreement only). More fundamental is to appreciate that the one is the mirror of the other, therefore the suspended interest the other side of the resolving interest, so that the resolving condition for the one party is the suspending condition for the other. Thus, in a reservation of title, payment may be seen as the suspending condition of the ownership of the buyer, but it is the resolving condition of the ownership of the seller. Under the lex commissoria, default or non-payment is the resolving condition for the buyer but the suspending condition for the seller in whom full ownership automatically re-vests. In a pure repurchase agreement (not involving fungible assets), failure to tender the repurchase price in a timely manner may similarly resolve any remaining title in the seller and vest it absolutely in the buyer. On the other hand, the tender itself may vest full title absolutely in the seller (assuming there was not a mere option of retrieval) and divest the buyer of any proprietary rights or expectancies. In a finance lease, it will often be the payment of the agreed instalments that resolves the title of the lessor and vests it in the lessee absolutely (assuming that was the agreement and there is no mere option for the lessee to acquire full title, whether or not against a further payment). In factoring, excess receivables—receivables that cannot be collected or were not approved by the factor—may in this manner be automatically returned when this becomes clear, a feat that would resolve the factor’s (or assignee’s) title and revest the relevant receivables absolutely in the seller/assignor. As just mentioned, it may not make much difference in this connection which party has the resolving or suspended title, provided both are seen as having proprietary protection. Only if under applicable law that is not so, and one party remains with only an obligatory reclaiming right (usually, it seems, the party with the suspended title, at least if it has also physical possession), is the situation different. But even if both parties have a proprietary right, there is still a question which party would incur the burdens and benefit of ownership and this is usually considered the party in physical possession or with sufficient control of the asset(s), who may then also incur some special duties to look after it. In that case, this party may also be able to collect the benefits attached to it, although the contract itself may of course provide otherwise. But these rights and duties then seem to relate more to physical possession than to the nature of the interest being resolutive or suspended, although by contract the parties may always agree differently. Whether it matters or not, it is often efficient to consider the party who is intended to obtain the ultimate full title as the party with the suspensive interest, the other with the resolving interest, but as was already noted it may also depend on whether the condition is positively or negatively expressed and, as we shall see, possibly on the way the proprietary interest is manifested (ownership, possession or holdership), at least in civil law. It may be repeated that in a reservation of title and in a finance lease, it is respectively the buyer and lessee who are normally considered to have suspensive title. The ownership is therefore suspended as regards them, and resolving as regards the seller and lessor respectively. Under the lex commissoria and in repos, the sellers normally appear to have the suspending title and the buyers the resolving one. Again, much more important is whether both parties may claim some proprietary interest (and protection) and this is only so if these conditions result in some duality in ownership: one party as owner under a resolutive condition and the other under a suspensive condition. In common law this is likely to be expressed in terms of future interests and that provides some framework also for movable assets (in equity). Such a framework is largely missing in civil law. As may be seen in Volume 4, section 1.2.2, the civil law of property thinks of each of the proprietary

150 Volume 5: Financial Products and Funding Techniques interests in terms of ownership, possession and holdership. Ownership expresses the underlying proprietary right the fullest; possession is the appearance of it and usually goes together with ownership (or otherwise, if bona fide, will lead to it through acquisitive prescription). It may also be constructive, in which case holdership arises, which is the situation where someone holds the asset for someone else (normally the owner and legal possessor). This triptych presents a fundamental set of distinctions in civil law, and goes to the manifestation, protection and transfer of the underlying proprietary right, here in terms of resolutive and suspensive rights, and concerns then primarily the ownership of the underlying conditional proprietary rights and the connected concepts of legal or constructive possession, and perhaps even of holdership of these rights. Thus, in civil law, the owner under a resolutive condition is normally also the legal possessor under that condition, while the other party has suspensive ownership and possession. The protection of the underlying rights is in the ownership or possessory actions. As regards the holdership of the assets, it may be too fanciful to split it into a resolutive and suspensive part. Holdership may also be too factual to do so (even though it may still be constructive). In any event the holder normally defends in tort and depends for the proprietary actions on the owner or possessor (except in Germany where the holder may borrow the possessory action). Yet if either the resolutive or suspensive owner/possessor also has the physical possession, this person cannot yet know whether s/he may hold for him/her or is indeed holding for someone else as ultimate owner/possessor. In that sense, there will be suspensive holdership in civil law terms. It would mean that, in a reservation of title, the physical holder holds the resolutive title for the seller, but is the owner/possessor of the suspensive title. It might thus be said that the physical holder has either a suspensive and resolutive holdership, depending on whether s/he has (for the time being) respectively resolutive or suspensive ownership. Again, where there is a duality of ownership, the resolutive and suspensive interests in title and possession so created (in civil law) are for each party truly each other’s complement and together constitute full ownership and possession in civil law terms. Thus, the seller still in possession under a reservation of title may be considered the owner and possessor under a resolving condition (and possibly the holder under a suspensive condition) pending full payment. In the case of a default, this right becomes full again and any holdership lapses. If the buyer has the asset, which is the more normal situation, the latter has suspensive ownership and possessory rights, but could be said to hold under the resolving condition of his own payment. If s/he pays, the holdership disappears; s/he will then hold for himself as legal possessor. If s/he does not pay, his/her holdership (for the seller/owner) becomes unconditional, although it is unlikely to continue. Because of these complications it may well be that the civil law triptych for the defence of proprietary rights must yield to negligence actions in practice when these rights become conditional. As already mentioned, in common law, the situation is somewhat different. It is on the whole comfortable with the notions of conditional or temporary title, which mirror in equity the defeasible titles in land law, but normally the distinction is not along the lines of the resolving and suspensive title. In common law, the (Roman law) triptych of ownership, legal possession and holdership is also unknown and the normal proprietary structures in chattels are (a) ownership, (b) (physical) possession (often bailment), and (c) equitable interests such as beneficial, future or conditional ownership rights: see in more detail Volume 4, section 1.3.1. Thus, in common law countries, future or conditional and temporary ownership rights in chattels are mostly considered equitable interests and concern executory, remainder and reversionary interests. They are all defended in tort and need not be explained here much further, but do not fit well into the civil law terminology of suspending or resolving title. They have their own typical formulations (in the sense of rights that last ‘as long as’, or given ‘on condition that’, etc). They may become connected in chains of ownership and are in the case of movable property all hidden interests that

Volume 5: Financial Products and Funding Techniques 151 are nevertheless proprietary and are as such notably not extinguished by statutes of limitation. On the other hand, they may not be acquired through prescription (as is possible for all proprietary interests in civil law), and are all lost when the legal interest in the asset is transferred to bona fide purchasers for value, even in the case of intangible assets such as receivables. This is unlike the attitude to proprietary interests in civil law, which are superseded by the better right of bona fide purchasers only of chattels (and not even then in all civil law countries). In common law, these future interests are also not directly related to possession which, if voluntarily transferred, results in bailment, but have their own structure in which some duality of ownership is, however, inherent, if only the split between legal and equitable title. The rules concerning physical possession or bailment may still cut through this, as under common law bailees as physical possessors have a strong separate protection right also vis-à-vis conditional or temporary title holders who obtain full title even after the bailee’s own conditional title has lapsed: see more particularly Volume 4, section 1.3.2. So, it is in essence in a bankruptcy of the bailee/buyer even under a reservation of title, when in common law a special exception had to be construed so that the position of the seller would remain properly protected, see section 1.5 above. The argument here is that conditional sales giving possession to the buyer may create even more than a buyer’s bailment, as a bailment itself always implies a return of the asset after its objectives have been met.296 The intention in a reservation of title is the opposite. In sum, conditional ownership rights under common law operate in a number of important aspects quite differently from conditional proprietary interests in civil law, but the notion is in essence not distinct, at least when in civil law both conditional owners of an asset are given proprietary status and protection in a duality of ownership. This was identified earlier as a question of the opening up of the (closed or numerus clausus) system of proprietary rights in civil law: see also Volume 4, section 1.3.8.297 In common law, this openness exists in equity (subject always to the protection of the bona fide transferee/assignee for value). Yet is should be appreciated that in common law countries segregation in bankruptcy may not be irretrievable be connected with the operation of (equitable) proprietary rights but is rather a separate issue through it is connected. It may be relevant in this connection that bankruptcy itself is an equitable remedy. In civil law, this connection is more obvious (although also there under pressure in corporate reorganisations upon insolvency) and the key question then remains whether the duality in ownership, and therefore the proprietary interest of either party, is accepted. In civil law there is much more of a conceptual approach in these matters, as sections 158–63 BGB show in Germany, although even in Germany the proprietary protection of future interests remains embryonic. Where, however, the proprietary interests of both partners under a conditional sale and title transfer become accepted, these interests are protected against claims of third parties,

296 See nn 237 and 273 above for the tenuous position of the bailor in a bankruptcy of the bailee. 297 In common law, the question needs to be considered who has legal or equitable title, which may not always be simple to determine. It is relevant because bona fides only protects against equitable interests, not the legal interest, except in outright sales (by statute). Another issue is here that multiple equitable interests may operate side by side, eg, where a seller sells the same object several times over, subject to reservations of title. All buyers may be bona fide and as such able to ignore other equitable interests (regardless of possession), but the one who gets possession is ultimately likely to be the winner, as its bailment will be protected (rather than the claim based on underlying equitable interest) and (exceptionally) develop into full title. See for discussion of these issues in early US case law nn 278/9 above. In civil law, only the bona fide purchaser with physical possession is likely to be protected. The result may therefore mostly be no different, though the argument is, and it leaves out the transfers in assets other than chattels. Here in common law, in the case of receivables, the emphasis is on the protection of the first collecting assignee assuming his/her good faith, see also Vol 4, s 1.5.3.

152 Volume 5: Financial Products and Funding Techniques including those of the creditors of the other conditional owner. The interests of either party then also become freely transferable (but must in countries like Germany and the Netherlands still be delivered by providing possession, which may, however, in their system be entirely constructive). Case law and doctrine show this, particularly in Germany, culminating as we have seen in the development of the dingliche Anwartschaft or proprietary expectancy. In the Netherlands, the concept of duality of ownership is retained instead and awaits further development, as we have seen.298 In both countries the situation is as yet less clear, in particular for finance sales such as repos, finance leases and factoring. In fact, as we have also seen, in Germany the proprietary expectancy is often considered a new kind of proprietary right, and the duality in ownership itself is then less favoured, which has also to do with their abstract system of title transfer: see section 1.4.1 above and Volume 4, section 1.7.3. Whatever the approach adopted for the reservation of title, it is then mostly thought not to be extended to other conditional sales. That is also the approach in the DCFR but it may be questioned whether this is helpful. It may be necessary to consider here more specifically also temporary or delayed transfers. In civil law, they are often distinguished from conditional transfers. It is true that temporary or delayed transfers may arise from contractually agreed time limits, but they may factually also result from conditions. The practical effect of contingencies or conditions and time limits is, therefore, often the same in terms of temporary or delayed transfers but the trigger is likely to be different. In contingencies, the event that triggers the transfer or return of full ownership (and therefore the temporary or delayed transfer) is uncertain, like payment in the case of a reservation of title or the tender of the repurchase price under a repurchase agreement. In a time limit, the event is certain and the title will transfer or revert at the agreed time, for example where title is given to A until a certain date, and thereafter to B, or reverts on that date to the original owner in full ownership. There is no true condition here. It may be noted that conditions in the title transfer may also result from the stipulation of certain uses; for example, title is given as long as a property can be used by grantees for a specific (charitable) purpose, but is meant to revert thereafter or is then transferred to other grantees for other purposes. In civil law terms, this would be a condition. It may cut short an interest, which does not thereby become temporary, but is conditional. This may seem simple enough, but conditions and time limits may be intertwined, and confusion often results. For example, in the case of a contingency, the uncertain event may be related to a date certain on which it is tested whether the contingency has matured, such as on the agreed payment or repurchase date. That date itself could also be flexible, such as the moment of delivery or completion of a project. Even if the testing date is certain, the triggering event may still be uncertain and there is, therefore, still a conditional transfer, the (un)certainty of the event and not of the date being the crucial element. On the other hand, in a time limit, the event may be certain, for example death, but the date still uncertain. Yet there is no condition but a time limit, and the result is therefore a temporary, rather than a conditional ownership. Even then it may not all be as clear as it looks. In the repo, there is a temporary transfer if one emphasises the repurchase date, but there is a conditional transfer if one puts the emphasis on the tender of the repurchase price. It is clear on the other hand that time limits may, like contingencies, be resolutive or suspensive of the title transfer and—it is submitted—then also result in a duality of ownership, the one complementing the other. Again, in common law, for movable property these time limits, like conditions, are well known in the equitable law of future interests and defeasible titles and not distinguished 298 See n 165 above.

Volume 5: Financial Products and Funding Techniques 153 in this manner.299 In civil law, these future interests resulting in temporary or delayed ownership rights may sometimes show some similarity to usufructs, especially when there are time limits set to certain user and income rights, but this is a wholly unsuitable construction in finance. In fact, the difference between conditional and temporary ownership is unlikely to have significant legal consequences in civil law either (cf also section 163 BGB). For the purposes of this study, it is usually unnecessary to make a distinction. Such a need arises only when, as under new Dutch law, a temporary transfer of an asset is indeed re-characterised as and converted into a usufruct (Article 3.85 CC).300 It must then be distinguished from a conditional transfer, which is in principle allowed (unless as a security substitute, as we have already seen) and is not treated in the same way. Although as just mentioned the temporary sale might sometimes have some features of a usufruct, this modern Dutch departure, which converts them all by statute and re-characterises them in this manner, is unusual, not helpful or properly thought through, especially its meaning in finance. In French law, there may be another need for the distinction. Here the argument is that in conditional sales the return of ownership is retroactive while this is not believed to be the case if the title is merely temporary and its return in that sense delayed.301 This is a difference which may well obtain elsewhere in civil law also. As to the details of these new interests, the proprietary relationship between both parties to a conditional or temporary sale and title transfer concerns foremost the balance between the rights of conditional or temporary owners of the same asset, but it was already mentioned that this has also an immediate effect on the rights of their creditors and their position in a bankruptcy of the other party. One could see here an internal and external aspect of conditional or temporary ownership rights. Particular practical issues are: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

the creation of the interest; the qualification of the arrangement as dual ownership, bailment, or executory contract; the comparison between the position of the seller and buyer; the shifting of the interests into replacement goods; the rights to physical possession, capital gains, and the liability for loss; the transfer of the interests of each party and the possibility of sub-encumbrances in each party’s interest; the protection of bona fide purchasers from either party; the consequences of default of either party, the execution duty or appropriation right and the entitlement to overvalue; the position of the creditors of each party; the effect of attachment of each party’s interest; and the position and characterisation or ranking of each party’s interest in the other party’s bankruptcy.

299 Although in a reservation of title there is always a contingency, and therefore no time limit, in countries like France and the UK, the reservation of title is often characterised as a delayed rather than a conditional title transfer, as is more common in Germany and the Netherlands: see text at nn 76, 120, 159 and 229 above. In fact, reference is made here to no more than the effect of the condition, which is indeed to delay the transfer, but the resulting title for the buyer is conditional and not temporary. 300 Unlike pseudo-security interests which are, as we have seen in s 1.2.2 above, not converted into real security interests, but are deprived of their proprietary effect under Art 3.84(3) CC. 301 See n 127 above.

154 Volume 5: Financial Products and Funding Techniques As we have seen in section 2.1.3 above, these issues used to attract considerable attention also in the US before the UCC was enacted. So far, civil law has had little on offer because of its general unfamiliarity with the duality of ownership concept. At this stage the prime issue in civil law is the extent to which applicable domestic law allows conditional ownership structures to operate and develop in a proprietary fashion for both parties. An immediately related issue is the effect of the transnationalisation in terms of the application or disapplication of domestic rules (if restrictive) to these newer financial and proprietary structures in internationalised transactions. In practice, the question will foremost be reduced to the single issue of how new patterns of funding and risk distribution, often internationally established, relate to local thinking, itself expressed in terms of: (a) the mandatory law of secured transactions; (b) (at least in civil law) the closed proprietary system or numerus clausus; (c) the applicability of the lex situs of the underlying asset in these aspects (particularly problematic in the case of bulk assignments of intangible assets and of the transfer of assets that habitually move such as ships and aircraft) or that are future,302 and (d) the conversion of foreign interests, here conditional ownership rights used in assetbacked funding, into a comparable or nearest domestic interest (if any) especially in local bankruptcies. Any flexibility at the transnational level in this regard, that is, any acceptance or recognition domestically of the transnationalisation of the ownership concepts for these purposes to allow conditional or dual ownership rights to operate fully cross-border in financial transactions, will unavoidably reverberate in the domestic markets and claim its effect on local legal practices, especially in bankruptcies. In fact, allowing these newer methods and structures of funding to be internationally effective in the end will also mean accepting them domestically in purely local transactions, at least those between professionals who also operate in a similar manner internationally, and impose them on local bankruptcy laws either directly or in appropriate cases though recognition (and incorporation) of foreign interests.

2.1.6. The Duality of Ownership in Finance Sales and the Unsettling Impact of the Fungibility of the Underlying Assets In more modern, now often internationalised financing arrangements, ownership-based funding techniques through conditional sales have acquired great importance as alternatives to secured transactions. However, lack of insight into the difference between the two and into their basic structure may still present considerable recharacterisation risks for the financier. The danger is that the proprietary interest is by law converted into a security interest requiring an execution sale with a return of overvalue instead of appropriation or that all proprietary protection is lost for lack of sufficient recognition. In the case of default, it allows in the first instance any overvalue to accrue to the defaulting party. This conversion, which is now imperative under Article 9 UCC in the US (and may then make the product also subject to filing for its effectiveness), deprives, as we have seen, the financier of an important alternative and potential benefit, especially if the underlying asset has a market-related value as in the case of investment securities. In return for

302 Receivable financing became an issue for UNCITRAL since its Report on the work of its 28th session: Official Records of the General Assembly, 50th Session, Supplement No 17 (A/50/17) (1995), paras 374–81. In 2001 it resulted in a Convention on the Assignment of Receivables in International Trade: see ss 2.3.6 and 2.3.8 below.

Volume 5: Financial Products and Funding Techniques 155 this benefit, the financier may have accepted a lower or different reward for this kind of funding, as discussed in section 2.1.2 above. In bankruptcy, especially under modern reorganisation statutes, further adverse consequences may follow in terms of a stay and possible dilution of the converted interest when considered a security. Even in countries where this risk is not great, there is, at least in civil law, a considerable danger that the proprietary nature of the ownership-based funding structure and of the parties’ interests thereunder might not be sufficiently recognised or, as in the Netherlands, might be denied proprietary effect altogether in the context of funding. It was pointed out before, that if the right of the financier remains merely contractual, it will impede the liquidity of the underlying assets: the owner would be in breach of contract upon a sale (unless the contract allows it), the rights of the financier would not move with them (although repos are possessory and the problem would rather be whether the financier can sell or rehypothecate them). As has already been noted, in such cases the arrangement may also be defined as merely an executory contract, giving the parties only contractual rights vis-à-vis each other, while ownership of the underlying assets will be allotted to only one of them (even if it may not be immediately clear which of the two parties this will be). This has certainly given rise to problems in finance leasing because, using this approach, the lessor may be assumed to have retained the full ownership of the asset, while the lessee has only a contractual right, thus being deprived of any proprietary protection in a bankruptcy of the lessor, and subject to the option of repudiation by the bankruptcy trustee followed at best by a claim for damages as common creditor.303 On the other hand, in the US the lessor may under Article 9 UCC only have a security interest, making the lessee the owner, although in equipment leases under Article 2A UCC, as we shall see in section 2.4.3 below, the ownership issue is largely ignored. In repurchase agreements, it may, in this approach, be the seller who is considered to remain the sole owner until its failure to repay the purchase price on the appointed day, the buyer at best having a security interest (if properly established), although in repos of investment securities, the owner could be the buyer, (especially) if the assets are fungible securities, as we shall see shortly, while in factoring of receivables, it is then probably the factor/assignee. Thus, in modern financings, unless there is recharacterisation into a secured transaction, the financier appears to result mostly as the owner in this kind of reasoning which does not want to give both parties proprietary rights. The immediate consequence is that it allows the trustee in a bankruptcy of this party to claim full ownership and repudiate the rest of the deal (considered purely contractual) if detrimental to the estate. This would allow the other (non-bankrupt) party, in repos the repo seller, to present only a claim for damages as a common creditor who will thus have to surrender any rights in the asset and allows the bankruptcy trustee of the financier or repo buyer to keep the asset if it has increased in value and ignore the seller’s claim to it (and force the latter to file for damages as an ordinary creditor instead). If on the other hand the bankruptcy trustee wants to rid himself of an asset that has declined in value and prefers to collect the repurchase price, the trustee could still uphold the counterparty’s contractual duty to repurchase. In a finance lease, the bankruptcy trustee of a lessor would then hold the lessee to the terms of the lease if beneficial to the bankrupt estate or otherwise reclaim the asset, even though the lessee has possession, leaving the latter as a common creditor (although the lessee might still have some rental protection or a retention right for the damages or in common law rely on bailment notions). This is often referred to as the ‘cherry-picking’ option of the bankruptcy trustee,

303 See for the situation in the Netherlands text at n 89 above. The status quo is respected as long as no further action of the debtor is required.

156 Volume 5: Financial Products and Funding Techniques and shows the lack of balance that follows where the proprietary status of both parties is not sufficiently recognised and the characterisation of the finance sale or repo as an executory contract results. It would appear that cherry-picking is the unavoidable result. Commercial logic and needs increasingly require the law to accept differentiation and to acknowledge the different requirements in this area and the different risk and reward patterns established by the parties. They also demand adequate protection, which in finance sales (or property-based funding) should be proprietary in nature for either party. As explained above, particularly in civil law, such proprietary protection depends on a more liberal acceptance of the duality of the ownership structure and, to that extent, also on some opening up of the (civil law) system of proprietary rights. The key is greater freedom for the parties in this connection than they mostly have at present in civil law, in order for them to arrange the details of these (proprietary) rights and the protection they bring through the formulation of the conditions in their contract, always subject to a better protection of bona fide purchasers or purchasers in the ordinary course of business against such interests: see more particularly Volume 4, sections 1.3.8 and 1.10. The transnationalisation tendency in modern financial products acts here as a creative and, at the same time, unifying force. Generally, international practices would not seek to force the new financial structures into the prevailing domestic patterns of secured loans, which could deform the product and introduce vast differences in treatment, nor would they reduce them to executory contracts. The problem remains, however, that the conditional ownership structure intended to be created in ownership-based funding and the desired proprietary protection of either party thereunder do not necessarily correspond with those maintained or authorised by modern codifications, including the UCC in the US. Because of these local peculiarities there may be little general principle left that could reassert itself at the transnational level except commercial logic duly expressing itself in customary law. The expectation, particularly of the party looking forward to gaining full ownership (in Germany referred to as dingliche Anwartschaft mostly limited to reservations of title), thus of the party under a suspensive ownership title, may therefore still not so easily be protected in a proprietary manner and be transferable as such. Moreover, as was shown in the previous section, there is as yet little guidance on how the proprietary relationship between both parties in a conditional sale must then be seen in civil law and leaves the proprietary status of the rights of either party under these modern conditional finance sales in some limbo. Short of full transnationalisation of the law in this area under the modern lex mercatoria (see Volume 1, sections 1.1.4 and 3.2.2), it is urgent for legal doctrine and case law to fill in the gaps. Again, as mentioned in the previous sections, there is significant case law from pre-UCC practice in the US, especially in connection with the reservation of title.304 Although now superseded by the UCC, it remains conceptually relevant. It led to confusion, but history has shown that much more may not always be expected from statutory law in this area, especially when ignoring the basic commercial needs and distinctions as in the unitary functional approach of Article 9 UCC in the US and in the new Civil Code in the Netherlands. As was noted before and as we shall see again in section 4.2.2, a particular problem arises here in the case of repos when fungible assets are involved, especially important in the case of investment securities repos and is a seriously disturbing element in that the underlying assets need not be physically returned. It is connected also to the issue of the inclusion of future assets. 304 See for some early attention to the subject in Germany, n 163 above and in Roman law and later France n 108 above. See for the US, WA Estrich, The Law of Instalment Sales of Goods including Conditional Sales (Boston, MA, 1926) and the references to US case law in nn 275–84 above.

Volume 5: Financial Products and Funding Techniques 157 In the minds of many, it may affect the proprietary status of the repurchaser in a bankruptcy of the financier even further. As only assets of the same sort need to be returned, it was already mentioned that this is often thought to affect the proprietary right in such assets, although proper tracing notions could still operate. But it must be accepted that there is a limit to tracing under these circumstances—it may be even worse when the repo buyer on-sells the securities or gives them as a possessory pledge, which is normally allowed or considered an implied right. As a consequence, it is then believed that the original seller has only a contractual right left to receive a similar quantity of assets when properly tendering the repurchase price, although in equity this is not an inescapable conclusion. Yet, as a consequence, netting the relative values has become all the more the common remedy in securities repos under the relevant master agreement. Again, it is the issue of ownership in future assets, the shifting of rights in replacement goods and the matter of tracing: see also section 1.1.7 above. It was submitted that in an advanced legal system, proprietary rights in prospective assets, especially replacement assets which can be sufficiently identified is a necessary concept, and should not be frustrated by physical notions of assets, which must exist and be set aside, where in fact only (intangible) rights in or to these assets are always the true issue in law. In this newer approach proprietary rights in fungible assets are entirely feasible as long as these assets can be adequately described or remain identifiable as a class. Nevertheless, where there are sufficient reciprocal transactions, netting is likely to be the easier remedy—it may be seen as an admission of the existence of merely contractual rights, but it is a practical solution that should not deflect from the underlying legal characterisation which, in the alternative view, is not merely contractual.

2.1.7. Finance Sales and Sharia Financing The issue of financial sales and Sharia financing was briefly mentioned before, and needs some further clarification. The essence is that a guaranteed return of funding is not compatible with sharia law, and that all rewards in this connection must be connected with some commercial risk sharing. It follows that mere interest (riba) cannot be legally charged. On the other hand, uncertainty (gharar) is also to be avoided as far as possible, and speculation (mayseer) and punting (qimar) are forbidden. Yet what type of risk is or must be taken by investors may be less clear and ultimately subject to clerical opinion. It is not uncommon in this connection to refer to equity, stake holding or beneficial ownership in the scheme, but again that does not necessarily clarify the nature and extent of the interest. In fact, all debt is discouraged, which even goes as far as not allowing assignments of receivables unless by way of payment (as this reduces debt). The transfer of other claims must involve rights to underlying physical assets. It has a profound impact on banking and also affects its regulation,305 the essence being that the element of profit and loss sharing in respect of any money given to a bank (instead of a traditional deposit) and lending model of banks, both against interest payment, often leaving banks with complete discretion as to these investments, leads to different managerial and regulatory concerns or forms of supervision and then also to different capital requirements (if any). These may more properly relate to losses where banks themselves participate as principals

305 See S Archer and RA Abdel Karim, ‘The Structure, Regulation and Supervision of Islamic Banks’ (2012) 13 Journal of Banking Regulation 228.

158 Volume 5: Financial Products and Funding Techniques (which participation may even vary during the project to guarantee banks a more stable return). One other concern of regulators may be how investors of this type (as clients of banks) are to be treated in a winding up of the bank. There may also be special corporate governance issues in respect of these investments and their management, which may give rise to regulation more akin to that of investment management. In all cases, risk and reward structures different from loan financing must be found, and where assets are involved, in secular terms, some form of finance sale is likely to become the answer. Indeed, in the approach of this book, sharia financing is often best explained in this manner. In practice, there may be no more than a cash flow that will be shared, while the underlying assets themselves need not be owned by the investors or funding-providing entities; they will most certainly not function as collateral backing up the funding either. If there is an SPV involved, which is often the case, it will serve to ring-fence the (net) cash flow, but it need not own the assets that generate it either. It is common in this connection to distinguish between asset-based and asset-backed financing, the first focusing on cash flows, the latter also involving some ownership interests in the underlying assets or (investment) activities. Schemes will often look as follows: a funding arrangement concerning the acquisition of real estate acquires the form of a lease, which allows the buyer with funding of the bank or more directly from investors through a kind of (non-interest-bearing) bond issue to pay off the purchase price through instalments, the bank (or investors selected by the bank or the bank on their behalf) being the temporary owner and retaining in this manner a financial interest in the transaction. It is in fact not much different from the old common law mortgage as a conditional sale: there is a direct interest in the instalment income, which will be shared with the buyer of the land, who will need some of it for operating expenses. In more complicated schemes, an SPV may borrow in the conventional manner, but on-lends the proceeds in the manner just indicated. It assumes that the instalment income of the SPV will be sufficient to service its debt.306

306 For the Islamic capital market in general, see OICU-IOSCO, Report of the Islamic Capital Market Task Force of the International Organisation of Securities Commissions (July 2004) available at www.iiibf.org/media/ ICMIOSCOFactfindingReport.pdf; OICU-IOSCO, Analysis of the Application of IOSCO’s Objectives and Principles of Securities Regulation for Islamic Securities Products (September 2008) available at www.iosco.org/library/ pubdocs/pdf/IOSCOPD280.pdf. See further N Sardehi, Islamic Capital Markets; Developments and Challenges (Saarbrücken, 2008); see also Michael JT McMillen, ‘Islamic Capital Markets: Developments and Issues’ [2006] Capital Markets Law Journal 1; SS Ali, ‘Islamic Capital Market Products—Developments & Challenges’ [2005] Occasional Papers published by Islamic Development Bank Group, Islamic Research and Training Institute; IMF Working Paper by V Sandararajan and L Erico, ‘Islamic Financial Institutions and Products in the Global Financial System: Key Issues in Risk Management and Challenges Ahead’ (2002) International Monetary Fund, Monetary and Exchange Affairs Department. For Islamic financial instruments in general and Sukuk in particular, see AA Sarker, ‘Islamic Financial Instruments: Definition and Types’ (1995) 4(1) Review of Islamic Economics 1–16. See also R Wilson, ‘Development of Islamic Financial Instruments’ (1994) 2(1) Islamic Economic Studies 103–15. See further A Ahmad and T Khan (eds), Islamic Financial Instruments for Public Sector Resource Mobilization, (Jeddah Islamic Research and Training Institute, 1997); Bill Maurer, ‘Form Versus Substance: AAOIFI Projects and Islamic Fundamentals in the Case of Sukuk’ (2010) 1(1) Journal of Islamic Accounting and Business Research 32–41; A Nathif and A Thomas, Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk (London, 2004). See also Moody’s, Special Report on Sukuk (February 2008); S Cakir and F Raei, ‘Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?’ IMF Working Paper (WP/237) (2007); A Khaleq, ‘Sukuk Products Backed by Pools of Assets Located in Non-Islamic Jurisdictions: Key Legal Considerations’ (2006) 7 Islamic Finance Review 32 (Euromoney 2006). For derivatives in Sharia, see AH Abdel-Khaleq and CF Richardson, ‘New Horizons for Islamic Securities: Emerging Trends in Sukuk Offerings’ (2007) 7(2) Chicago Journal of International Law; OI Bacha, ‘Derivative Instruments and Islamic Finance: Some Thoughts for a Reconsideration’ (Apr–Jun 1999) 1(1) International Journal of Islamic Financial Services; AA Jobst, ‘Derivatives in Islamic Finance’ (2007) 15(1) Islamic Economic Studies, available at http://ssrn.com/abstract=1015615; MH Kamali, ‘Prospectus for an Islamic Derivatives Market in Malaysia’

Volume 5: Financial Products and Funding Techniques 159 Legal characterisation of these schemes will be necessary especially in the case of a bankruptcy of the debtor under the scheme, which also poses the question of the law applicable to the scheme and the applicable bankruptcy laws, particularly important if the bankruptcy happens in a non-sharia country. The first may be the law of the debtor or more likely of the location of its assets in the situs-related approach of traditional private international law. It is doubtful whether a choice of law by the parties in the funding agreements will be relevant here, although English law is often chosen in international schemes and may indeed explain the structure as one of a future interest to clarify the situation, but it was pointed out before that in proprietary matters the lex situs is traditionally considered the objectively applicable law. If assets are located in Muslim countries, Sharia law may conceivably come into it more generally, especially if the insolvency plays out there as well. This may also raise the issue of ranking, and even of the residual liability of all participants, the concept of limited liability in the Western sense not being absolutely fixed in these countries either. There are two perspectives here: those who funded the bankruptcy scheme will want to rely on some proprietary rights in the underlying assets in the sense of an asset-backed facility. Segregation from the SPV or operator (if bankrupt) is then a key issue. If, on the other hand, the funding party is bankrupt, obviously the operator of the scheme does not want to be curtailed in the use of the assets notwithstanding the bankrupt’s interests. In a bankruptcy of the scheme, the problem will be recognised as the traditional conflict in finance sales or trusts. Who has got what? In Sharia financing there are here two special risks: the characterisation of the proprietary interests and clerical opinion. In the Nakheel sukuk restructuring in Dubai in December 2009, it transpired that investing bond holders in the bankrupt scheme were not sure what they had in terms of a beneficial interest or proprietary rights in the scheme they were financing (which concerned the development on the reclaimed land in Dubai), although in the end they were paid

(1999) 41(4/5) Thunderbird International Business Review 523–40. See further a newsletter in Finance Renaissance, ‘ISDA to Launch Sharia-Proof Derivative Standard’ (12 November 2008) available at http://financerenaissance. blogspot.com; A Salehabadi and M Aram, ‘Islamic Justification of Derivatives Instruments’ (Oct–Dec 2002) 4(3) International Journal of Islamic Financial Services; S Ahmad and N Ridzwan Shah Mohd Dali, ‘A Review of Forward, Futures, and Options From The Shariah Perspective: From Complexity to Simplicity’ (2006) 3 Journal of ISEFED. In respect of (hedge) funds in Sharia law, see the IOSCO reports cited at the beginning of this footnote, respectively pp 31–35 and 11–13. See further S Mohamad and A Tabatabaei, ‘Islamic Hedging: Gambling or Risk Management?’ (27 August 2008) available at papers.ssrn.com/sol3/papers.cfm?abstract_id=1260110; AH AbdelKhaleq, ‘Offering Islamic Funds in the US and Europe’ (24 May 2005) International Financial Law Review, available at www.iflr.com; M Mohammad Taqi Usmani, Principles of Shari’ah Governing Islamic Investment Funds, an online publication by accountancy.com.pk, available at www.cba.edu.kw/elsakka/islam_ investment_funds. pdf. See for newsletters, ‘Key Trends in Islamic Funds’ (June 2008) in Eurekahedge available at www.eurekahedge.com/news/08_june_EH_Key_Trends_In_Islamic_Funds.asp; IFSB-6, Guiding Principles on Governance for Islamic Collective Investment Schemes (2009) available at www.cpifinancial.net; newsletter by Bill Gibbon and Trevor Norman, ‘Hedge Funds and Shari’ah compliance in the GCC’ (2008) CPIFINANCIAL available at www. cpifinancial.net/v2/FA.aspx?v=0&aid=10&&sec=Islamic%20Finance; newsletter ‘Sharia Compliant Hedge Funds: Legal Problems in Respect of Long/Short Strategy and the Role of the Prime Broker’ (July 2007) in Eurekahedge available at www.eurekahedge.com/news/archive_2007.asp; see further the newsletter ‘LSE Welcomes First Shari’ah Compliant Exchange Traded Funds’ (December 2007) available at http://ifresource.com/2007/12/11/ lse-welcomes-first-shariah-compliant-exchange-traded-funds/. For some of the issues that arise in the regulation of Islamic capital market products and services, see R Wilson, ‘Regulatory Challenges Posed by Islamic Capital Market Products and Services’ available at www.sc.com. my/eng/html/iaffairs/ioscoislamicpdf/regulatorychanges.pdf). For an overview of the regulatory framework and key regulatory institutions and industry associations in Islamic finance, see also C Alexakis and A Tsikouras, ‘Islamic Finance: Regulatory Framework—Challenges Lying Ahead’ (2009) 2(2) International Journal of Islamic and Middle Eastern Finance and Management 90–104; Bank Negara Malaysia, Shariah Governance Framework for Islamic Financial Institutions (May 2010) available at http://islamic-finance-resources.blogspot.com.

160 Volume 5: Financial Products and Funding Techniques under the restructuring. In the US, in a bankruptcy of the issuer, therefore of the party requiring the funding, the scheme (at least in respect of US assets) would likely be recharacterised or converted into a secured loan under Article 9 UCC. The date of filing then also becomes an issue. Conceivably, such a filing would itself undermine the whole intent and purpose of the scheme as a finance sale qualifying under Sharia law. Sharia banking of this type is sometimes thought to be conducive to narrow banking in the sense that it discourages high gearing in banks. As all depositors have a business-related interest, their return will depend on how much money the funding can make under the scheme. Since a Muslim bank cannot invest in interest-bearing instruments or in any guaranteed returns across the board, it must take risk in the underlying activities or investments of its customers (a mere service fee may be considered interest), which may restrain it. It is clear that a general liquidityproviding function of banks is here seriously constrained. This type of banking also tends to be inefficient in terms of cost. Nevertheless, like all Sharia financing, it is bent on restraint and may therefore particularly forestall a boom and bust mentality in banks. In bankruptcies, this is buttressed by the expectation that in the Sharia tradition investors may not be able to hide behind notions of limited liability, although in the positive law in Muslim countries, the concept of limited liability is well established also in bankruptcy, but this is arguably against the tenor of Sharia law and the overriding principle it propounds. The Dubai financial problems in 2009 provided something of a test, but ultimately did not greatly affect and clarify these products, which headed towards a US dollar equivalent of about one trillion at risk by the end of 2010, no more, however, than about 1.5 per cent of global financial assets at the time. On the other hand, this market, which for non-Muslim investors is largely organised from London, avoided the toxic and other mortgage-related products (CDOs) that rocked Western markets in 2008, but liquidity issues and lack of standardisation still affect its progress, while these products may also not be very suitable for short-term funding. How derivatives and hedge fund activity in these products can be organised is also debated. China and India and other non-Islamic countries are increasingly considering issuing in this market through their banks or agencies, however. Tax treatment of these products is also widely reviewed.

2.1.8. International Aspects: Private International Law Approaches to the Law Applicable to Proprietary Rights. Bankruptcy Effects In section 1.1.5 above, the private international law issues concerning proprietary rights and the subject of transnationalisation were introduced; see also Volume 1, section 3.2.2 and Volume 4, section 1.10. In Volume 4, sections 1.8 and 1.9, these private international law aspects of property were more extensively explored, especially in respect of chattels moving from one country to another, when, under the lex situs approach,307 a choice needs to be made between the laws of 307 The lex situs notion finds general acceptance in proprietary matters, see also Vol 4, s 1.8.1, if only because they are often so closely related to enforcement which, in terms of repossession and enforcement, is more naturally a question of the law of the country of location of the asset (although particularly in bankruptcy the proceedings may be opened elsewhere). Indeed Art 22(5) of the EU Regulation on Jurisdiction and Enforcement of Judgments in Civil and Commercial Matters of 2002 (superseding Art 16(5) of the earlier Brussels Convention of 1968) accepts for enforcement the exclusive jurisdiction of the courts of the situs, which apply their own law. In proprietary matters, the lex situs notion is, however, particularly strained when the assets are intangible or move frequently, as in the case of aircraft and ships, so that the situs becomes virtually fortuitous. For intangible claims it is not unreasonable to view them instead as located at the place of the debtor, again because of the close relationship with enforcement, which usually must take place there, or otherwise at the place

Volume 5: Financial Products and Funding Techniques 161 the country of origin and destination. In this traditional approach, it is now widely accepted that the law of the country of origin will apply to the creation and perfection of the original proprietary right, even if created under the contract law of yet another country, but that the law of the country of destination will impose a recognition regime under which only foreign proprietary rights properly established at the original situs but largely equivalent to those in the country of recognition will be accepted. The others might be rejected or, always provided that they were properly created, still converted into nearest equivalents: see for the notion of equivalence and the accommodation process more particularly Volume 4, section 1.8.2. There is an element of judiciary discretion here. For limited proprietary rights such as secured interests, where equivalents might be more difficult to find, this is especially relevant in enforcement in the new country, more so in bankruptcy when not opened at the original situs. It could even be in a third country. In such situations, the lex concursus might prevail over the new lex situs, at least for the limited (but important) purposes of the bankruptcy itself. This may create problems if a bankruptcy trustee subsequently seeks to collect the asset from its (new) situs, where neither the original nor the lex concursus attitude to the particular proprietary interest may find favour. Problems may also arise from disparity in registration and other formation and perfection requirements between the country of origin and destination even if there is otherwise equivalence when some of the equivalent foreign interests are not registered in the recognising country while similar local interests in the destination country would be invalid without it, again particularly relevant for secured interests. The fact that the original requirements in this respect are or cannot be sufficiently advertised in

of the creditor: see n 339 below and accompanying text. In case law, at least in the case of intangible assets, more room is sometimes assumed for party autonomy and the more convenient national law may then be chosen by the parties: see more particularly Vol 4, s 1.9.2. For ships and aircraft that move internationally, the fortuitous nature of their situs often does not change the situation dramatically in so far as the creation and recognition of proprietary rights and charges in them are concerned, certainly as to their recognition elsewhere, while as for creation and perfection their proper situs may be considered the place of their registration. It would not avoid the recognition problems in the case of enforcement if ships or aircraft were arrested elsewhere and subjected to a foreign execution, but that seems unavoidable. There is also a classic situs problem when charges shift into manufactured goods or proceeds. In the first case, the situs of their manufacture may be considered the place of the conversion: see the Scottish case of Zahnrad Fabrik Passau GmbH v Terex Ltd [1986] SLT 84. For shifting into the proceeds or receivables, an argument can be made that the situs is the place of the delivery of the asset or of the payment, the law of which would therefore determine any additional formalities of the continuing charge (which could even be seen as an automatic assignment) or indeed the possibility of such a shift giving the original seller collection rights. Any continuation of the original charge in the asset backing up any receivable as an ancillary right would then also be covered by this lex situs, as would indeed be any rights of bona fide successors in the converted property or even of the receivable. In this connection, reference should also be made to repos in fungible assets when only assets of the same sort need to be returned; see also the previous section in fine. As the assets to be used will only be known at the time of (re-)delivery, a similar argument may be made in favour of the application of the law of the place of delivery as the true situs for this purpose. The place of delivery is then the actual place of delivery and not the agreed one. In the case of the use of a book-entry system it would be the place of the intermediary used for this purpose (PRIMA): see also Vol 4, s 3.2.2 and the (limited) facility under the 2002 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary for parties to choose the applicable law in respect of book-entry transfers. Another situs problem arises in respect of registered shares, which are often deemed located at the place of the register. The law of this place then determines the manner of transfer and the way charges may be created in the shares. It does not seem necessary that the law of the place of the register is also the lex societatis as companies may choose to maintain registers outside their country of incorporation. A similar approach may obtain for registered bonds, for depositary receipts and indeed also for shares and bonds subject to book-entry systems. It may allow internationalisation of these systems under their own transnationalised rules: see Vol 4, s 3.2.3.

162 Volume 5: Financial Products and Funding Techniques the country of destination (in its filing system if any), may be considered an extra impediment for their recognition in that country. Thus, a foreign reservation of title in assets such as professional equipment that was moved in the meantime to the US may have no effect there as perfected security and retains therefore at best the status of an attached but unperfected security interest for lack of filing, with the low rank (just above unsecured creditors) that follows, while in a bankruptcy the general lien of the trustee may put it in the rank of ordinary creditors. In any event, it would be converted into a security interest in the US with the loss of the appropriation facility upon default. For conditional sales and conditional title, there may be public policy considerations and impediments to recognition elsewhere when the asset moves, or in foreign bankruptcies, in which connection the reservation of title may also provide guidance. What interests us here is primarily finance sales such as the finance lease, repurchase agreement and factoring. They will be discussed more extensively below. In all cases, it may be useful or even necessary to distinguish clearly between the (a) contractual, (b) proprietary and (c) enforcement or (d) bankruptcy aspects and, in the case of modern finance leasing, also between (e) the derivative or collateral rights of the lessee against the supplier, which are in fact rights exerted against a third party as far as the lessee is concerned. Further distinctions may have to be made between (f) the types of proceedings in which these issues may arise. Besides enforcement, the nature of the legal structures concerned may also be tested in preliminary, provisional or summary proceedings (even in bankruptcy), or in ordinary proceedings on the merits. Parties should be aware that the recognition of foreign proprietary interests may result differently in each of these proceedings even in the country of the new situs, in view of their different objectives or the different manner in which the recognition of the interest is invoked, for example as a defence, a collateral issue, or as the main issue. Whatever the proceedings in which foreign proprietary interests arise, are invoked, or are made the subject of litigation, whether at the (original) situs or elsewhere, it remains basic in all of them that international contractual issues regarding them arise when the parties to the arrangement are in different countries. In the traditional private international law approach, which still looks for local laws to apply, the domestic law of the place with closest connection, now often presumed to be the law of the party that must perform the more characteristic obligation, will normally be deemed applicable in these contractual aspects (unless parties have chosen another law in areas of contract where they can do so). It does not prevent the contract from validly creating charges or other types of proprietary interests not accepted or recognised by the proper law of the contract as long as the asset is in a country or will move to a country where they are so accepted or recognised. It follows in this approach that even a contract regarding chattels is international when the parties are in different countries regardless therefore of whether the chattel being sold or made the object of a charge moves or is intended to move to another country. In fact, it will often remain where it is. This does not distract from the internationality of the sales agreement, but it is likely to mean that in a proprietary sense the transaction is not international. Indeed, in the lex situs approach, international proprietary issues proper arise only when the asset moves between countries, which may or may not be the consequence of a sale. Only in such cases, there is the need to determine the relative impact between the law of the place of origin and destination on the status of the proprietary right. As mentioned above, while the principle of the lex situs applies, it means here applicability of the law of the country of origin in matters of creation and of the law of the country of destination in matters of recognition of the foreign interest so created, with or without adjustment of the relevant interest to the nearest equivalent in the destination country, which suggests a considerable amount of judicial discretion. Under the prevailing private international law view, there is therefore a two-step approach and it is no longer

Volume 5: Financial Products and Funding Techniques 163 strictly speaking an issue of choice of law any longer. This is especially relevant in international enforcement or bankruptcy, foremost when an asset subject to a charge has moved to the country of the enforcement or bankruptcy. In enforcement, which in this view is normally considered an exclusive prerogative of the courts of the (new) situs, international issues will thus foremost arise when the asset moves. They are then subject to the recognition and fitting-in process of the lex executionis or lex concursus at the new situs in terms of ranking and the characterisation in this regard of finance sales. But enforcement issues may also present themselves in an international context in the case of a bankruptcy opened at the centre of affairs of a bankrupt with assets in other countries (even if they have not moved) to the extent the extraterritorial effect of such a bankruptcy is accepted in the country of the location of the asset. As enforcement proceedings thus take place in a country different from the situs, it may be asked, however, what kind of precise effect this may have at the situs. Ultimately this may be a matter (of recognition) by the law of the situs itself in a foreign bankruptcy or bankruptcy in a third country. In other words, the enforcement is not international, only claims to enforcement are. Again, there are here questions of jurisdiction and of recognition of bankruptcy proceedings if conducted outside the country of the situs. This recognition may thus be distinguished from the recognition of a foreign proprietary right when the asset has moved to the country where any of these procedures is initiated. In bankruptcy, there arises in either case the question of how foreign charges in those assets are treated, but the answer may not be the same. For the bankruptcy trustee to collect the various assets and move them to the country of the bankruptcy, the question of full recognition of the bankruptcy decree and the bankruptcy trustee’s powers at the situs of the assets will arise, and will then depend on whether foreign bankruptcy jurisdiction will be accepted at the situs, but probably also on the extent to which the bankruptcy court was or will be able to accommodate the foreign proprietary interests, specifically any charges or similar security interests or conditional ownership rights in them. It raises the question of proper bankruptcy jurisdiction and also the issue of the proper opening requirements of these procedures (with their insolvency requirements and the usual need for more than one creditor) as seen from the perspective of the recognising country. There may be a further difference in the recognition of reorganisation and liquidation proceedings in view of their different objectives. So it goes for the international recognition of any other types of proceedings in which the foreign proprietary rights were an issue, such as preliminary, injunctive, pre-judgment attachment proceedings or proceedings on the merits. Thus, the collection right under a factoring arrangement, or the appropriation right under a conditional or finance sale, may receive different treatment at the situs if raised in or outside foreign enforcement proceedings, and again may be assessed differently if a foreign provisional measure, injunctive relief or full foreign proceedings on the merits are requested to be recognised. If for lack of sufficient international bankruptcy recognition, the trustee is not allowed to collect at the situs and to move the asset into the foreign bankruptcy jurisdiction (whatever its effect on the proprietary interests created in them), the lex situs and the charges created thereunder may still be impacted to the extent that the trustee is still allowed to exert some bankruptcy effect into them. So even if the courts of the situs will not surrender the asset under the circumstances because they do not sufficiently accept the foreign bankruptcy jurisdiction or the treatment of the assets and the proprietary or security rights in them by the bankruptcy court, the bankruptcy adjudication in respect of them may still not be entirely irrelevant and the foreign trustee may have some management power. This is more directly also the case when a foreign secured interest holder wants to share in the proceeds of the bankruptcy. In that case, the foreign secured creditor

164 Volume 5: Financial Products and Funding Techniques is likely to be asked to account for its foreign interests in the manner imposed by the bankruptcy court, therefore subject to this court’s attitude towards the foreign interest and its fitting-in and ranking under the lex concursus. It has already been said that this law itself may well be somewhat stretched and adapted to make this possible. The conclusion so far must be that under present private international or conflicts of laws approaches, the validity, status and rank of, or powers under, conditional or finance sales (as indeed also under security interests) may be differently decided in the various types of proceedings and may be different again for a foreign asset that has in the meantime moved to the country of these proceedings and for an asset that remains elsewhere upon recognition and enforcement of the foreign proceedings at the situs. In any event, the international status of the ensuing judicial decisions may be very different and subject to different recognition possibilities. In fact, it could even happen that a decision reached on the status of foreign proprietary interests in provisional proceedings, or even in proceedings on the merits, is not fully accepted in bankruptcy proceedings even in the same country as the ranking, and the fitting-in process may then require special handling. On the other hand, the bankruptcy findings concerning the foreign proprietary interests may not have any further status or impact outside these bankruptcy proceedings, even in the country of the bankruptcy. The above discussion very much concerned the proprietary regime in respect of individualised existing assets. The most important issue may, however, be a different one in this connection and concerns the ownership and status of finance sales and secured transactions in the international flows of goods, services, money, technology and information. These are likely assets in transformation from raw material, to semi-finished and finished product, upon sale further transformed into receivables and hence upon payment into a bank balance and poses also the important issue of the charges in intangible assets, notably monetary claims, where there is hardly a situs proper. Each step potentially takes place in a different country, therefore at a different situs in respect of classes of assets of a composite nature (chattels in transformation, attendant services and technologies, depending on the stage of production, which might be substantially virtual, the end result being intangible receivables and bank balances, all without clear locations). The simple question becomes then how international flows themselves may be used for fund raising and in what form. This will be discussed for floating charges below in section 2.2. It poses in particular the question of legal transnationalisation if we accept that cutting up these flows into domestic parts around lex situs notions no longer leads to a rational approach overall and can no longer be expected to produce an efficient legal regime by adding up these domestic legal pieces. It might have been manageable when these flows were small, but they are now far larger than the GDP of the largest countries, in Europe even of all EU countries together. It may be clear that the traditional private international law approach, which still looks for the applicable (domestic) laws in this manner, has run its useful course and is no longer responsive to legitimate present-day needs in terms of legal efficiency, transaction cost and operability in these flows.

2.1.9. International Aspects: Uniform Laws and Model Laws on Secured Transactions. The EBRD Effort For finance leasing, some international action has been proposed through uniform treaty law, as in the UNIDROIT Leasing Convention of 1988: see more particularly section 2.4.5 below. The international aspects of the factoring technique have already been discussed more fully in the context of the international assignments of claims in Volume 4, sections 1.9.1 and 1.9.2. They involve tripartite structures, always of particular difficulty in private international law, hence the

Volume 5: Financial Products and Funding Techniques 165 effort at unification of some of their more important rules, not only in the UNIDROIT Factoring Convention of 1988 but more comprehensively in the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade: see sections 2.3.5ff below. But the UNIDROIT Conventions achieved few ratifications, the UNCITRAL Convention none at all. Clearly, they did not convince the international business community and were not needed in this form. Rather it was argued before, and will be below, that legal transnationalisation is the more proper answer in these areas and may not come through treaty law, but rather through a bottom-up law-formation process using the other sources of law of the modern lex mercatoria, especially transnational custom and practices. This was the discussion in Volume 1, particularly its sections 1.4 and 1.5. In 2005 UNIDROIT issued proposals also of interest in the area of repo financing of investment securities in its project concerning securities held with an intermediary, aiming therefore at some uniform law in this area, a first draft having been published in that year. This is now the (2009) Geneva Convention on Substantive Rules for Intermediated Securities (‘the Geneva Securities Convention’, not entered into force either, also for lack of sufficient ratifications (a minimum of three)). It devotes no special attention, however, to repos and appears to treat them in the same way as security interests (Article 11). There is an optional Chapter V that deals more extensively with collateral transactions. It also covers title transfer collateral agreements, which then include repos (Article 31(3)(c)). It has already been said that in practice, protection is usually sought in the technique of bilateral netting for all mutual obligations, including delivery obligations (see further section 4.2.4 below). The various UNIDROIT and UNCITRAL uniform treaty laws in the areas of secured transactions and finance sales will be discussed in more detail below in sections 2.1.10 (mobile equipment), 2.3.5 (factoring and trade receivables) and 2.4.5 (leasing). The Geneva Convention on intermediated securities (or security entitlements) was discussed in Volume 4, section 3.2.4 and see also section 4.2.8 below. Another approach to harmonisation is through model laws. But a key realisation must be that treaty law of this nature has not so far grappled successfully with the concept of finance sales in its various applications and not generally with any financial structures transnationally. For the above and other reasons discussed in the relevant sections below, disappointment has been the result. If successful, uniform treaty law of this nature would introduce the same law in the Contracting States to avoid any conflict of laws and is then intent on eliminating the need for private international law rules to determine the applicable domestic laws.308 In the absence of uniform treaty law, private international law approaches may thus still

308 Moreover, these treaties are seldom comprehensive and commonly still rely on traditional private international law for aspects outside their scope: see also Vol 1, s 1.4.14. They may do so even for those aspects within their scope if not specifically covered by the relevant Conventions, in which connection a difference between interpretation and supplementation is often still made. Mostly, in matters of interpretation, the general principles on which these Conventions are based first prevail, even though it is often unclear what these principles are, especially in the proprietary and enforcement aspects. Also, the scope and coverage of these Conventions are often not sharply defined so that one cannot be sure when such general principles may be invoked and relied upon. At least in Art 4 of the 2009 Geneva UNIDROIT Convention on Substantive Rules for Intermediated Securities, no distinction is made any longer between supplementation and interpretation. The reference is to the purposes of the Convention, the general principles on which it is based, its international character and the need to promote uniformity and predictability in its interpretation. The reference to good faith in other Conventions of this type in the aspect of supplementation is deleted, see further also Vol 3, s 2.3.7. There is in this text no reference to conflict of laws either, but it should be noted first that under its Art 2 the Geneva Convention only applies if the law of a Contracting State is applicable and that much domestic law applies explicitly, the Convention being minimalist in its uniform rules; see also the Note of the UNIDROIT Secretariat of November 2011 in respect of the Convention’s references to sources of law outside the Convention. The relationship to other sources of law, especially international custom and practices within the modern lex mercatoria, remains unclear.

166 Volume 5: Financial Products and Funding Techniques remain relevant, at least in the more traditional and parochial views, also for repurchase agreements, although, where affecting Eurobonds, transnationalisation tendencies may be expected also in the proprietary aspects of repos and secured transactions in these instruments, see Volume 1, section 3.2.2. Once adopted, they are not or should not be subject to further domestic amendment and are meant to take precedence over national law. To repeat, in this book, it has been submitted over and again that the lex mercatoria and its various sources of law and their hierarchy apply in the professional sphere at large, independently from the residence of the participants, who must by definition be considered substantially internationalised when involved in commerce. In this vein, uniform (mandatory proprietary) treaty law has a place within the hierarchy of norms of the lex mercatoria in the manner explained in Volume 1, Part III without any reference to conflict of laws rules unless the Conventions themselves contain them, but even then, their application may still be preceded by fundamental legal principle and customary laws or industry practices or general principle. Even in proprietary matters, there may still be substantial room for party autonomy—it was argued throughout— which also needs to be respected subject to the rights of bona fide purchasers and purchasers in the ordinary course of business of commoditised products. Uniform laws, common in the US among the various States, are not Conventions in the above sense. Although unification is clearly the objective and models are as such presented (by the American Law Institute and the Commissioners on Uniform State Laws), they remain State law and there is no obligation on States to adopt and where they do there may and do exist (minor) differences between States, even in the UCC. Where interstate (or international) conflicts arise, there is, therefore, still a need for a conflicts rule (see section 1-301 UCC), which allows the uniform law of the particular State to be applied if the transaction bears an appropriate relation Conflicts rules may also not be avoided when a preliminary question arises as to which country’s law applies if there is an international aspect to the case (whether of a contractual, proprietary or enforcement or bankruptcy nature). In this view, the uniform treaty law is then only applicable if the applicable private international law rules point to the law of a Contracting State while these private international law rules themselves could still differ between them. However, uniform treaty law itself often introduces a different approach for Contracting States and renders the uniform law directly applicable in the courts of Contracting States, as the 1980 Vienna Convention does for the international sale of goods if parties come from Member States: see also Vol 1, s 2.3.1. In this manner, the UNCITRAL 2001 Convention on the Assignment of Receivables in International Trade ties its application in Art 1 to the assignor being situated in a Contracting State. Art 3 of the 2001 Mobile Equipment Convention (see next section) ties its application directly to the debtor, conditional buyer or lessee being situated in a Contracting State. On the other hand, the 2009 UNIDROIT Geneva Convention of Substantive Rules for Intermediated Securities ties the sphere of application of this Convention to the applicable conflict rules designating the law in force in a Contracting State. Whatever the approach in this connection in Contracting States, in non-Contracting States, the application of these Conventions can only be considered as a preliminary matter of conflict of laws. Applicable conflicts rules must then point in the particular instance to the applicability of the law of a Contracting State: see, for a further discussion of the complications especially in connection with EU Directives, again Vol 1, s 2.3.2. Indeed, only where the Uniform Treaty Law is applied by the courts of Contracting States ex officio as their lex fori are conflicts rules avoided unless resort to a local law must still be had under it in matters of interpretation and gap filling as just explained. The 1980 EU Convention on the Law Applicable to Contractual Obligations (Art 12) introduced a uniform choice of law regime for assignments to be applied by and therefore relevant in the courts in the EU (not necessarily by arbitrators), especially in the interpretation and supplementation of factoring and assignment Conventions in ratifying EU countries. It left many open questions and was perhaps not as rational as it might have been either. This was not much changed after its replacement by the 2008 EU Regulation (Art 14) on the same subject: see for a critique Vol 4, s 1.9.3. Ultimately the ECJ decided that it did not apply to the proprietary effects. A more comprehensive effort to formulate conflicts rules of this nature was made in the just mentioned 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade to interpret and supplement it if and when its uniform laws proved incomplete: see s 2.3.8 below.

Volume 5: Financial Products and Funding Techniques 167 to the State concerned. If there is uniformity between the laws that may so be deemed applicable, the importance of these conflicts rules is only to determine that no other law applies. The unification effort through model laws is different again. Model laws are directed to domestic legislatures and are intended to be adopted in national laws, possibly with present or later modifications. The objectives of model laws may differ, however. In the 1994 EBRD Model Law on Secured Transactions, unification is of secondary importance; the aim was rather to provide guidance for new departures in the national laws of countries (here of the former Eastern Bloc) not used to financing through private capital. There is a clear economic objective. Other model laws, like the UNCITRAL Model Law on International Commercial Arbitration, may mainly aim at greater international uniformity. The outstanding features of the EBRD Model Law were that it applied only to the business sphere (Article 2) and did not attempt to cover conditional or finance sales (Comment, Article 1.2). It did not, however, maintain a functional approach and parties were free to organise their funding activities in the way they deemed fit, which, at least in the professional sphere, appears to be the correct approach. Nevertheless, the reservation of title was covered and characterised as a secured transaction (see Article 9) and required an execution sale upon default, returning any overvalue to the buyer. Whether this was suitable in high-inflation countries or whether this restriction was necessary in the professional sphere was already doubted, as the overvalue would go to the defaulting debtor. It should also be realised that this approach applies to reservations of title in other than consumer goods. We are here concerned with sales-price protection. Normally, however, the charges created pursuant to the Model Law are meant to secure loan credit and are therefore seen as ancillary to credit agreements—see Articles 4 and 18.1—but, according to the Comment, the expression ‘secured debt’ has a broad meaning and largely depends on what the parties agree in this connection. The debt need not be existing or owing at the time the charge is granted—see Article 4.3.4—provided it can be and is properly identified in the security agreement (Article 4.4), but the maximum amount to be secured must be stated (except in the case of purchaser money security: Article 4.5). The idea is to leave room for further secured credit. The type of asset that may be encumbered in this connection may be movable, immovable or intangible property: see Articles 1.1 and 5. Again the expression ‘charged property’ is intended to have a broad meaning and depends largely on what the parties agree. It may cover individualised items or categories of property and cover the fruits: Article 5.9. A charge is valid notwithstanding any agreement not to encumber the asset if it concerns monetary claims (Article 5.4) but the Model Law is not clear whether a charge may cover property that is not transferable by nature. Certain classes of shares may not be so transferable (without consent or co-operation of the company). The assets must be identified either specifically or generally if they concern a class of assets (Article 5.7). The charge may cover future assets provided they can be and are sufficiently identified in the security agreement (Articles 5.8–5.9), but it cannot be properly created in respect of such goods before the asset is owned by the debtor (Article 6.8), although in that case the charge relates back to the registration (in the case of a non-possessory charge). As regards the inclusion of future receivables, the Model Law takes no position on when they arise and their possible inclusion is, as in the case of debts covered, also left to sufficient identification. Altogether it may be noted that this Model Law takes a restrictive view on the debt that can be covered and the assets that may be included in the security. This is an important deviation from the US model of Article 9 UCC. Another important feature is the reliance on publication or registration of non-possessory interests for their validity (except in the case of purchase money security). It must follow within 30 days from the date of the security agreement: see Article 8. This is an important departure from the practice in most civil law countries for non-possessory security in movable property. Here the Model Law follows the example of Article 9 UCC in the US,

168 Volume 5: Financial Products and Funding Techniques but there is no advance filing or relation back of the charge (see Comment, Article 8.1) except, as just mentioned, that future assets which are sufficiently identified in the security agreement may be covered as at the date of registration. The priority therefore normally dates from the date of the creation of the charge, which, if non-possessory, is the date of registration (Article 17) except that purchase money security always has the highest priority (Article 17.3). In line with what was said before, the registration in turn is only possible in respect of an identifiable secured debt with an identifiable debtor, ruling out the coverage of unspecific future advances and unspecific future assets. The registration is per debtor and debt, and not per secured asset. The Model Law does not enter into the details of the registration system, but appears to assume that at least for chattels and intangible assets the most modern computerised systems will be put in place to support its approach. There is only a limited protection for bona fide purchasers (Article 21). For a critical analysis of filing systems of this nature see sections 1.6.2 above and 2.2.3 below and Volume 4, section 1.7.7. Enforcement is always by way of execution sale, but without the need for a court order: Article 24. Any buyer will receive title free from the charge: Article 26. However, the beneficiary of an encumbered claim may collect instead: Article 12.1. Article 28 deals with the distribution of the proceeds of an execution sale, giving the debtor any overvalue (Article 28.3.6).

2.1.10. International Aspects: The 2001 UNIDROIT Convention on International Interests in Mobile Equipment (Cape Town Convention) UNIDROIT produced a Convention aiming at the creation of an international interest in mobile equipment.309 Especially its Aircraft Protocol is of interest, and successful. As such it stands out amongst the other projects mentioned in the previous section. The background is that the need for internationally supported asset backing for funding has greatly increased through the privatisation of airlines (also railways), with the attendant need to raise international financing, which can no longer depend primarily on state guarantees, while the major assets of these companies (which are at the same time its major capital goods) often have no fixed lex situs, so that domestic security interests or other asset backed funding in them are constantly endangered. The aim was the creation of a distinct type of international interest under the Convention resulting from a security agreement, a reservation of title, or a finance lease (Article 2) in mobile equipment as defined in Article 2(3). There is a two-instrument approach: a general treaty that for its force and effect depends on the entering into Protocols for the different types of equipment and which are more specific even in substantive issues like notably any insolvency impact and effect. Realistically, the US functional approach is abandoned, and the recharacterisation of conditional sales, reservation of title and leases is thus avoided. For purposes of the Convention, mobile equipment concerns categories of equipment that habitually move between states and are identifiable (and not future although there is also a category of prospective interests that are intended to become international interests in identifiable equipment still acquire their rank from the day of filing), such as aircraft, aircraft engines, helicopters, ships, oil rigs, containers, railway rolling stock, satellites or other space property and categories of uniquely identifiable

309 See for a comment, MJ Stanford, ‘UNIDROIT Convention on International Financial Leasing and the Preliminary Draft UNIDROIT Convention on International Interests in Mobile Equipment’ (1999) 27 International Journal of Legal Information 188; see also P Winship, ‘International Commercial Transactions’ [1999] The Business Journal 2001 (ABA).

Volume 5: Financial Products and Funding Techniques 169 objects. Parties may derogate from the provisions of the Convention only in a number of default remedies: Article 15. This reflects the mandatory nature of proprietary law in which connection a new uniform international regime is created under the Convention. It shows and is particular important in Article XI of the Aircraft Protocol which deals with insolvency and allows here a number of alternatives. Its approach is here Protocol specific and may therefore be different for different types of equipment. For aircraft equipment it allows ratifying states a choice, although it may also opt to retain its own bankruptcy regime. Alternative A is considered the hard rule and Alternative B the soft rule. Alternative A is in principle a self-help remedy which, after a short waiting period between thirty-five and sixty days, gives the funding institutions the right to repossesses the aircraft or receive from the debtor the curing of all past defaults and a commitment to perform all its future obligations. Alternative B requires on the other hand on a court order to allow the repossession. This obviously creates delays and uncertainty. Friction always surfaces between transnational law of this treaty type and domestic laws in ratifying states where domestic actors remain responsible for faithful implementation which depends domestically on the hierarchy of the applicable norms. Surprisingly, the interpretation and supplementation provisions of the 1980 Vienna Convention on the International Sale of Goods are still followed in Article 5 with their unfortunate ultimate reference to domestic laws in matters of gap filling; see also Volume 3, section 2.3.7. Rather it would appear that the Mobile Equipment Convention itself is sufficiently comprehensive to determine its own regime on the basis of systemic interpretation, thus avoiding in matters in principle covered by the Convention references to domestic laws with their fragmenting effect. It will spill over in interpretation, as the distinction between interpretation and gap filling can never be fully clear. In the interpretation provision, at least the Vienna Convention is not followed in allowing the good faith notion to operate. Rightly, it has no place in proprietary matters, which are largely the subject of this Convention. The interest created under the Convention must result from an agreement in writing, and requires registration if the debtor or the asset are from a Contracting State (Articles 7 and 16). The registration is not debtor but asset-based (according to the manufacturer’s serial number, which therefore provides the key to the search) and is a filing system that does not require documents to be deposited. UNIDROIT designates the registry or registers.310 Lack of registration will result in the nullity of the interest. Proper registration, on the other hand, makes the interest effective (in its proprietary and obligatory effects) in all Contracting States. In the case of a default, the beneficiary of the interest has one or more of the following rights in respect of the assets: taking of possession, the selling or granting of a lease, collecting the proceeds or any income or profits arising from the management or use of these assets, or applying to the courts for authorisation and direction in any of these remedies (Article 8). Where the interest is a reservation of title or finance lease, the creditor will terminate the arrangement and take possession and appropriate full title under Article 10. Again, the finance sale is here fully recognised as an alternative to secured financing and as a different structure. Article 29 deals with priorities of the international interests inter se, and they conform to the rule ‘prior in time, prior in right’. The interest is valid against trustees in bankruptcy, at least in all Contracting States, and other creditors of the debtor (Article 30). Bona fide purchasers of an asset with a registered interest are not protected. This suggests a search duty for all buyers, quite

310 The registration activity was farmed out to an Irish company (Aviareto) and became effective on 1 March 2006. The facility is open 24 hours a day, 7 days a week. In order to register, a party must open an account at the registry, which provides a code, giving access. The debtor must (electronically) consent to the registration.

170 Volume 5: Financial Products and Funding Techniques different from the filing system under Article 9 UCC in the US. Yet, ultimately it cannot be avoided that the lex executionis or lex concursus have the final say on the validity and fitting-in process, especially relevant if the enforcement or bankruptcy and the asset are outside a Contracting State. The Convention deals with the problem when it applies (Article 3). In other words, it deals with the minimum contact with a Contracting State necessary for the Convention’s application to be triggered and therefore for the international interest to emerge. The rule is that the Convention applies when the secured debtor, conditional buyer or lessee (as the case may be) are situated in a Contracting State. Major ratifying states include the US (2004). Within the EU there was an issue whether at least part of the Convention should be ratified by the EU on behalf of its members—it did so in 2009 for its competencies in the matter (coverage of Denmark being excluded). At EU level, there was a further political complication concerning the sovereignty over the airport in Gibraltar. Ireland chose not to wait for a conclusion of this issue and became the first ratifying EU Member State in 2005. The Netherlands followed in 2007, Luxembourg in 2008, Malta in 2010 and Latvia in 2011. There are now 80 ratifying states. There are at present three Protocols to the Convention: for Aircraft Equipment (2001, ratified by 80 states), Railway Equipment (2007), and Space Assets (2012). The last two are not yet in force. It follows that, so far, the Convention has been mainly effective through its Aircraft Equipment Protocol, which has proved to be important and is of all this type of conventions the most successful by far.311 The reason is that it is well drafted, relatively simple, and pragmatic, mindful in particular of the differences between secured interests and finance sales, which leaves real structural flexibility to the parties.

2.1.11. Domestic and International Regulatory Aspects It is not so far likely that conditional or finance sales and secured transactions are directly the subject of regulation. In terms of banking products, they may as such, however, become subject to the regulatory concern of banking regulators, who may wish to investigate whether the use of finance sales or newer secured products are sufficiently transparent, legally sound, and not sold or promoted as financial or investment products to unsuspecting parties, especially consumers or small investors. These are primarily conduct of business concerns but regulators may also consider the legal effectiveness of modern credit-risk hedges when invoked to reduce capital adequacy requirements. The legal structure of these transactions and the type of protection they give to the lender, borrower or investor are then also relevant from this perspective which is more primarily an issue of financial stability. In this area, broader public policy concerns may also arise as public order issues in terms of the application and preservation of the system of private law and of property and bankruptcy law, particularly in civil law countries with their traditionally closed system of proprietary rights and a more systematical or intellectual approach. The unitary functional approach of Article 9 UCC in the US, converting finance sales into secured transactions, may be indicative of some similar concern. At least it was inspired by the disparate attitudes which had developed between the various states of the Union earlier in this area (see section 2.1.3 above), but it ultimately sought to

311 Passenger volume was 43 billion in 2018, number of aircraft 22,680, estimated to be increased to 47,600 by 2038.

Volume 5: Financial Products and Funding Techniques 171 impose an intellectual approach that created tension with legal reality and proved untenable or at least in need of fundamental exceptions, especially for finance leases and repos, as we have seen. It was submitted all along that concerns with closed systems of proprietary rights, with intellectual congruity, and considerations of this nature are secondary to the satisfactory functioning of the economy and its legitimate efficiency or risk management requirements. Indeed, internationally, in the Mobile Equipment Convention, as we have seen in the previous section, and now also in the EU Collateral Directive (see Volume 4, section 3.2.4 and the next section), these concerns are largely abandoned, and pragmatism has started to prevail. It shows that no fundamental public policy issues were at stake, at least not any derived from systemic considerations.

2.1.12. Concluding Remarks. Transnationalisation and the Issue of Party Autonomy in Proprietary Matters. The EU Collateral Directive What does all this add up to? At the very least it means that there is a large area outside secured transactions where major funding operations with some other form of proprietary protection are increasingly situated. By talking about secured transactions all the time, and more so by forcing new, asset-protected funding structures into a unitary system of secured interests, we are making a significant mistake (absent public order constraints) and entering a world of unreality. The ownership- and security-based systems of asset-backed funding and protection need to be clearly distinguished. The former normally conform to the pattern of conditional sales of assets, the latter to the traditional secured loan, while sales credit protection is likely to assume the form of the former. Conditional or finance sales present funding through the sale of assets. There is no loan. If the repurchase price is not tendered in a timely manner, the buyer becomes the unconditional owner of the assets s/he bought, and there is no execution sale and return of any overvalue. Only if there is a clear loan, identified by an agreed interest rate structure, is the situation different, and any proprietary support will then function as a secured transaction and be converted into it. If not, the different risk and reward structures of these funding alternatives should be clearly recognised and accepted. In most legal systems researched here, these insights remain embryonic, although moving in the direction of greater clarity, with English law probably the most sophisticated and, surprisingly, US statutory law (Article 9 UCC) on this point perhaps the least, although US case law is not insensitive to the problems of recharacterisation. This conclusion is all the more unexpected as it concerns here two common law countries, while academic opinion, shared by many in England,312 often stresses the intellectual and practical superiority of Article 9 UCC. This is undoubtedly correct in many aspects, especially in the treatment of the floating charge, but not, it was submitted, in the unitary functional approach to finance sales.313 312 For England see the Crowther Report (1970) and Diamond Report (1989) and, eg, MG Bridge, ‘Form, Substance and Innovation in Personal Property Security Law’ [1994] Journal of Business Law 1. 313 As was shown, in the US, the unavoidable result has been that the modern finance sales, like repos, finance leases and receivable factoring, became difficult to place. Where they must be considered secured transactions, the filing requirements apply to their ranking and any omission to file reduces their rank to just above that of the common creditors. Modern bankruptcy law concepts with their disposition, return of overvalue, stay and dilution possibilities may have a further detrimental effect. Only in England does the law seem to leave ample room for the modern finance sales, including any proprietary effect they may produce for either party, although there is not much discussion of these aspects either. In the US it required amendment (introduction of Art 2A UCC for equipment leases and s 559 Bankruptcy Code for investment repos) while the text of Article 9 itself allows some flexibility in respect of disposition needs upon a default of the party requiring the funding through the factoring of receivables: s 9-607.

172 Volume 5: Financial Products and Funding Techniques Civil law has had little to contribute in the realm of ideas. In one of the latest efforts at recodification, the modern Dutch law approach, security substitutes are simply refused any proprietary effect, see section 1.2.1 above even though it is not made clear what they are or when they arise. The result is that the modern finance sales are threatened under new Dutch law. Unlike US law, it does not even convert conditional sales into secured transactions. Case law is stepping in to sort matters out. In the EU, the 2008–09 DCFR did not consider the concept of finance sales either— see Volume 4, section 1.11—and confines conditional ownership rights to reservation of title, which it then promotes to a special proprietary category, all in the German legal tradition, which is on the whole unaware of, or unreceptive to, financial dealings and their needs, whether at the national or transnational level. Thus, in many countries there remains a substantial recharacterisation risk for finance sales, converting them either into secured transactions or into mere contractual interests. In the meantime, one may ask why ownership-based funding has become so much more popular in the last 20 years, as shown in repos, finance leases and factoring or receivable financing. It may be the possibility of lower cost for the party requiring financing and, particularly, the greater variety of financial products it supports, motivated by the need for different risk and reward structures and choice. Certainly, the conditional sale and ownership transfer, leading to split-ownership rights, seems more in tune with the unbundling of risk increasingly practised in international finance. Importantly, opening up the proprietary systems by using the concept of conditional ownership in financing may lead to harmonisation internationally on the basis of an extended notion of party autonomy and greater risk management choice (subject to the protection of the commercial flows, as we have seen), as it provides a bridge between common and civil law, albeit at a conceptual cost to civil law lawyers. It may show that the split ownership in conditional sales and title transfers allows for structures in civil law very similar to those of the trust in common law countries: see also Volume 4, section 1.10.314 But this can only be done if supplemented by a better bona fide purchaser and assignee protection, or of purchasers and assignees operating in the normal course of business in commoditised products of this nature. The result is a more dynamic but also better harmonised law concerning collateral operating internationally: see for a summary also Volume 1, section 1.1.6. Thus, development of a more transnationalised concept of ownership, already existing in the area of commercial paper and documents of title, where it is historically the product of the international law merchant (see Volume 1, section 3.2.2) may further facilitate the characterisation, recognition and adjustment of proprietary interests when the assets surface or play a role in other countries. This was found to be very relevant for intangible assets such as receivables when embodied in negotiable instruments (see Volume 4, section 1.5.7). Transnationally, the Eurobond is the most important modern example (see also note 14 above) but it should be so more generally now for all receivables, and then also for other types of personal property. This would also affect the security and particularly conditional ownership interests created in these assets, resulting in a modern dynamic concept and use of movable property law, including receivables: see further Volume 1, section 1.4.4. The technique of transnationalisation in respect of an international portfolio of movable assets was explained in section 1.1.8 above and may revolve first around the notion of movable assets being located at the place of the owner (no matter their physical location in different countries), 314 It is likely that further ratification of the Hague Convention on the Law Applicable to Trusts and on their Recognition of 1985 (since 1992 effective between the UK, Canada, Australia and Italy), to which the Netherlands has now also acceded, and ratification of which has also been considered in France (see Vol 4, s 1.6.7), will provide its own stimulus in this approximation process.

Volume 5: Financial Products and Funding Techniques 173 thus making its law applicable to securities, charges or finance sales in worldwide assets of the owner. Second, party autonomy would here enhance the prospect of greater dynamism, subject to a transnational rule protecting bona fide purchasers or purchasers in the ordinary course of business, and therefore the commercial flows. The resulting transnational interests would still need recognition in local bankruptcies, however, especially in enforcement. This would be a matter of transnational custom or practice, or party autonomy, as the true source of transnational law, still subject to a fitting-in process under local bankruptcy or other applicable enforcement laws in terms of an expanded notion of nearest equivalent. Transnational public order concepts could further facilitate and refine this process. The EU Collateral Directive—see section 1.1.9 above—although limited in scope, is a significant indicator of these modern trends and an important pointer to the development of the lex mercatoria in this area, particularly in its clear distinction between secured transactions and finance sales, its inclusion of future assets including receivables and cash, and its lack of formalities. The 2001 Mobile Equipment Convention (see section 2.1.10 above), although also limited in scope, may be found significant in catching modern trends as well. These developments invite discussion on all types of conditional ownership and their operation even in national laws.315 It has been noted above that this may well have a similar opening-up effect in the civil law of property as the concept of good faith, fairness or reasonableness (Treu und Glauben) is having in the civil law of contract. Debate in this area is necessary, urgent and greatly to be encouraged. Unfortunately, it must be noted that the DCFR has not been able to make any innovative contribution. Greater imagination and courage will lead to an approximation of the different proprietary approaches in international dealings and may well be a necessary prelude to understanding and accepting legal transnationalisation better. In fact, in international commerce and financing, there is no real reason or intellectual justification for the fragmentation of the ownership concept along purely domestic lines; it is also illogical. Once this is understood, it will also be seen that there is no reason or justification for the differences to remain operative in purely domestic transactions either. It is clear that, in terms of legal support for newer financial structures, conceptually, civil law has further to go than common law, but in the end, regardless of the disappointment of the DCFR and earlier the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade, it is unlikely ultimately to hinder the need and tendency to protect modern funding techniques and achieve the necessary cross-border standardisation. Civil law may also use this opportunity to broaden the facility of transfers in bulk and the reclaiming, shifting and netting concepts in the process, thus providing at the same time a better structure for floating charges and tracing facilities. Domestically, this is likely to depend on statutory law that may become increasingly product-specific: see for recent French law in respect of floating charges, repos, securitisations and other newer financial products section 1.3.1 above. It is likely to be destructive of the closed systems of proprietary rights in civil law in the countries concerned. Implementation of the EU Collateral Directive in EU Member States (see Volume 4, section 3.2.4 and section 1.1.8 above) may have a similar effect. If it wants to continue to support modern finance, civil law is likely to increasingly incorporate the common law (equity) attitudes in this area although not necessarily the ideas of Article 9 UCC, which, notwithstanding its many virtues, proved a statutory distraction in being inimical to conditional or finance sales: see section 2.1.1 above. For civil law to adapt to the more traditional common law approaches is logical, as it has proved to provide the more imaginative, flexible 315 See for a summary also Dalhuisen (n 269).

174 Volume 5: Financial Products and Funding Techniques and efficient support for modern financing (in equity, see also Volume 4, sections 1.3.7–1.3.8 and 1.10.2), one reason probably why all large financial centres are in common law countries. It is a positive development that deserves to be guided and encouraged through further study in this important area of the law, not only for practical reasons, important as they are, but because such studies could also underline a welcome approximation of a number of fundamental common and civil law concepts. For the academic observer, this approximation is therefore of special theoretical interest. Again, the EU Collateral Directive was a significant move forward.316

2.2. Modern Security Interests: The Example of the Floating Charge 2.2.1. Types of Floating Charges or Liens. Problem Areas In section 1.1.6 above, it was noted that the (non-possessory) real-estate mortgages and the (possessory) pledges of chattels were the traditional security interests. The former remain important; the importance of the latter is now mostly limited to investment securities (which are more likely to be repo-ed instead), although for these instruments the emergence of bookentry systems removes in fact the possessory concept of secured transactions in them, as we shall see in section 4.1.3 below. As significant are modern non-possessory security interests in movable property (chattels). They also created the security assignment of receivables, which are non-possessory by nature (at least in a physical sense). It has already been said that floating charges may be seen as the more modern and efficient expression of non-possessory security interests in movable property. In truth, they concern the use of future commercial flows as security for present and future debt mainly in the form of working capital, that is the money needed to pay workers and purchase new supplies pending the sale of finished products and/or the (connected) rendering of services, and their payment. The rationale is business need: inventory and receivables are often the only asset classes that a business can offer as security for working capital. But inventory, which may first concern basic commodities and subsequently semi-finished and finished products, must be transformed and such products are often commingled with other assets, services and technology or information in the manufacturing process. As end-products, they must be sold and receivables collected as soon as possible. They cannot be individualised and set aside; the charge must move with the transformation of these assets which must be sold free and clear when the charge moves into receivables and bank balances and ultimately in replacement inventory. Because of this transformation by the manufacturer/borrower and the need for a sale and delivery, no physical possession can be given to the lender. Even the manufacturer/seller/borrower cannot be required to hold onto them. Worse for 316 A last observation may be in order and is also a repeat of what has already been said before in s 1.1.1. The equality of creditors is often presented as a justified concern and as an argument against the proprietary effects of all kinds of financial schemes likely to protect the financier, as finance sales also do. But this equality or the so-called par conditio creditorum is not truly the basis of the system of creditors’ protection or a fundamental legal principle, although in civil law endlessly paraded as such. It is the ranking (and the separation or segregation of assets including reclaiming facilities), and not the equality, that is the essence of modern bankruptcy and of creditors’ relationships more generally. What happens here is a reshuffling of proprietary interests between financiers in more modern ways, who thus re-allocate the risk of default of the counterparty substantially amongst themselves as professional operators. Any detriment is hardly likely to affect the common unsecured creditors, who in bankruptcies are unlikely to get much anyway. It was submitted before that protecting them better—if that became a policy preference—can only be done effectively by giving them a flat percentage of all the assets of the bankrupt estate.

Volume 5: Financial Products and Funding Techniques 175 the lender, upon a sale, the assets must indeed be released from the charge in order to be sellable and the only protection for the lender is then a shift of the charge into replacement inventory and/or the receivables if credit is extended by the manufacturer, or otherwise to the proceeds in the case of payment, which suggests a charge on or moving into a cash account. The floating charge and its fate in many countries are the best example of the struggle concerning the move towards non-possessory security interests in a modern financial and legal environment and they required a fundamental shift, especially in civil law thinking. Traditionally, security interests, whether or not possessory, were created in a specific asset, which had to be clearly identified and set aside. This was a nineteenth-century development, which created considerable problems for bulk transfers/assignments and the inclusion of future (even replacement) assets at the same rank, problems that remain most vivid in civil law today. These problems need to be overcome for floating charges which, to be effective, cover pools or certain classes of changing assets, of which inventory and receivables are the best known and most important. Equipment might also be included. The key is that in a floating charge the secured assets may change all the time and are therefore not as such identified and set aside, but can only be described. If the charge shifts into proceeds, these may be collected by the lender while the outstanding amount of the loan is reduced accordingly and the lender, which is likely to be a bank, will normally organise the collection for the borrower or hold the account in which the borrower is habitually paid. The security in its last phase may thus become possessory and therefore much stronger. Depending on the terms of the loan agreement, payments or proceeds may, however, also accrue to the borrower (in whole or in part), so that at least this money can be re-used by the latter, in that case again free from the charge, to acquire new materials and attract new labour. Normally, at least some part of the proceeds will remain available to the borrower for these purposes. To repeat, floating charges are mostly used to raise and maintain working capital for going concerns. In other words, a business may buy materials, produce semi-finished and finished products, sell them and expect payment. This all takes time during which the materials and the workforce must be paid. Payment for the sale of the manufactured products may be further delayed because credit terms are being offered. Pending such payments, the business will be short of money, or, to put it differently, this repeating cycle of production must be financed. Unless it has sufficient own funds, the business will be forced to borrow and that is the more normal situation and lenders will ask for security. These loans are likely to amount to some form of revolving credit, the total outstanding amount of which may then be closely tied to the value (from time to time) of the inventory or receivables and proceeds317 under the charge, and there may be no fixed repayment schedule. Repayments thus fluctuate with the fluctuations in the value of the collateral, while the loans may be increased when the value of the collateral increases. There will, however, normally be a certain time frame (say five years) and an agreed interest rate structure in respect of any balances so outstanding. Thus, the value of inventory and receivables as pools 317 Proceeds (or cash or bank balances received upon a sale in payment) are the most difficult to safeguard as collateral unless collected by the lender. It may therefore lead to situations where the lender bank becomes the collecting agent for the borrower/seller of the assets, or in which the borrower must keep its collection account at the lender bank. On the other hand, in the US under Art 9 UCC, it is not necessary for the lender to have control of the proceeds in order to retain it as collateral, but commingling by the debtor is a danger and makes the lender dependent on the tracing facility—see ITT Commercial Finance Corp v Tech Power, Inc 51 Cal Rptr 2d 344 (1996), which allowed certain presumptions to be used in this connection as to the origin of the collected and commingled proceeds, in the sense that if some of the moneys could be traced to the collection of certain receivables given as security to the lender, the debtor has the burden of proof that the rest of the account balance was not so acquired also.

176 Volume 5: Financial Products and Funding Techniques are combined in calculating the amounts to be repaid from the proceeds or added to the loan from time to time. This raises the question of proper valuation, and there may be possibilities of debtor fraud. In this type of arrangement, the relationship between lender and debtor is likely to be proactive on either side. For the financier, the concern is with the cycle of production and collection. If less is produced and more collected, the collateral shrinks and the loan may be reduced out of cash proceeds. This is different from term loans, where a bank awaits the return of its money along fixed repayment schedules and only checks from time to time on the continuing creditworthiness of its borrower and the existence of its floating security. Only in the case of a default will the lender intervene and see what assets (in terms of inventory, receivables and proceeds under the charge) may be around to repossess. There may also be a transactional loan under which a certain amount is advanced for certain inventory only and is repaid out of the sale of that inventory. The charge is then unlikely to be floating as far as the inventory is concerned, but may still shift into receivables and proceeds connected with the sale of the inventory in question. Naturally, all kinds of permutations are possible. In all situations, any security that the borrower may obtain from its buyers securing its receivables is also likely to be transferred to the lender. In the US that may take the form of the transfer to the lender of so-called chattel paper which comprises promissory notes secured against the sold asset (elsewhere that would likely be a reservation of title, the benefit of which can normally also be transferred to the lender, but this may then require a separate act of transfer). There are traditionally a number of fundamental legal issues connected with the floating charge (therefore especially those in inventory, receivables and proceeds). They may be summarised as follows: (a) What are the requirements for creating a non-possessory security interest, in terms of existence, identification, disposition rights in and delivery of the assets? (b) In particular, can future assets be sufficiently identified to make a security interest in them possible? (c) Are there sufficient disposition rights of the debtor in future assets and what are the other delivery requirements or formalities (for non-possessory security transfers) so that there can be a transfer in a legal (proprietary) sense of these assets if sufficiently identified? (d) Can delivery requirements (if any) be entirely constructive? How do they operate in respect of non-possessory security interests and the inclusion of future assets? (e) What does identification mean in respect of receivables? Are they identified with reference to an (existing) debtor or an existing legal relationship out of which they arise, or is any other reasonable description acceptable? (f) Can assets be transferred as a class or in bulk (rather than by individual identification through lists which require regular updating), therefore all at once by the mere statement to the effect in the security agreement or by a reasonable description therein? (g) Can at least replacement goods, replacement receivables, and proceeds of sales be considered sufficiently ‘identified’ and ‘delivered’ (even in bulk) and as such be deemed included? (h) How are chattels sufficiently identified and delivered upon incorporation into other products, and how do they remain so? (i) Do transfer restrictions on the underlying assets, especially assignment restrictions in respect of receivables, affect the disposition right of the debtor and therefore the charge? (j) How is the transfer of receivables effected? Does it require notification to the account debtor? Quite apart from the identification requirement, what is the effect on the possibility of a bulk assignment? How does it affect the assignment of future receivables?

Volume 5: Financial Products and Funding Techniques 177 (k) If there is a bankruptcy of the debtor (which ends the debtor’s rights to dispose of assets) before the (future) assets emerge, are they still included in the charge? Could this be different for finance sales under applicable law? (l) How do floating charges rank? Can the charge even in respect of future assets relate back to the time of the security agreement (or filing)? Does it make a difference if they become possessory, for example in respect of collections? (m) Can the charge protect future loans? Does the legal relationship out of which these new loans arise need to exist as a minimum for the charge to cover them? (n) What are the formalities in terms of publication or filing, and what does this filing achieve? Is it intended to warn (otherwise bona fide) purchasers of the asset and to impose on them a search duty or is it merely a facility to advise later lenders or other creditors? If professionals, might they be presumed to know that all assets of borrowers are usually given as security? (o) What steps are to be taken upon default? What is required in terms of repossession and what type of disposition is necessary especially in respect of pledged receivables and proceeds? May they be simply collected by the creditor on the debtor’s behalf without any execution sale?

2.2.2. Different Approaches. Comparative Legal Analysis We have already seen that different legal regimes respond very differently to the various issues and challenges concerning the floating charge identified at the end of the previous section. Again, it should be remembered that the true struggle here is the facility to use future commercial flows to support present and future debt. Undoubtedly Article 9 UCC in the US gives the clearest answers (see section 1.6 above) while providing the most favourable regime in allowing in its section 9-204 the largely unfettered transfer (in bulk) even of all later-acquired property (whether or not replacement assets) as security for all present and future debt. Moreover, the security relates back in all cases to the filing of a finance statement, even if the loan is only given later (section 9-308(a)). It means that in the US in principle, a debtor/borrower can give all its present and future assets (movable property) to secure any present and future debt this debtor has or may have in respect of a particular lender. Description depends on the loan agreement and need only be reasonably clear. A security transfer has no further formal requirements except that filing is normally necessary to achieve proper priority. Whether and to what extent this provides sufficient protection is left to the parties to decide and is not a matter of public policy. Banks may obtain a firm hold over their borrowers in this manner, but it was already pointed out that in practice this is mitigated in the US by the fact that a loan can be paid off at any moment in time (unless otherwise agreed, which may not be considered a reasonable term and may therefore not be binding, at least not in consumer relationships). It means that if another bank can be found that will give better terms, it will advance the money for the repayment of the first bank against a later and therefore lower-ranking security, although once the first bank’s loan is repaid, the first bank’s security will be cancelled so that the second bank’s security will move up. If, on the other hand, a bank is inclined to terminate its lending function, good reasons may have to be given and a good faith obligation, particularly including a reasonable notice period, may be implied.318 But, even in the US, in order to create a security interest, the debtor must at least have some disposition rights in the assets (section 9-203(b)(2)). That would seem fair enough, but these rights can be entirely prospective, while the creditor (unless a professional insider who has a 318 See KMC v Irving Trust Co 757 F2d 752 (1985).

178 Volume 5: Financial Products and Funding Techniques search duty) may ignore the interests of others of which s/he is not aware (except in the case of pure bailments and equipment leases under Article 2A UCC). This is particularly relevant for all adverse equitable interests. Note that Article 9 has here an entirely different approach from Article 2 concerning the sale of goods, which for a transfer still requires in section 2-105 that the goods be existing and that they can be identified before an interest in them may be transferred. In this approach, an intervening bankruptcy of the debtor does not affect its earlier security transfer of future assets that physically accrue to it only after the bankruptcy. The transfer itself may be in bulk and is simply the result of the finance statement in which they need only be globally described (section 9-203(b)(3)(A) UCC), see also section 9-108 UCC, which requires a reasonable description (note again that section 2-105 UCC in respect of the sale of goods is stricter). There is also a facility for the security interest liberally or even automatically to shift into replacement or commingled goods and proceeds: sections 9-315 and 9-336 UCC. Buyers in the ordinary course of business are protected (therefore in respect of assets that come out of inventory regardless of their good faith except in respect of any resale restrictions of which they know (see section 1-209(9) UCC), as are all bona fide consumer purchasers in respect of all consumables (section 9-320 UCC). In the case of default, the collateral can be repossessed. In that case, goods must be disposed of at the best possible price, but receivables may be collected (in due course on their due date) and proceeds taken. In either case, any overvalue is to be returned unless otherwise agreed (section 9-609ff UCC; see further section 1.6 above). The US system concerning floating charges is in essence simple because it breaks radically with more traditional concepts of existence, identification, disposition rights, and delivery requirements of the assets, and has proven effective. As noted, in other countries, there has been much greater vacillation, partly because of system constraints within the legal systems concerned, which, as we have seen, proved insensitive to practical needs for no other than systematic considerations. In civil law, in particular, modern non-possessory security interests must be fitted into the traditional system of the creation of proprietary rights with its strict requirements as to disposition rights, existence, identification, and (often) delivery. This obviously creates problems in respect of classes of assets and the inclusion of future (even replacement) assets and also in respect of the concept of variable collateral whose ranking and priority relate back to the creation date of the charge no matter whether the assets only emerge later, even after the bankruptcy of the debtor. This is particularly relevant when advances have already been made to a debtor secured on assets that may be produced only after a bankruptcy of the debtor in a situation in which his business continues (at least for the time being in or outside reorganisation proceedings). As we have seen, in civil law, party autonomy may not be able to overcome these constraints, which are innate in the civil law concept of property and its transfer and creates special problems for bulk transfers and assignments. Again, in many civil law countries there is no concept of transfer in bulk or shifting of proprietary rights into replacement or commingled goods through notions of tracing, constructive trusts, or otherwise, even if in the case of commingling a form of pooling may result: see also Volume 4, section 1.10.2. The inclusion of future advances or loans has proven equally difficult in many countries, equally for reasons of identification. Dutch law, even in its 1992 new Civil Code, remains substantially hemmed in by all these considerations, and it is not easy to create a floating charge under it. As we have seen in section 1.2.2 above, it may well be impossible,319 in which connection the need to notify all 319 Under the new Netherlands Civil Code of 1992, a floating charge is not foreseen, and must be cobbled together on the basis of party autonomy, therefore through contractual clauses: see s 1.2.2 above. But the problems in respect of the inclusion of future assets (chattels as well as receivables, absolutely or relatively future, and whether

Volume 5: Financial Products and Funding Techniques 179 receivable assignments to individual account debtors was a serious further (new) impediment, relieved in 2004, but such assignments each still require a document and form of registration for their validity. This restrictive approach can be explained by the outspoken policy of the new Dutch Code to reduce the rights of secured creditors. Yet the fact is that the room so created usually accrues to the benefit of junior secured creditors and not to unsecured creditors. Statistics bear this out and the lot of common creditors was not noticeably improved after 1992, which was not surprising. In France, under earlier statutory law, there was a broader charge possible on a business (fonds de commerce), which could even cover real property leases, industrial property rights and the equipment of a business, but it could not amount to a fully-fledged floating charge covering changing pools of inventory and accounts receivable, all for lack of sufficient identification (except if receivables could be identified with regard to certain future debtors).320 Under more modern law, the traditional notification requirement for the assignment of receivables was, however, lifted (Loi Dailly) if they are used for financing purposes including securitisations (titrisation)321 and altogether since the amendments to the Code civil in 2016 as we have seen. Since 2006, floating charges have been made possible by statute, but more experience may be needed to see how they develop: see section 1.3.1 above. Common law traditionally lays less stress on systemic considerations, and in any event in equity does not insist on identification to the same extent, as we have also seen. The trust is the classic example, and by trust deed a trust can be created over pools of present and future assets, subject to an adequate description. The law in common law countries does not have the same problem with the inclusion of future assets either; see section 1.5.2 above for the English variant of floating charges. The traditional equitable facilities of tracing of the interest in replacement assets, including receivables and proceeds, also help, as do the notions of constructive or resulting trusts. Equitable assignments do not need individual account debtor notification either. In the US, the law built on these facilities in Article 9 UCC, but even in England there sometimes remain problems with bulk transfers including future assets, at least in the sale of goods (Sale of Goods Act 1979, section 16), and also with the priority of floating charges in the sense that they rank only just above the unsecured debtor as the charge crystallises only on the day of default322 or sooner if control is acquired when the charge becomes fixed. In England, it is therefore still essential to distinguish clearly between fixed and floating charges, the former having a higher status (and are often included in charges over a whole business, for example mortgages in real estate). It follows that in floating charges, (a measure of) control by the security holder over the asset is here the distinctive feature under English law as such control results in what would be considered a fixed charge. Since for floating charges there should not be control of the creditor over the asset, the mere promise to set aside certain property may create them. It would at the same time appear to make a bulk transfer possible,323 but it is still important to make some distinction here. In England the floating charge is not compatible or not replacement assets) are made much greater under Art 35(2) of the Dutch Bankruptcy Act 1896, amended at the same time, and which lays stress on the existence of the asset in the control of the debtor before a security interest in them can pass. The wording is such that a conditional sale of future assets might be easier to achieve and stands up better in an intervening bankruptcy of the transferor. 320 See s 1.3.1 above. 321 See for the Loi Dailly, s 1.3.5 above. 322 It also means that the debtor’s right to set-off remains intact until the crystallisation. In 2003, the UK Law Commission proposed an advance filing system in respect of floating charges, which would result in a treatment much like that under the UCC and remove the distinction between fixed and floating charges and potentially move the latter up to top rank: see n 205 above. 323 See n 205 above.

180 Volume 5: Financial Products and Funding Techniques with control over the asset but all the same it gives control over the liquidation process; hence the idea that ‘fixed charges are for priority and floating charges for (ultimate) control’ but only after repossession upon crystallisation in the case of a default.324 As for the inclusion of future receivables in England, they must come into existence before they can be included (see more particularly Volume 4, section 1.5.6) but it does not suspend the assignment agreement and the assignment is perfectly valid and effective as at the assignment date although in the case of a fixed charge the priority would only be established as from the day the claim materialises. In the case of a floating charge, the priority dates from its crystallisation on the day of default when the claim must exist. In England, there followed another typical feature, in that a floating charge was likely to have its own receiver in a liquidation, which often covered a whole business. In practice, it amounted to a private administrative receivership outside the control of the courts in competition with a bankruptcy trustee, who was so supervised. In reorganisation proceedings, this facility has been deleted since 2002 by the Enterprise Act, which makes the administrator responsible to the courts while s/he must attend to the interest of all creditors, if necessary, with a view to restructuring the company. This is clearly meant to achieve a better balance between all interests and is a modern example of control slipping away from secured creditors (with an already weakened priority) to the bankruptcy trustee.325 This is not surprising in reorganisation proceedings, which require some early stay of all repossession proceedings in order to preserve the business before a plan can be considered (see also section 365 US Bankruptcy Code). On the other hand, as was observed in section 1.1.9 above, repossession itself remains the clearest expression of private control and separation. It continues unabated and private control is even enhanced in other areas, notably by modern netting agreements, which, if used in finance, are commonly allowed even to ignore any stay provisions: see in particular the US bankruptcy amendments since 1992 and 2005 and the EU 2002 Collateral and 1998 Settlement Finality Directives. In civil law, the German approach is rather unique in the area of floating charges in that it overcomes at least to some extent the typical formal civil law transfer restrictions by relying in case law substantially on party autonomy. It is concerned with the extended or broadened securities transfer of chattels and intangibles, the Sicherungsübereignung or Sicherungsabtretung, through the introduction of certain techniques. Thus the Raumsicherungsvertrag allows for the setting aside of assets with reference to a location or warehouse, regardless therefore of the content, resulting in this manner in a bulk transfer facility for pools or classes of assets within a certain space; the Verarbeitungsklausel allows for their conversion into other products in which the charge is then automatically extended, and the Vorausabtretungsklausel allows for an anticipated assignment of all future receivables derived from the sale of these assets: see more particularly section 1.4.1 above. On the other hand, in a bankruptcy the charge ranks low, a mere preference (Absonderung) in the distribution of the proceeds after deduction therefore of the cost of liquidation. There is no repossession, so that the pace of disposition and liquidation of these assets cannot be forced either. It is another example of control slipping away from secured creditors to the bankruptcy trustee. Fixed charges (which are security interests proper with repossession remedies and disposition rights attached through Aussonderung) will rank higher, as may also senior statutory preferences 324 In the US a similar low priority still applies to charges that are attached but not perfected (filed), in bankruptcy further undercut by the lien of the trustee, which has the effect of reducing the attached but not perfected secured claims to the ranks of ordinary creditors. 325 This goes against the suggestion of some authors in the US who seek to further privatise or contractualise the recovery process. See for an analysis and criticism of this trend J Westbrook, ‘The Control of Wealth in Bankruptcy’ (2004) 82 Texas Law Review 795.

Volume 5: Financial Products and Funding Techniques 181 in the distribution (although most tax liens are now eliminated under the German Insolvency Act of 1999). Intervening bankruptcy is not likely to disturb the picture in respect of receivables, even if future, as under German law nothing more needs to be done to complete their transfer. Yet as far as identification goes, there is still a need to be able to identify the relationship out of which the receivable may arise or at least the (future) debtor. The receivable as replacement for the goods upon a sale may as such be considered sufficiently identified if the goods were part of the charge: see further Volume 4, section 1.5.6. In respect of future advances or loans, on the other hand, the existence of relationships out of which they arise may play a (restraining) role. The replacement notion thus acquires special importance and creates a special class of assets in respect of which a different (and more liberal) transfer regime is applied, as least in the context of facilitating floating charges in Germany. In the case of future chattels there may, however, have arisen some greater doubt about their inclusion in the security under section 91 of the 1999 German Bankruptcy Act, because of the delivery requirement. It would have to be based on an anticipated transfer of constructive possession (constitutum possessorium). This may be easier for goods that do exist even if not yet owned by the debtor (considered relatively future) and for replacement goods as future assets (such as future finished products made from products under the charge) than for absolutely (non-existing) assets that may have to be delivered by third parties. It all hinges on whether the expectancy of the secured creditor may be given a proprietary slant (Anwartschaft) or whether perhaps the debtor has become an agent or conduit for the creditor, so that the debtor’s powers of disposition are no longer relevant. In Volume 4, section 1.7.9, it was noted that to overcome these systemic problems in civil law, related as they are to the intricacies of the general law of property, the vital importance and close connection should be stressed between: (a) the contractual description or identification possibilities to include them; (b) the possibility of an anticipated delivery of future assets, whether or not absolutely or relatively future, and their automatic transfer to the chargee when future goods emerge with retention of the original rank; and (c) the concept of a shift at least into replacement goods, inclusion thus depending on either a valid description and sufficient identification in the contract or being implicit in legal notions such as (i) generality of goods or bulk, (ii) asset substitution, (iii) tracing, and (iv) commingling.

2.2.3. Modern Publication or Filing Requirements. Their Meaning and Defects. Ranking Issues in Respect of Floating Charges An important feature of Article 9 UCC in the US is its filing requirement (with some minor exceptions) for the perfection of the security and the relation back of the ranking to the moment of filing, even in respect of future assets. The filing requirement (not only for floating charges) is often believed to be a major achievement of the US system, but beyond establishing the ranking of the charge, it means in fact very little especially in terms of publicity, and has not generally been followed elsewhere, especially not in Germany, where the floating charge (and other nonpossessory security interests in personal property) remains hidden, as is generally also the case for reservation of title. England and France have some more incidental filing requirements, but no generalised and simplified system either: see sections 1.3.1 and 1.5.3 above. In Volume 4, section 1.7.7 and in section 1.6.1 above, a critical note was proffered in respect of this US feature and it may be worth repeating some of it here. First, in the US under Article 9 UCC, the filing itself does not guarantee anything, especially not the existence or extent of the

182 Volume 5: Financial Products and Funding Techniques collateral or the capacity of the debtor to dispose of the assets in this manner, or indeed the existence of any valid security agreement at all. Thus, the debtor may have void title so that the creditor receives nothing, although the security interest holder may be protected against a voidable title if unaware of it, but this does not result from the filing. The collateral may not exist either, as in the case of future property. Nevertheless, the lien may relate back to the date of filing as soon as the asset emerges, although the contract to acquire a future asset may itself be pledged (as a general intangible) under section 9-102. Other assets of the debtor may be excluded altogether because the debtor has an insufficient interest as in the case of leased property under Article 2A UCC. On the other hand, for other property found in the possession of the debtor there may be inclusion in principle, but the point is that the filing has no relevance in this connection either. It also does not protect against statutory or judicial liens in the same assets, which are not normally published, or against any purchases in the normal course of business or against bona fide purchases by consumers of consumables, as we have seen, which will be free and clear of any charge regardless of the filing and there is no investigation or inspection duty for these purchasers. In fact, only charges under Article 9 can be filed. There may be others that might prevail. Possessory interests of all kinds, at least in consumables, may in particular prevail over any interest so filed. Although the filing guarantees nothing, it is relatively costly and time-consuming, while the filing systems in many States of the US are still cumbersome, the place of filing and investigation sometimes uncertain, and filing may be necessary in any one of several States where the debtor is engaged in business. In the meantime, the name of the debtor may have changed, or the debtor may have been subject to a merger or reorganisation. Here again the registers guarantee nothing. Most importantly, they do not allow for the filing of adverse interests of third parties (if not themselves secured creditors under Article 9) in the property to protect them against later security interests. For all these reasons, bona fide creditors may find little protection in these filing systems. They are not general debt registers and only concern some security interests, no more. It was observed before that they mainly serve as a warning for professional lenders who reshuffle the risk of default among themselves, the commercial flows being in any event protected. Common creditors miss out, as they always did, and filing does nothing for them, less bothersome perhaps if one realises that these professionals are usually the largest class of these unsecured creditors at the same time. The consequence is that the benefits of this filing system are in practice much less obvious than they appear at first. Consequently, there is much less of an example in the US model than would seem from its face. It primarily establishes an easy, simple and certain method of creating priorities, which also could be achieved through a notarial registration and time-stamping (as is done in the Netherlands). Even in the US, scepticism has been expressed, although no abolition suggested. Filing was not part of the earlier drafts of Article 9 UCC.326 In Europe, not much need has been felt for a similar system, particularly in Germany, understandably so, it would seem. Clearly a credit system can work very well without it and filing systems do little to lighten the burden of due diligence of lenders. The 2002 EU Directive on Financial Collateral explicitly ignores all domestic filing requirements for the validity of security in, or conditional sales of, stocks and shares (in dematerialised form), the interests in any event being considered here in principle possessory (though not physical). The 2009 DCFR believes in filing (see Volume 4, section 1.11) but bona fide purchasers and even assignees may be protected regardless although it may help creditors to see where they are. 326 See G Gilmore, Security Interests in Personal Property (London, 1965) s 15.1.

Volume 5: Financial Products and Funding Techniques 183 In an international context more than lip service is often paid to filing notions, which may be quite destructive of the interest when invoked elsewhere where it may not be effective, as we have seen. Publicity is often thought to be the cornerstone of proprietary rights. That is in itself untrue—see also Volume 4, section 1.1—as is clear from the ownership of chattels and claims. Nevertheless, the accent on possession or on filing as substitute publicity suggests its importance. Indeed, as an alternative, some form of filing also appears in the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade and it is also an important aspect of the 2001 UNIDROIT Mobile Equipment Convention, there only for limited classes of high-value equipment. Generally, it was submitted that the concepts of publicity, possession and filing in this connection are often poorly understood. Publicity in itself, for example an advertisement in the newspapers, does not create or confer proprietary rights or status. Possession is no indication either and may in any event be purely constructive, at least in civil law. Filing does not guarantee much either as we have seen. The legal meaning of both filing and possession in the context of secured transactions always needs to be further defined to acquire proper content. As things now stand, bona fide purchasers and even purchasers in the ordinary course of business, at least of commoditised movable assets, are normally protected and have no investigation or search duties, as mentioned before, so that filing (rightly) has no meaning for them. This is very different from real-estate registers, which cannot be so ignored. The essence is therefore (except in the Mobile Equipment Convention, where it concerns some specific high-value items) to warn other creditors who should and will make their own inquiries, at least if they are professionals such as banks. It works therefore between a number of professional funding insiders and is only meant for them to better protect themselves against the others and to acquire some transparency. It may make due diligence somewhat easier, but it probably makes little difference. In common law countries, these are the same insiders that may create equitable proprietary rights to operate among themselves who are thus very aware of these facilities. In fact, Article 9 is the statutory expression and elaboration of the equitable floating charge in the US, and the filing requirement has to be seen in that limited context. Again, outsiders, especially bona fide buyers in the ordinary course of business, are always protected and thus also the ordinary commercial flows. The bottom line is thus that a filing system makes life somewhat easier for those who should make their own investigations anyway. They still have to, even in the US system, especially in the many aspects enumerated above, which filing leaves open. It was never immediately apparent what filing systems add here to justify their cost and expense, even if access were easy and there was no confusion possible on where to look. On the other hand, it undermines any remaining protection of bona fide creditors and in particular pushes away further any theories of apparent ownership in the debtor to protect them; see also section 1.1.11 above. Again, what filing usefully does do is to determine precisely the moment of charge and therefore its priority in time, but this can be achieved in other ways. Thus, the Dutch chose a registration system that is not public for all non-possessory charges in movable property (but they do not have much of a floating charge). Filing then underpins the priority of the charge, and its introduction is as such regularly suggested in the UK in the nature of an advance filing and relation-back system of priority, lastly in a Law Commission consultation paper of 2002.327 But again banks will know that in a normal business all is given as security in one form or another, that they are always late in respect of new advances, although normally loan documentation or even the law in the US allows the debtor to pay off loans early, so that higher-ranking priorities are deleted. Whatever they know or may discover from the filing register, they have to find out the details for themselves as no filing system can reveal all. 327 See n 205 above.

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2.2.4. Special Problems of Assignments in Bulk In order to be effective, floating charges require the possibility of a bulk transfer of the assets to be covered, which should transfer all at the same time and in the simplest possible manner. Best is a transfer of a security interest simply by contract without further delivery needs or, if these are still imposed, especially in the case of chattels, through mere constructive delivery. To be effective, specific identification of the assets should be replaced by a reasonable description of the pool or class to be transferred, and future assets, especially if replacements should be allowed to be included, never mind the absence in them for the time being of disposition rights of the transferor. As pointed out before, the notion of replacement asset may acquire here a special significance in terms of identification and disposition rights, in that at least all replacement assets—be they other inventory in terms of new materials or (semi-) finished products, receivables or proceeds—may be considered sufficiently identified and then automatically covered. Floating charges often also cover receivables. They are likely to be preferred to inventory because they are more liquid and may be accompanied by a collection agreement for the lender, who thus acquires a possessory facility. The transfer may in such cases simply result from proper tracing but may also be achieved by bulk assignment of present and future claims to the prospective lender. It is important that this transfer technique works well. They are also conceivable in other types of funding situations, such as receivable financing or factoring and securitisation; see for a fuller discussion section 2.3.1 below. These funding techniques may overlap with floating charges, especially if in the latter a collection facility is included for the lender, who may in that case even take (some of) the credit risk, as we shall see in factoring.328 At the heart of all these structures is therefore a bulk assignment of present and future claims: see also Volume 4, section 1.5. To facilitate these nationally and then also transnationally is therefore most important. As in the case of bulk transfers of chattels, specificity, identification and delivery issues, including the requirement of prior disposition rights in respect of each asset, should be avoided, first to make the bulk transfer a possibility at all, and further to reach also future receivables, but in bulk assignments there are also a number of other problems. As in the case of chattels, individualisation should be avoided, notably any requirement of notification and documentation in respect of the transfer of each individual claim. In many countries also in the civil law, bulk assignments are increasingly facilitated, at least for financing purposes, but this has often required statutory amendment. Thus, in France in 1981 notification was deleted as a validity requirement under the Loi Dailly in professional funding arrangements, in so-called titrisation, a French statutory form of securitisation since 1988,329 and altogether in 328 When it comes to the raising of capital, bulk assignments are a necessity in at least two other types of situations: there may be project financing against future income, as eg in the construction of toll roads or utility supply systems, and there may be securitisation or financing through asset-backed securities, see more particularly s 2.5.1 below, when a future income stream is transferred to underpin an issue of corporate bonds used by the issuer exactly to fund the acquisition of this cash flow. 329 The subrogation approach remained preferred, however, in France: see Lamy, Droit du Financement, Affacturage (1996) 1344, 1347 and JP Dumas and R Roblot, ‘Cession et nantissement de créances professionelles’ Repertoire de droit commercial Dalloz 1 (April 1998), see also n 141 above, but it is not effective in respect of future claims and is in any event individualised per claim and dependent on actual payment of the face amount. It also creates problems with the discounts normally applied for collection, maturity and the taking over of credit risk and the result might not be a sale of receivables in legal terms. See for older literature on factoring in France, C Gavalda and J Stoufflet, ‘Le contrat dit de “factoring”’ [1966] Juris-Classeur Périodique (edn G), ‘Doctrine’ no 2044; J-L Rives-Lange and M Contamine-Raynaud, Droit bancaire, 4th edn (Paris, 1986) s 481, and C Gavalda, ‘Perspectives et réalités juridiques de la convention dite d’affacturage’ [1989] Semaine Juridique 534; El M Bey, ‘Les tiers dans la complexion de l’affacturage’ [1994] Recueil général de jurisprudence de droit administratif et du conseil d’état 207. See for case law Cour de Cass 21 November 1972, D jur 213 (1974) and Cour de Cass, 14 October 1975, Bull Civ IV, 232 (1975).

Volume 5: Financial Products and Funding Techniques 185 Belgium (as far as third parties are concerned) and since 2016 now also generally in France. It is better to forget for the moment the Dutch contrary move in its new Code of 1992, which was inexplicably hostile to the bulk assignment,330 a mistake repaired in 2004, at least for financing purposes. Also, in terms of documentation, one does not want individualising requirements for assignments. German law and English equitable law331 do not impose any. Documentation may in some countries even attract stamp duty, which distorts all the more and should be avoided if only for that reason. In France, the documentation requirement remains generally in force, however, and takes a special form under the Loi Dailly and in titrisation. Practically speaking some document is always there, even if, as in England, often structured as an agreement to assign and not as an assignment itself (in order to avoid stamp duty), but in bulk assignments it should at least be the same document for all claims. If registration or filing is required, again one document should suffice in which the secured assets are globally and reasonably described rather than each and every one of them being identified and specified. This proved a particularly difficult issue in modern Dutch law after 1992, the Code of that year having also overlooked this particular problem. Case law stepped in subsequently to iron out some of the complications, but the whole set-up is confusion for no obvious practical reason, only because the basic issues were never properly considered.332 Another issue is the liquidity of monetary claims itself. This goes first to the question of their severability from the agreement out of which they arise, their transferability notwithstanding assignment or other restrictions in the underlying agreement, and subsequently to the defences of the debtor against the assignment (unless reasonable), and set-off rights against the assignor being used against a subsequent assignee unaware of them. This is the issue of commoditisation of monetary claims. So far it is not considered a fundamental issue or a justified requirement of commerce and finance in civil law, although in respect of chattels, the law has long been wary of their illiquidity and nowhere favours clauses limiting their transfer and giving these restrictions third-party or proprietary effect in the sense that transfers can be undone on the basis of them, at least not in respect of bona fide transferees. A similar rule is necessary for receivables, but mostly still wanting. Section 2-210 of the UCC in the US deals with this issue more extensively and fundamentally, but only for sales receivables as discussed in section 2.3.1 below. Without it, in a bulk assignment of receivables for finance purposes, the assignees/financiers may not know exactly what they are getting and what therefore the true value of the support of a receivable portfolio is for them, wherever the receivables themselves may originate or be deemed to be located. No wonder, therefore, that more modern law, like the US example, inclines to making receivables ever more independent from the underlying contract out of which they arise, including assignment restrictions therein, although even in the US there is still some way to go before they will 330 See for factoring in the Netherlands especially, CA Knape, ‘Factoring’ [1994] Weekblad voor Privaatrecht Notariaat en Registratie 6141; see also J Beuving, Factoring (Dissertation, Nijmegen, 1996) and n 95 above. It remains considerably handicapped. In 2004, a registration requirement was substituted for the notification requirement (as in the case of security transfers of intangibles): see n 65 above. 331 See for factoring of receivables in England, FR Salinger et al, Salinger on Factoring: The Law and Practice of Invoice Financing, 3rd edn (London, 1998) with emphasis on the practical rather than legal aspects of factoring; see for a legal analysis of receivable financing more generally F Oditah, Legal Aspects of Receivables Financing (London, 1995). Indeed, under English law, factoring implies a sale of the receivables to the factor, subject to certain defined classes of receivables being returned under certain circumstances: see also R Goode, Commercial Law, 3rd edn (London, 2004) 745. Whether this return is automatic also in a bankruptcy of the factor remains mostly undiscussed. See for a solid comparative analysis also, B Bjorn, Factoring, A Comparative Analysis, The Legal and Practical Implications of Factoring as Practised in the United States, England and Denmark (Dissertation, Odense, 1995). 332 See ss 1.2.1 and 1.2.2 above.

186 Volume 5: Financial Products and Funding Techniques be treated essentially as promissory notes, which by definition have that independence and are therefore free from these dangers for a bona fide purchaser/assignee. This issue will be more fully discussed in section 2.3.1 below. In fact, in a modern legal set-up, receivables should indeed be treated much like promissory notes, except perhaps that the set-off against any assignor should be maintained; see also the discussion in Volume 4, section 1.5.9. To facilitate bulk assignments further, preferably any monetary claim, wherever deemed to be located, should be capable of inclusion, which then requires a form of transnational law to be effective. If that is not possible, at least it should be clear which claims may go under the same domestic legal regime (are therefore deemed situated in the same country and covered by its laws). To overcome the applicable law problems in this regard, uniform treaty law has been proposed. Indeed, originally, the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade was presented as a Convention to facilitate the raising of capital on the basis of receivables wherever originating (assuming this was in Contracting States). The idea was that domestic and foreign claims (however defined, and they could also be for services rendered) could thus be included without distinction. Only subsequently did it transpire that the true need was rather for an (international) facility of bulk assignments proper in respect of all classes of claims, including future and foreign claims, with uniform law particularly in (a) the transfer of future claims, (b) the formalities such as notification and documentation, (c) the possibility to split out the receivable from its contractual base (while in this way also limiting the defences and set-off rights of the debtors under the receivables as well as the impact of any assignment restrictions), and (d) the priorities between various types of assignees of the same receivable pool. Hence the struggle to broaden the original UNCITRAL draft in that direction, in which connection the funding element became less pronounced. In its final form, it now also means to apply to securitisations, project financing, and pure collection agreements. So far it has not been successful. The reasons will be analysed more extensively in section 2.3.8 below. As in many of these international efforts, the approach is not sufficiently innovative and comprehensive to be convincing and there was too much confusion at the theoretical level. As may be deduced from the above, there are three prongs to a successful modern assignment law at least in respect of receivables: (a) doing away with old-fashioned notions of identification, existence, disposition rights and delivery requirements so as to allow for bulk assignments that may also include future claims; (b) deleting notification as a requirement for validity of the assignment; and (c) reducing debtor defences and improving liquidity. In particular, the assignment should become effective immediately upon the contract of assignment, regardless of notification to the debtor and individual documentation in respect of each claim. Indeed, on the German model, the assignment agreement should effect the Einigung or proprietary transfer at the same time (unless explicitly postponed or conditioned by the parties to the assignment). Only then are bulk assignments truly effective. That also seems to be the system of the UNIDROIT Factoring Convention (Articles 1(2)(c), 5(b), 8), although poorly expressed, but it was an approach ultimately not sustained in the UNCITRAL Convention (Article 8). Under the UNCITRAL Convention, the notification of debtors is not covered and would therefore appear to be left to domestic laws pursuant to Article 27. That is a serious blow to bulk assignments (and to the Convention). Professionalism and commerciality should have had an effect and it is perhaps logical that in countries like France notification requirements were lifted in professional funding facilities, even though the debtors themselves could still be consumers. The UNIDROIT (Article 1(2)) and UNCITRAL (Article 4) Conventions both aim at covering professional dealings and funding arrangements only, but in terms of notification UNCITRAL did not draw the logical conclusion. The UNCITRAL Convention maintains a similarly ambivalent attitude in respect of the documentation requirement. After (rightly) deleting it in earlier

Volume 5: Financial Products and Funding Techniques 187 drafts, it finally referred the matter to the law of the place of conclusion of the assignment or, if the assignment is cross-border, to either the law applicable to the assignment or the law of the location of assignor or assignee (Article 27). This also seems unfortunate, and seriously damaging to the concept of bulk transfers (unless all claims originate in the same country). Like in the matter of notification, it makes domestic law, with all its variations, applicable in one of the most important aspects of assignments, and seriously undermines a unitary approach that would have made a bulk assignment of all receivables originating in Contracting States possible. As we shall see, the Convention is more liberal in respect of the assignment of future assets and in depriving assignment restrictions from their proprietary or voiding impact, but this cannot obscure the fact that an important opportunity was missed to promote international financing by facilitating bulk assignments of all sorts.

2.2.5. International Aspects of Floating Charges. Limited Unification Attempts Earlier, in sections 1.1.4 and 2.1.8, it was said that, under traditional private international law notions, the application of the lex situs finds general acceptance in proprietary matters, if only because they are often closely related to enforcement, which is more naturally a question of the law of the country of location of the asset. It was noted, however, that the lex situs notion is strained when the assets are intangible (like receivables or other monetary claims) or move so frequently (as in the case of aircraft and ships) that their situs becomes accidental. It may easily be seen that there is also a problem in the case of bulk transfers or bulk assignments of assets from different countries of origin (however determined). Contractually, we may mean one type of charge and try to include all, but it would still depend on the country of location of the assets and its laws whether that objective can be achieved. In view of the large differences between the laws of various countries, especially in matters of floating charges, as we have seen, it is unlikely that unity of regime can be maintained in respect of an international portfolio of assets under present private international law rules or approaches. It is possible that in some countries we may achieve more than in others and in respect of some assets we might even achieve more than the lex contractus allows but, again, party autonomy is not traditionally decisive in this area of proprietary rights where the objectively applicable law is likely to prevail, although especially for receivables there is pressure for greater party autonomy in this area, as we shall see. As we have seen, in the case of a movement of a tangible movable asset cross-border, a distinction is commonly made between the regime of the creation of a charge in the country of origin and that of the recognition of the charge in the country of destination, which recognition may only be expected if there are reasonable equivalents of the charge in that country. It follows that even if the charge was created over assets in one country, a unitary legal regime would not then be likely to continue in the countries of recognition if the relevant assets were moved to different countries in their various stages of transformation or as end-product. The unity of the applicable law may thus be broken when assets under a (floating) charge start to move. In the case of enforcement of the charges in them, the law of the new situs, wherever they are or may be considered to be at that moment, may in particular have something to say, maybe even more the applicable bankruptcy statutes (even of countries other than those of the situs if the bankruptcy is subsequently recognised at the situs). There is also a classical situs and applicable law problem when charges shift into manufactured goods, other inventory, or receivables and proceeds, assuming their location is in different countries. Their laws may not react in similar ways. In the first case, the situs of their manufacture may be considered the place of the conversion, the laws of

188 Volume 5: Financial Products and Funding Techniques which then apply.333 For shifting into receivables and proceeds, an argument can be made that the situs is the place of the delivery of the asset or of the payment, the laws of which would therefore determine the possibility of such a shift and the additional formalities in respect of the continuing charge (which could even be seen as an automatic assignment). Here again unity in the applicable law will be lost if delivery and payment happen elsewhere. Any continuation of the original charge in the asset backing up any receivable as an ancillary right would then also be covered by this lex situs, as would indeed be any rights of bona fide successors in the converted property or even of the receivable. Again, any unity in the applicable law is likely to be lost. There were always special problems with the location of receivables. For intangible claims, it was thought not unreasonable to view them as located at the place of the debtor, again because of the close relationship with enforcement, which usually must take place there: see also Volume 4, section 1.9.2. Especially for bulk assignments of receivables, the place of the seller/creditor has therefore been proposed exactly to preserve unity in the applicable law.334 This is a utilitarian and pragmatic approach, now sometimes also proposed as a technique for tangible movable assets (therefore all considered to be located at the place of the owner/debtor), but this unity is unavoidably lost in the case of enforcement if debtors are located in different countries. As already noted, in case law, at least for intangible assets, mostly receivables, more room is now sometimes left for party autonomy, and a more convenient national law might then be chosen by the parties in respect of all transfers in the assignment agreement: see in particular Volume 4, section 1.9.2 and section 2.3.5 below.335 This party autonomy in the choice of the applicable law could then also lead to the transnationalisation of the law in this area and could even be transposed to chattels. As we shall see in section 2.3.5 below, the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade, already referred to at the end of the previous section, proposed an international regime for bulk assignments of (present and future) receivables originating in different Contracting States (as defined), although it ultimately proved disappointing, as also mentioned in the previous section and it has not received sufficient support to become effective, probably because it left too much still to an old fashioned conflicts of laws approach in the many details it did not properly cover. No transnational regime has yet been proposed at the formal level for tangible (present and future) movable property transferred in bulk as part of a floating charge or otherwise, except in a more limited and indirect way in the EU Collateral Directive where the charges are meant to be possessory, however: see Volume 4, section 3.2.4 and section 1.1.9 above. In the EU, in the DCFR, the floating charge is not given a special place and whatever there is, it is regressive even compared to the present German situation: see Volume 4, section 1.11.4. An international project in this field simply setting out basic principles could be of considerable interest.

2.2.6. Domestic and International Regulatory Aspects Floating charges, where legally operative, are an important facility protecting lending activity, especially in respect of working capital, thus becoming an active risk management tool for professional lenders. However, they raise considerable (often systemic) private law problems, especially in civil law countries as we have seen, which may be remedied through legislation, as in Article 9 UCC in the US, and now also in France, see section 1.3.1 above, but in many other countries they 333 See the Scottish case of Zahnrad Fabrik Passau GmbH v Terex Ltd (1986) SLT 84. 334 See n 348 below and accompanying text. 335 See in particular n 348 below.

Volume 5: Financial Products and Funding Techniques 189 remain legally problematic. There is no keen regulatory interest in facilitation (or curtailment), although it has often been said that the limitations which, especially in civil law countries, derive from its intellectual system and basic notions of identification, specificity, disposition rights concerning the relevant assets and other transfer requirements, are meant to protect common creditors as a matter of public policy. It has been shown that that is unlikely; the result is rather a reshuffling of interests between various classes of preferred and secured creditors. Rather, it is for the financial services industry itself to seek further legislative support if it deems such desirable as was done in a limited fashion in the EU Collateral Directive. It shows that there are no real public policy constraints. Public policy should favour the cheaper financing that may result and lift all systemic considerations that have inhibited this facility so far in many civil law countries for no obvious reason other than preserving the system.

2.2.7. Concluding Remarks. Transnationalisation The above presents a mixed picture of progress in terms of floating charges transnationally. In many countries, they remain bedevilled by specificity and existence requirements, undercutting the possibility of bulk transfers and a shift in replacement assets, and by a need for disposition rights in respect of the assets they cover, especially problematic when they are future assets even if mere replacements of former ones in a production and distribution process. Assignments of receivables present further problems, first in terms of a bulk transfer, but also in terms of the substantial independence of the receivables in respect of the contractual environment out of which they arise and in terms of simple transfer requirements, in particular doing away with burdensome individual notification and documentation requirements, especially necessary to make bulk assignments in financial structures effective. One must assume in this connection that the requirement of specificity will increasingly be relaxed, and that the direction is further one of ever greater independence of receivables, therefore in the direction of what the promissory note became as a negotiable instrument, at least in respect of receivables resulting in the ordinary course of business from commercial dealings in the professional sphere. This issue of liquidity, which is more fundamentally faced in section 2-210 UCC in the US, will be dealt with more extensively in the next sections. Ultimately a fundamentally different approach to the concept of receivables as assets and the vesting of proprietary rights in them is suggested. Not only floating charges, but also receivable financings, factoring, securitisation and project financing are affected, as we shall see. To overcome conflict of laws problems when receivables have debtors in different countries, one technique proposed above rests on the idea that all personal or movable property is located at the place of its owner, the law of which could then also cover any charges or similar interests in it worldwide. This could be a matter of transnational party autonomy supported by transnational practices or custom. It could even free up the types of interests that may be created, always subject to the protection of the international flows, as we have seen, and still subject to recognition of these interests in local bankruptcies or other enforcement procedures. It is therefore not a watertight solution also because there may still be some need for adjustment to make them fit into local rankings, especially in local bankruptcies, but it may be better than what we have. If the law of the owner allows it, bona fide collecting transferees and assignees would then be protected everywhere, as would be any purchaser in the ordinary course of business if these assets were commoditised. Again, this is the issue of protection of the (transnational) flows and is also a matter of finality. But even if we allow the domestic law of the owner to determine these issues, it follows that there would still be differences in local bankruptcies or other enforcement proceedings elsewhere

190 Volume 5: Financial Products and Funding Techniques in which these assets and priorities figure. Here unity must come from treaty law or otherwise in practice foremost from transnational custom more generally accepted also in local bankruptcies. At least in respect of contractual assignment restriction, there was some progress in the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade, already mentioned and as we shall see more particularly in section 2.3.5 below, but, outside the US, still not much domestically, as demonstrated in the new Dutch Civil Code. Another problem besides the assignability of future receivables and assignment restrictions is the retroactivity of the rank, again important in respect of all securities transfers of future assets and their use to secure future advances. Other serious points that are transnationally relevant are the doing away with notification and documentation needs in respect of the validity of the assignment. Here again, there is no guidance in the UNCITRAL Convention, which has left these matters ultimately to domestic laws as well as the related matter of the priority of assignees inter se. Transnationalisation of the concepts and approaches based on the justified needs of the transnational financial community and their professional clients is the better answer to be achieved through transnational customary law as part of the modern lex mercatoria. Again, also in this area, the common law approach to equitable charges may present the best guidance, as further elaborated in Article 9 UCC in the US (or otherwise for receivables the promissory note). Indeed, equitable proprietary interests (in a common law sense) form the basis of the modern lex mercatoria in this area in terms of custom or even general principle: see also Volume 1, sections 1.4.6 and 3.2.2 and Volume 4, section 1.10.2 (and for the hierarchy of norms in this connection, Volume 1, section 1.4.12). As for the more limited subject of receivables and their transfer (also as security), the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade was found to be insufficiently progressive and not adequately reflective of modern needs to deserve ratification or serve as a model, even though it is receptive to the coverage of future claims and at least deprives assignment restrictions of their voiding effect: see more extensively the discussion in section 2.3.5 below. The DCFR follows German law in these aspects and, although still better than what most civil law countries can produce and support in terms of a floating charge, is not responsive to modern needs either: see Volume 4, section 1.11.4. It accepts the German contractual expansion of the Sicherungsübereignung, but was not capable of a more fundamental reassessment of the situation and may be regressive in respect of floating charges, even in terms of German law. It is unlikely therefore to receive much support, and never could have expected it in England or in the remaining common law jurisdictions in the EU. Again, the true problem is that the concept of future commercial/cashflows as an asset class of its own based on adequate description remains underdeveloped and the concept of party autonomy in proprietary matters insufficiently studied.

2.3. Receivable Financing and Factoring. The 1988 UNIDROIT Factoring Convention and the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade 2.3.1. Assignment of Monetary Claims in Receivable Financing and Factoring. The Issue of Liquidity In section 2.2, we dealt with floating charges, also those covering receivables. It was clear that, for their effectiveness, they have a bulk transfer at their core in which future assets, especially those

Volume 5: Financial Products and Funding Techniques 191 replacing the ones released from the charge, which may be new inventory, but also new receivables, may be included, often to cover at the same time future borrowings or advances in what effectively are revolving credits. They provide a key modern example of secured financing, as yet by no means legally accepted everywhere, as we have seen. The subject of the following sections will be receivable financing and factoring. They depend even more on a bulk assignment of present and future receivables (see section 2.2.4 above), and are as such important other financing alternatives. They may overlap with floating charges when the latter also cover receivables and may include in that connection collection facilities for the lender, which is not uncommon, as we have seen. In that case, the lender may even take some credit risk. This is very much a feature of factoring. On the subject of assignments of monetary claims proper (whether individually or in bulk), these assignments present a number of traditional problems which may be grouped in clusters more fully discussed in Volume 4, section 1.5.336 This discussion will not be repeated; for the present discussion the issues may be narrowed as follows: (a) the assignability of the claims (including their existence and identification, their possible assignment in bulk, and the effect of provisions prohibiting assignments); (b) the validity of the assignment (including any notification requirement and other formalities, documentation, or registration needs which may specifically impair bulk assignments, that may also be considered affected if there was not enough identification or if there was uncertainty concerning the disposition rights, especially in future claims); (c) the protection of the debtor in terms of liberating payments, defences and set-off rights, or against other extra burdens and risks; the assignee may here acquire a better right against the debtors than the assignor had; (d) the type of (proprietary) rights that result from the assignment; and (e) the position of various assignees of, and other interest holders in the same claims inter se. Again, it is useful that in these discussions contractual issues are clearly distinguished from proprietary and enforcement issues. They arise in all of these five areas and in the case of monetary claims it is not always easy to distinguish between them, in fact also not always between the five categories themselves, which may overlap, as Dutch case law amply showed.337 Yet these distinctions have merit and at least give some framework, more particularly also in international assignments under traditional conflicts of laws rules, which may be different in respect of each aspect mentioned. The question of types of assignments, their purpose, and their contractual, and especially their proprietary characterisation in terms of outright, conditional or security transfer is then also raised. 336 The major problems of assignments discussed in Vol 4 concern (a) the contractual requirements and formalities in terms of notification and documentation with possibly registration or publication for security assignments; (b) the assignability of the claims especially important for unspecific or future claims but also for the impact of contractual assignment restrictions, the extent therefore in which claims may be separated from the legal relationship out of which they arise, and the simultaneous transfer of closely related duties with or without a release of the assignor; (c) the type of interests that can be created and transferred through assignments especially in terms of conditional or security transfers; (d) the effect of the assignment on the underlying contract in terms of amendment or novation, the preservation of any connected securities and the ability of the original parties to continue to amend the underlying agreement at least in the non-assigned aspects; (e) the protection of the debtor against multiple assignments and his/her facility to make a liberating payment whilst maintaining his/her defences and set-off rights and avoid extra burdens; (f) the ranking of various assignees in the same property and their entitlement to collect from the debtor or recover from those collecting assignees with lesser rights, the entitlement to the enforcement against the debtor or to initiate alternative enforcement against other assets of the debtor in the case of his/her default, especially if the assignment was less than a full assignment. 337 See n 347 below.

192 Volume 5: Financial Products and Funding Techniques In bulk assignments, these distinctions may acquire a further importance, particularly the assignability of monetary claims. In financing schemes involving receivables, liquidity or commoditisation of financial claims has become an overriding issue, as we have already seen above in section 2.2.4 in connection with floating charges. Restrictions of the assignment possibility and overly protective defences of debtors under the assigned claims against payment requests of assignees are not favoured in this approach. Another particular concern may be set-off rights of these debtors against the assignor shifting to the assignee, who may not have been aware of them. In situations of insolvency, the bankruptcy law impact may have to be more specifically considered here also.338 It was suggested before that the proper analogy in terms of commoditisation of monetary claims, especially receivables, is provided by the promissory note as negotiable instrument, including the effects of the transfer, except perhaps in the aspect of the set-off against the assignor, which may be a benefit or defence that the debtor might maintain upon the assignment. All other defences would be valid only if there were otherwise a substantial extra burden for the debtor. In other words, in a more modern environment, the debtor must co-operate, especially if the claim on him must be given as security to obtain the funding that makes the giving of credit to him possible in the first place. The traditional rule in this connection is that one may freely transfer one’s monetary claims (through assignment) but not one’s liabilities (through delegation). In its generality, that is now a fairly obvious proposition. A debtor should normally not be interested in the person or entity whom s/he must pay as long as s/he can get a proper release, but a creditor is interested in who pays him. This is a question of credit risk. It may be different in the case of rendering of services, where the right to it may be more personal. A lawyer might be hired by someone, but the right to this service would not normally be considered transferable without consent. That goes also for employment situations. But at least in the realm of payments, as a general proposition, unilateral creditor substitution is possible, but not unilateral debtor substitution (or delegation), that is, substitution without consent of the other party in the relationship. However, in practice the rights and obligations are not always easy to separate. Rights are often accompanied by obligations. Thus, the creditor has a right to payment, but at the same time a connected duty to release the debtor if the latter does pay and not to bother him thereafter. It is the issue of the liberating effect of the payment for the debtor. Moreover, the creditor has the duty to receive payment at the agreed time in the agreed place. The creditor may have other connected obligations, for example the duty to arbitrate in the case of disputes. There is therefore in an assignment of receivables often the question of the transfer of closely related duties. What are they and is it automatic? Does the assignor remain responsible for their implementation, or can the debtor object to the assignment on the basis that s/he has not consented to the transfer of these related duties? If s/he consents, is such consent tantamount to a novation with loss of the accessory rights? If the claim is expressed in a negotiable promissory note, this may all be clearer, a facility stretched in the Eurobond which may contain a whole framework with many terms, see Volume 1, section 3.2.3, which are all deemed to transfer with it. As has already been noted, there may be other defences which the debtor may reasonably have against the assignment and therefore against payment to the assignee, like the imposition of extra burdens or risk (for example, in terms of interest, where the agreement was a floating rate, which the assignee may handle differently) and the loss of any set-off rights. Neither the 1988 UNIDROIT Factoring Convention nor the 2001 UNCITRAL Convention on the Assignment 338 See also Vol 4, s 1.5.12.

Volume 5: Financial Products and Funding Techniques 193 of Receivables in International Trade (see section 2.4.5 below) go explicitly into these aspects, although Article 15 of the UNCITRAL Convention requires the debtor’s consent if any of its rights or obligations are affected. It seems too strict and also implies a novation danger (with the loss of all connected rights) if this consent is forthcoming. In the US, in particular, section 2-210 UCC envisages the reduction of defences (but only in respect of receivables deriving from a contract for the sale of goods), at least in the sense that reasonable extra burdens may have to be accepted by the debtors, and even the possibility of a transfer of duties if the creditor has no substantial interest in having the original promisor perform, although the original promisor remains liable to perform or for breach of any of these duties in the sense of a guarantor. Another important principle of section 2-210 UCC is that it allows the monetary obligations under a contract for the sale of goods always to be separated from the underlying agreement, and it makes any contractual obligation not to assign them ineffective as against assignees. This is followed by sections 9-404ff UCC, which allow a security transfer of monetary claims more generally and also favour any contractual limitation of the debtor’s defences in that context. It means that the assignee may in fact have a better right than an assignor (just as the owner of a promissory note upon negotiation has a better right than the original creditor under the contract with the debtor), all the more so when receivables are used as security to raise money. This is the legal expression of the concept of the liquidity of claims and independence of the assignment or a matter of abstraction, see more particularly Volume 4, section 1.5.9. It has already been said that the reason for the more liberal approach in the case of claims being used for security is that the extension of credit, of which the claim for payment is the result, must be financed, for which the claim itself is the natural security. In other words, buyers obtaining credit cannot have it both ways: obtaining credit and requiring the resulting claim against them not to be used for financing purposes by the creditor, who must fund himself to make the credit possible, do not go together. Both the UNIDROIT and UNCITRAL Conventions have accepted that assignment prohibitions no longer affect the transfer in its proprietary aspects (in Articles 6(1) and 9 respectively). It would have been better if sections 2-210 and 9-404ff UCC had been more fully followed, and notably the curtailment of the defences also considered. Contractually, the assignor of course remains liable for breach of contract vis-à-vis the debtor if an assignment prohibition is ignored or extra burdens result from the assignment, but the assignee should not be affected even if s/he knew or could have known of the restriction or problems. S/he should not even be dependent for the validity of the transfer on his/her bona fides (which in the case of assignments, at least in civil law, is not a normal protection). Only unreasonableness or connivance could still render the assignee liable to the debtor in respect of the restrictions of these defences. That would be in tort. It may be recalled in this regard that transfer restrictions in respect of tangible assets rarely have third-party effect and do not undermine the effectiveness of their transfer, whether or not the transferee knew of any such restrictions. It is time that this rule was also maintained for the transfer of intangible assets, but most laws remain resistant: see more particularly Volume 4, section 1.5.5. It means that they do not understand the meaning of liquidity in this context. In fact, the liquidity of claims, especially trade receivables but also service invoices (like those of law firms) is becoming greatly important and the crucial issue. It is clear that the economic significance and meaning of modern financial assignments is largely dependent on the assigned claims being free from transfer restrictions or other defences, except when these are strictly reasonable. An unsuspecting or bona fide collecting assignee should also be able to ignore liens or charges in these receivables unless they may be considered normal in the trade when the ‘first in time, first in right’ principle may still apply and protect him. In this connection, it should be noted, however, that in Germany, for example, in the verlängerten

194 Volume 5: Financial Products and Funding Techniques Eigentumsvorbehalt (the extended reservation of title shifting into proceeds, see section 1.4.1 above) receivables remain often encumbered by hidden liens of the original suppliers to the seller that survive and take precedence over any bulk assignment of the types just mentioned. These hidden liens thus remain effective vis-à-vis bona fide assignees/factors. As we shall see later, this remains a serious impediment to the business of funding through receivable financing or the factoring of receivables. It is often given as the reason why receivable financing remains less developed in Germany, where suppliers may be assumed normally to benefit from a reservation of title in whatever they supply a manufacturer/seller, while the latter’s receivables are then normally subject to these charges of the suppliers. This is also likely to be the case in many other civil law countries. Naturally, the (presumed) existence of these charges then makes the receivable portfolio less valuable and makes assignments for funding purposes more difficult or less meaningful.339 So do the possibilities of set-off. It is also likely to increase the costs of this way of funding. In practice, the difference is not truly between publicised and hidden charges. These charges must always be assumed to exist, and professional lenders would realise that and investigate. That is due diligence. The question is rather how effective they still are vis-à-vis such lenders. Indeed, in the US, these liens may appear more clearly from filing statements, but for professional lenders or factors that should not itself make much of a difference. They know this as a fact of life and must investigate. But the key issue is that bona fide assignees may at least be protected against unperfected earlier liens but only upon collection: see for greater detail Volume 4, section 1.5. Even then, as professionals, they may still have some search duties, but not others. This tracks the equitable nature of these charges in common law countries. In most civil law countries when chattels are given as security, at least bona fide lenders are protected against any prior charges therein and it is submitted this should be extended to collateral in intangible claims. Whether there should still be some search or investigation duty in this connection is another matter. Because in civil law these charges are normally not filed or otherwise published, this issue may not normally arise. Still, the professional lender, who should be suspecting, could be required to make further enquiries. On the other hand, it could be argued that this is excessive, and in any event, unwarranted, again because the original suppliers of the borrower, in order to be paid, should accept that the receivables of their debtor need to be given as security-free and clear, so that the debtor can more readily borrow the funds to make the payment possible. It follows that no special search duty would exist. In the US, Article 9 UCC cuts through this and makes collection subject to older perfected liens (but not others), in a limited derogation therefore from the common law (equity) rule, perfection thus implying knowledge, and does not appear to distinguish here between insiders such as other banks or suppliers and the rest.

2.3.2. Receivable Financing and Factoring: Origin and Different Approaches. The Recharacterisation Issue in the US What is factoring? What is receivable financing? Is there a difference? Factors were traditionally commercial agents who would sell products and collect receivables for their principals (although in their own name and sometimes for their own risk as del credere agents, which would amount

339 In Germany, there is the further problem that an earlier factoring agreement may prevail over a later verlängerten Eigentumsvorbehalt. A distinction is here often made between recourse and non-recourse factoring: see for the different views, P Bülow, Recht der Kreditsicherheiten, 4th edn (Munich, 1997) Rdnr 1457ff.

Volume 5: Financial Products and Funding Techniques 195 to a collection guarantee for the seller).340 These factors, who could be local shopkeepers, were often used by foreign companies to sell their goods inside a country until such time that these sales became sufficiently substantial for foreign companies to set up their own sales organisation. The factors, being free to select counterparties, would often carry their credit risk. However, in finance, the term ‘factoring’ acquired a special meaning and developed as a separate funding tool in the US in the 1930s on the basis of some (collection) guarantee to the manufacturers in respect of receivables.341 These receivables were then often prepaid to manufacturers by factoring companies of this type. This was called ‘American factoring’, which in this manner included both a guarantee and a funding aspect. When insurance companies subsequently began to object to the credit insurance aspects of this type of activity, the factoring companies started to buy the receivables outright. It followed that factors took care of all collection business of their client for a lump sum payment. There were then a number of discounts calculated: for the service, for the credit risk, and for interest (as immediate money was given for receivables that would run for a certain period). In the US, receivable or assignment statutes followed in several States, covering both this type of outright sale on the one hand and security assignments of receivables on the other, on the basis of which loans were granted, usually by banks. Under applicable State law, some required registration of both types as security assignments, others the marking of them in special assignment books of borrowers. Sometimes only a written document was required. All these different State statutes were eventually replaced by Article 9 UCC after 1962, which converted these facilities into secured transactions as we have seen. This would suggest that the credit risk remains in essence with the borrower, although other arrangements can be made and are common in non-recourse financing. In fact, Article 9 UCC in essence converted all portfolio assignments into secured transactions except if only made for collection purposes, and therefore without a transfer of credit risk or any funding component. This leaves room for the question how much opportunity there still is for other arrangements, especially recourse factoring, which may amount to a conditional sale of receivables. There is here danger of recharacterisation as a secured transaction although the 1999 UCC Revision tried to deal with the consequences of its unitary approach in Sections 9-318 and 9-607/608 when the assignment does not secure indebtedness, see further section 1.6.3 above. Eventually, both banks and insurance companies entered this field in a major way, raising the respectability of this business, although some specialised enterprises still remain active in this area. The arrangement is now often one under which the factor (bank) gives a revolving credit (to a certain limit and for a certain time). It means that the borrower retains the proceeds; there is hardly any point in the lender collecting and reducing the loan in order immediately to give a further loan to finance new receivables, assuming the total of the receivables remains more or less constant, as would be the need for and amount of working capital required in respect of them. Also, it may endanger the ranking. One sees here the close connection with a floating charge 340 Agents of this sort were common also in the US. Earlier, common law had denied them much protection, especially a lien on the goods and collections they handled in respect of their commissions. Case law later helped, but only the English Factoring Act of 1823, amended in 1842, 1877 and 1889, started to protect them more adequately. In commerce, better communication facilities eroded the need for this type of factor. Subsequently, the ‘credit factor’ or collector and/or guarantor of accounts emerged. 341 This was done through a type of banker or banking institution, called a factoring company, which was at first denied the commercial factor’s lien in the US until the NY Factor’s Lien Act of 1911 and similar legislation in other States of the US. This new legislation gave the collecting factor a lien on the receivables and collections in respect of his/her claims for (re)payment, amounting together to a floating charge, but separation from commercial activity was not encouraged by the courts, which could still deny the lien if no inventory was involved at the same time.

196 Volume 5: Financial Products and Funding Techniques (see section 2.2 above), except that the latter usually also covers inventory and sometimes even equipment. In a typical US arrangement, especially in respect of smaller manufacturing or service companies, the factor or bank may also engage in prior investigations of the creditworthiness of its client’s customers, establish credit lines for them, do the book-keeping, send billing statements, and collect. Each receivable is then normally purchased or deemed to be purchased and acquired by the factor/bank at the time at which its client provides its customers with the goods or services. Often there is no recourse and the factor assumes all risk (including set-offs if counterclaims against the assignor still arose for the debtors under the receivables. It is clear that, in practice, this collection facility gives the factor added (possessory) security and the right to convert his lien in the proceeds into an appropriation facility. Article 9 UCC makes this expressly possible and then dispenses with the disposition need and execution sale. In the UK, receivable financing or factoring caught on as a separate business only after World War II. In the 1960s and 1970s, it spread to the European Continent where earlier the practice of invoice discounting had developed. Again, this left a lot of risk with the factors, especially in terms of counterclaims and set-off rights of the debtors (or even older hidden liens), an important difference from the discounting of negotiable instruments, which had served as an (improper) example. In Europe, modern factoring arrangements subsequently tried to minimise these risks, mainly through larger portfolios and more turnover or through forms of recourse against the borrower, as we shall see. What were often missing were sympathetic assignment laws. They could still require notification for the validity of each assignment and were in any event unlikely to limit assignment prohibitions and debtors’ defences: see for these developments more generally Volume 4, section 1.5 and section 2.2.4 above. The continental discount business subsequently encouraged the English practice. It developed more quickly as the big commercial banks became involved and (equitable) assignment facilities were better developed in common law. Factoring as a business tends to be cyclical. It is (except in the US) an alternative to secured lending (particularly through floating charges), involves additional services and often a different risk structure. It has as a consequence its own price, under competitive pressures often leading to slimmer margins than in secured financing. That is obviously the attraction to customers or assignors but a lesser incentive for banks. As in the US, an ongoing relationship is normal under which the factor acquires and collects his client’s claims and funds him on a continuous basis, but the arrangements may vary greatly in the details. There may be prepayment by the factor/lender of a given portfolio of receivables, amounting to a funding arrangement, normally for between 70 and 90 per cent of the total face value of the outstanding receivables. The remainder may then be repaid to the customer/borrower upon collection or partly serve as the factor’s reward, which may be in the region of 0.5 to three per cent of the portfolio. Where there has been a sale of the receivables and the factor assumes all risk and expense of the collection, it was already said that there will be an appropriate discount allowing for both a reward and the time factor and risk in the collections. If the factor is not taking all credit risk in the portfolio, an important aspect of the arrangement will be to define the factor’s credit exposure, therefore his liability for any shortfall in the collections. Particularly in Europe, this has led to forms of so-called recourse financing, that is, factoring in which the factor may be able to return non-collected or non-approved receivables to the party needing financing—known in the US as a ‘charge-back’ or ‘limited recourse’ arrangement: see also section 9-607(c) and (d) UCC. If approval of individual receivables by the factor is a precondition, it may be according to the so-called credit line method or order approval method. In the former method, there is a rolling credit limit for each account debtor beyond which claims are not accepted by the factor

Volume 5: Financial Products and Funding Techniques 197 (alternatively, there may be a limit on the total sales of goods to each customer that will qualify). In the latter method, each order from a prospective customer needs prior approval. Recourse factoring in this manner is then distinguished from the so-called full service, old line, main line or non-recourse factoring. It raises the question what the status of the receivables is that have been transferred in excess or that are transferred but not subsequently accepted. It suggests a form of conditional assignment, under which the assignor retains some exposure and also some interests in the portfolio. This is rare in the US, where, as noted, normally there is an outright sale for a price of the whole portfolio with the factor acquiring all the collection risk and cost. This sale is, however, still covered by Article 9 UCC as we have seen and therefore subject to its formalities. It is a somewhat curious departure: see also section 1.6.2 above. It subjects the arrangement to filing if involving a substantial part of the receivables portfolio of a debtor seeking financing in this manner. Its significance is that it bars junior assignees (other banks) from collecting instead of relying on the more normal equity law rule that bona fide collecting assignees prevail: see also Volume 4, section 1.5.9. There is no exception here for assignees who are not professionals or insiders. In the case of an outright sale, it does not, however, subject the arrangement to the disposition and appropriation rules of Article 9, with a return of overvalue, in which connection the difference between both is maintained: see also the special regime of sections 9-607/9-608. Conditional sale characterisation is here better avoided, the probable reason why a special provision for a charge-back was entered. Returning to the questions ‘what is factoring?’ and ‘what is receivable financing?’ it follows, first, that in factoring there need not always be a funding structure; there could be merely a collection agreement. Indeed, collection seems the key in factoring, but there may be some transfer of credit risk to the factor, and therefore some guarantee for the creditor. In receivable financing, on the other hand, the accent is more particularly on the funding. It could technically be without collection and any transfer of credit risk but collection is normally combined with receivable financing, which, without it, appears to be rare. If there is also some transfer of credit risk in the underlying receivables to the lender, then receivable financing could be equated with the funding form of factoring (although it may also take the form of a secured loan or may be equated with it in the US). The terminology is not stable, however, and more description is needed in each case properly to capture the role of receivable financing or factoring and their legal characterisation in the contractual and proprietary aspects. The terms are often used interchangeably. Internationally, the subject of factoring and receivable financing has received the attention of UNCITRAL and earlier of UNIDROIT, as we have seen. UNIDROIT produced a Convention on International Factoring at the same time as it produced the Leasing Convention in 1988. It has been signed by 14 countries and is ratified by six (France, Italy, Nigeria, Germany, Hungary and Latvia). It became effective on 1 May 1995, six months after the third ratification by Nigeria. UNCITRAL produced a Convention on the Assignment of Receivables in International Trade in 2001, which has only three signatories (Luxembourg, Madagascar and the US) and one ratification (Liberia). The drafting of these Conventions suggests particular problems with factoring and receivable financing internationally. They derive mainly from lack of liquidity and from the problems with the bulk assignment inherent in the transfer of portfolios of present and future receivables, which, as we have seen, may create further complications when debtors under these receivables are in different countries. What is then of special interest are the formalities of the assignment so as to be effective vis-à-vis foreign debtors under the receivables (which raises the issues of identification, notification, publication/registration and documentation), the right of the assignee to collect and retain the proceeds, the liquidity of the claims, and the liberating payment of the debtors, who may be very differently protected against assignees’ claims under their own laws, and the priority between various assignees of the same pools of assets inter se.

198 Volume 5: Financial Products and Funding Techniques The UNIDROIT and UNCITRAL projects are also of interest because it was earlier thought that international unification efforts in the area of secured and related transactions were unlikely to succeed.342 The lack of ratifications may still bear this out.

2.3.3. Factoring: The Contractual Aspects As in the case of finance leasing and repurchase agreements, as we shall see, a precise legal definition of (financial) factoring and/or receivable financing may not be useful or practical, as parties will contractually structure and vary the arrangement considerably and continuously. Indeed, as we have seen, as far as factoring and/or receivable financing is concerned, there may be very different forms. Yet there are certain characteristics that recur and have led to identifiable types. In this connection, it is particularly important to distinguish between the contractual and proprietary aspects. On the contractual side, there are broadly three possibilities as already noted. First, (a) there may only be administration and collection, and therefore a mere collection agreement, under which there is a full assignment to the factor in order to give him the facility to take all necessary collection measures as owner of the receivables, but s/he does not take any risk and the assignor gets what is collected (minus a collection fee) and regains title in non-collected receivables. Second, (b) there may also be a credit risk transfer. It means in essence the granting of some form of a guarantee of payment by the factor who takes over the risk of non-payment under the receivables, therefore all (in non-recourse or old-line factoring) or part (in recourse factoring) of the credit risk. In the latter case, there is likely to be some guarantee, but uncollected receivables might still be returned to the party requiring the funding (assignor). Also, the risk of set-offs might be taken into account. This hardly lifts the arrangement above mere collection but there may also be an arrangement under which the factor (assignee) takes the risk in principle but mitigates it by only doing so upon approval of the receivables or classes of them before they are included, or if they are included in the bulk assignment they may be returned. As we saw in the previous section, another way to manage the credit risk might be for the factor to limit the credit lines the assignee gives to his customers. Finally, (c) there may also be a funding aspect, and therefore an advancing of capital. This is usually done through an advance purchase of the receivables. It may be, and in fact normally is, combined with a collection agreement and also some guarantee of payment, which may well result from an agreed discount to the nominal value of the portfolio for the credit risk. As we have seen before, funding of this nature is at the same time the area properly called ‘receivable financing’. Indeed, in factoring proper there is normally a cocktail of at least two of the contractual possibilities just mentioned, while collection seems always to be part of it (which besides the funding aspect distinguishes it from receivable financing). So, there is either a guaranteed collection or a funding arrangement under which the financier also collects. Some of this is reflected in Article 1(2) of the UNIDROIT International Factoring Convention.

342 See U Drobnig, ‘Vergleichender Generalbericht’ in KF Kreuzer (ed), Mobiliarsicherheiten, Vielfalt oder Einheit? (Baden-Baden, 1999) 226, stating that ‘mere recommendations, even if emanating from an international organisations of the highest repute, will not command sufficient moral or other support for adoption by any sizeable number of States’. UNCITRAL subsequently concluded that unification of the law of security interests in goods was in all likelihood unattainable and after the emergence of the UNIDROIT Factoring Convention of 1988, it made its own attempt in the area of receivables as from 1992 resulting in 2001 in the Convention on the Assignment of Receivables in International Trade: see s 2.3.5 below.

Volume 5: Financial Products and Funding Techniques 199 There is in fact merit in not using the terms factoring or receivable financing at all when only one of these three possibilities is envisaged, therefore when there is only collection, a guarantee, or a mere sale or funding. The 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade barely attempts a definition. The reason is that its attention shifted to international bulk assignments, rightly so it is submitted, as the legal problems are mostly in the assignment of a multitude of claims and not in the collection, guaranteeing, or funding aspects. In the first two possibilities of factoring (collection and guaranteeing payments), which may thus be combined, the essence is that the factor pays the creditor/assignor the amounts due from his customers, discounted by a collection fee and, if there is a guarantee, by a further fee for this service. Usually, the payments are then made by the factor to the assignor on their due date or indeed only upon collection or, in the case of a guarantee, as soon as it becomes clear that collection has failed and the factoring agreement will spell out the assumptions and details in this regard. If there is also a funding aspect, it normally takes the form of immediate payment upon a sale and transfer of the whole portfolio of claims, which will discount the collection cost, the maturity and the risk element in the portfolio. It could also take the form of an advance payment. If the full nominal value of the portfolio is paid (minus collection fee and maturity discount), a guarantee is implied for which there must be some other reward. Sometimes some reimbursement is negotiated if collection beyond a certain amount fails.

2.3.4. Factoring: The Proprietary Aspects For factoring proper, there must also be a proprietary aspect, therefore a form of transfer of the receivables to the factor, even if there is a mere collection or security agreement. Without this proprietary aspect, again it may be better not to speak of factoring or receivable financing. There are here also three possibilities: (a) the transfer can be outright; (b) it can be conditional; or (c) it can be by way of security, although in the last case it would then be better not to speak of factoring or receivable financing either. On the proprietary side, there can never be a cocktail, even though there may be some confusion in this aspect, also in the UNCITRAL Convention as we shall see. The nature of the transfer is normally an assignment (although in France there is also the possibility of subrogation),343 here more properly a bulk assignment, therefore a transfer of a multitude of claims in one assignment. It may also include certain classes of future claims. This is assuming of course that such a bulk transfer facility exists under applicable law and is effective (which again cannot be the case if notification to each debtor is a precondition of the validity of assignments, subject to some recent exceptions if the assignment is for financing purposes) or when there is no assignability under that law of future claims. Further problems with bulk assignments are (a) the inclusion of foreign claims or (b) the involvement of assignments to foreign assignees. That is the prime reason for new uniform treaty law, which for its effectiveness also presupposed the possibility of the assignment in bulk, including the facility of covering future receivables. The UNCITRAL project ultimately perceived this, and thus aimed for bulk assignments as a better regime than that of many domestic laws.344 As was suggested earlier, rather 343 See n 141 above. 344 The preparation of rules of (financial) bulk assignments that would operate both at national and international level is from a practical perspective greatly desirable, but has always been resisted by the legal experts preparing these Conventions for fear that states will not accept such a more general approach outside the realm of international factoring: see eg F Mestre, ‘Explanatory Report on the Draft Convention on International Factoring’ [1987] Uniform Law Review 45, 53. This was also the worry in UNCITRAL and no world law of bulk assignments is contemplated.

200 Volume 5: Financial Products and Funding Techniques than legally facilitating funding, that became the major legal focus of the Convention and its true significance, even if it ultimately proved a disappointment, as will be discussed more fully below. In collection agreements, one commonly sees an assignment under which a portfolio of present or future receivables is transferred to the factor, often for no other reason, however, than to facilitate his collection activity and status, while s/he will transfer his/her collections to the assignor whenever received. This exposes the assignor to the creditworthiness of the assignee/ factor. Best is to imply a kind of trust structure with the assignor as beneficiary to protect him against a bankruptcy of the collector. This is the normal response in common law countries but unlikely in civil law. A security interest in the collections is here another possibility, assuming it is possible, and can be perfected in respect of ever-changing receipts. The transfer may also be characterised as being a conditional transfer. In pure collections, the transfer is in any event of a limited nature, only for collection purposes, and is as such indeed conditional. It may be different when the collection is guaranteed. In such a case, the transfer may be outright, but there is still the bankruptcy risk in respect of the factor who has not yet paid. More normal is the outright transfer when a whole portfolio is transferred for a price in advance. That is funding, obtained at the various discounts already mentioned. In (guaranteed) collection and in funding arrangements, the transfer of the receivables may therefore be, and often still is, conditional, in the latter case especially in recourse financing, as we have seen, in the US now replaced by a charge-back under section 9-607 UCC. Thus, although there will normally be one assignment in bulk, often including unspecified future claims or classes of them, especially in recourse factoring the transfer of individual claims may still be conditioned. It may be deemed completed only upon approval of each of them when they arise, or when not exceeding in total a certain amount per debtor. This goes to the assumption of credit risk, therefore to the guarantee, which may thus be conditioned or limited. To put it differently, if these conditions are not fulfilled, the factor retains a right to return the claims rather than take the collection risk. Another condition in this connection may be that the claims are not contested by the debtor. As we have seen, in a bankruptcy of the factor who did not fund but merely managed and collected, there may still be a trust structure implied, at least in common law countries. In collections, the other aspect here is the rights to the collections already made but not yet transferred to the original party. The key to understanding this mechanism is that the assignment of the relevant claim is undone when these conditions are not or no longer fulfilled. It leads or should lead to the automatic return of the relevant claims to the assignor, at least in countries that are willing to give this return obligation proprietary effect so that it becomes automatic. Otherwise, there must be a repurchase and retransfer, particularly problematic of course in an intervening bankruptcy of the factor. There is here an obvious problem with the automatic retransfer in the German abstract system of title transfer—see more particularly Volume 4, section 1.7.9—unless one assumes that the condition also affects the real agreement or dingliche Einigung, which is indeed often accepted. However, in Germany, the proprietary effects of factoring seem hardly ever to be considered and the impression is often created that factoring in a German sense is no more than a contractual scheme pursuant to an outright or unconditional transfer, never mind approval requirements or other conditions.345 It is a mere Forderungskauf. This is in line with German thinking about 345 See for a brief discussion Bülow (n 339) See also (1987) 100 BGHZ 353, in which the commercial morality of s 138 BGB was found not to interfere with the assignment in bulk of future claims in a factoring agreement. Recourse financing may in Germany not be characterised as a sale of receivables at all but rather as a way of granting credit. The characterisation of Sicherungszession would then logically follow, with the further risk of re-characterisation as an Absonderungsrecht in bankruptcy: see also s 1.4.2 above. It seems undesirable and not to respond to the nature of recourse financing as commonly understood.

Volume 5: Financial Products and Funding Techniques 201 receivables being mere obligatory rights but does not conform to international practice. Yet also in the US and even in England, the automatic re-transfer of (some) receivables under these circumstances is little discussed. Instead, especially in civil law countries, there may only be a right and duty for the assignor to repurchase the receivable and a right and duty for the factor to re-transfer. These transfers would not then be bankruptcy resistant. As mentioned before, a conditional transfer structure could result instead if the bulk assignment is used for funding purposes in the sense that a portfolio of present and future receivables is sold and transferred for ready cash but only up to a certain total of collections. Any excess claims that may accrue under such an assignment are then (automatically) returned. Again, in this arrangement, the credit risk may be taken over by the factor against a discount but there may still be conditions, which may lead to a re-transfer of claims in some circumstances. It may then be effective even in a bankruptcy of the factor. As just mentioned, for a funding rather than collection arrangement, the form of a secured transaction may also be used. The receivables are then assigned as security. Again, this is an important difference and may entail different formalities in terms of notification to the debtor, publication and documentation and there may also be a different situation upon default. In a security arrangement, there may have to be an execution sale; in any event any excess collections above the principal and interest and extra receivables will have to be returned while the security interest automatically lapses or is returned. If there is a shortfall, immature claims may still have to be sold off in an execution sale. In countries like France (and earlier in the Netherlands), there may, in the case of a security, not be any collection right at all, even of mature claims, although the new French law of March 2006 lifted this requirement: see section 1.3.1 above. In the US under sections 9-607 and 9-608 UCC, a disposition (often to professional debt collectors) with a return of overvalue is necessary for a security assignment. Only in the case of an outright sale as part of a funding or collection transaction are parties free to determine the conditions and dispense with a disposition and return of any overvalue. This approximates a conditional-sale type of funding regardless of the professed policy of Article 9 UCC converting all conditional sales into security transfers. Elsewhere in pure conditional sales of receivables, upon default of an assignor in repaying the loan or interest, the factor may not only be entitled to collect, but will also be able to retain excess collections unless there is an agreed maximum. There would be no question of an execution sale. The right to collect was always the advantage of the conditional sale of receivables in factoring in France (even if it did not automatically entail the right to retain any excess collections). Another important point here is that unlike a conditional sale, a security assignment creates an accessory right of the beneficiary/subsequent assignees, who can avail themselves of this security upon further assignments. When is an assignment a conditional sale and when is it a security transfer in funding situations? We look first at the precise terms, but they may not be fully conclusive. It was submitted before that only if there is no true sale but rather a loan as demonstrated by the existence of an agreed interest rate structure (see section 2.1.1 above) may the arrangement, even if structured as a sale, become vulnerable to conversion or re-characterisation. It means that for its validity, the arrangement will then be subject to all the formalities of the creation of a security interest. Neither the 1988 UNCITRAL Factoring Convention nor the 2001 UNIDROIT Convention on the Assignment of Receivables in International Trade have a clear view of the proprietary aspects of bulk assignments and the difference between a conditional sale and secured transaction in this connection. The UNCITRAL Convention, although more concerned with the proprietary aspects of assignments and with the facility of the bulk assignment, only mentions in Article 2 the possibility of a securities transfer besides the outright transfer. It does not go into the conditional transfer and disposition duties. The UNIDROIT Factoring Convention, which is less concerned

202 Volume 5: Financial Products and Funding Techniques with proprietary issues, goes into neither. In view of the confusion on the conditional transfer aspect and the possibility of a conversion into a secured transaction, it would have been better if the UNCITRAL Convention had at least mentioned the conditional sale as a different way of transferring receivables. It might then also have gone into some bankruptcy aspects. As we have seen, in the Netherlands, there is the not unrelated problem that all kinds of security substitutes, of which the conditional sale must be considered an important one, are outlawed altogether in their proprietary aspect (Article 3.84(3) CC). In that country under its Civil Code, bulk assignments were in any event ruled out—except for security purposes—because of the requirement of the new Code that all assignments other than security assignments had to be notified to the debtor in order to be valid. It was certainly one of several curious innovations in the new Code. Both these impediments have led to factoring being conducted entirely as secured transactions (with all its limitations in terms of bulk assignments and inclusion of future receivables), and therefore to a departure from the international practice. An international Convention in this area should at least cure both these defects and make a bulk assignment including future receivables possible, allowing the security and conditional assignment in the process. Notification requirements must then also lapse and one document describing the receivable class to be so transferred so suffice. It is to be noted that in the meantime (in 2004) the new Dutch Civil Code was amended in order to at least allow (again) assignments without notification, but it continues to require a document and registration system in respect of each of them and remains more generally hostile to bulk transfers and the conditional sale for financing purposes. It seems an unnecessary complication.346

2.3.5. International Aspects. The UNCITRAL and UNIDROIT Conventions. Internationality and Applicability In focusing on the efforts of UNCITRAL and UNIDROIT in the area of international assignments, especially those in bulk, the key question becomes when an assignment is international and what the covered concerns and issues are. What uniform or other law should or does apply?347 346 See for this latest Dutch departure, nn 65 and 68 above. 347 In more recent Dutch case law, even in proprietary aspects, sometimes the law of the underlying claim and in other cases the law of the assignment have been held applicable following Art 12(1) and (2) of the 1980 Rome Convention on the Law Applicable to Contractual Obligations, rather than on the law of the debtor or that of the assignor. Art 12(1) and (2) has since been replaced with similar wording by Art 14(1) and (2) of the 2008 EU Regulation on the same subject: see Vol 4, s 1.9.5. There are in the Netherlands three Supreme Court cases in this connection, the last two of which have elicited considerable international interest: see HR, 17 April 1964 [1965] NJ 23; HR, 11 June 1993 [1993] NJ 776; and HR 16 May 1997 [1997] RvdW 126. For a discussion of the first two cases, see JH Dalhuisen, ‘The Assignment of Claims in Dutch Private International Law’ in Comparability and Evaluation: Essays in Honour of Dimitra Kokkini-Iatridou (Dordrecht, 1994) 183, and for the last one THD Struycken, ‘The Proprietary Aspects of International Assignment of Debts and the Rome Convention, Art 12’ [1998] LMCLQ 345 and E-M Kieninger, ‘Das Statut der Forderungsabtretung in Verhaltnis zu Dritten’ (1998) 62 RabelsZeitung 678; see also A Flessner and H Verhagen, Assignment in European Private International Law (Munich, 2006). In 1964, with reference to the never-ratified Benelux Uniform Private International Law Statute (Arts 17 and 21), the law governing the underlying claims was deemed applicable to their assignability and to the requirement and formalities of assignment when Indonesian subsidiaries assigned their claims on an Indonesian Bank to their Dutch parents for recovery out of the assets of the bank located in the Netherlands, except that the law of the debtor was considered applicable to his/her protection (liberating payment) and to the protection of other third parties. In the proprietary aspects proper, as in the position of subsequent assignees, there was some suggestion at the time (in the opinion of the Advocate General) that the law of the assignment applied. In this case, the

Volume 5: Financial Products and Funding Techniques 203 An assignment imposes a new contractual layer of interests and also raises, as we have seen in section 2.3.1 above, important transfer or proprietary issues besides issues of assignability and validity. The proper protection of the debtor is another weighty aspect of assignments as is the issue of the relative rights of various assignees inter se of the same pool of assets. assignments were deemed properly made under the applicable Indonesian law governing the claims (excluding the expropriation laws, which were considered discriminatory) and recovery in the Netherlands was allowed against assets of the Indonesian Bank there, therefore regardless of a nationalisation decree concerning the assignors. In 1993, the issue was a German Globalzession of future claims by a German supplier to his/her German Bank. Later sales of the supplier of caravans to a Dutch customer resulted in Dutch terms in claims that under Dutch law could not have been validly assigned, as at the time of assignment they were absolutely future, and the buyers had as a consequence refused to pay the German assignee bank. The problem was resolved by the Dutch Supreme Court with reference to Art 12 of the Rome Convention (although not yet in force at the time), and ultimately identified as a problem of assignability under Art 12(2), and therefore governed by the law of the underlying claim, rather than as an issue of the validity of the assignment (as the lower courts had found), covered by the law of the assignment under Art 12(1) (now Art 14(1) of the 2008 EU Regulation), although strictly speaking it did not refer to validity requirements and formalities of the transfer, where in 1964 the HR had accepted the law of the underlying claim. In the end, the characterisation of the issue in terms of assignability rather than validity determined the issue and aligned the 1993 decision with the one of 1964. In 1997, the issue was a verlängerter Eigentumsvorbehalt (a reservation of title extending into the receivable and its proceeds) under which, according to German law, the sale of goods to a Dutch manufacturer who on-sold them to an end-user resulted in a claim in which the original German supplier had a preferred position. Dutch law does not accept the verlängerter Eigentumsvorbehalt and the assignment of absolutely future claims it entails. It now also requires notification for such an assignment to be valid except where a security interest is created according to Dutch law while all alternative securities are invalid (Art 3(84)(3)). The Dutch manufacturer went bankrupt and the question was whom the end-user had to pay. This was resolved in favour of the German supplier with reference to the applicability of the law governing the assignment pursuant to Art 12(1) of the Rome Convention (now Art 14(1) of the 2008 EU Regulation on the Law Applicable to Contractual Obligations (Rome I) replacing the earlier 1980 Rome Convention on the same subject), therefore the law covering the validity rather than the assignability under Art 12(2), which would have been the law of the underlying claim, which, between two Dutch companies, would have been Dutch law. Who had the collection right was in truth a proprietary issue, according to most authors, not covered by the Rome Convention. Not so, or no longer so, in the opinion of the Dutch Supreme Court, which applied Art 12 in proprietary matters, probably by way of analogy. Whether these proprietary issues are put under Art 12(1) as a question of validity of the assignment (as the HR did) or under Art 12(2) as a matter of assignability, both solutions seem to allow for party autonomy in the proprietary aspects of an assignment, either as a matter of party choice of law under the assignment agreement (Art 12(1)) or under the contract producing the assigned claim (assuming it was contractual). Dutch case law seems here to follow German law, which has always had difficulty in distinguishing between the proprietary and contractual sides of assignments because it does not qualify claims as proper assets. Neither does modern Dutch Law, as we have seen. Yet German law is different in so far as it appears to accept that the law applicable to the underlying claim applies also to the proprietary aspects of the assignment. Again, in Germany it may be the consequence of German law considering claims as mere obligatory rights: see G Kegel, Internationales Privatrecht, 6th edn (Munich, 1987) 478; C von Bar, ‘Abtretung und Legalzession im neuen deutschen internationalen Privatrecht’ [1989] RabelsZeitung 462; C Reithmann and D Martiny, Internationales Vertragsrecht, 5th edn (Cologne, 1988) nos 214ff; but cf also Kieninger, above. There is support for this view also in France: see Y Loussouarn and P Bourel, Droit international privé, 3rd edn (Paris, 1988) nos 424 and 425, and H Batiffol and P Lagarde, Droit international privé, 7th edn (Paris, 1983) no 611. In England, Dicey and Morris on The Conflict of Laws, 14th edn (London, 2006), Rule 126, 1181, also follows this approach. However, the applicability of the law of the assignment in proprietary matters is supported in two German dissertations on the Rome Convention: see H Keller, Zessionsstatut im Lichte des Übereinkommens über das auf vertragliche Schüldverhältnisse anzuwendende Recht (Munich, 1985) 145, and E Kaiser, Verlängerter Eigentumsvorbehalt und Globalszession im IPR (1986) 219. On the other hand, the applicability of the law of the underlying claim in the proprietary aspects was defended in a more recent Dutch dissertation: see LFA Steffens, Overgang van vorderingen en schulden in het nederlandse internationaal privaatrecht (Deventer, 1997), but in the Netherlands, RIVF Bertrams and HLE Verhagen preferred the law of the assignment, ‘Goederenrechtelijke Aspecten van de Internationale Cessie en Verpanding van Vorderingen op Naam’, 6088 (1993) Weekblad voor Privaatrecht Notariaat en Registratie, 261.

204 Volume 5: Financial Products and Funding Techniques If assignor and assignee are in the same country, the assignment is in its contractual aspects purely domestic even if in respect of foreign claims, which for the moment we may assume to arise when the debtor under the claims is elsewhere. This would not in itself create an international issue on the contractual side of the assignment, and the law of the country of both assignor and assignee applies to this aspect except if they choose another one. Yet if the debtor is in another country, s/he becomes unavoidably involved, even though in principle as passive spectator: when is the assignment valid as regards him/her? Whom does s/he need to pay? How does payment to the assignee discharge him/her? Under his/her own law s/he might be very differently protected. Does it apply as to him/her? If the assignment is to an assignee in another country, it would appear to be international, at least on the contractual side, but the assignment may still be domestic, at least in respect of the domestic claims of the assignor (that is, claims between the assignor and debtors located in the same country as the assignor, although even these could be subject to a foreign law). Nevertheless, this assignment in its contractual aspects must be considered international and there may be a conflict of laws problem as to the contract law applicable. If the parties do not choose otherwise, under traditional conflicts rules, the law of the assignor will then apply as the law of the country where the most characteristic performance takes place, except perhaps in pure collections where the assignee may (subsequently) perform the more characteristic obligation: see Article 4 of the 2008 EU Regulation on the Law Applicable to Contractual Obligations replacing the earlier 1980 Rome Convention on the same subject. Thus, as a general proposition, international contractual problems arise only when the assignor and assignee are in different countries, although for debtors there are also problems in terms of their protection and liberating payment facility if they are elsewhere. In the proprietary sense, however, problems strictly speaking only arise when the asset moves. This is very clear for chattels. More poignantly in assignments the question of the location of the claim is posed. Some see it at the place of the creditor/assignor, others at the place of the debtor/payor. Article 2(g) of the European Bankruptcy Regulation 2002 (now Art 2(9)(viii)), which deals with the recognition and enforcement of bankruptcy decrees in the EU, takes the latter view. It is submitted that at least from an enforcement point of view, this is the better approach: see for a broader discussion Volume 4, section 1.9.4. It means that in a proprietary sense international issues only arise when the debtor moves. That is rare and is not a major assignment problem. The situation here is quite different from the international sale of goods requiring delivery elsewhere.

See for a more commercially oriented view in England, Goode (n 331), 1110 and M Moshinsky, ‘The Assignment of Debts in the Conflict of Laws’ (1992) 109 LQR 613. In the proprietary aspects, Goode, Moshinsky (except for bulk assignments) and Dalhuisen opt for the law of the debtor, Struycken and Kieninger (and Moshinsky for bulk assignments) for the law of the assignor, and Verhagen for the law of the assignment. In the US, the UCC in security transfers of claims opts for the law of the assignor who seeks financing: s 9-103(3), reinforced in s 9-01(1) of the 1999 Revision. Note that the ‘debtor’ here is the person seeking financing and therefore the assignor of the accounts. It is not therefore the ‘account debtor’. The more traditional common law rule is the law of the underlying debt being assigned: see also Vol 4, s 1.9.4. The proprietary aspects are often more hidden in claims than in physical assets. They may surface directly, however, as in the question of which subsequent assignee has the better right to collection and proceeds, or whom the debtor must pay. Indirectly proprietary issues may surface in the question of validity of the assignment, as in the Dutch case referred to above (only by default, because the HR thought that Art 12(2) of the Rome Convention was limiting in its coverage), or even within the context of assignability. Can they be transferred, and how is it done in terms of their existence (future claims), nature (highly personal claims), transfer (prohibitions of assignments), modalities of transfers (pools and bulk assignments), manner of transfer (notification), type of proprietary right to be created (security or conditional ownership right), protection of the debtor (extra burdens leading to ineffective assignments)?

Volume 5: Financial Products and Funding Techniques 205 If one were to put the location of the debt at the place of the debtor, it follows that the law of place of the debtor must normally be considered competent in the proprietary aspects of assignments as the (normally unchanged) lex situs. It should determine who truly is the owner of the claim, therefore to whom the debtor must pay (and his protections in this regard) and who is entitled to enforce the claim against him. It also goes to the question of priority in the case of multiple assignments. The enforcement and ownership laws therefore tend to become the same (unless enforcement is sought against the debtor’s assets in yet another country). That is logical and at the same time best protects the debtor, who is entitled to such protection as the passive party. If, on the other hand, one puts the location of the debt at the place of the creditor or assignor, an assignment becomes international in a proprietary sense when the creditor moves to another country, which for businesses is rare or when there is an assignment to an assignee in a foreign country. As in the case of chattels, which move to another country as a consequence of a sale, one should then ask whether the proprietary law of the country of origin or of destination applies. In the creation of the interest, it would be the law of the assignor, but in the recognition of its effect it would be the law of the place of the assignee. The Conventions seek to overcome these problems by imposing a unitary substantive law regime for assignments in cases when conflicts of laws could arise. It has already been said earlier that the UNCITRAL Convention tries to do two things at the same time: achieve a unitary regime for international assignments and create a more rational regime for bulk assignments, with the emphasis having shifted to the latter in the course of the deliberations. Because of the different views on when an assignment is international (which may depend on the contractual or proprietary aspects being considered), a key point is the applicability of this type of Convention. If one takes the perspective of the bulk assignment, one assumes that the fact that (prospective) debtors are in different countries should kindle the application of a Convention of this nature. The UNCITRAL Convention introduces here rather the notion of international assignments, which are assignments between assignors and assignees in different countries and (domestic and other) assignments of international claims which are considered claims that have a creditor (assignor) and debtor in different countries: see Article 3. From the perspective of bulk assignments, the simpler rule would have been to cover all assignments with any debtor or even prospective (future) debtor in a country other than that of the assignor. To connect this kind of international assignment with the Contracting States, Article 1 requires that at least the assignor is located in a Contracting State. Thus, assuming the assignment is international in the sense just mentioned, for its application the UNCITRAL Convention only requires that the assignor is located in a Contracting State (Article 1(a)). This seems a simple and sensible rule. So, the Convention applies to all international assignments of an assignor in a Contracting State.348 Naturally, the Convention would be more effective if the debtors elsewhere were also located in a Contracting State, and even the assignee, but it is not strictly necessary for the Convention to operate. But for a debtor to become directly affected, s/he must be located in a Contracting State or the law governing the receivable should be the law of a Contracting

348 It follows that for the Convention to have any effect, at least the assignor and one (prospective) debtor must be in different Contracting States or the assignment must be to an assignee in another country which need not be a Contracting State. This does not prevent the assignee in a non-Contracting State from invoking the assignment against the assignor and the debtor(s) under the Convention if accepted in their laws. It is of course a bonus if the assignee is also in a Contracting State but it does not appear to be strictly necessary. A requirement to that effect would have been difficult to handle if there were a consortium of assignees in different countries, some of which might not be Contracting States. In fact the assignee will often be an SPV as part of an asset securitisation scheme in a tax haven country, not so likely ever to become a Contracting State.

206 Volume 5: Financial Products and Funding Techniques State (Article 1(3)). That would also appear to be the situation for the assignee. On the other hand, Article 2 of the UNIDROIT Factoring Convention takes a different approach. For the UNIDROIT Convention to apply, it is necessary that the receivables assigned under the factoring agreement arise from sales or service agreements between the supplier and a debtor whose places of business are in different states provided either: (a) those states as well as the state in which the factor has its place of business are all Contracting States; or (b) both the contract of the sale of goods out of which the receivable arose and the factoring contract are governed by the law of a Contracting State (Article 2). For this purpose, the relevant place of business is in each instance the place of business most closely related to the relevant contract and its performance. However, parties may always exclude the application of the Convention either in the factoring agreement or in the underlying sales agreements out of which the receivables arise (Article 3), but only in whole and not in part. This is logical for a Convention that also covers proprietary rights which cannot be amended by the parties. Under both Conventions, courts in Contracting States must apply the Convention directly if these rules of applicability are met. There is therefore no need first to determine what law is applicable under the traditional conflict of laws rules, applying the Convention only if it was adopted by the relevant state, the law of which would thus be applicable. Although in UNCITRAL at one stage there was some discussion of this latter approach, it was abandoned. Even a clause similar to Article 1(1)(b) of the 1980 Vienna Convention on the International Sale of Goods (CISG), which requires the Convention to be applied also if the rules of private international law point to the law of a Contracting State, was not retained. The (alternative) reference in the UNIDROIT Factoring Convention (Article 2) to both the sales and factoring contract being governed by the law of a Contracting State has some similar effect, but would appear to lead to unnecessary complication.

2.3.6. The UNIDROIT and UNCITRAL Conventions. Their Content, Field of Application, Interpretation and Supplementation. Their Role in the Lex Mercatoria Notwithstanding the attempt to create a uniform law, especially important in the aspects of assignments in bulk, as assignments for financial purposes usually are, and in which aspect there emerged a fairly comprehensive approach in the 2001 UNCITRAL Convention even though it still uses conflicts rules in areas governed by it but not specifically settled in it (Article 7). That makes the determination whether there is a gap or not a major issue and, as we shall see, a destructive one, especially since the Convention does not contain clear definitions of the basic concepts it uses. In fact, the crucial notification and documentation requirements were ultimately both left to domestic law. The UNIDROIT Factoring Convention uses similar language, here somewhat more comprehensible as this Convention is patchier in its coverage. No less disturbing is the rest of the formula on interpretation and supplementation of both Conventions, which, also in these aspects, each use the language of Article 7 of the CISG. In that Convention, the formula applies only to contractual situations where a distinction was made between interpretation and supplementation. In this contract approach, for interpretation, regard must be had to the international character of the Convention, the need to promote uniformity in its interpretation and the observance of good faith in international trade. For supplementation, regard must be had to the general principles on which the Convention is based and otherwise to the rules of private international law.

Volume 5: Financial Products and Funding Techniques 207 Whatever the merits of these rules in contractual matters (and even there they can be much criticised, see Volume 3, sections 2.3.6–2.3.7 and Volume 1, section 1.4.14), in assignments the important issues are often more proprietary than contractual. This being the case, it is submitted as a start that the reference to good faith is inappropriate in proprietary matters and should have been omitted. It certainly is not meant to protect bona fide collecting assignees regardless of superior rights of other assignees of which they may not know, although such a rule might have been beneficial. The reference to private international law in gap filling (the question of what is a gap still being a matter of interpretation) is in any event likely to destroy whatever unity the Conventions bring. As in the earlier Hague Sales Conventions and also in the UNIDROIT Contract Principles, this reference should also have been omitted. It creates a search for the applicable national laws in any situation of doubt on the coverage, applicability and meaning of the Convention, while the merits of the conflict rules in these areas, even as unified in the UNCITRAL Convention (the drafting of common conflict of laws rules was a sequel to the reference to private international law in areas where the Convention needs supplementation, although Contracting States may opt out of them), are in serious doubt and widely contested. Thus, unnecessary uncertainty and lack of uniformity would result in any instance where conceivably a void in the coverage of the Convention could be construed. As this can be done virtually at random, especially since the Conventions are short on definitions of their main concepts, it deprives them of substantially their meaning. In the UNCITRAL Convention, for lack of a uniform rule, it means, for example, reliance on diverse local laws to determine whether, for the assignment of a receivable, there is a need for notification and individualised documentation. It was already said that the reference to local laws in this manner is likely to destroy any international bulk assignment covering debtors in different countries. Especially in the UNCITRAL project, there should have been enough in the Convention itself to accept a legal regime that could be explained and supplemented through analysis of the Convention from within, supplemented by international practices.349 Interpretation and supplementation should not be separated either and the reference should, it is submitted, in both cases have been to the international character of the Convention, international practice and custom, its general principles, and the need for its uniform application. Conventions of this nature should in any event be placed in the hierarchy of the lex mercatoria as a whole: see Volume 1, sections 1.4.14/15. In the UNCITRAL Convention a reference is made to practices and custom only in Article 11 determining the rights and obligations of the parties to the assignment where the language of Article 9 of the CISG is followed, which looks at custom essentially in terms of implied conditions of the contract. This is also too limited a view, especially in the proprietary aspects. They are not normally considered a matter of party autonomy (unless one takes a much broader view and uses the equitable analogy from common law practice): see Volume 3, section 2.3.6. In its uniform conflict provisions, applicable in matters not settled by the uniform rules of the Convention, the UNCITRAL Convention accepts applicability of the law of the assignor for

349 This is much less true for the UNIDROIT Factoring Convention, but see for a discussion of the general principles in that Convention F Ferrari, ‘General Principles and International Uniform Law Conventions—A Study of the 1980 Vienna Sales Convention and the 1988 UNIDROIT Conventions in International Factoring and Leasing’ (1998) 10 Pace International Law Review 157. The liquidity of claims regardless of an assignment prohibition in Art 6, the assignability of future claims in Art 5, the abolition of the notification requirement for the validity of the assignment in Arts 1(2)(c) and 8, and the maintenance of the debtor’s defences in Art 9, were correctly identified in this connection as general principles but do not in themselves provide a coherent assignment regime.

208 Volume 5: Financial Products and Funding Techniques the relations between various assignees (Article 30).350 Assignability (not as such mentioned or defined) seems to be covered by the law applicable to the assigned claim, as is the relationship between the assignee and the debtor and also the proper protection of the debtor (Article 29). This is another important impediment to bulk assignments. The particular aspect is here of course the protection of the debtor and the question whom s/he should pay and what his defences and setoff rights are. Beyond the uniform rules of Articles 18 and 19, it seems best covered by his own law, but the Convention takes another view and opts for the law covering the underlying claim. It stays close to Article 12 of the EU Rome Convention on the Law Applicable to Contractual Obligations (now Article 14 of the 2008 EU Regulation) on the same subject (Rome I), itself much contested and often unclear: see more particularly Volume 4, section 1.9.5. Whatever the merits of this approach, the result is that it is particularly uncertain to what extent the proprietary and enforcement issues are covered, now no longer accepted by the ECJ in respect of Article 12 of the EU Regulation, and to what extent therefore the law of the assignment or the underlying contract applies in these aspects. Assignability itself, made subject to the law of the underlying claim, could have important proprietary aspects in determining what claims can be transferred and how and what interests may be so created and transferred. Proprietary aspects, such as the shift of a reservation of title into proceeds, might, however, also end up under the heading of validity of the assignment, as Dutch case law showed, subject therefore to the law of the assignment.351

2.3.7. Details of the UNIDROIT Factoring Convention The UNIDROIT Convention on International Factoring dates from 1988 and is now effective having received the minimum number of three ratifications (France, Italy and Nigeria, later joined by Germany). It gives a definition of factoring and describes it as a contract between a supplier and a factor under which the supplier assigns his commercial receivables352 and performs at least two of the following four functions (Article 1): (a) providing finance for the supplier; (b) maintaining the accounts relating to the receivables; (c) collecting the receivables; and (d) protecting against default in payment by the debtors. Again, it is to be noted that no clear distinction is made between contractual and proprietary issues nor between an outright sale of the receivables (when the factor takes overall risk at a price), a security transfer (when the factor provides a secured loan), a conditional transfer (when the factor takes over only certain risks in the portfolio), or a mere collection agreement (when the factor does not take over any risks in the portfolio at all). As a consequence, the types of risk transferred and the reward structure appear not to be directly considered by the Convention. 350 The question of priority among succeeding assignees in the same receivables proved one of the most difficult issues. Initially, four alternatives were suggested: (i) first in time, first in right; (ii) first notification to the debtor; (iii) first registration in a register to be created; or (iv) a private international law rule. Eventually the fourth alternative was adopted and the law of the place of the assignor was chosen. This avoided the issue and represents a serious shortcoming in the Convention. As an alternative an optional filing system was introduced at the same time, allowing for priority on the basis of the date of filing or registration, a system especially favoured by the US delegates (even though of limited impact in the US under Art 9 UCC in view of its automatic perfection rule for accounts). The solution lies in a better protection of the bona fide later assignee who acquires sufficient power in the collection of the receivables and effectively collects. This is the equity rule in common law countries, as we have seen. 351 See n 348 above. 352 Therefore, one assumes, only contractual monetary claims for payment arising out of sales of goods or the supply of services, although this definitional issue may have to be determined on the basis of domestic law pursuant to the applicable conflicts rule.

Volume 5: Financial Products and Funding Techniques 209 This is nevertheless the essence of modern factoring. As we have seen, factoring is a structure under which financing may even be provided through a conditional sale of receivables. The conditions then concern the risk distribution and reward structure, in the sense that, especially in recourse factoring, certain receivables are automatically returned to the supplier if they prove difficult to collect, or are not approved. Even in non-recourse factoring, claims may be returned if an agreed total amount has been collected by the factor. The Convention does not concern itself with these variations and their different legal consequences. Under the definition, pure collection agreements, which normally have an administration function only, seem to be covered. So, it seems, are outright sales, which will always include administration and collection. It is not immediately clear why they should have been included, and this may only be understandable against the background of the US approach in Article 9 UCC. More naturally, secured transactions providing financing are covered if combined with administration and/or collection. Although, as just mentioned, different risk patterns and proprietary structures are not specially considered, all non-recourse or recourse sales of the portfolio, if combined with administration and collection, seem to be covered. In fact, it is hard to see what is excluded. But the UNIDROIT Factoring Convention provides only a small number of uniform rules. The most important ones are that the receivables need not be individually specified in the factoring agreement but only must be identifiable at the time of the conclusion of this agreement. Future receivables may thus be included, while neither needs the contract out of which they arise to exist nor needs the debtor to be known, but they are transferred only at the moment at which they come into existence (Article 5(b)), although it is stated that there is no need for any new act of transfer. It is therefore automatic. Nevertheless, the effect of an intervening bankruptcy of the assignor may still depend on the applicable lex concursus (even if the bankruptcy is in a Member State). Notably, Article 35(2) of the Dutch Bankruptcy Act requires that claims must have become part of the patrimony of the assignor for the assignment to be effective in a bankruptcy, and that the prior assignment of future claims cannot be effective in respect of claims that enter the assignor’s estate only after his bankruptcy. This is not a common rule, however. Notification is not a constitutive requirement of the assignment (even if Article 1(1)(c) is not the clearest in this connection, which leaves the danger that the issue will be determined according to domestic law under Article 4(2)) and becomes relevant only in connection with the payment duty of the debtors (Article 8). The Convention thus avoids problems of individual notification and specification of the assignment in that connection. Strictly speaking it leaves open also the question of individualised documentation, therefore in respect of the assignment of each individual claim. Again, it may become a matter of local law under Article 4(2), destroying in the process any operation of bulk assignments internationally. As the Convention does not go into the different types of factoring and especially not into the assignment as a security interest or conditional sale, it does not deal with any extra formalities in that connection either, such as documentation, registration or publication of the interest. Assignment restrictions in the underlying agreement are ineffective, although the supplier remains liable to the debtor if s/he assigns in breach of such a restriction (Article 6). Other defences of the debtor remain valid against the factor, however, as well as any set-off right (Article 9). Any payments of the debtor to the factor are not recoverable, however, in the case of default of the supplier under the underlying sales agreement as long as the debtor can recover them under applicable law from the supplier, unless the factor has a payment obligation to the debtor in respect of the receivable (and only to that extent) or knew of the supplier’s non-performance when s/he received the payment (Article 10). Extra burdens for the debtor are not considered in the context of payment excuses. The Convention also does not consider to what extent receivables may be split out, whether closely related duties (or rights) are transferred at the same time, and whether

210 Volume 5: Financial Products and Funding Techniques the supplier is then discharged from such obligations. Also, the question whether the assignment may amount to an amendment or novation is not considered, except that in Article 7 it is said that the accompanying security interests only transfer with the claims. It would have been more logical to assume an automatic transfer as accessory right unless the assignment agreement had provided otherwise. Formation, validity or assignability issues are not further considered either. Also, the Convention does not devote special attention to the debtor’s protection, proprietary and enforcement aspects, except that as to the payment duty of debtors, Article 8 imposes a duty for them to pay the factor if, and only if, they have no knowledge of any other’s superior right to payment and proper notice in writing is given. What a superior right in this respect is remains notably undefined. As has already been pointed out, this puts a heavy burden on the debtors who would not appear to obtain a liberating payment otherwise. The likely result is that in case of doubt, they will pay neither supplier nor factor and it might have been much better if the notification rules of Article 8 had not left any doubt about the payment duty. Especially notification given by both supplier and factor or by the factor with the clear authority of the supplier should have released the debtor upon payment, no matter what other knowledge s/he might have had. Any dispute should subsequently be a matter between assignees and supplier. The Convention does not go any further into the possibility of double assignments and does not address the various rights assignees may have concurrently under different types of assignments either. The effect of the avoidance or termination of the assignment agreement or the failure of warranties of ownership on any payments made by the debtor to the factor also remains undetermined. In all these areas it is left to conflict of laws rules to point to the appropriate applicable domestic law. The Convention does not contain any special conflicts rules in the areas where no uniform rule is given and does not determine the proper situs of the claim for proprietary or enforcement issues either. It contains in Article 4 the by now usual interpretation and supplementation language in matters covered by the Convention derived from the CISG giving preference to the general principles of the Convention before (the normal) conflicts rules are applied. It was criticised in the previous section and is an undesirable addition, although more understandable in the context of the UNIDROIT Factoring Convention with its more limited uniform regime (which is moreover largely confined to contractual assignment aspects) than that of the UNCITRAL Convention.

2.3.8. Details of the UNCITRAL Convention. Its Operational Insufficiency As we have seen, UNCITRAL started to develop a Convention (rather than a model law) on receivable financing as from 1992. Ultimately its focus shifted to the facilitation of international bulk transfers. The ultimate title became the Convention on the Assignment of Receivables in International Trade. The final text was completed in 2001. It presents a more comprehensive effort than the UNIDROIT Factoring Convention in that it covers many more assignment aspects and aims at a much more comprehensive uniform regime. The Convention is not limited to bulk assignments of trade receivables,353 and has or should have particular relevance in the context of

353 The term ‘receivable’ is only loosely defined in Art 2 as a contractual right to payment of a monetary sum and could then also include credit card loans or bank loans, eg in the case of asset securitisation.

Volume 5: Financial Products and Funding Techniques 211 the commoditisation of all types of receivables internationally. Success of a Convention of this nature could substantially benefit the financial services industry and its practices and also facilitate international collection. It was therefore an important project. Indeed, as for the scope of the Convention, at an early stage it was decided not to define the purposes of the assignment. Thus, any particular funding objective became irrelevant and a decision was taken not to limit the ambit to receivable financing either but to focus on assignments more generally as ultimately reflected in the title. It follows that, unlike in the UNIDROIT Factoring Convention, there is no attempt here to describe the substantive scope or material objective of assignments covered by the Convention. It is clear therefore that this is not exclusively a factoring or receivable financing Convention as other types of assignments (but only of contractual monetary claims or ‘receivables’: see Article 2(a)) are also covered by it. Indeed, they may also play a role in floating charges, securitisations, and project financing. Even though bulk assignments became the focus, individual assignments are not excluded. They remain covered except for personal family or household purposes. The true focus is, however, bulk assignments of (professional) receivables for whatever purpose but there still remains some ambivalence. As the type of financings are no longer defined, it becomes more important to spell out the proprietary alternatives in terms of outright transfer, conditional transfer, or security transfer, their different structures and possibly formalities. In later drafts, it became particularly unclear whether the Convention also applied to conditional and temporary transfers of receivables and to mere collection agreements; only the outright transfer and a security assignment seem to be considered (Article 2(a)), although many details of the latter are not spelled out either. All the same, the definitions (in Articles 2, 3 and 5) bear out the bias towards bulk transfers of professional receivables and receivable commoditisation. Article 2(a) separates contractual claims for payment of monetary sums (which are all considered receivables for the purposes of the Convention and could include liquidated claims for damages, although the coverage of monetary tort claims was deleted) from the rest of the contract (the issue of severability therefore), while any restrictions on the transfer in respect of them are not effective vis-à-vis the assignee: see Article 9. As regards the defences and set-off, however, the debtor may continue to maintain them against the assignee, but agreements not to raise them are generally upheld (Articles 18 and 19). This also applies to set-off rights against the assignor, which normally still shift to the assignee. The idea that the debtor in a modern society has to accept some transfer burdens, especially if the claim against him needs to be used to raise the financing for his payment, still does not find expression here. It is to be noted that the separation language suggests that closely related obligations, such as accounting or arbitration obligations, or royalty or similar payment obligations that come with the receivable, do not transfer with it. Under Article 7(2), however, this could remain a matter of applicable domestic law (and also the question whether the assignor was discharged under the circumstances), if not preceded by the application of the general principles on which the Convention is based, whatever these may be in this connection. The questions of delegation of other duties, transfer of whole agreements and the characterisation of the assignment as novation or amendment are not or are no longer broached in the ultimate text either, and could therefore also become matters of applicable domestic laws, probably the one of the assignment under Article 28; it is an undesirable situation. Clearly, the commoditisation of receivables does not attain the level of sections 2-210 and 9-406(d) UCC (see Articles 9 and 18), but the Convention nevertheless represented a step forward as compared to the law of many civil law countries. Importantly, the Convention is also liberal in the identification requirements and therefore favourable to including future receivables as a matter of uniform law (Article 8). These were two important achievements.

212 Volume 5: Financial Products and Funding Techniques The determination of the status of the rules of the Convention was a delicate matter. The prevailing view was that assignments were basically structures of party autonomy, allowing the parties to choose the law applicable to their mutual rights and obligations as well as to derogate from or vary the effect of individual provisions of the Convention, but this cannot affect the rights of persons not parties to such an agreement (Article 6). This is a clear indication that proprietary issues cannot be so settled. However, there is no clear view of what the proprietary issues are, even if upon a proper construction the Convention largely seems to concentrate on them. This confusion led to the interpretation and supplementation provisions of Article 7, directly derived from the CISG and there applicable to only (some of) the contractual aspects of international sales, already criticised in the previous sections, especially in its reference to good faith in the interpretation of the Convention, hardly understandable for proprietary issues. Also, the language of Article 11(2) and (3) concerning usage, also derived from the CISG and relying on implied terms, therefore on party autonomy, is hardly appropriate or sufficient in proprietary matters. But the major shortcomings of the Convention are in its failure (not immediately obvious from Article 8) to provide for a uniform notification regime (or its waiver) and documentation or formalities regime (or their waiver). This is most unfortunate, especially in the context of bulk assignments, all the more so as under Article 27 it would not appear immediately clear which local law might be applicable. The reliance in these aspects on domestic law destroys any notion of an international bulk assignment. Closely related is the Convention’s failure to establish a uniform regime for priorities. We are here concerned with the right of the assignee in the receivables over the right of a competing claimant. Instead, the Convention refers the matter to the law of the assignor (Articles 22 and 30), or leaves it to the Contracting States to opt for one of the systems set out in the Annex to the Convention (Article 42). Inspired by the UCC filing system,354 the Annex itself prefers a system based on registration of an assignment (Articles 1ff of the Annex). But states may also opt for a prior tempore rule, based on the time of the contract of assignment (Articles 6ff of the Annex), which conforms to the German situation. Finally, they may also opt for a priority rule based on the time of the notification of the assignment (Articles 9ff of the Annex), which is also wholly unconducive to bulk assignments and, rather, reflects old French law. There was apparently no room for an alternative rule protecting the bona fide first collecting assignee as is the common law rule (in equity).

2.3.9. Domestic and International Regulatory Aspects Beyond the private law aspects and bankruptcy ramifications of receivable financing and factoring and the need for a better regime both domestically and internationally, no public policy and regulatory concerns have surfaced so far in this area.

2.3.10. Concluding Remarks. Transnationalisation In terms of international financing, the essence of the use of receivables in terms of collection and/ or funding is the possibility of their bulk assignment even if the claims are future and payable by debtors in different countries and/or the portfolio is transferred to an assignee (factor) in another country. Key issues are their legal commoditisation, meaning in particular the separation of the 354 See for a critique s 2.2.3 above.

Volume 5: Financial Products and Funding Techniques 213 claims from the contract out of which they arise, their assignability, the abolition of third-party effect of transfer restrictions, the limitations (as to what is reasonable) of the defences of debtors under these claims against payment requests by assignees, and the lifting of any specificity and individualisation requirements to make a bulk assignment and the inclusion of future receivables possible. As was noted before, another particular and related issue is here the independence of the receivable in respect of the legal relationship out of which it arises. Elimination of documentation and notification requirements in respect of the assignment of each individual claim is a further key requirement to support their transfer in bulk. Other important issues are the nature of the assignment in its proprietary aspects, therefore either outright, conditionally, or as security. Another important issue is the ranking of the various assignees among themselves. Ultimately this represents a new approach towards this asset class, the proprietary rights that can be vested in them, and the manner in which they are created and transferred. As we have seen in section 2.2, this is important for the operation of floating charges, in which the substitution of assets, especially inventory and receivables, is a major issue in the context of using them as security for funding. In receivable financing and factoring, only receivables are involved either in collection schemes, which may include some guarantees concerning credit risk, or in funding transactions, which may entail their outright or conditional transfer, the latter being especially important in recourse financing or when receivables must be returned after a certain amount of collection. Security transfers are in this context perhaps less common although quite possible. Especially in the US under Article 9, there is here again a tendency towards a unitary approach, as we have seen. Internationally, the diversifying impact of the location of the debtors under the receivables on the applicable law should preferably be eliminated. Similarly (even if of lesser importance) the effect of location of the assignee on the applicable legal regime should also be neutralised; hence, the potential usefulness of uniform treaty law in this area. The technique of transnationalisation was explained before: locate all claims worldwide at the place of the assignor and allow party autonomy in the funding structures, including their proprietary aspects, subject to protection of bona fide collecting assignees. Local bankruptcy laws would recognise these structures as an expression and recognition of transnational notions of party autonomy in this area, or of emerging international practices or custom. Finding nearest equivalents domestically would still be important to fit these newer interests into domestic rankings of creditors in executions, especially in bankruptcy. This should be a liberal process and the bias must be in favour of acceptance. If only for four rules—liquidity (and independence) in principle, including the lifting of any third-party effect of assignment restrictions; coverage of future claims (subject to reasonable description); abolition of the notification requirement for the validity of the transfer; and limitation or abolition of any documentation requirement—one should be grateful for any international Convention in this area. They are the key to successful bulk assignments. International uniformity in these four areas would be of great importance. If at the same time foreign debtors could be brought in more easily, that would be an added advantage (depending on their being in Contracting States) while the concept of the bona fide collecting assignee should also find international recognition. Again, the analogy with promissory notes presents itself. That would be the basic programme in terms of transnationalisation and was indeed the original programme of the UNCITRAL Convention. It followed that the ultimate recourse to domestic laws in the matter of notification and documentation in that Convention became a severe blow to its credibility. It cannot then provide a uniform rule for priorities between assignees either. It also proved weak in properly identifying the proprietary issues in the transfer of receivables, particularly in the lack of recognition of conditional ownership transfers inherent in several forms of recourse factoring and in collection agreements. This was coupled with total confusion in matters of supplementation

214 Volume 5: Financial Products and Funding Techniques and interpretation; the Convention should notably have been more careful with any reference to good faith in its interpretation, which, as it now stands, also applies to its proprietary aspects. It is inappropriate, and could only serve some purpose if meant to indicate some greater judicial discretion in explaining the Convention. It was accompanied by a fallback into private international law, that is domestic law in every aspect where there could be the slightest doubt on the clarity or completeness of the Convention. Much more important in this connection would have been a clear reference to transnational custom and practices to precede the application of any domestic laws. That would have sustained the notion of the hierarchy of norms in the lex mercatoria in which local law remains important, but only as the default regime: see also Volume 1, section 1.4.14 and Volume 3, sections 2.3.7 and 2.3.8. That being said, it was already noted that the UNCITRAL Convention makes some useful progress in the areas of the liquidity of claims (and limitation of the effect of assignment restrictions) although it could have gone further in curtailing the defences and it also remains vague in the transfer of connected obligations. It also made significant progress in the inclusion of future claims, but this does not in itself justify the effort. As it is, it provides less than a sound basis for international bulk assignments, which should have been and increasingly became its proper perspective. It is not surprising, therefore, that it has disappointed and hardly found ratifications so far. It was a missed opportunity in terms of transnationalisation and unification, even if foreign debtors are more easily included and an assignment to a foreign assignee is facilitated. The UNIDROIT Factoring Convention was found too incidental in its coverage to provide much of a coherent regime either and to give adequate guidance. Its incorporation of similar supplementation and interpretation rules is likely to have the same debilitating effect as it has for the UNCITRAL Convention. It may be asked whether efforts of this sort should not concentrate on a number of key principles per financial product only: see the discussion in section 1.1.10 above on the definition of the basic characteristics of modern financial products and sales-price protection.

2.4. Modern Finance Sales: The Example of the Finance Lease. The 1988 UNIDROIT Leasing Convention 2.4.1. Rationale of Finance Leasing Since the late 1950s, finance leasing has rapidly developed as a means of financing capital goods and has found wide acceptance in most modern economies. Its rationale is to provide the user of assets (usually major types of equipment) with a financing alternative to (secured or unsecured) lending. Thus, instead of the user buying the assets himself, either with his own or with borrowed funds (probably secured on these assets themselves), in a lease, a finance company will acquire the assets for the user and to his specifications and will put them at his disposal for which the user will make regular payments to the finance company. The term ‘lease’ is often used here, but its legal meaning needs be defined, and does not necessarily have the same meaning as it traditionally had in the temporary use or rental of housing and land in particular. That is not the correct analogy. In this arrangement, the asset is often only of special use to the lessee, and this type of lease is therefore normally for the useful life of the asset. Lease payments will be made during that time at regular intervals to compensate the lessor for his outlay and to allow him a profit margin. Although the agreed lease period will correspond with the theoretical lifespan of the asset, it is likely that there will still be some use in the assets at the end of the lease period. Any residual

Volume 5: Financial Products and Funding Techniques 215 rights in them may then automatically transfer to the lessee at that time, or the lessee may have an option to acquire such rights at such time against a nominal payment. At least that became the continental European model. For reasons that will briefly be summarised below, this right or option to acquire the residual value is normally deleted in the UK and the US, mostly to avoid any analogy with hire-purchase (as a consumer transaction) in the former and with secured transactions in the latter, both as a matter of recharacterisation. It would make the rules protections and formalities concerning them applicable, which may be generally undesirable. Thus, in these countries full ownership and use reverts to the lessor. The idea is always that instead of the user applying his own funds (for which s/he may have a better use) or borrowing them at the prevailing interest rates (probably against the security of the lease assets themselves), there is no such use of his own funds or of (secured) borrowing under a finance lease, but the user or lessee makes regular payments for the use of the asset bought for him by a financier. As was submitted in section 1.1.8 and 2.1.2 above, the crucial difference is the absence of a loan agreement of which an agreed interest rate structure is the indication. If such a loan agreement were, however, in existence, the lease would become tantamount to a secured transaction. Again, that is then a matter of re-characterisation, a danger particularly in the US, as we have seen, as a consequence of the UCC’s unitary functional approach, a source of much litigation in this area in the US. Normally, the finance lease will not be an interest-bearing device. Naturally, it has a reward structure expressed in the instalments to be paid by the user/lessee to the financier/lessor. They have a cost and fee component, but that is neither economically nor legally the same as interest, although often so confused. There is a choice here. The finance lease is likely to be somewhat more expensive than a loan secured on the same assets would have been for the lessee, but there are other benefits for him, although depending on the competition for this business, the cost could also be lower. Again, the key is to appreciate that there is a true funding alternative with a different risk and reward structure. In practice, finance leasing has become an established way of funding all kinds of capital assets, in particular larger and more costly pieces of equipment, such as aircraft or aircraft engines, and sometimes ships or even real estate, as in manufacturing plant. The concept is now also used in the consumer sphere, for example for car and household good leasing, often to avoid legal restrictions on hire-purchase, which is a very similar arrangement. There may be another public policy issue—protection of consumers—restricting the use of this alternative, or converting it into a hire-purchase but only for them. As just mentioned, the reason for this type of lease arrangement is normally that the (professional) user or lessee prefers not to buy the lease assets himself, with the attendant need to finance them and carry them on his own balance sheet. As to the latter aspect, in countries like the UK, the US and the Netherlands, under prevailing accounting rules, the lessee may now have to do so. There were also often tax advantages, now eliminated in many countries. It is nevertheless the convenience that counts, and the availability of a financing alternative leading to another risk and reward structure, to greater liquidity for the lessee, and particularly to more room for other acquisitions by him and, in some countries. There may be other reasons, such as the possibility of 100 per cent financing and the saving of legal and mortgage registration costs in real-estate leasing. Again, there may also be tax benefits. As just mentioned, in exchange, the lessee might accept a somewhat higher charge compared with any interest s/he might have had to pay if s/he had borrowed the money (assuming s/he was in a position to do so on reasonable terms) in order to acquire the asset himself. This is in turn the attraction for the financier. This has led to a specific market for this type of service, the cost and risk of which is not the same as in loan financing. In fact, the interest costs of such an alternative will be used as one of the benchmarks for determining the financial costs or benefits of the leasing structure.

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2.4.2. Legal Characterisation As already explained in section 2.1.2 above, the key to the understanding of the finance lease from a legal point of view is that parties in finance leasing take a special kind of risk management perspective in terms of ownership and protection, especially the financier/lessor, against default of the other party if that party is the user/lessee of the assets. The risk structure is notably different from that assumed in a loan secured on the same assets and leads as a consequence to a different reward structure. In a secured loan transaction, upon default there is a repossession of the asset, an execution sale by the creditor (financier), and return of overvalue to the debtor (user/owner), while in the finance lease, upon default of the lessee there is appropriation of full ownership (including any overvalue, unless otherwise agreed and always taking into account the repayment of any instalments already paid) by the lessor. This is important to him as there will be no time loss and special procedures, and the asset may thus immediately be released to others. It also tends to leave the lessor’s own finance arrangements intact. Again, this different recourse and the different distribution of values in finance leases signify a difference in the risks parties take, which in turn leads to a different reward. From a legal and practical point of view, the (secured) loan and lease structure are therefore not truly comparable and are indeed two different ways of financing, which should not be equated or confused. There is approximation only if there is a clear loan, signalled by the existence of an agreed interest rate structure. There is unlikely to be one in finance leasing but, in that case, one would assume a conversion of the lease into full ownership for the lessee subject to a security interest for the lessor. The formalities for the creation of such a security interest will then have to be observed—in the US those of Article 9 UCC. That is re-characterisation and the US approach under Article 9 UCC where all funding structures using personal property in support are automatically converted into secured transactions, whether or not there is a true loan situation, an approach much criticised before: see for a summary section 2.1.1 above and also sections 1.1.8, 1.6.3 and 2.1.2. The fact that there may be an automatic right at the end of the lease for the lessee to acquire full title or that there is an option for him to do so for a nominal price or that the lease itself is for the useful life of the asset should not make any difference, even if in the US under Article 9 UCC the conversion into a security interest may be based on these features and not on the existence of a loan structure proper. As we have seen in section 1.6.3 above, that created all kinds of problems with leases, repos and recourse factoring in the US. Certainly, in finance leases, the lessee has the physical possession and use of the assets. This is likely to figure as a protection for the lessee upon a default of the lessor (in common law in terms of bailment) but that does not itself make the arrangement a secured loan either. It has been assumed throughout that in such cases, the proprietary protection of the lessor may be better expressed through conditional ownership rights in the lease assets under which they become subject to appropriation by the lessor in the case of a default (notably in the continuing payment of the agreed instalments) by the lessee. This is just like a seller who, upon a default by the buyer, has an appropriation right under a reservation of title (in the US also converted into a security interest, however, as we have seen) or the financier in a traditional hire-purchase.355 In common law, there is here a defeasible (conditional or temporary) title in equity (transposed from land law). There may also be a lease as a term of years (in equity also transposed from land law). 355 The hire-purchase is practically the same as a reservation of title except that often special hire-purchase companies are involved and these schemes operate especially for consumers, who, under applicable law, may receive special consumer protections (for example, in terms of a return of overvalue upon default even if in consumer goods there seldom is any). The practical difference is that reservations of title and hire-purchases are foremost sales protection devices; the finance lease is a funding vehicle.

Volume 5: Financial Products and Funding Techniques 217 If there is bailment at the same time, that may survive the bankruptcy of the lessee as such but may under its own terms also terminate upon an event of default, resulting in a right to immediate repossession (see note 256 above and also Volume 4, section 1.3.2). Although the finance lease is in essence a simple financial structure, it follows from the foregoing that its legal characterisation has remained much in doubt. There are basically three issues: (a) the contractual aspects of the finance lease, which are the simplest, but normally include that the assets are provided by the lessor at the lessee’s specifications against regular payments of lease instalments; (b) the proprietary aspects of the lease, which are more complicated as they concern the questions whether, when and how the lessor or lessee or both have ownership rights in the lease assets and the attendant protection in a bankruptcy of the other; and, more recently, (c) the collateral rights of the lessee under the supply agreement between the lessor and the supplier of the lease assets, which may lead to third-party contractual or derivative rights of the lessee against the supplier under the supply agreement between supplier and lessor. This is a notable exception to the notion of privity of contract: see for this notion Volume 3, section 1.5. The proprietary issue arises as the lessee is economically speaking often considered the owner of the asset and this may also have legal consequences, especially where the lessee has the use of the asset during its entire economic life, all the more so if also given the residual rights in the lease assets after payment of all lease instalments, either automatically or by way of option. In any event, the lessee has a right to consume the asset while in possession. The asset may even have been built to its specific standards and might as such not be of much use to others. There are, however, some residual retrieval rights of the lessor. To repeat, some division of proprietary rights in the nature of a split between lessor and lessee during the time of the lease suggests itself. It has already been noted that this is not a difficult concept under common law used to defeasible or temporary titles even in chattels (in equity), although in the US it is now prima facie indicative of a security interest under Article 9 UCC. In civil law, any duality in ownership outside the accepted number of defined proprietary rights is generally controversial, but exists in many countries, at least in the conditional ownership inherent in reservations of title and hire-purchases, although it has already been noted several times also that it remains mostly unclear how in such cases the proprietary rights of each party work and relate to each other and to the rights of (bona fide) purchasers of the asset: see in particular section 2.1.5 above. In the dual ownership characterisation of the finance lease (unless otherwise agreed), the lessor has in civil law terms the title and possession under the resolutive condition of full payment of the instalments, the lessee under the suspending condition of his full payments: see again section 2.1.5 above. Whether this structure can legally also obtain if the lessee is not given residual rights in the asset upon the end of the lease may be less clear, but, as economically the lessee has received all value, its position as conditional owner in the meantime would not need to be in doubt. Some kind of alternative may present itself in civil law countries following the German tradition in terms of the creation of a proprietary expectancy for the lessee or in German a dingliche Anwartschaft, as we have seen, which could be considered a new proprietary right in itself, thus transcending (in civil law) the notion of the numerus clausus of proprietary rights in this manner. All the same, it remains necessary to define its essentials no less than the construction of the resolutive/suspending condition. In common law, the conditional ownership is not an issue in itself, even if created in chattels, when it is equitable and often hidden behind trusts, but again as we have seen in the US under Article 9 UCC, it may in finance now be converted (by law) into a security interest if it is considered to secure payment or performance of an obligation (sections 1-201(a)(35) and 9-109(a)(5–6) UCC). This also affects the finance lease, especially if the lease is for the economic life of the asset, as we have already seen, or if the lessee is given the residual rights in

218 Volume 5: Financial Products and Funding Techniques the assets upon the end of the lease, although not necessarily if the lease allows for a full amortisation of the acquisition costs of the lessor through the lease payments. The borderline is unclear, however, and much litigation has resulted in this area, more than in any other under Article 9. The consequence of conversion into a secured transaction is full ownership of the lessee subject to a security interest for the lessor. In the US, it creates a need to file the interest to safeguard its priority, and for a disposition in the case of the lessee’s default and a return of any overvalue to him. This re-characterisation thus results in another kind of transaction. Partly to alleviate these problems for at least some type of leases (but also to introduce collateral rights of the lessee against the supplier), eventually a new Article 2A UCC was introduced to distinguish a newer type of lease: this is the equipment lease: see sections 1.6.2–1.6.3 above. It concentrates (often) on shorter leases, puts special emphasis on the lessee’s involvement in the specifications of the lease assets, and gives him collateral rights under the supply agreement. It left the proprietary position of both parties under the lease in doubt, although it is clear that the lessee has more than purely contractual rights. So has the lessor, at least in the bankruptcy of his lessee: see sections 2A-301 and 307(2) UCC and section 1.6.3 above and the next section below. The exact nature of these respective rights remains unclear, however. In practice, the borderline depends still much on the wording of the lease agreement and on the facts of the case. Especially for longer leases the idea of conversion into a security interest is not abandoned. Any construction of a duality in ownership is here particularly to be avoided as it may indeed be considered to give the lessor no more than a security interest. In the Netherlands, the finance lease also became vulnerable, as it looked like a substitute security which was deprived of all proprietary or third-party effect under Article 84(3) of the new Civil Code of 1992. As we have seen in section 1.2.3 above, case law has tried to remedy the situation, leaving, however, the proprietary position of the lessee much in doubt. The result is the opposite of the one in the US, where the lessee becomes the owner upon conversion of the lease into a security interest for the lessor. In the Netherlands, the lessee risks having no more than a contractual right that is not protected in a bankruptcy of the lessor, whose bankruptcy trustee may then be able to cancel the contract under the general rules of executory contracts. In the 1960s, some European countries such as France introduced legislation concerning the finance lease, mostly, however, to control leasing companies as lessors. This legislation seldom clarified the proprietary and collateral issues. In fact, the qualification as a conditional sale and transfer gave rise early on to some problems also in France, where as a general rule condition can no longer mature in a bankruptcy of either party, so that title could remain with a bankrupt lessor notwithstanding proper payment by the buyer (or lessee) if due after the bankruptcy date. There is the attendant problem of the status of instalments already paid, a situation only for reservation of title, remedied through an amendment of the French Bankruptcy Act in 1980: see section 1.3.5 above. Whatever the characterisation problems and consequences in some jurisdictions, in principle, the finance lease can be characterised as (a) a conditional sale, much in the nature of a reservation of title, or term of years in chattels. This is so even in the US unless the conversion criteria of Article 9 UCC are reached when it becomes (b) a secured transaction, which, it is submitted, is only a proper re-characterisation if there is an underlying loan agreement as evidenced by an interest rate structure. The lease can also be expressed as (c) an outright sale and ownership transfer to the user. At the other end of the scale, it is possible that the finance lease is expressed in terms that are (d) purely contractual. This is normal for short-term leases under which a mere temporary user right is transferred. In that case the term ‘operational lease’ is commonly used in Europe. It is really a rental agreement, for consumers usually referred to as a consumer lease in the US. The finance lease may also be (e) an equitable interest operating behind a trust, or more directly as an equitable proprietary interest, as we saw with protection in bankruptcy, but not against bona fide purchasers. In the US there is now also the further possibility of (f) an equipment lease under Article 2A UCC.

Volume 5: Financial Products and Funding Techniques 219 Again, the boundaries are not always clear. Normally in an operational lease, the lessee has not had the lease assets built or bought to his own specifications. There is no financing aspect either. It means that the lessee in an economic sense can hardly be considered the owner, has normally only minor maintenance duties, has no right to acquire full ownership, and certainly has no rights against the original manufacturer or supplier of the assets. True finance leasing, properly speaking, concerns the variant which presents a dual, split or conditional ownership arrangement, under which the lessee acquires some proprietary right, much as under a reservation of title or hire-purchase. It creates the problem of the precise definition of the proprietary rights of each party. The various other possible characterisations (depending on the wording of the lease document and the facts of the case) fall into well-established other legal categories (except the US equipment lease) and the term ‘finance lease’ should preferably not be used in those cases. Practically speaking, under most national laws, these alternatives have, from a legal point of view, prevented the finance lease from developing into a single, newer legal structure. Naturally there is always a contractual aspect to the lease, but even here there is no single contractual structure. Indeed, in practice, the lease assets are often acquired by the lessor to the lessee’s specifications and are then new. This may give rise under modern law to collateral rights for the lessee under the supply agreement, as we have seen, but not all lease assets are built to the specification of the lessee. That is clear in respect of land, although new buildings may be put onto it to the lessee’s specifications and included in the finance lease. By way of definition, the only thing that can be said is that under modern law a proper finance lease combines (always) contractual, (often) collateral and (always) proprietary aspects, the last short of a full transfer of ownership to the lessee. To complete the picture, there may also be a sale-leaseback of an asset already obtained by the lessee who wants to refinance it through a finance lease and will then more likely continue his direct legal relationship with his supplier or builder.

2.4.3. Comparative Legal Analysis So far German356 and French law357 seem largely uninterested in the proprietary and collateral aspects of finance leases, while Dutch law, if not now outlawing the finance lease in its proprietary 356 In Germany, the finance lease is considered a purely contractual arrangement, unless the lessee automatically acquires full title upon payment of the last instalment, or (perhaps) if there is at least an option for him/her to acquire full title without payment of further consideration. See for the various theories on the nature of the finance lease, PW Heermann, ‘Grundprobleme beim Finanzierungsleasing beweglicher Güter in Deutschland und den Vereinigten Staaten von Amerika’ [1993] Zeitschrift für vergleigende Rechtswissenschaft (ZVglRW) 362ff highlighting in particular the tripartite aspects of many of these arrangements following the US lead. Others see a mere credit agreement, which is also the approach of s 3(2)(1) of the Consumer Credit Act (VerbrKG) of 1 January 1991. The consequence of a secured transaction is not, however, commonly drawn. The German Supreme Court (BGH) traditionally characterises the finance lease as a rental agreement (which may, however, under German law imply some proprietary protections for the lessee whose lease can in any event not be interrupted by a sale of the title by the lessor) (BGHZ 71, 189), only more recently with some emphasis on the financial nature of the arrangement (BGHZ 95, 39) This is not, however, considered as a fundamental shift by F von Westphalen, ‘Leasing als “sonstige Finanzierungshilfe” gemäß s 1(2) VerbrKrG’ [1991] Zeitschrift für Wirtschaftsrecht 640 and by SM Marrinek, Moderne Vertragstypen, Band I: Leasing und Factoring (Munich, 1991) 72. The former author explicitly maintains the BGH interpretation outside the ambit of the VerbrKG, the latter argues for a sui generis approach with emphasis on both the financial and user aspects of the lease. Others see a contract of a mixed nature with aspects of financing and purchasing for the lessor and of payment of interest and commission for the lessee: see CW Canaris, Interessenlage, Grundprinzipien und Rechtsnatur des Finanzierungsleasing (Tübingen, 1990) 450ff. 357 In France, the finance lease was covered by Loi 66-455 of 2 July 1966, now codified in Arts L 313-7–L 313-111 CMF. It is inconclusive in the proprietary aspects. Some see finance leasing simply as a financing method without

220 Volume 5: Financial Products and Funding Techniques aspects as a pseudo-secured transaction, tends to characterise the finance lease as a purely contractual arrangement, as we have seen.358 In Germany, the focus of the discussion also remains on the characterisation of the finance lease as a rental agreement, which, under German law, may itself have some proprietary aspects in that it may survive at least the sale of the asset by the lessor and also his bankruptcy. That is the position in real estate: see section 566 BGB. It may also be the Dutch approach after case law validating finance leases assuming the conditional sale characterisation or dual ownership concept cannot establish themselves for finance leases in that country. As we have seen, the French enacted a special leasing statute in 1966 on the crédit-bail mainly from a desire to supervise lease companies. It is now superseded in the Code Monetaire et Financier (CMF), but was not fundamentally changed. It qualifies the lease as a rental agreement but with an option to buy, although not all rules of a rental agreement apply, and many contractual and proprietary issues appear to remain unresolved. There is no clear guidance in other countries either. On the whole, separate leasing statutes remain uncommon in Europe, with the notable exceptions of Belgium (1967), Spain (1977) and Portugal (1979), all requiring an option to acquire full ownership at the end of the lease. In that sense, they all suggest conditional ownership, although an automatic right to acquire the full interest upon payment of all the lease instalments would have been a stronger indication. In this connection, the characterisation as hire-purchase has also been proposed, and is often followed in the Netherlands,359 especially in view of the regular payment aspect. This characterisation is, however, problematic where there is no transfer of ownership at the end, and may not be available in the case of immovables and registered chattels, such as ships and aircraft. Other drawbacks are that it may make typical consumer protection applicable to what, in a finance lease, is essentially a transaction between professionals. There could notably be an execution sale upon default of the lessee, who would also be entitled to any overvalue. In the UK, where an automatic right or an option of the lessee to acquire full title upon the last lease instalment is also considered indicative of a hire-purchase,360 such a right or option is for that reason normally avoided in the lease contract as it may subject the arrangement to the mandatory rules of the protection of consumers. Probably to avoid these, there is now also a developing market for car leasing and the leasing of other more common goods with a longer life, such as kitchen equipment, in the UK. In Canada, on the other hand, the boundary between finance leases and secured transactions is the main issue, as in the US, but in the Uniform Personal Property Security Act of 1982 this boundary problem has been resolved somewhat differently. Every finance lease for a term longer than one year must be published. Although it does not create a security interest with its own proprietary status and execution regime, it makes the lessee the legal owner of the asset. However, it also creates a priority right for the lessor in an execution upon the lessee’s default, which is rather in the nature of a statutory preference or lien. In the UK, a similar approach was advocated by Professor Diamond in his Review of Security Interests in Property for the Department of Trade and Industry of 1989 while, however, opting for a three-year characterising it further in terms of secured or ownership-based financing, and emphasise the sui generis nature of the arrangement: see P Cordier, Note under Cour de Cass, 9 January 1990, (1990) Gaz Pal 127. Others seem to accept some kind of security interest: see G Marty, P Raynaud and P Jestaz, Les suretés, la publicité foncière, 2nd edn (Paris, 1987) 355. There are also those who see a mere rental agreement: see El Mokhtar Bey, Note [1987] La Semaine Juridique: Juris Classeur Periodique 20865, later also noting the hybrid character of the finance lease in terms of a sale, a rental or an option: see his/her ‘Des conséquences de la jurisprudence de la chambre mixte de la Cour de Cassation du 25 novembre 1990 sur la symbiotique du crédit bail’ [1992] Gaz Pal 568. 358 See n 90 above and accompanying text. 359 See WM Kleyn, Leasing, Paper, Netherlands Association ‘Handelsrecht’ (1989). 360 Goode (n 331) 709, 721; see also n 239 above and accompanying text.

Volume 5: Financial Products and Funding Techniques 221 minimum term. This UK document (at 9.7.16) still sees the essence of the finance lease in the circumstance that the aggregate rentals approximate to the full credit price or that the lease is for the full working life of the goods, although shorter-term leases may apparently also qualify as finance leases. As we have seen in the previous section, in the US since 1988 the finance lease, if an equipment lease under Article 2A and not a secured transaction under Article 9 UCC, is defined in section 2A-103(l)(g) UCC, originally inspired by the active role of the lessee in the selection of the goods: see for the resulting tripartite character of the arrangement also section 2A-209(1). As to the details, one of the following must occur: the lessee receives the supply contract before signing the lease; the lessee’s approval of this contract is made a precondition of the lease; the lessee receives before signing the lease an accurate and complete statement of the major clauses of supply contracts; or (if there is no consumer lease) the lessor informs the lessee to this effect and allows direct contact with the supplier to receive from him directly an accurate and complete statement. The equipment lease must further conform to the lease definition of section 2A-103(1)(j), which requires transfer of possession and use and specifies that a sale, including a sale on approval or a sale and return, or retention or creation of a security interest, cannot be an equipment lease. It is the reason why in the US under Article 2A there is no emphasis on amortisation through the rentals and certainly not on the arrangement being for the useful life of the asset, the latter aspect (but not necessarily the former) being an indication of the lease being a security interest instead of an equipment lease. The option to acquire full ownership rights at the end of the lease for a nominal value would be a similar indication of a security interest. Thus, in the US, in the equipment lease, the emphasis is foremost on the involvement of the lessee in the supply agreement (and his direct rights against the supplier) and on the limited nature of his user right, rather than on any proprietary aspects. They present a further lease alternative but still as such carry the risk of leading to a secured transaction under Article 9 if the lease is accompanied by any future rights of the lessee in the full title. Yet under an equipment lease there is more than a mere contractual arrangement. In particular the lessee in (physical) possession is protected as bona fide purchaser against outside interests in the lease asset as well as against any sale by or on behalf of the lessor to any other bona fide purchaser: see sections 2A-301 and 307(2) UCC. Note that the lessee’s interest being an equitable proprietary interest is normally cut off at the level of the bona fide purchaser, but a special statutory exception is here made to that general rule.361 Note also that equity does not strictly speaking require physical possession of the purchaser either. The equipment lease appears to be somewhere in between a rental and secured transaction. Thus, on the one hand, in order to remain within the ambit of the finance or equipment lease, there are proprietary rights of the lessee, but they are limited so as not run the risk of the equipment lease being converted into a secured transaction. It cannot therefore be a conditional sale and transfer, although it might still borrow from the defeasible or term-of-years concept of title in land; see also the discussion in section 1.6.3 above. On the other hand, the lessee’s rights against the supplier are considerably extended.

2.4.4. International Aspects of Finance Leasing The confusion which may exist locally about the precise legal definition and consequences of the finance lease structure, especially in its proprietary and therefore bankruptcy protection but also in its collateral aspects, may also have international repercussions as many assets subject to 361 See also n 265 above for the bailment aspect.

222 Volume 5: Financial Products and Funding Techniques finance leasing are likely to travel, a situation particularly applying to aircraft and their engines and to ships. With the enormous increase in international trade, many leased objects may increasingly move across borders for other reasons. Another aspect may be that lease companies are set up in far-away tax havens and do their business offshore. While travelling abroad, the proprietary status of the lease assets may change under the traditional rules of private international law. This may not be that relevant if both lessor and lessee are in the same country (of origin of the lease asset) and one of them goes bankrupt in that country. Their lex contractus may adhere to the original characterisation, therefore the one of the country of origin. But if for example the lessee had substantial interests in the country of destination of the lease asset, s/he may be declared bankrupt in that country when the whole characterisation issue may be replayed and the question of recognition of the original proprietary status is also to be considered. It may even be that in the country of the bankruptcy, leases of this nature are only contractual so that the lessor may perforce be considered the full owner subject to an executory contract that his bankruptcy trustee might be able to terminate. Assuming on the other hand that there are proprietary rights at stake, in the proprietary aspects, the lex situs is usually still thought to be applicable, conceivably leading to discrepancies between the law of the place of origin or of destination. This is particularly problematic in the area of limited or secured, split or conditional proprietary rights not known elsewhere. As we have seen before (see Volume 4, section 1.8.1) in such situations under the traditional conflicts of law rules, the lex situs of the place where a proprietary right first attached is deemed applicable in the creation of proprietary aspects, always subject in its consequences to recognition by the next country. This largely depends on that country being able to fit the foreign property right into its own proprietary system (or ranking regime in bankruptcy) without too much difficulty or adjustment and then comes down mostly to finding the nearest equivalent. This unavoidably raises the question of the precise meaning of the arrangement under its original law and subsequently of the continued significance of any particularities thereunder in the country of recognition. As just mentioned, a finance lease may thus be qualified in the recognising country as a mere contractual right, even if different in the country of origin and not accepted either under the applicable lex contractus. In the recognising country it might also be considered a reservation of title or a hire-purchase subject to mandatory rules of the same country. This also raises the question of compliance with the applicable formalities if the arrangement is qualified at the original situs as a security interest and of the relevance of this qualification and these formalities in the country of recognition. This is the issue of the fitting-in process at the new situs. It is necessarily a question for the recognising court, particularly important if at the same time it is the execution or bankruptcy court. In Volume 4, section 1.8.1, it was already noted that it is in essence a question of acceptance of acquired rights, in which connection different courts in different countries may well take a substantially different view. Some may be more flexible than others, which may only recognise the foreign proprietary rights to the extent that there are clear (rather than near) equivalents under their own law. As we have seen before, in this approach, proprietary rights may be enhanced or deprecated when assets move to another situs. Thus, reservations of title in goods coming into the US may become mere security interests that need filing for perfection, or would otherwise have a very low rank as merely attached interests. On the other hand, goods subject to purchase money security travelling from the US to Germany may find that there is full reservation of title status there including an appropriation right upon default (regardless of any filing). It may also depend on the purpose for which and the procedure under which these foreign rights are invoked, for example in preliminary or interlocutory proceedings, in proceedings on the merits, or in enforcement or bankruptcy proceedings: see section 2.1.8 above. Conflicts rules and their precise impact are often obscure and the final

Volume 5: Financial Products and Funding Techniques 223 result unpredictable, the more so since it may be unclear in advance where the goods may travel or which court may become involved, for what purpose, and in what procedure. In an international context, there may also be problems in the law applicable to the contractual aspects, all the more relevant if the entire lease is considered essentially contractual. They are likely to arise when lessor and lessee are in different countries rather than when the asset moves. It means, however, that even if the asset moves but the lessor and lessee remain in the same country there should not be any consequence for the contract. If the lease was always merely contractual in the country of origin, nothing much may change from that perspective, but especially for longer leases the country of destination might still assume proprietary consequences. Further problems may arise if the supplier is elsewhere. There may be more readily available contractual conflicts rules, in the EU notably under the 2008 Regulation succeeding the Rome Convention of 1980 on the Law Applicable to Contractual Obligations, followed earlier by a similar project of the Hague Conference, updated in 1986. The law of the party performing the most characteristic obligation is then likely to prevail, which may well be the law of the lessor (and his tax haven). However, in tripartite structures where each of the three parties (lessor, lessee and supplier) may be in a different country, there is no clear conflicts rule that will bring about the desirable dovetailing of the law applicable to the supply contract and to the lease, as the characteristic obligation under each is different and the party performing it in each case is different as well. A contractual choice of the same law in both the lease and supply contracts may help but is not always achievable. If the lease operates behind a trust it is even conceivable that the 1985 Hague Trust Convention applies: see Volume 4, section 1.8.4.

2.4.5. Uniform Substantive Law: The UNIDROIT (Ottawa) Leasing Convention of 1988. Its Interpretation and Supplementation The uncertainty which results both from the confusion that exists with regard to the proper status of leasing under many national laws and the absence of clear conflicts rules in the proprietary/ enforcement and contractual/collateral aspects of financial leasing if considered a tripartite arrangement, may be particularly undesirable when leasing occurs in an international context. This was the reason the finance lease caught the attention of UNIDROIT in the early 1970s and this organisation subsequently perceived a need for an international unification of the basic terms by providing for uniform law in the form of a treaty. The ensuing Convention of 29 May 1988 came to fruition at a diplomatic conference in Ottawa after 14 years of preparation, in which at first (until 1985) the approach of uniform rules—each time to be contractually incorporated—rather than of a Convention producing uniform law was favoured. The contractual approach could still have raised problems in the proprietary aspects, which are normally not considered determinable by a contractual choice of law. Hence the preference for treaty law. At the end of 2006, there were 14 signatories to the Convention, including three EU countries and the US as major industrial nations. So far there have been nine ratifications (France in 1991, Italy in 1993, Nigeria in 1994, Hungary in 1996, Latvia in 1997, Panama in 1997, the Russian Federation in 1998, Belarus in 1998 and the Republic of Uzbekistan in 2000). The Convention became effective in May 1995, six months after the third ratification. It is only a partial codification and is further subordinated to any other present or future treaty law in any of its aspects (Article 17), relevant for example to the CISG in the area of the supply agreement. Even before it entering into force, the Convention created some considerable interest in legal scholarship and contributed to a better understanding of the finance lease as a major modern

224 Volume 5: Financial Products and Funding Techniques financial instrument, although it may be doubted whether the rather fundamental differences in approach between common and civil law, and therefore the characterisation issues, were properly considered.362 The Convention is clearly the product of many different views and various compromises, which have not contributed to its clarity. Particularly in the demarcation from the operational lease and in the proprietary aspects of the finance lease, the Convention has not been able to provide much light, and doubt remains as a consequence, especially on the proprietary position of the lessee, probably because such doubt was not lifted in the US either, in Article 2A UCC, which was formulated during the same period and served as an example. The major innovation of the Convention, which here follows the US model, lies indeed in the collateral rights it gives the lessee against the supplier of the leased assets with whom the lessee normally has no direct contractual relationship. Real-estate leasing was excluded from the start as it is less likely to be internationalised; so was any leasing for personal, family or household purposes. Operational leasing was covered at first but ultimately deleted. As purely contractual arrangements, operational leases were believed not to give rise to substantial international complications incapable of solution under existing conflicts laws, even though, as suggested earlier, the borderline is by no means always clear, even under the Convention, and the deletion is likely to create problems. For this reason, it was criticised by the US representatives who probably wanted something even more like their equipment lease. The Leasing Convention, according to its Preamble, is only an attempt at formulating ‘certain uniform rules relating primarily to the civil and commercial law aspects of international financial leasing’. It concentrates in fact mainly on some contractual and collateral aspects and is incidental in the ownership and enforcement aspects. In these latter aspects it contains some uniform conflicts rules, limited, however, as we shall see below, to the narrower issues of the law applicable to any publication requirement of the lease (Article 7) and to the question whether the lease asset has become a fixture (Article 4(2)). Beyond these few instances in which a conflicts rule is given, the rules of the Convention are supplemented by the general principles on which it is based before the normal private international law rules are to be applied (Article 6(2)). This language was borrowed from the CISG. The deduction of these general principles would be of particular interest in view of the incidental coverage of the Convention, more particularly so in the proprietary and enforcement aspects, where contractual provisions including a contractual choice of law may be ineffective. Yet the Convention does not provide much of a framework in these and other aspects and general principles appear to be particularly absent in the proprietary area. Thus, there is heavy reliance on private international law; also, it seems in all aspects of doubt on the 362 See MJ Stanford, ‘Explanatory Report on the Draft Convention on International Financial Leasing’ [1987] Uniform Law Review I, 169, hereinafter ‘Explanatory Report’, and further (among many others): RM Goode, ‘The Proposed New Factoring and Leasing Conventions’ [1987] Journal of Business Law 219, 318, 399 and ‘Conclusion of the Leasing and Factoring Conventions’ [1988] Journal of Business Law 347; El Mokhtar Bey, ‘La Convention d’Ottawa sur le crédit-bail international’ in II Etudes et Commentaires 15643, 726 (1989); M Reinsma, ‘UNIDROIT Convention on International Financial Leasing’ in WM Kleijn et al (eds), Leasing, Paper, Netherlands Association ‘Handelsrecht’ (Alphen aan den Rijn, 1989) 66; CT Ebenroth, ‘Leasing im grenzüberschreitenden Verkehr’ in EA Kramer (ed), Neue Vertragformen der Wirtschaft: Leasing, Factoring, Franchising (Bern, 1992) 117, 192; C Dageförde, Internationales Finanzierungsleasing in Europäisches Wirtschaftsrecht, Abteilung A: Monographien Band 2 (Munich, 1992) 97, which also contains an extensive bibliography on the subject; D Levy, ‘Financial Leasing under the UNIDROIT Convention and the Uniform Commercial Code, A Comparative Analysis’ (1995) 5 Indiana International and Comparative Law Review 267; and F Ferrari, ‘General Principles and International Commercial Law Conventions. A Study of the 1980 Vienna Sales Convention and the 1988 UNIDROIT Conventions on International Factoring and International Leasing’ (1998) 10 Pace International Law Review 157. See more recently R de Koven and B Hauck, Commentary UNIDROIT Model Law on Leasing (Oxford, 2008).

Volume 5: Financial Products and Funding Techniques 225 coverage of the Convention. In view of its rudimentary character, the unity it brings is therefore likely to be very limited. In matters of interpretation (assuming it can be distinguished from supplementation or gap filling under Article 6(2)), Article 6(1) refers to consideration of the object and purpose of the Convention as set forth in the Preamble, of its international character, of the need to promote uniformity in its application, and of the observance of good faith in international trade. This language is also derived from the CISG and is typical for contractual matters. It was already said in sections 2.1.9 and 2.3.6 that the meaning and significance of this language in proprietary and enforcement aspects is unclear and the reference to good faith inappropriate. In a proper internationalist approach, the reference in respect of both interpretation and supplementation should have been to the international character of the Convention, its general principles, the need for its uniform application, and to international practice and custom as has already been submitted in connection with the CISG (Volume 3, sections 2.3.6 and 2.3.7). In any event, the application of a Convention of this nature should be achieved within the hierarchy of the lex mercatoria as a whole (see Volume 1, section 1.4.14), which leaves room for the application of private international law rules only if all else fails.

2.4.6. The Leasing Convention’s Sphere of Application, its Definition of Finance Leasing The Convention applies only to international leases. According to Article 3, the international status of leasing is normally considered to be triggered by the residence or place of business of the lessor and lessee being in different Contracting States rather than by the location or movement of the lease asset. This is also the approach of the CISG with the additional requirement in the Leasing Convention that the supplier is also from a Contracting State or that both the supply and leasing agreement are governed by the law of a Contracting State (which can be so chosen by the parties). It follows that the lease asset itself need not be in a Contracting State. This approach is understandable in the contractual aspects to which the CISG was limited, but much less so in the proprietary and enforcement aspects, important in questions of leasing, in which location and especially movement of the asset are the more essential issues. As a practical matter, the Convention can only provide solutions in proprietary and enforcement matters if the jurisdictions where the assets are located or move to are Contracting States, notwithstanding the definition of its sphere of application in Article 1 (unless there is recognition of its regime in non-Contracting States where the lease asset is located, which seems unlikely). The lex situs of third countries cannot be affected by the Convention, whatever the latter may pretend in proprietary and enforcement matters in respect of assets elsewhere, although it may still limit the parties in their own dealings concerning the assets among themselves. On the other hand, it follows from the approach of the Convention that the proprietary status of the assets in Contracting States may be subject to its regime even if they never move, which may also be somewhat surprising. It was the reason for excluding real-estate leasing from the Convention’s scope. But even if they move, that may not make the lease international in terms of the Convention. It follows that where the lex situs is changed as a result of the asset moving between Contracting States, finance leases not covered by the Convention (for example because the lessor and lessee are in the same Contracting State) may be treated differently in the proprietary and enforcement aspects in the relevant Contracting State that receives the asset. It fractures the proprietary and enforcement regime between leases covered by the Convention and those that are not so covered (in view of the narrow contractual definition of the scope). Again, this regime for lease assets

226 Volume 5: Financial Products and Funding Techniques covered by the Convention is dependent on the place of business and the will of the (foreign) participants in the lease rather than on the location of the lease asset, which will apply to the others that equally move to the Contracting State in question. The definition of finance leasing under the Convention is in any event vague and must be seen as guidance rather than as a clear legal demarcation circumscribing the Convention’s applicability (Article 1). This is immediately clear where: (a) the text refers to plant, capital goods or other equipment as the object of the supply agreement in the context of the financial lease; (b) the lessee is not supposed to be primarily dependent on the skill and judgement of the lessor in selecting the lease assets; and (c) the rental payments are supposed to take into account in particular the amortisation of the whole or of a substantial part of the cost of the equipment; while (d) there may or may not be an option to buy the equipment whether or not for a nominal price. It is clearer still from the absence of any particular concept of the finance lease either in its contractual, proprietary or enforcement aspects. Key elements appear nevertheless that: (a) the lessee sets the specifications and approves the supply agreement at least in so far as it concerns his interest (undefined), even though the lessee is not supposed to countersign it, while s/he may still rely on the lessor’s skill and judgement and the latter’s intervention in the selection of the supplier or the goods, although not primarily so (Article 8); (b) the lessor acquires the lease assets while granting the lessee the right of use and putting him in possession of the assets against payment of rentals; and (c) the rentals must substantially amortise the acquisition costs. There is no reference to the lessee acquiring the use of the asset for substantially all of its useful life, which, however, seems implied in the amortisation requirement.363 As already mentioned, there is neither an automatic transfer of ownership to the lessee at the end of the lease nor an option. Here the Convention appears to recoil from giving legal significance to the notion of economic ownership. It also appears that economic ownership in terms of care for the lease assets is not fully put on the lessee, although this could of course be agreed in the lease contract, as will normally be the case. In fact, as the risk is usually insured it was believed better to leave the insurance duty to contractual stipulation.364 Although it is altogether possible to get some idea of the Convention’s notion of finance leasing, the Convention gives the impression that it does not want to be pinned down, and uses at the beginning of Article 1 advisedly the word ‘describe’ rather than ‘define’. The result of this approach is that no true legal notion of the finance lease emerges, whatever the intent, reinforced by the incidental nature of the provisions, especially in the proprietary and enforcement aspects. The most notable result is extra doubt on the borderline with the operational lease, which is not covered, and with bipartite lease situations, which are also outside the scope of the Convention.365 Where the lessee receives the assets directly from the supplier before the lease agreement is signed, there may also be some doubts about the applicability of the Convention. The leaseback appears excluded altogether as the lessee has in that case fully negotiated and signed the supply agreement, taken possession and most likely become the owner in the process, although possibly subject to a reservation of title. There must even be doubt on the applicability of the Convention when the lessee has co-signed the supply agreement. The Convention requires that the lessee knows of and agrees with the terms of the supply agreement, but there is no reference to him (counter) signing it when the provisions concerning his collateral rights would in any event be superfluous. On the other hand, it remains unclear what the minimum level of involvement of

363 See also Explanatory Report (n 362) 40 (no 70). 364 ibid 61 (no 114). 365 ibid 32 (no 52).

Volume 5: Financial Products and Funding Techniques 227 the lessee in the supply agreement must be. It is a further indication that the facts of the case need to be carefully considered in each instance to determine whether the Convention may apply, not necessarily a happy situation. The factual approach is also the attitude of the UCC in the US (section 1-201(a)(35), 1-201(37) old) but is there only to distinguish between the finance lease and a secured transaction. As mentioned before, consumer leasing is clearly excluded from the Convention: Article 1(5). From the reference to the parties’ place of business in Article 3, it is also clear that the Convention considers leases only among businesses or professionals. As already mentioned also, real-estate leasing is not contemplated either,366 although the application of the Convention does not cease merely because the equipment has become a fixture to, or is incorporated in, land: Article 4(1).

2.4.7. The Proprietary Aspects of Finance Leasing under the Convention The Convention notably avoids any clear statement on ownership and possession except in the context of granting quiet possession to the lessee (Article 8(2) and (4)), which is a different and, in the context of the Convention, factual concept. As regards the lessor, the Convention states that the lessor ‘acquires’ the equipment (Article 1(1)(a)), while Article 7 assumes that the lessor has real rights without defining them (earlier the term ‘ownership’ was deleted), while only Article 8(1)(c) suggests the possibility of ownership in the lessor. The Convention does not exclude the possibility of subleasing (Article 2) and supposedly also not the possibility that the lessor acquires the asset subject to a reservation of title by the supplier depending on the payment terms between them. However, it avoids any consideration of the proprietary relationships also in that case. The lessee’s right is generally expressed in terms of the use of the equipment in return for payment of the rentals, without any reference to a term or to the useful life of the lease assets (Article 1(1)(b)). It might follow from the amortisation reference in Article 1(2)(c) (not necessarily so considered in the US, however).367 As there is no need for a lessee’s option to buy the equipment (Article 1(3)) or an automatic right to acquire full title upon payment of all the rentals, no proprietary implications (in terms of a conditional ownership) can be deduced from such an option either. More important is probably that in the case of default by the lessee or upon termination of the lease, there is no automatic return of the asset to the lessor: Articles 13(2) and 9(2) respectively. On the other hand, there is no foreclosure in the case of default either; if the default is substantial there is a right of termination and repossession for the lessor, the conditions and status of which repossession right are not further defined or described. Repossession suggests nevertheless some proprietary protection of the lessee, perhaps further borne out by the transfer provision of Article 14, under which the lessor cannot thereby alter the nature of the lease. The transferring lessee, on the other hand, requires the prior consent of the lessor. As his transfer will normally involve the asset itself, the Convention expressly states that such a transfer remains subject to the rights of third parties (Article 14(2)), as is presumably the case for reservations of title of suppliers and rights of head lessors, but also to claims to full title by bona fide purchasers from the lessee.

366 This follows from the text of Art 1(1)(a), which refers to equipment; see also Explanatory Report (n 362) 36 (no 63). 367 See s 1.6.3 above.

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2.4.8. The Enforcement Aspects in Finance Leasing under the Convention This leaves us with Article 7, applicable in enforcement situations. It is probably the most interesting Article of the Convention, the subject of much debate and the result of a myriad of compromises. It allows the lessor to maintain his real rights (whatever these may be) against a trustee in bankruptcy of the lessee (without further definition of the type of insolvency or related procedure) or in individual enforcement action of any of the lessee’s creditors. It is certainly noteworthy that the Convention, contrary to earlier proposals, gives this facility only in enforcement, not therefore in proceedings on the merits or in injunctive proceedings and probably also not in reorganisation proceedings in anticipation of insolvency or in preservation measures. More importantly, it does not mention similar rights in terms of ownership, possession or even use of the lessee in enforcement actions against the lessor. One may deduce from Article 14 that in that case ownership may be transferred to third parties without affecting the lease, but one cannot be sure, and it would in any event suggest that the lessee has then more than purely contractual rights, as already discussed in the previous section. If under the applicable domestic law (as determined by the Convention) the validity of the lessor’s real rights depends on publication, compliance with that requirement is under the Convention a precondition for the real rights of the lessor to be asserted in enforcement (also, apparently, if the goods have moved to another country). One must assume that this is relevant only if enforcement is in a Contracting State. In this connection there is also a jurisdictional question, which may be differently resolved in preliminary attachment proceedings as a preservation measure (if meant to be included in Article 7 at all), execution proceedings, and in bankruptcy. In order to find the applicable law in connection with this publication requirement, a uniform conflicts rule is given in Article 7(3), referring to: (a) the law of the place of registration for ships and aircraft; interestingly (b) the law of the residence of the lessee for other equipment meant to move; and (c) the lex situs for the rest. In the meantime, these provisions concerning publication are the nearest pointer to the financial lease being also covered by the Convention if considered a type of secured transaction under applicable law. Only in that connection would publication seem to become relevant. It leaves the question why the Convention insists on publication for such leases under applicable domestic law even when assets have moved to another Contracting State. Nobody outside the country of publication can possibly derive much protection from it, except if willing to conduct a costly and (for him) unfamiliar search. It is of interest in this connection that, although the lessee’s creditors with proprietary protection are not meant to be affected by this regime in their priorities in the lease assets (Article 7(5)), bona fide purchasers are not mentioned nor any repossession rights of the lessor or any rights in the lease assets of head lessors—cf also the wider provision of Article 14(2). The Convention clearly did not want to go into these details,368 nor, as we have seen, into any ownership claim of lessor or lessee. For these interested parties (as for any others) there are at most the general principles on which the Convention is based, which, as suggested above, are not much developed and otherwise the normally applicable conflicts rules, which, as also earlier suggested, may not be very clear when lease assets are moving. The uniform conflicts rule for publication set out in Article 7 of the Convention in any event does not appear indicative of any general principles on which the

368 Explanatory Report (n 362) 51 (no 93).

Volume 5: Financial Products and Funding Techniques 229 Convention is based and cannot therefore apply more universally in the proprietary and enforcement aspects of finance leases covered by the Convention. In fact, it is likely that in the case of disputes the modest uniformity the Convention brings will be overwhelmed by private international law issues.

2.4.9. The Contractual Aspects of Finance Leasing under the Convention The basic assumption of the Convention is that parties will normally make their own arrangements. This notion is supported by Article 5, which allows exclusion of the applicability of the Convention altogether, but only when all parties, including those to the supply agreement, agree. It is a reconfirmation of the tripartite principle underlying the finance lease in the eyes of the Convention, but so rigorously applied it is probably a novel departure. Without this clause, not all provisions of the Convention would appear directory, therefore at the free disposition of the parties, particularly the proprietary and enforcement references. The likely result of exclusion is that the rights of the lessor are weakened, probably also in respect of third parties, who are therefore not adversely affected, but it should be doubted whether proprietary or other thirdparty or creditors’ rights could be impacted by an exclusion of the Convention’s applicability by participants in this manner. It would suggest that the proprietary and enforcement aspects of the Convention, modest as they may be, are in essence contractualised. Short of full exclusion, the parties may ‘in their relations with each other’ also derogate from the Convention, therefore without the consent of any other party not part of that relationship. It also allows the contractual derogation from any individual provisions concerning proprietary rights, such as the one in Article 7, although presumably only as long as third parties are not adversely affected.369 Also the interpretation and supplementation provision of Article 6 could thus be varied. Yet there are three instances in which even then derogation (short of full exclusion) is not possible. These mandatory rules concern first any exception to the warranty of quiet possession in the case of gross negligence of the lessor, an exclusion thought in principle to be allowed under common law (Article 8(3)). Second, any agreement requiring a defaulting lessee to pay damages that put the lessor in a better position than s/he would have been in if the lessee had fully performed the lease agreement is voided (Article 13(3)(b)). Finally, where the lessor has terminated the lease agreement, s/he is not entitled to acceleration of the rentals except in the context of computing damages (Article 13(4)). Although one can understand the gist of these mandatory rules, one may doubt whether they are appropriate or necessary among professionals to whom the Convention is limited. As for the directory contract rules of the Convention, there is no particularly coherent pattern in the provisions. The main obligations of the parties are particularly for the lessor to grant the lessee the right to use the lease assets and for the lessee to pay rentals to the lessor. They are not further detailed, and the Convention limits itself in fact to a number of secondary (though important) issues. Article 8(1) states that the lessor shall not incur liability to the lessee in respect of the equipment, except to the extent that the lessee has suffered loss as a result of his reliance on the lessor’s skills (apparently with or without the lessor’s knowledge) and to the extent of the latter’s intervention in the selection of the supplier. This limitation is balanced for the lessee by

369 ibid 78 (no 149).

230 Volume 5: Financial Products and Funding Techniques his direct action against the supplier under Article 10. It puts the main burden of performance on the supplier, to which Article 8(2) and also Article 12 in the case of non-conform delivery are, however, important exceptions.370 In his capacity as lessor, the latter will also not be responsible for any third-party liability in respect of injury or damage caused by the equipment, but s/he may be so liable as deemed owner, for example under applicable product liability statutes. Article 8(2) contains the lessor’s warranty of quiet possession (subject to any broader warranty mandatory under the law applicable pursuant to the rules of private international law) except against rights derived from a lessee’s act or omission, a provision which, as already mentioned, cannot be varied in respect of any superior rights of third parties derived from an intentional or grossly negligent act or omission of the lessor. To the extent that it implies a warranty beyond the consequences of the lessor’s own behaviour, this approach was criticised at the time for putting a responsibility on the lessor not deemed compatible with his passive role in the supply of the lease assets.371 It is certainly to be noted that in this respect Article 8(2) goes beyond the approach of Article 8(1). Article 9 requires the lessee to exercise normal care in the use of the equipment while Article 13 finally deals with default of the lessee. The normal feature is here that the lessor may recover any unpaid rentals together with interest and damages. The special feature is that in the case of substantial default (not, however, defined) the lessor may accelerate future payments if the lease contract so provides, while leaving the lessee in possession for the agreed period, or otherwise terminate the agreement and immediately recover possession, apparently without further formalities, while also claiming damages so as to place him in the same position as would have resulted from full performance. This may include the remaining rentals but would also have to discount the remaining value of the assets for the lessor, who is under a duty to mitigate: see Article 13(6). It may well mean entering (if possible) into a replacement lease, which is then likely to be an operational lease. The contract may liquidate these damages, provided they do not result in a figure substantially in excess of those resulting from the Convention, a provision which may not be varied by the parties either. The lessor must make a choice and may not do both—accelerate payment and terminate with recovery of possession—and may in any event do neither before s/he has given the lessee a reasonable opportunity to remedy his default, without the Convention clarifying what this entails. The right to terminate and immediately recover possession without further proceedings was explicitly made an alternative in order to avoid any doubt on this facility, which is crucial and might not have existed under common law. The acceleration principle also needed confirmation in the US. Section 2A-109 UCC already allows it when the lease contract is substantially endangered.

2.4.10. The Collateral Rights in Finance Leasing under the Convention As mentioned before, the Convention is, at least for Europeans, exceptional in its clear acknowledgement of the tripartite nature of the finance lease, following in this respect the modern US approach, and draws clear consequences from this state of affairs in Articles 10, 11 and 12 by treating the lessee largely as a party to the supply agreement, even though s/he is not supposed to have signed it.372 S/he may still have substantially relied on the guidance of the lessor, and is

370 See further s 2.4.10 below. 371 See comment by E Gewirtz and J Pote [1998] International Financial Law Review 24, 25. 372 Explanatory Report (n 362) 62 (no 116).

Volume 5: Financial Products and Funding Techniques 231 in any event only supposed to have approved the terms in so far as they concern his interests. The manner in which his approval of the supply agreement must be expressed is left open (see Articles 8(1)(a), 1(1)(a) and 1(2)(a) respectively). Article 10 states that the duties of the supplier to the lessor shall also be owed to the lessee as if s/he were a party to the supply agreement, the same as if the equipment was directly supplied to him, but presumably only to the extent that these duties concern him. This is supported by section 2A-209(1) UCC, which introduced a similar approach, also abandoning the contractual privity notions in this connection. The lessee does not, however, have any right to terminate (or presumably vary) the supply agreement without the consent of the lessor: Article 10(2). On the other hand, Article 11 makes it clear that the lessee is not bound by any later variations in a previously approved supply agreement to which s/he has not consented. Naturally, the supplier is liable for damages to either the lessor or the lessee and not to both (Article 10(1)) but otherwise the relationship between the lessor and the lessee in their claims against the supplier is not covered. While Article 10 gives the lessee the direct rights which the lessor may have against the supplier, it does not appear that the lessee owes the supplier any duties which the lessor may have had under the supply agreement, notably the obligation to pay. However, the lessee will have to accept any exceptions the supplier may derive from his relationship with the lessor, especially when the latter is in default of payment, in which case the lessee can no longer insist upon the performance of the contractual duties by the supplier vis-à-vis him. It appears, however, that any exceptions derived from the lessor’s behaviour in other contracts with the supplier cannot be used as an excuse for the supplier’s duties vis-à-vis the lessee under Article 10. Finally, Article 12 examines the non-conformity of the delivery, either, it seems, at the time of delivery or surfacing later. While not affecting the lessee’s direct rights against the supplier under Article 10 (see also Article 12(6)), for the lessee there is here an action against the lessor either to reject the equipment or to terminate the lease, subject to the lessor’s right to remedy the default for which, however, no time frame has been set. In either case, the rights of both parties are as if the lessee had agreed to buy the equipment from the lessor on the terms of the supply agreement. The defences of the lessor, including force majeure, would then derive from this agreement; bankruptcy of the supplier would not be one of them, nor would the inability to obtain similar equipment if under the law applicable to the contract the risk had not yet passed and the goods had perished or if, after delivery and the passing of risk, hidden defects emerged. Because of this particular construction which assumes the direct applicability of the supply agreement between lessor and lessee, one could ask oneself which law applies here as regards the remedies, defences and the passing of the risk. Is it the one of the supply agreement under which the supplier performs the characteristic obligation or should the lessor be substituted for this purpose? If there is a contractual choice of law in the supply agreement, would it also be effective in this case? Similar questions may be asked under Article 10, where, however, the duties of the supplier are the issue. They will normally be covered by the law applicable to the supply contract.373 There are also some uniform rules in Article 12: the lessee may withhold the rentals until the lessor has remedied the default or the lessee has lost the right to reject the equipment. If s/he terminates the agreement and claims damages, s/he has the right to reclaim any payments less any benefits derived from the equipment. S/he has, however, no other claims against the lessor except as result of the latter’s act or omission. Wherever the CISG applies (which assumes that the supply agreement should be considered a sale) conflicts rules are avoided and there will be more clarity, 373 Dageförde (n 362) 153.

232 Volume 5: Financial Products and Funding Techniques but only in the aspects covered by that Convention. In the case of conflict, the CISG will prevail over the Leasing Convention, according to Article 17 of the latter. While the Convention elaborates on the collateral rights of the lessee under the supply contract in the above manner, it is of interest that there are no provisions at all on the direct relationship between the lessor and supplier. National laws resulting from the applicable conflicts rules must provide the answers. They may easily differ. The tripartite nature of the arrangement nevertheless begs the question what the precise relationship is between the lease, the supply agreement, and the parties thereto. This is particularly important if one of these contracts fails (for example, for reasons of invalidity or force majeure). The Convention does not cover this point, but it could be assumed that the lease agreement is ancillary to the supply agreement even if the latter is concluded later and is therefore dependent on it and fails with it. It may, however, also be argued that the supply agreement depends on the lease, at least to the extent that the supplier is aware of the situation, which will normally be the case, so that there is mutual dependence. This may fit better with the tripartite approach of the Convention.374

2.4.11. Domestic and International Regulatory Aspects Except in private law legislation concerning the characterisation and operation of the modern finance lease in the very different ways discussed above, finance leasing has not so far attracted much public concern or regulatory interest and has remained largely scandal-free.

2.4.12. Concluding Remarks. Transnationalisation It is clear that there are considerable characterisation problems with finance leases and that there are great differences in approach between different countries. This largely has to do with the proprietary aspects and with the lack of experience, especially in civil law, with conditional sales and transfers. In that sense, it is an aspect of the closed system of proprietary rights in civil law countries. Only when at the transnational level the proper questions are asked in terms of the contractual and collateral rights and duties and especially on the proprietary/execution side of the structure, can the finance lease be properly explained and function internationally. At least such insights would operate as a proper critique of what is from time to time proposed. Internationally, the UNIDROIT Convention was meant to provide greater clarity, but ultimately it only managed to cover a narrow field. It does not apply to the operational lease, the leaseback, and probably also not to any other arrangement where the lessee receives the goods from the supplier before the lease agreement has been concluded, or to situations where the lessee is a co-signatory of the supply agreement, or where there is no supplier involvement at all, as in the case of the leaseback. Consumer and real-estate leases are in any event excluded. As especially in relation to the operational lease, the demarcation line remains unclear, the facts of the case will continue to play an important role in determining the applicability of the Convention, which, in the absence of much guidance on what a lease is, introduces considerable uncertainty. The Convention further requires that the lease contract is concluded between parties having their place of business in different Contracting States, while the supplier must also be from a Contracting State, or that both the lease and supply agreement are governed by the law of a Contracting State (which can be so chosen by the parties). Cross-border leasing in this sense 374 Explanatory Report (n 362) 109.

Volume 5: Financial Products and Funding Techniques 233 is, however, exceptional, and is only likely to exist in very major capital goods such as aircraft, aircraft engines and their spare parts, and possibly ships. Generally, leasing companies have subsidiaries in the place of the lessee or vice versa or are otherwise incorporated in tax havens, which are not so likely to become Contracting States. These factors will limit the impact of the Convention further.375 The Convention, moreover, contemplates only a partial codification.376 It does not manage to present a coherent notion of the finance lease, probably because it was not able to choose between the basic models and could not bridge the gap between countries, like the US, that limit the proprietary rights of the lessee for fear of creating a secured transaction, and place emphasis instead on the collateral rights of the lessee under the supply agreement, and those countries, especially from the civil law, that enhance the proprietary rights by assuming or requiring an option for the lessee to acquire full title upon payment of all the instalments or an automatic transfer of full title to the lessee at that time.377 Altogether, the Convention is the product of greatly diverging views on its scope and coverage presented at the various drafting stages. It has resulted in a lack of clear legal criteria all around, which significantly limits the Convention’s usefulness,378 quite apart from its limited scope. It may indeed be asked whether it is right for any state to tie itself by treaty (which cannot easily be changed) to such an incomplete and vague regime.379 Also in this area, progress may now only 375 In proprietary and enforcement matters, notwithstanding the limited coverage of these aspects in the Convention itself, the Convention does not appear to be applicable if the situs or place of enforcement is not in a Contracting State. This raises jurisdiction questions. They may be resolved differently, depending on the type of procedure: injunctive, on the merits, or enforcement. In the last instance, there may be further differences in the case of preliminary attachments as provisional or preservation measures (if meant to be covered by Art 7 at all), executions and insolvencies or bankruptcies. 376 Where the Convention does not succeed in formulating uniform law, a uniform conflicts rule is sometimes given, as in the just-mentioned aspect of the law applicable to publication or in the question of the lease asset having become a fixture to or incorporated in land (Arts 7 and 4). The applicable law is otherwise left to be deduced from the general principles underlying the Convention, which, in the absence of a comprehensive notion of the finance lease itself, may hardly exist, certainly in the proprietary aspects. Barring any such principles, the normally applicable (not uniform) domestic conflicts rules remain in force, and will therefore continue to be relevant in most instances. Notably the uniform conflicts rule given for publication would not appear to have any further relevance in proprietary matters. However, the uniform substantive rules given for the collateral aspects of the lease may well prove to provide more of a system, based as they are on the tripartite notion of the lease and contractual dependency of the lease and the supply agreement. 377 It is to be noted that, with the exception of three incidental mandatory rules meant to protect the lessee against any misbehaviour of the lessor, of which the need may well be questioned in dealings among professionals, the Convention contains only directory or so-called default rules, which may be set aside by the parties in their contract. In view of the sophistication of most lease agreements, which are greatly standardised, it must be assumed that this normally happens in most aspects. The entire Convention can, on the other hand, only be excluded by the agreement of all three parties to the lease. This would then also affect (any) proprietary and enforcement aspect involving third parties. Again, this is less understandable and presents a further limitation of the effect of the Convention. It is another indication that the Convention’s impact, at least in the important proprietary and enforcement areas, has not always been fully thought through. 378 What is altogether left of any real effect that may be anticipated from the present Convention in terms of uniformity across borders in international leasing appears to be modest. That would be so even if the Convention were widely ratified, tripartite cross-border leases were frequent, and were not normally fully determined in the lease contract itself (except for formation and avoidance, proprietary and enforcement aspects). On the other hand, an effort of this nature unavoidably involves compromise in which conceptual clarity suffers. This shows here in the limited detail in the coverage of the contractual, and particularly of the proprietary and enforcement, aspects. 379 Even where the Convention appears to take a view as in the acceptance of the modern tripartite nature of the scheme and, as a consequence, puts emphasis mostly on the lessee’s collateral rights under the supply agreement, it cannot clearly say what kind of involvement the lessee is to have in the supply agreement. The Convention may not even apply if there is either too much in the sense that the lessee becomes a signatory, or too little when there

234 Volume 5: Financial Products and Funding Techniques be expected from further transnationalisation in which the Ottawa model is not likely to play a great role. The structure of a conditional sale and transfer is valid and needs further elaboration, particularly in the proprietary and bankruptcy aspects. Here the 2001 Mobile Equipment Convention may hold out greater promise in clearly covering finance sales, including the finance lease, but only for limited classes of assets: see more particularly section 2.1.10 above. In Europe the DCFR has a section on leasing: see Volume 4, section 1.11.4. In conclusion, it would appear that the true transnationalisation of the law in this area under the modern lex mercatoria as perceived in this book with its various sources of law and their hierarchy now presents a better answer. It puts heavy emphasis on industry custom and practices supplemented by general principle and party autonomy as a limited facility to create proprietary rights subject to the protection of bona fide outsiders in the international flows of assets to the extent they are habitually leased.

2.5. Asset Securitisation and Credit Derivatives. Covered Bonds 2.5.1. Asset Securitisation and Financial Engineering. The Problem with Assignments Securitisation presents an important modern facility to remove risk from a balance sheet. It is particularly relevant for commercial banks, which may in this manner remove classes of loans, like mortgages, student loans or credit card balances. It may also be of importance to industrial companies, for example car manufacturers, who may move receivables or car loans they gave to their customers or dealers in this manner. The reason for banks to use this facility is often concern about capital adequacy or liquidity needs in respect of certain classes of loans. By moving such loans, they reduce their capital requirements in respect of all risks connected with these assets (especially counterparty or credit risk, position or market risk, and all liquidity risk, even operational risk). They may also see advantages in acquiring other types of loan assets instead, or in simply going liquid. They may even want to pay off some borrowings of their own. For industrial companies, asset securitisation frees up and shortens their balance sheet which may be for them the main purpose and allows them subsequently to give more loans. It is of course also possible that selling these assets presents a profit, although that is seldom the prime consideration.380 Thus, especially for banks, asset securitisation has become an important risk management tool. At the heart of such a securitisation is first the transfer of loan assets or similar claims to a special purpose vehicle or SPV created to the effect. As the assets concerned are usually contractual rights, like loan assets or receivables, they must be separated from the contract out of which they arise and can only be transferred to this vehicle through assignment or novation. It has already been pointed out that to clarify the situation and commit the debtor fully, in theory a novation may be the better way. It terminates the underlying contracts and eliminates problems there may be in respect of any remaining residual contractual obligations, for example any duty may be only an operational lease. Where the Convention insists on the costs of the lease asset being substantially amortised in the rentals, it will not say either that the lease is meant for substantially the useful life of the asset. It proved not even willing or able to spell out that the full economic burden in terms of risks and costs is borne by the lessee. Although from the warranty of quiet possession in Art 8 it appears that the lessor may be less passive in the eyes of the Convention than is normally assumed, one cannot be sure. 380 See also SL Schwarcz, ‘The Universal Language of Cross-border Finance’ (1998) 8 Duke Journal of Comparative & International Law 235.

Volume 5: Financial Products and Funding Techniques 235 to extend further credit under old loan agreements out of which the particular loan being transferred arose. The consequence of novation is that the old contract disappears, and a new contract is created, fully releasing the old creditor, normally the bank. However, novation is a tripartite agreement, which requires in respect of each indebtedness the consent of the debtor/borrower, who therefore holds a veto. An important side-effect is that all (accessory) personal and real security interests protecting the claim are released at the same time and would have to be renegotiated. Even then, the original rank would be lost, and other secured interests would move up. Because of each debtor’s consent requirement and the loss of all collateral (and its rank), novation is unlikely to be a feasible route, certainly not when a whole portfolio of financial assets is to be transferred in bulk, as novation always requires separate action in respect of each debtor, each of whom must be handled separately. Thus, securitisation of a large loan portfolio through novation is impracticable, and would also be costly. That leaves us with the assignment option. It poses the considerable problems inherent in assignments, more fully discussed in Volume 4, section 1.5 and, with reference to bulk assignments, summarised in sections 2.2.4 and 2.3.1 above. The key is severability or the separation of the cash flows from the underlying contracts out of which they arise, here mainly loan agreements, the liquidity and transferability of these monetary claims (to repayment of principal and interest payments), the effect of any transfer or assignment restrictions in the underlying agreements, and the excuses of the debtor (for example a debtor’s right to a set-off against the assignor to reduce the payment to the assignee), the finality of the transfer, and the question of required notice and type of documentation or formalities. Whether security interests protecting such claims are then also automatically transferred is another important issue: see also note 24 above. Another key here is that in the nature of all assignments, only rights not obligations can be transferred (unless closely related and that remains a matter of interpretation) and the underlying contracts remain in place. This may concern regulators who might still find that there remain residual obligations of the bank, for example, under revolving loan agreements, to provide more credit (for example, to extend more advances to students during their period of study), against which capital must then still be held. Other obligations may be deemed to be sufficiently closely related so that they transfer with the claim, like the obligation to release the debtor upon payment or the duty to arbitrate in the case of disputes. In negotiable instruments like Eurobonds, a whole framework of rights and connected obligations may be incorporated in the document and is transferred with it, at least that is the idea, but it is unlikely to happen in the case of an ordinary loan document. Securitisation in terms of capital adequacy relief may then become a matter of negotiation with regulators, especially if the securitisation is large, which it normally is. If many loans are involved, there is an obvious need for the possibility of a bulk assignment. Here again the complication of notification to the debtor arises, especially where under the applicable law it is still required for the validity of the assignment. It renders bulk assignments practically unfeasible. A similar result arises where assignment prohibitions still invalidate assignments. In such legal systems, all individual contracts would first have to be researched to determine whether there is such an impediment. These matters have been discussed before and are here only mentioned to complete the picture. A modern assignment regime will have to deal with these complications, but it was already shown that it is a fact that many legal systems struggle, which still bedevils the securitisation practice. Statutory intervention may be required—see for France section 1.3.6 above. It has already been said several times that modernity means here that in respect of receivables a situation is created in which they are treated as much as possible as negotiable promissory notes (in terms of independence and defences) without, however, the physical element so that an assignment in bulk even of future (replacement) receivables can be made and a reasonable description in the assignment agreement suffices as adequate identification.

236 Volume 5: Financial Products and Funding Techniques To avoid not only novation but also assignment complications, it is not uncommon that another bank or investor takes some interest in a particular pool of loan assets through a kind of syndicated loan book structure or sub-participation. There is then no novation nor assignment need, and the arrangement may take the form of a participation agreement, but could also be a trust under which the new investor becomes a beneficiary of the loan portfolio (against payment of a purchase price). Yet these alternatives do not remove the loans from the bank’s balance sheet and are therefore unlikely to be given full capital adequacy relief. As we shall see in the next section, risk layering may also take this form and that is here more common. In practice, there is therefore the need to securitise instead when, as in factoring and receivable financing, all the problems of assignments and in particular of bulk assignments surface (although not necessarily those arising from the transfer of future assets, as in a securitisation all claims are likely to exist or at least the legal relationship out of which they arise). From a legal point of view, these complications may make the transfer less than certain or safe as far as the payments to the assignee are concerned in respect of whom there may in any event still be any original set-off rights of the debtor against the assignor, although in the original loan agreements, the debtor may have been asked to do away with many of its defences precisely to make securitisations possible. It follows, nevertheless, that the assignor may remain residually involved in often uncertain ways and could therefore retain some risk exposure as the original contracts all remain in place. For the assignee, a key concern is always to ring-fence the cash flow and separate it sufficiently from that of the assignor/bank as a whole. Adequate legal separation is therefore also crucial for him. It has already been said that for bulk assignments to become efficient, there should not be a legal requirement of notification for the validity of the assignment, and many legal systems have been changed to the effect, as we have seen. For the assignee to be paid, however, notification to the debtors would still be necessary as a practical requirement, as until such time, the debtors may still validly pay the assignor. It may still mean thousands of notices. One common way to avoid this problem and facilitate proper and timely payment is for the former creditor/assignor/ bank to continue to collect as the collecting agent for the assignee under the existing loans (as agent only). This is normal (at a fee to the assignor) and also safeguards established banking relationships of assignor-banks. In fact, the loan debtor(s) of a bank may not be informed of the transfer at all. Again, this is possible only under assignment laws or practices that do not require notice to the debtor(s) as a prerequisite for the validity of the assignment. It is often a better way as it leaves the debtors undisturbed and also avoids the issue of assignment restrictions in the underlying loan agreements. It leaves, however, questions of proper segregation, whether the collecting assignor or bank retains some proprietary interest in the cash flow it collects, and what the precise status of the assignee is in any subsequent bankruptcy of the former. There remain here problems and dangers for the assignee. The issue of the nature of an agency for collection purposes was raised in section 2.3.4 above. Naturally, the collection facility exposes the assignee in a bankruptcy of the collecting assignor, certainly if the latter does not set the collections aside sufficiently. But even if the collection agent did so, the assignee may still have problems in civil law. In common law, the natural attitude is to assume a constructive trust with tracing facilities. As the situation may be very different in different countries, normally (to avoid all kind of conflict of laws problems—Volume 4, section 1.9) a class of debtors may be chosen in one single country that has a favourable assignment regime. One must assume that their law is controlling (although that is not undisputed in private international law—see Volume 4, section 1.9.2, and a practical argument can be made that it should be the law of the assignor—see section 2.3.5 above). At least in the rights to the collections, the laws of the assignor, now turned collection agent, are likely to apply, although they may be increasingly transnationalised.

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2.5.2. SPVs and Credit Enhancement The transfer of assets in this manner depends on finding a willing partner or counterparty or assignee, which is often difficult and always causes delays. In securitisations, it is common for a bank/assignor to create its own assignee through the incorporation of an SPV to which the assets are transferred (assigned). It cannot be a subsidiary, as this would lead to consolidation, and it is normally a company whose shares are put in the name of some charitable institution or a trust whose beneficiaries are likewise some charities. They are entitled to a fee and to any remaining liquidation proceeds upon the end of the scheme, which are usually few. The servicer in charge of the entire arrangement will often be the original bank (or originator), which means to remove risky assets in this manner. If the originator is not a bank, it may hire an investment bank to be the servicer for which a fee is paid. The next problem is how the SPV is to pay for the assigned assets. There is no point in the assignor/bank providing it with a loan to make payment possible. It would not reduce the bank’s risk assets; it may even increase them if mortgage debt is removed in this manner and an unsecured loan to the SPV appears instead (which may have a higher risk weighting for capital adequacy purposes). It is normal for the SPV to securitise the deal. This means raising funds in the (international) capital markets through a bond issue—hence the term ‘securitisation’. Securitisation therefore implies access to the capital markets and a public placement of new securities, normally bonds. The mere creation of an SPV to which risk assets are transferred is not therefore securitisation proper, as there is as yet no issuing activity in the capital markets (note that the term securitisation refers here to issuing new bonds and not to collateralisation). Although the term ‘securitisation’ is now often used more broadly for any removal of financial assets from a balance sheet and for layered instruments created in that connection, as we shall see, this is not strictly speaking correct, and may confuse. More importantly, the issuing of bonds at the same time connects banking with the capital markets. This is a vital connection in modern banking, which, in view of its massive scale, could no longer fulfil its liquidity-providing function without it. To be able to do a securitisation and therefore successfully issue and sell its bonds in the capital markets, the SPV must first show a good, valid and uncomplicated assignment, which depends largely on the applicable legal regime, as we have seen (or on the lifting of all assignment restrictions and the surrender of any set-off rights in the texts of the underlying loan agreements), hence again the great importance of modern bulk assignment laws, which must be assignment-friendly. As noted in section 1.3.6, in France a special transfer regime was created in this respect at least for domestic securitisation to so-called Fonds Communs de Creance (FCC), which, since 2008, may also be a company. To access the capital markets, the bonds of the SPV must be investment grade and have a high credit rating and the SPV will normally not be able to obtain this without credit enhancement of its credit standing. The SPV will have to obtain this credit rating from the rating agencies for its senior bonds and these agencies therefore have a substantial say in the structuring of the securitisation, which virtually requires their approval. The objective is usually to obtain a triple A credit rating for the senior class, which is likely to cover at least 90 per cent of all bonds.381

381 The rating agency commonly undertakes a comprehensive assessment of the securitisation process and its management. For the different risks involved, they will often use statistical models including historical data and stress tests, especially to assess non-credit risk which is not truly their expertise—they assess credit risk only, but it will also guide them in the adjustment of their ratings in deteriorating market conditions. In real estate-related schemes eg, this may then also cover the market risk in these assets. As early as 2004 IOSCO issued guidelines for self-regulation of credit rating agencies.

238 Volume 5: Financial Products and Funding Techniques A first step in this credit enhancement process may be collateralisation. The bonds so issued may then be directly supported by the cash flow transferred to the SPV. The cash flow (usually the interest payments and the repayments of principal) will then be used as collateral for the bond holders under a security agreement. It means that the originator, who is likely to remain the collection agent, sets these moneys aside, not transferring them to the SPV, but keeping them for bond holders directly as their security. Hence, also the notion of asset-backed securities (or ABSs), which are bonds specially protected by this cash flow and repaid out of it. These cash flows themselves may derive from mortgages (resulting in mortgage-backed securities or MBSs as a specific form of ABS—they could be sub-prime mortgages also) or even from bond or other loan portfolios. It might sound strange that a bank might want to securitise a portfolio of bonds rather than sell them, but they may be substantially illiquid, as in the case of lowly rated corporate bonds and some (non-OECD) country bonds. Securitised products, which the bank itself bought as an investment, may also be included. Collateralisation in this manner gives rise to another assignment, now a security assignment of a future cash flow by the SPV to the bond holders, who will become entitled to it. Again, it is necessary for the applicable law of assignment to be sufficiently up to date and responsive in this regard, in particular allowing the bond holders in such cases to collect the collateral directly from the collection agent upon (an event of) default. This results in a so-called pass-through securitisation, in which the investors receive pass-through certificates together with their bonds. The bond holders will thus have direct recourse to the cash flow of the SPV, often collected by the originator/assignor and segregated, but not to the assignor or originating bank itself. To enhance the SPV’s credit further, there are a number of other techniques: the bank may transfer more loans than the total net face value of the bonds. This means that there may be a balance in the SPV at the end if all borrowers paid, which the bank must somehow seek to retrieve, probably through a subordinated loan structure. It follows that in respect of these excess transfers (only), the bank gives a subordinated loan to the SPV in order to avoid an immediate loss in the originating bank; there is no gift. The assets could also be sold at a discount to the SPV, with the same possibility of a surplus in the company later, but it would lead to an instant loss for the assignor that would have to be reported, and this approach is therefore normally also avoided. Again, it would raise the problem of what to do with any surplus in the SPV if all debtors under the securitisation paid and a subordinated loan is the common answer. This introduces the subject of subordination (see also section 1.1.10 above), which is crucial in terms of credit enhancement and again assumes a friendly and sophisticated legal system to understand and support it (in terms of a disclosed third-party benefit). Instead, or in addition, certain guarantees might be given by the assignor/bank, but it must be careful that it puts enough distance between itself and the SPV to make the removal of the assets effective from a regulatory (for banks, especially from a capital adequacy) point of view. It may therefore be better to organise a guarantee from another bank (at a cost to the SPV). As we shall see later, this guarantee may now also take the form of a credit default swap or CDS. For reasons further explained in section 2.5.8 below, in the US, the originator should not retain an interest in

Wrong practices had been spotted: collateralised debt obligations (CDOs) were often given higher ratings than governments and corporate bonds that yielded lower returns suggesting that these were in fact less risky; the occurrence and effect of downturns in real estate markets might be underestimated; the models could become overtransparent so that originators could structure to obtain more favourable ratings whilst there could be improper disclosure practices with regard to these models and model assumptions; a fear of overreliance on statistics based on incorrect data; disregard of conflict of interest. This all played out in the financial crisis of 2008.

Volume 5: Financial Products and Funding Techniques 239 or exposure to the transferred assets, for example, by agreeing to take them back if they become non-performing, lest the scheme be recharacterised as a secured transaction. It is further possible for the SPV to issue several classes of bonds. This is so-called mezzanine financing, one or more classes of which may be junk and subordinated, so that the risk of senior bond holders is reduced and their standing rises, but the junk bond holders will get an extra reward for their higher risk, for example, 10 per cent interest, or even more. It means that the asset or loan portfolio that is transferred to the SPV in this way is financed by investors who acquire a different (lower) rank and (higher) reward, the highest rank of which (usually the holders of the senior bonds) is further supported by a guarantee (or CDS or oversupply of loans, as we have seen). The result is that senior bond holders always take first in any cash flow that results in the transferred asset or loan portfolio of the SPV, and may also have CDS. That is likely to lead to a triple A rating for these bonds. Again, it is a question of negotiation with the rating agencies, which can be protracted as they may demand more in terms of credit enhancement to give the highest rating. The lower-ranking subordinated investments are likely to receive no rating at all. All has its cost, and the SPV must remain capable of servicing all debt and of paying all expenses and enhancements out of and within the cash flows assigned to it, including all its own costs, and it should not incur extra, and especially not unforeseen, expenditure. Thus, whatever the originator organises in terms of guarantees or other support must be paid for, leaving less for bond holders. The guarantees will therefore be limited perhaps to no more than a 2 per cent loss in cash flow. Whatever the SPV gives in terms of (extra) reward to lower-ranking bond holders is also taken away from the senior bond holders and there cannot therefore be too many of the former either. Other costs of the SPV are also a concern and must be paid. The SPV will therefore normally be debarred from hiring personnel, and its activities will be narrowly circumscribed and defined in the founding documents (trust deed or corporate documents). On the basis of this scenario, the SPV is likely to be run by a trust company that is paid a fixed fee. There should be no other costs. The SPV should also not receive tax bills, as they could vary from year to year, and it could complicate matters in unexpected ways. The SPV is therefore normally organised in a tax haven (although the debtors in the original portfolio may have certain tax advantages that they do not want to lose by paying effectively to a foreign offshore company, again a reason why they may not be told anything about these arrangements while the originating bank continues as collecting agent). Any currency mismatch between the underlying cash flows and the denomination of the bonds is another aspect for bond holders (and rating agencies) to watch and avoid. There are other pitfalls in these structures. As already mentioned, banking supervisors may remain to be convinced that the loans, and particularly all obligations in respect of them, are effectively removed from a bank’s balance sheet before capital adequacy relief will be given (in full). The stand-alone nature of the SPV is itself another major structural hazard. It is necessary for it to remain bankruptcy remote from the assigning bank or other originating institutions. It means that, should the bank or other institution go bankrupt, the SPV is not affected. This requires above all that the assignors should not be seen as the de facto shareholder and/or manager of the SPV, risking a lifting of the corporate veil of the SPV. It is another reason why the SPV will normally be a charitable trust or company with an outside shareholder and separate management, however narrowly circumscribed in its tasks. The scenario will be pre-cast. This being said, the originator will normally remain the collection agent and manage the cash flow (for a fee), as we have seen. To repeat, here it is vital that any moneys collected by a securitising bank from the debtors as agent for the SPV are clearly separated out and so marked in the bank’s books or, better still, deposited with another bank so as to avoid any danger to bond holders if the originating bank should go bankrupt (of course the other bank may also get into difficulties). The bank’s failure should then not impact on the SPV, although debtors are still likely

240 Volume 5: Financial Products and Funding Techniques to be disorientated by such a bankruptcy, and this may result in some collection problems for the SPV in such circumstances, as each original debtor will now have to be advised and must redirect payments to the SPV or another collecting agent. There may also be additional claims for a set-off, now against the assignee. There is always a possibility that for the legal, tax and regulatory reasons mentioned, these schemes may prove not to be fully effective. Hence, the need for a multitude of legal opinions. But securitisations of this nature have become popular, at first in the US, and now also in Western Europe. They are necessary for banks and other institutions like the finance companies of car producers giving loans to the purchasers of their cars. They are now common risk management tools for banks, both in respect of credit, market and liquidity risk, although more particularly in respect of the former. A final observation may be made about liquidity. Securitisation is often viewed as a way in which non-liquid assets—bank loans—are liquidified. This is an important aspect in terms of liquidity management, but it is to some extent a false perspective, as this type of liquidity depends on market sentiment and may not continue. The markets may dry up as was shown to happen in the financial crisis of 2008–09, the fear being that underlying debtors may not pay. The liquidity so provided is therefore fragile. This differs from the liquidity of government securities, as that is based on the idea that governments will always pay because at least as long as they issue in their own currency and can print the money (a facility abandoned in euro countries). The result may be that the securities lose their intrinsic value through inflation, but at least the investors will be paid the nominal amounts due them.

2.5.3. The Layering of Risk Newer developments in this area of risk management are based on a more aggressive slicing or tranching of the credit risk being transferred by originating banks. The result is that less risky tranches of underlying pools of risk assets, for example loan portfolios or credit card balances, are created and sold. No new bonds are necessarily issued, and cash flows might not be assigned as collateral, but often are. These schemes may take the form of subparticipations already mentioned in the previous section. Legally, we are then talking about contractual rights to cash flows in terms of principal and interest payments that are sold after being pooled. These pools need as such to be properly set aside, segregated and divided into tranches. Again, this could be done through a mere subparticipation agreement at one end of the spectrum of possibilities or an SPV at the other. As already mentioned in the previous section, if there is no SPV, segregation often takes the form of some trust structure in common law countries, therefore of some proprietary transfer of a future income stream. This may create problems in civil law, and may then still require the interposition of SPVs to which the asset pools are formally transferred and which subsequently issue to interested investors various types of entitlements, contractually slicing the cash flow pools among them. There may be no securitisation or issuing of bonds proper. This is likely to mean that the underlying loan assets out of which the (pooled) cashflows arise may not be removed from the balance sheet of the originator, and there may not be capital adequacy relief for the latter either, but at least the originator receives immediate cash. But even if there is a trust structure or SPV, these various investor rights to slices of the underlying cash flow pools need not be expressed in the form of bonds issued and properly ranked. It is common in this connection to speak of collateralised debt obligations or CDOs, which could be collateralised bond or loan obligations, CBOs or CLOs, all being structured facilities. As

Volume 5: Financial Products and Funding Techniques 241 promissory notes, bonds have obvious advantages in terms of tradability because of their simplified transfer facility as negotiable instruments, but they must be uncomplicated instruments as far as the terms are concerned while the investment product that may result from a slicing of the underlying cash flow may be more complex. So, it may not be possible to express these claims on the pool in the form of a negotiable instrument. If they are merely expressed contractually, it follows that they will have to be assigned for their transfer. If these products are widely offered to investors and meant to be traded as investment products thereafter, they may require a formal prospectus which would explain them in detail. More problematic is probably that traders when trading these products depend on a trading sheet describing them rather than on bulky prospectuses. This is understandable, but these sheets often describe the product very inadequately, and they may therefore be bought with the purchasers hardly knowing what they are buying. Who makes these trading sheets is often obscure. Still, in principle it is for the buyer to beware; at least for professional investors there is caveat emptor in the international marketplace, but mis-selling may nevertheless remain an issue. In these schemes, participation in the top slice, say 20 per cent of the participants, may be promised a certain interest and maturity in exchange for an immediate payment by the investor in that slice to the originator, and the entire cash flow of the pool will then first accrue to that class. To this effect, other slices will be subordinated for a higher reward, also against an immediate payment to the originator by the investor, but only what is left of the cash flow will accrue to them. The bottom slice or slices may be retained by the SPV or originator as unsellable, the reason being that if the cash flow is not sufficient, those tranches are most likely to get nothing. What the student should understand and get out of this is that it is possible in this manner for a tranche in a pool of bad or mediocre debts to achieve a triple A credit rating when all income first accrues to a top slice that is relatively small as some debtors will pay at least something, all of which would accrue first for the top tranche that is therefore likely to get paid if it is only small enough. Guarantees or CDS may have been bought to give some further protection to the various classes of investors, especially to support the higher tranches. The relevant underlying cash flows may be set aside as further security. It should also be understood that in respect of each investor, these various slices may be further pooled and then repackaged and sold on, so that there is layer upon layer. It complicates the risk picture, and it may become non-transparent where the underlying risks really reside and who has what. When risks are parked or pooled in SPVs in this manner, they are also called special investment vehicles or SIVs. These SIVs may allow banks to immediately transfer the risks of their lending activity and park them, often even before the underlying deals are done. These risks are then considered off-balance-sheet for the originating bank immediately and there is no capital adequacy cost. The slicing or tranching will be done subsequently when these risks and rewards are sold off to investors. The idea is here to create an active and instant market in bank debt of this nature, which again may, but need not, lead to the issuance of new bonds of different rank in a full securitisation. In the latter case, the international capital markets will be accessed and the risk spread through them. If there are no bonds issued to the public, the slices are likely to be retained in a narrower circle of financiers/investors—other banks, insurance companies and hedge funds—as these participations are likely to be more difficult to trade. To repeat, the originator may retain some risk here, particularly in the lower tranches if they cannot be sold. That is its choice, and some of these loans may already been written down anyway. These lower slices or tranches may also remain parked in the SPV. That may create funding problems for the SPV, and here again the originator may accept the retention of some risk in terms of guarantees and funding. It has already been explained in the previous section that this may have capital adequacy consequences for the originator. That may not have been the original idea, but the originator will

242 Volume 5: Financial Products and Funding Techniques be aware of this and balance it against its other needs. At least to the extent tranches are sold, the originator receives liquidity and reduces that risk. For originators to retain some interest has also become the desire of modern regulation, so that the originator continues to care at least to that extent for the quality of the underlying assets. This is the ‘skin in the game’ philosophy. Under newer regulation (2009) in Europe, originating banks must retain at least 5 per cent, and that is also the idea in the US Dodd-Frank Act of 2010.382 It is supposed to guard against rapid acquisition of loan assets, which are immediately turned over to third parties so that their quality is no concern to the originator. The result is that banks keep on supervising and managing the risk in the underlying portfolios, notably with timely foreclosure of defaulting borrowers in mortgage loans, as lack of such care may destabilise the pyramid of layering built on them. Again, since the ultimate end-investors may have lost sight of the roots of the cash flow, they cannot manage the underlying flows at that level, and neglect will be the likely result, enforcement and foreclosure being costly, unless the originator is forced to keep an interest. As just mentioned, parking and retaining a slice of the risk in the SIVs may create special funding problems for the SIV, and then conceivably also for the originator. Indeed, when, in 2008, it became problematic to find replacement funding for what was often short-term funding in these SIVs (which would normally issue commercial paper (CP) in the short-term money markets), it forced originators or servicers into taking the remaining slices back or providing funding to the SIVs they had created (and who had already paid them for the cash flows) with the attendant capital adequacy cost. In fact, they had often committed to standby credit lines in this regard in order to uphold the credibility of the SIVs for investors and then accepted the capital adequacy cost up front. The fund management industry became involved also, even money-market funds, while providing loans to SIVs through CP. They also bought protection through CDS. This later created considerable problems for money-market funds, which were not supposed to take any substantial risk at all,383 and affected their credibility, but also caused serious refunding problems for SIVs at the same time, further complicated when CDS itself proved less than reliable. The excesses to which these new and necessary risk management devices gave rise will be discussed briefly in section 2.5.5 below, as will regulatory issues and action in section 2.5.11 below. For the student, the most important aspect of this discussion is to understand that it is possible to create a pool of very mediocre assets that nevertheless can produce a top slice with the highest credit rating. As long as some still pay and the top slice is small enough, there may result a sound investment, even in a sub-prime pool.

2.5.4. Synthetic Securitisations. Credit Derivatives or Credit Default Swaps. The Total Return Swap, Credit Spread Options and Credit Linked Notes Whatever the problems, asset securitisation and forms of risk layering have become a common tool to restructure a balance sheet, and is particularly useful for banks to remove certain types of loan portfolios such as a cocktail of mortgages, or even credit card balances, in order better to meet capital adequacy requirements, to free up capital for other uses, or to retire debt. Other

382 See Vol 6, n 36 and s 3.1. 383 See for operation at that time of these funds in narrow banking, Vol 6, s 1.2.6.

Volume 5: Financial Products and Funding Techniques 243 financial entities, not subject to stringent capital adequacy requirements, may want to do the same for similar rebalancing purposes. Car finance companies may thus move car loans to create room for others; credit card companies may move credit card receivables and commercial companies some trade receivables. But the process is complex, may involve extensive negotiations with rating agencies, is costly and takes time. It also requires a legal system sympathetic to bulk assignments, as we have seen, and assets must be readily transferable. There should be no ongoing commitments to lend or guarantee. The originator should not have given such undertakings (possibly through CDS) either. Ideally, it removes all risks (credit, market and liquidity risk) in connection with the assets so moved (without substantially affecting the underlying contracts and debtors) and reduces any applicable capital adequacy or liquidity requirements accordingly, but where the concern is only credit risk, it may be possible to create a simpler (and much cheaper and quicker) structure that removes only that risk, often to other banks or insurance companies. In principle this technique could apply to removing any other type of risk as well. Another advantage may be that in these structures the originator retains a direct relationship with its clients. Removing credit risk can be done by negotiating a third-party guarantee. That is a traditional way to reduce credit risk and if the result is a first demand, independent and primary guarantee of a third party (see sections 3.3.13 and 3.3.16 below), it may well be that even bank regulators would accept that, depending on the creditworthiness of the guarantor, the relevant credit risk of the bank in question is being removed and the capital adequacy requirement in banks therefore reduced. A standby letter of credit is a similar facility; see again section 3.3.16 below. Such guarantees are, however, less common to guarantee banks’ loan portfolios. They cannot be achieved instantaneously either, and depend very much on finding a willing counterparty. They are also costly and there is no ready market in them. A modern, more common way of achieving a similar result is through the creation of credit derivatives or CDS, which may even result in so-called synthetic securitisations, as we shall see.384 The terminology may be a little confusing. A derivative such as an option, future or swap is a financial product the value of which is determined by the value of an underlying asset (see section 2.6.1 below). A credit derivative is rather a financial product the value of which is determined by the creditworthiness of a third party that takes over a credit risk. It stands to reason that these credit derivatives have become particularly popular with banks, allowing them to reduce credit risk and to employ their capital more efficiently. These credit swaps can be traded, and it is normal to see quotes as protection givers or traders are likely to offer a spread. A CDS quoted at 100 means that the protection buyer must pay 100,000 annually for 10,000,000 of debt it protects, until its maturity, usually paid quarterly. Importantly, trading gives here an idea of the credit of the protection buyer although volumes are often low so that the result may create less transparency than would be desirable, and illiquid markets may thus disfigure the information. It is important, however, to realise that although we speak here of ‘trading’, no assets in a physical sense are being transferred. The facility transfers risk only and is purely contractual, thus avoiding the pitfalls of inadequate leges situs in proprietary matters. Only contractual rights are traded. Party autonomy is supreme here (although potentially subject to regulation, see section 2.5.10 below). Theoretically, the guarantee could still be secured on physical assets of the guarantor, which would introduce a proprietary element, but only in such cases, and therefore

384 See G Dufey and F Rehm, ‘An Introduction to Credit Derivatives’ (2002) 3 (65) Journal of Risk Finance; F Partnoy and DA Skeel Jr, ‘The Promise and Perils of Credit Derivatives’ (2007) 75 U of Cincinnati LR 1023; Perkins, ‘Corporate Restructuring: The Impact of Credit Derivatives and Distressed Debt Investing’ (2010) 21 Journal of Banking and Finance Law and Practice 192.

244 Volume 5: Financial Products and Funding Techniques not normally. Margin could also be called, as we shall see, and has become the more normal protection method: see for this concept section 2.6.4 below. The transferability of the benefit of the guarantee still suggests that the risk the guarantee protects is itself some kind of proprietary right. That is very much the (commercial) thinking behind CDS, but legally an improper characterisation. Although sales language is used in terms of a protection seller and protection buyer, and the buyer pays a price, it should not confuse. Again, only the credit risk is removed or transferred by contract (of guarantee), not by a contract of sale proper, which would suggest the transfer of an asset and a proprietary transaction. Thus, although in an economic sense risk is here perceived as a tradable commodity, or even some kind of investment activity in which investors can participate by buying fractions, legally, risk is not something that can be owned and transferred; although, again, the idea is easier to understand when we talk about the subsequent transferability of a guarantee or contractual obligation of the guarantor or protection seller and a contractual benefit or right for the protection buyer. It need not only be a guarantee in the traditional sense. Although CDSs are the best known, there are other types of protection imaginable: these include total return swaps (TRS), credit spread options (CSO), and credit linked notes (CLN), as we shall see. The risks may also be insured (pooled in that manner) or guaranteed in other ways. In a CDS proper, in exchange for a one-off or annual premium (mostly paid quarterly), the outsider or protection seller will make a payment to the protection buyer upon the occurrence of a previously defined credit event (or event of default) such as the downgrading, default or insolvency of a debtor, or more likely of a class of debtors. The protection buyer means to cover a reference asset or a class or portfolio of reference assets, which are the financial assets in respect of which the bank incurs a credit risk that it wants to remove. In this respect, one also speaks of a ‘single name CDS’, or an ‘index or basket CDS’, as we shall see. The ISDA Swap Master Agreement (see for this master agreement, section 2.6.7 below) may be used in this connection to define the events of default.385 For single name CDS, it will lead to the termination of the contract CDS covers and the protection may take the form of compensation in terms of a cash settlement, being the difference between the face value and the market value of the underlying investment, or the transfer of the reference asset to the protection seller at face value. In the latter case, the investor receives the par value of the investment (default asset). In the former case, the cash settlement will be the par value minus the recovery or residual value of the investment. It requires a valuation which, if no agreement can be reached, may have to be determined by an auction of the asset. This is usually organised by ISDA, and commonly settles the matter for all CDS contracts outstanding with a particular protection buyer in respect of a particular debtor. In the case of an index or basket CDS, the contract will not end when there is a credit event in respect of one of the component reference entities. The protection buyer will receive compensation proportional to the weight of the reference entity in the index or basket. There are other ways to terminate or change the exposure associated with CDS. Reference is sometimes made to ‘novation’, which means in this connection the replacement of one or more of the original counterparties to the protection contract. This may be the result of the intervention of a central counterparty (CCP): see section 2.6.4 below.386 The term is also used in the case of

385 See PC Hardin, ‘A Practical Guide to the 2003 ISDA Credit Derivatives Definitions’ (2004) Euromoney Institutional Investor Plc 134. 386 Early efforts by ISDA (since 2003) achieved a form of legal standardisation in this connection. See for the importance of standardisation also s 2.6.5 below.

Volume 5: Financial Products and Funding Techniques 245 early termination or when there is bilateral novation netting (or compression, see section 3.2.3 below) cancelling out mutual CDS agreements. Offsetting through entering new CDS contracts with other market participants cannot result in such netting (unless there is a multilateral netting agreement or CCP in place). The result is less CDS exposure, but increased counterparty (settlement) risk. In order to buy protection of this sort, one does not need to own the ‘reference instrument’ or ‘risk or default asset’, whatever it is called. It is quite possible to buy protection in respect of an investment or asset of someone else in the hope of a profit when that investment or asset lowers in value as a consequence of the increase in credit risk in the underlying exposure. This is sometimes called a ‘short’ or ‘naked’ position. The protection seller, on the other hand, speculates that the risk assets will rise in value. In that sense it is not different from any other derivative, the speculation being in the change in value in an underlying exposure or investment, here usually (the credit risk in) a funding or loan structure. As in the case of a first demand guarantee (see section 3.3.16 below), in CDS, the key to the success of the scheme is the simplicity of the recovery possibility. Other terminology is used, but the problems are very similar. An important difference is, however, that while in first demand guarantees the aim is ‘pay first, argue later’, in the case of CDS the scope for further argument is excluded altogether. That has to do with the nature of the liability that is guaranteed, which is here credit risk pure and simple. In first demand guarantees such as letters of credit, credit risk in respect of payment is the first concern, but there may still be quality issues that may have to be argued out later as the underlying transaction is likely to have been a commodity sale. In financial transactions of this kind, we have a pure credit risk transfer in respect of loan assets where quality risk is not an issue.387 This still leaves the problem whether the protection giver will be able to pay on the appointed date. One of the main risks in this market, which goes to its credibility, is therefore, the question of undercollateralisation of CDS positions. The use of CCPs may be one answer here as we shall see, and margin calls another. To counter this problem, there may also be CLNs (see below). Other protection facilities were also mentioned. In a total return swap (TRS), the protection seller will guarantee the income on an asset or asset class. In this scheme, the protection buyer is

To promote standardisation in CDS further, there was a so-called Big Bang in April 2009 in the US, followed by the so-called Small Bang in Europe. The main result of the 2009 changes was to introduce process and product uniformity by codifying best practices across the board, see Otis Casey, The Markit Magazine (Spring 2009); T Colozza, ‘Standardisation of Credit Default Swaps Market’, University of Pisa, Dept of Economics and Management (11 December 2013); CESR, Consultation Paper, ‘Standardisation and Exchange Trading of OTC Derivatives’ (19 July 2010). It was supplemented by the creation of an Events Determination Committee, which decides when a credit event has occurred triggering the CDS and an auction mechanism that allows cash settlements instead of delivering the underlying asset the credit risk in which was protected. This had created problems for naked sellers who would have to bid for these assets (although they had the benefit of not requiring an evaluation of the post-default value of the protection buyer’s position). Tailor-made products remain normal in this market, but a considerable incentive was created to limit risk through better standardisation based on market practices, which had already found broad acceptance. 387 A closely related issue may be the one of independence, from which letters of credit benefit and which is usually also considered an aspect of modern first demand guarantees: see ss 3.3.12 and 3.3.15. It is a crucial notion for the effectiveness of these instruments, also when used as credit enhancement vehicles. Whether protection s ellers give a similar benefit may be less clear in credit swaps. As in first demand guarantees, it is a question of careful drafting so that a primary, independent commitment results to which no further conditions are attached: see RD Aicher, DL Cotton and TK Khan, ‘Credit Enhancement: Letters of Credit, Guaranties, Insurance and Credit Swaps (the Clash of Cultures)’ (2004) 59 The Business Lawyer 897, 959.

246 Volume 5: Financial Products and Funding Techniques likely to be guaranteed a fixed interest (Libor or Euribor) return on the value of its investment in these assets while the protection seller receives any excess income (taking into account the assets’ total return, which is likely to be variable). This swap will normally run until a stated maturity date, but if a credit event as defined occurs, it may terminate early. It is not otherwise dependent on a credit event. Credit (and market) risk is thus shifted from the beginning without any transfer of assets. The scheme may also involve equities and then result in an equity swap. Misuse of these structures has been signalled: in the US, in takeover situations a 5 per cent holding must normally be disclosed. TRS may achieve a separation between voting and beneficial rights and may allow the acquirer to avoid the reporting requirements. In a credit spread option (CSO), a fixed income instrument of the protection buyer is protected. The protection seller will compensate for any greater spread than an agreed reference spread against a benchmark (say Libor or US Treasuries). If, for example, because of credit deterioration (or market forces) a US dollar bond is quoted in the market with an effective yield over US Treasuries higher than the agreed spread (which means that the value of the bond has diminished accordingly), the protection seller will make up for the difference in asset value at the option of the protection buyer. Thus, there may be a put option for any protection buyer who wishes to guard against any spread increase. Here again there is protection not only against credit risk but against any decrease in asset value for whatever or no apparent reason (in volatile markets or during financial crises). Again, no credit event is necessary and there is no transfer of assets. Particularly CDS may be accompanied by funding. It is one answer to under-collateralisation and an important progression in the whole idea of the credit derivative. In that case the protection seller will give the protection buyer a loan upon the maturity of which all defaults in the protected assets are deducted from the repayment of the principal of the loan. This obviously gives the protection buyer a great advantage in terms of recovery and set-off. Credit Linked Notes (CLN) elaborate on this idea, and here the notion of securitisation proper may also come in. Under them, securities or notes are issued by the ‘protection buyer’ to the ‘protection seller’ who pays for them and is repaid the face value of these notes by the ‘protection buyer’ at the end of the term if no credit event has occurred. If there has been a credit event, the pro rata loss will be deducted from the principal to be repaid by the protection buyer to the protection seller/investor. In the meantime, the protection seller can sell or pledge these notes to obtain liquidity. The CLN structure is less common than that of CDS proper, takes longer to arrange, and is more difficult to achieve, especially if there is a securitisation or capital market component, but is more interesting. In fact, in this manner, the credit risk may be shifted to the capital markets and its investors who are then effectively selling the protection. An SPV may be created in this connection to which the credit risk is transferred by CDS and which issues notes to the public as per CLN. The result is credit protection combined with securitisation folded into a capital market transaction. Here the notion of a synthetic securitisation comes in, in which in this manner both CDS and CLN may play a role. It means that protection is bought from an SPV to which the risk is transferred. The SPV is paid for this and issues notes to back up this risk, the proceeds of which will be reinvested, usually in highly rated securities, to create an income. This will serve as further comfort for the protection buyers and investors. The notes are repaid by the SPV (out of the cash flow of the reinvestments and of the CDS payment), allowing for a deduction for any payments that will be due when a credit event occurs. In the meantime, these notes may trade in the public bonds markets and their market price may become a useful indication of the credit risk of the protection buyer (or a special risk asset class of the latter), usually a commercial bank. The securitisation is considered here ‘synthetic’ because it does not involve the transfer of risk assets but only credit risk. It has already been mentioned that it avoids asset transfer problems like those connected with (bulk) assignments and thus leads to simplified documentation and

Volume 5: Financial Products and Funding Techniques 247 (in the absence of a securitisation) also better protects the confidentiality of the credit protection. It may also be used to insulate other risks. The introduction of an SPV in schemes like these raises all the complication of SPVs and their credit enhancements necessary to make a public offer, as discussed in the previous section. Through CDS, the SPV will, however, already have some income that may also help to reassure investors. Where funding is an important part of the scheme, the SPV will further have to reassure bond holders that interest and principal (after any deduction for matured credit risk) will be paid on the due dates. This may be done by the originator pledging the loan assets in respect of which the credit risk is transferred as well as their income as collateral, leading to a kind of passthrough already discussed in the previous sections. The SPV which will reinvest the proceeds of the bond issue may also set the income aside and pledge it to the bond holders. Credit derivatives have developed quickly during the last two decades. In 2005, The British Bankers Association estimated the global market to cover US$5 trillion equivalent in 2004, expected to pass US$8 trillion in 2006. In the event, it proved to be US$ (equivalent) 34.5 trillion. By 2007 it was $62.2 trillion, falling to 26.3 trillion in 2010, rising again to $32 trillion by 2012 but by 2017 it was only $9.4 trillion. The reason for the decline is thought to have been compression at first and subsequently the role of CCP clearing.388 In this connection, compression is a technique through which two or more counterparties replace existing contracts with new ones. It is often considered that the netted face value of CDS is in the order of 10 per cent of the unnetted face value.389 Their impact on the investors was more fully tested in the 2007–09 financial crisis: see section 2.5.5 below. They are not traded on exchanges and traditionally there was no transaction reporting to regulators either. The lack of transparency and clearing became an issue after 2010, hence also the regulatory preference for CCP clearing. It was always evident that in economic downturns when banks weaken, the transfer of their credit risk to others, especially insurance companies, could have the effect of destabilising these as well. The spread of risk, while generally applauded, may thus create greater weakness all around, especially when this spreading is limited to a small circle of banks and insurance companies (as happened in the events leading up to the 2007–09 financial crisis). It also may hide where the true risks are. But this technique has virtue, especially if the risks are transferred to a much broader range of investors in the capital markets (through proper securitisation).

2.5.5. Excess of Financial Engineering? The 2007–09 Banking Crisis It should be noted that in the securitisation practice as it developed, especially in the sub-prime market in the US in the early part of the twenty-first century, high gearing was an important factor and developed at least at three levels: of sub-prime mortgage borrowers, of SIVs and of investors in the various tranches. All depended on easy credit. In this connection, SIVs and investors were often funded short term which, coupled with the investments not only becoming toxic but also illiquid, is considered to have been at the start of the subsequent crisis. Again, from a legal point of view, it should be remembered that mainly risks or types of risks are transferred in purely contractual arrangements, either through sub-participations at the level of the originator, which would fund its loans in this manner through investor participation,

388 I Aldasoro and T Ehlers, ‘The Credit Default Swap Market: what a difference a decade makes’ (June 2018) BIS Quarterly Review. 389 See IOSCO Report FR05/12, The Credit Default Swap, 5 (June 2012).

248 Volume 5: Financial Products and Funding Techniques or through SIVs to which these loans would first be transferred. Investors, often other banks, insurance companies or hedge funds, would thus become involved in the funding and would in exchange for it receive (part of) the cash flow, which they would divide among themselves as reward. The level of reward would be determined by the degree of risk they took. The highest class (triple A) gets a more modest return but would have recourse to the whole cash flow; only if there was something left after these investors had received their reward in full would other tranches benefit. This is the meaning of subordination.390 Their claims could be secured by underlying cash flows. That is the idea behind asset-backed funding or CDOs. That protection was unlikely to be extended to the lower classes. It meant that there would be problems if the underlying cash flows fell short when the SIV itself (or, if there is no SIV, the originator or servicer) would not be able to pay all investors. These problems were aggravated when the originator or SIV retained some lower tranches which needed funding and the habitual cheaper short-term funding dried up while these assets became ever more illiquid. Even holding the top tranches could become difficult for traders and hedge funds as liquidity in them also became an issue and the short-term funding in respect of them problematic as well. It has already been said that the slicing itself or the multiple tranching could become so convoluted that it is no longer properly understood by investors, again often commercial banks and their clients, nor probably by originators or the traders, and the buyers of the relevant CP. The roots of these layers in the original products or indebtedness may no longer be traceable by end-investors in these various tranches in pools, which become removed, while only the first underlying pool can be known with some certainty. In the meantime, trading volumes may increase disproportionally as each layer will create its own market while the underlying indebtedness is not increased. The appreciation (or lack thereof) of the roots of the cash flows in the ultimately underlying financial assets or pools and the risks taken therein easily leads here also to mispricing of these tranches. In crisis situations, theoretical values, if they could be established at all, may then start to diverge seriously from done trades. That became another feature of the problems that arose in 2008–09. In the absence of continued funding short term, fire sales could become necessary. In a ‘mark-to-market’ environment, at least for capital adequacy purposes, big losses would then have to be recorded even by those who were not party to these sales but were holding similar assets, increasing the pressure upon all. It did not help that in the CDS markets protection buyers started to ask for more margin or collateral. 390 It has already been said that if slices of risk were offered by SIVs to the public, and also if there was public funding, eg through a commercial paper programme, there would at least be some prospectus to explain it all and there would likely also be a credit rating, which went into the evaluation of at least the best tranches, also if subsequently given as collateral in asset-backed CP. Trading of these tranches and of the CP could follow and would then give an indication of values and of risk assessment on a continuous basis. This suggests important safeguards and transparency, at least in normal times. Risk assessment, management and valuations by credit rating agencies are important here, but ultimately also unreliable as, in respect of risk in the underlying instruments, all operate on the basis of standard deviations from statistically established patterns, see also n 373 above. In evaluating the market risks in the underlying assets, for example housing, the rating agencies (which do not assess market risk themselves, only credit risk) would thus follow established statistical models, which indicated that during the period considered house prices only rose, but that proved not to be a reliable guide for the immediate future. Thus, in the sub-prime mortgage market in the US, rating agencies assumed that house prices would continue to rise on the basis of past performance and then concluded that the risk in the better tranches of pooled subprime mortgage portfolios was low, but the situation was turned on its head when house prices started to fall. The consequence was that when no one paid, default also resulted in the safest tranches. Even a triple A is not risk free; it is all a matter of comparative risk. This also had a consequence for the future, falling house prices now becoming the statistical norm, so it would be almost impossible to get or maintain a triple A rating except in a smaller slice of the total.

Volume 5: Financial Products and Funding Techniques 249 The immediate result was the collapse of the interbank market as it became hard for banks to determine where the risks among themselves were. It created an instant liquidity problem in those institutions that were mismatched in their funding, as banks normally are in their loan book, aggravated by, if also depending on, short-term financing for this type of investments if they had bought tranches from other banks or retained some in their own schemes or kept a trading book in them. The same uncertainties affected the judgement of regulators and other investors, although risk spreading in this manner remained an important benefit and could have saved the system if it had been sufficiently diverse and had also included the capital markets to a greater extent. Another problem identified earlier was that loans in the underlying pools of assets, the risks of which were sliced and redistributed in this manner, were often not properly monitored, so that the foreclosure rate dropped and risk increased. As risk was laid off immediately, underlying borrowers were often not sufficiently vetted by the originator either. This was in essence the scenario that played out in international banking in 2008, subsequently further complicated by the economic downturn, which required increasing write-offs in banks also in respect of their ordinary loan business. It resulted in a serious crisis in international banking, even if the proximate cause was that sub-prime mortgage lending in the US became suspect in a severe real-estate market downturn. These loans had often been laid off on other financial institutions, also in Europe, through the risk-layering schemes described in the previous sections, and then affected even the better tranches when massive default in the underlying portfolios was feared. The larger problem was, however, easy credit for all and an over-leveraged society as a whole: see Volume 6, section 1.3.4. In such a highly leveraged environment, the early crisis in the interbank market had an instant ripple effect on all lending activities.391 This affected therefore not only the short-term lending to SIVs but also of banks for their loan book, for their committed credit lines (for example for buyouts and other large investments) as well as for their financing of high-yielding risk layers retained in their own schemes or acquired from their SIVs, and their residual liquidity-providing obligations to the SIVs themselves. For corporate clients, even ordinary working capital borrowing became difficult to obtain in these circumstances. This is how contagion works in a high-leverage environment. The subsequent effect on the real economy further compounded the problems in banks. It even threatened the smooth operation of the payment system, especially where insolvencies were feared among the members: see also section 3.1.6 below for the handling of this risk in payments clearing systems. It forced the Fed in the US and the ECB in Europe into unprecedented levels of liquidity support as lenders of last resort, in the US even to investment banks. Ultimately governments had to come in to save the banking system and to provide the ultimate safety net, not only therefore for depositors but more especially for all banking obligations, so as to safeguard their continuing money-recycling function and no less their role in the payment system. It soon appeared that the quality of internal risk management systems was another issue. Some proved simply inadequate (in the midst of all the commotion, in 2009 the French Société Générale lost about $7 billion through a rogue trader), but there was also a question of sophistication to adequately cover new configurations of risk. This is an internal banking problem that regulation can hardly cure but for which under Basel II

391 It was the immediate cause of a bank run in the UK, involving Northern Rock, a mortgage bank of which few had ever heard. It had offloaded some of its loan book through securitisation and had not itself invested unduly in sliced products, but for the risk assets (lending) it retained, it had substantially financed itself short term in the interbank market. That became its problem when that market dried up. This short-term funding later came in for criticism of regulators and is indeed a matter of proper liquidity management, but is a well-known banking strategy. In any event, many (unsupervised) non-banks are involved in similar business activities, although they do not have the easy access to the interbank markets or deposits.

250 Volume 5: Financial Products and Funding Techniques since 2008392 regulators required at least some extra capital to be held for operational risk. For the rest, Basel II, infelicitously introduced in 2008, proved an instant flop in terms of the capital it had required in banks as we shall see in Volume 6, section 2.5. However, the adequacy of methodology and systems can often only be judged in retrospect after a crisis while valuations remain problematic in the meantime, especially in respect of illiquid instruments. Where the ‘mark-to-market’ principle was attacked in the circumstances,393 theoretical valuations became necessary but were no less dependent on sophistication and proper methodological and system support. Again, the origin of the cash flows in many could not be established as tracing to their roots could mean going through many different layers. In any event, if the market does not support these valuations, further losses will follow unless these instruments are held to maturity, for which they need to be continuously funded while there may be no repayment at all. The issue is whether regulation and its reform can help: see for this discussion also Volume 6, section 1.1.7. This also concerns the role of credit rating agencies, valuations, mark-to-market accounting, off-balance-sheet risks, the role of SIVs and capital adequacy. It also goes to gearing and maturity mismatching in the funding of investments. The role of trading activity in banks may then also be reconsidered, but it remains a necessary activity, at least to balance foreign exchange, swap and repo books and no less if an active market in these risk tranches is to be maintained. The best test is to invite the judgement of the international investment community at large through full securitisation, that is placing these investments in the open market in their incipiency, but that takes time and effort, which may be contrary to responsive risk management and is also costly. The spreading of risk through hedge funds in a more informal manner has then also its use. Excess must be identified and prevented, but where excess starts is not easy to say. The benefit of the spreading of risk in the manner as explained above cannot be abandoned. Especially the possibility of securitisation and the connection between banking and capital markets in that manner must be maintained, at least if we wish banks to provide liquidity in ever larger amounts and on a global scale. Smaller banks cannot do this adequately and it is an illusion that they are safer. Whatever is being said, the resulting lower level of liquidity is likely to prove socially unacceptable. It deprives us of much of what we want and could also be highly detrimental to economic growth. One problem in terms of operational risk is becoming clear, however. Few in a bank seem to have a sufficient overview of what is happening and where the big risks are. We have systems and their managers, we have internal auditors, we have compliance officers, we have risk managers, but it appears not to add up. All are to a greater or lesser extent pure technicians, engaged in a process that appears to dominate them, rather than their dominating the process in which they are involved. Regulators are no better and work by checking manuals. Internal and external supervision may be too dispersed, inadequate or simply stupid. Few know what exactly is going on and nobody knows when the music will stop, even if everybody realises that some time it will. All are in it as long as the economy hums along, including politicians who want ever more and cheaper funding for everyone. That is where the votes are. Thus, no one seems to be willing or able to call a halt. As banking is innately highly profitable and these high profits yield enormous tax revenues, in good times there is little incentive for caution to be imposed, including by governments. Rather, the tendency then is to take ever more risk and, by slicing it, to create the impression or façade of proper risk management, but in 2008

392 See Vol 6, s 2.5.10. 393 See Vol 6, n 210.

Volume 5: Financial Products and Funding Techniques 251 the lack of sufficient risk diversification and dependence on high gearing brought the system down, obvious in retrospect when many culprits were found, but it was not clear to anybody in command before the crisis: see further the discussion in Volume 6, section 1.3.

2.5.6. Abuse of Financial Engineering? The Enron Debacle The use of SPVs (or SPEs: special purpose entities) and the transfer of risk (rather than assets) to them first came under special scrutiny in 2001 in the ignominious Enron affair.394 It suggested early on the possibility of serious abuse in the art of financial engineering which, although perhaps staying within the strict letter of the law, may have led to a significant breach of the trust of (Enron) investors, with management riding roughshod over them, and with its Board neglecting its own disclosure, fiduciary and ethical duties. But here again, there were few whistleblowers when all seemed well. After the collapse, the abuse proved less clear cut than it appeared at first in the public perception. In a sophisticated financial environment, clearly one may structure well beyond what laws concerning disclosure and fiduciary duties and financial regulation contemplate, thus taking advantage of unavoidable legal and regulatory lag. Especially in terms of breach of fiduciary duties, there may be some civil action, but it is often less clear what the cause of action in such cases truly is, while it may even be more difficult to conclude criminal liability, as criminal law is commonly forced to use more precise concepts. Naturally, if there is clear lying, fraud or theft, a criminal prosecution will be facilitated, but there are many borderline situations.395 394 See for details WC Powers Jr et al, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp (2002), and WH Widen, ‘Enron in the Margin’ (2003) 58 The Business Lawyer 961; SL Schwarcz, ‘Rethinking the Disclosure Paradigm in a World of Complexity’ (2004) University of Illinois Law Review 1, and earlier SL Schwarcz, ‘Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures’ (2002) University of Cincinnati Law Review 1309. 395 One of the main Enron schemes (called Raptor) centred on a so-called ‘accounting hedge’ in which not credit or counterparty risk, but P&L (profit and loss account) volatility was transferred to an SPE (here also called a special purpose partnership or entity) in order to mask future losses. Enron’s management wanted and prided itself on stable profits, and the SPE was meant to assume the market risk in some volatile Enron assets (in fact investments in other companies that had risen considerably in value but could fall). This could have depressed earnings and could not otherwise be properly hedged against a fall in price of these investments because they were not easily tradable and there was no derivative market in them nor an acceptable imperfect hedging possibility. Enron thus sought to create its own hedging entity in the nature of an SPE. It took over the volatility risk by writing put options giving Enron the right to sell the protected assets at a fixed price to the SPE during a certain period. The SPE was substantially owned by a third party, as all SPVs are, in order to be effective and to prevent consolidation (although shareholders were still shielded by Enron, as we shall see, but apparently this did not present a serious flaw). The first problem was that the put option had to be paid for by Enron, which would be a substantial cost, depressing its income. To circumvent this problem, the SPE obtained from Enron a call option in the same volatile assets at the same striking price as the put. It took away Enron’s upside potential in the investment, but it was not concerned about it; it wanted a stable price and no fall. The more serious complication was that the SPE (as all SPVs) had no substance, and there could be no guarantee that it ever could pay up under the put. In fact, it could not without it acquiring substance. Hardly anyone would provide such substance in good time, certainly not the capital market in a securitisation without a high rating for the SPE pursuant to some substantial credit enhancement and transparency of the scheme. Thus, there could be no securitisation (the issuing of new securities by the SPE in the capital market). It followed that Enron itself had to provide the substance in one form or another, but the involvement of Enron had to be managed in such a way that no extra cost to Enron would occur while no consolidation of the SPE would result either. That became the main challenge of the scheme. In fact, Enron first sold their own shares (which it had in Treasury) to the SPE at a substantial, but perhaps not unusual, discount to present market prices (thus diluting present shareholders, but still with some profit to itself) in exchange for an obligation of the SPE not to sell them and cash in or pledge them. It allowed the SPE (which

252 Volume 5: Financial Products and Funding Techniques In the case of Enron some successful prosecutions followed, but they were not unaffected by later Supreme Court review.396 In the event, financial engineering proved the tool Enron management used to sustain Enron’s high earnings and their own share of it by moving the risks and losses of some major investments into off-balance-sheet SPVs (the particular Raptor SPE scheme being only one of many). The strategy was conceptually simple: parking adverse risks in SPVs, therefore off-balance-sheet. Even though this might have worked while the chances of a liquidity crisis were not necessarily increased by it, it was motivated by management considerations that raised serious conflicts of interest. They underlay the entire scheme through which in the end many retirees and employees of Enron (besides others) holding Enron shares in their pension plans were seriously hurt. Management intent in an environment of conflicts of interests may have been here the true measure of the legality or illegality of the schemes. In other words, if they had been intended as a sensible way to protect Enron shareholders rather than its management’s income and bonuses, they might have been easier to defend, although the use of these schemes as mere accounting tools or gimmicks might even then still have been questioned. As in the case of risk layering, the true test of the plan and the protection for investors would have been in proper securitisation through the capital markets, which would have invited the investors’ judgement on the scheme. It would have signalled investors’ and rating agencies’ confidence in it upon full disclosure or the lack thereof. The market would thus have become the ultimate judge, even if it must be admitted that in the layering of risk and the pricing and liquidity

had no cash) to pay for these shares through a promissory note (this might have been an illegal margin transaction which requires a 50 per cent down payment). To retrieve the income that might so accrue to the SPE in the form of Enron dividends and to counter the dilution of Enron shareholders’ income, Enron bought a minority participation in the SPE and agreed on a division of distributions with the outside majority shareholders such that it received by far the largest slice of the income, but left the outsider an attractive minimum return. It thus made sure that no excessive profits accrued to outsiders. It must have been confident that no consolidation resulted from its participation in the SPE even though the outsiders were shielded in this manner. One problem was that although a cushion was so created in the SPE in terms of value and as a back-up for the put, a decline in value of Enron shares themselves would erode this value and thereby the value of the put option if the assets that it meant to protect declined in value at the same time. In the event, this started to happen, so that the scheme had to be restructured (without it, Enron would have had to accept the decline in the credibility of the put and thereby incur a loss in the assets it wanted to protect). The result was a forward sale of more (declining) Enron shares to the SPE (which this time were not yet issued) at a further discount against a further note as the SPE still had no funds to pay cash. The result was among other things a further dilution of existing Enron shareholders. That was the true cost for shareholders of the scheme in which in fact a discount in Enron shares so sold was to support the investment that needed protection. In the end, when Enron shares declined further, this technique could no longer be sustained. The scheme had to unwind when the truth came out, the ‘accounting hedge’ proved to have failed, and the real losses in the protected assets had to be taken. Enron entered a liquidity crisis, as in view of the uncertainties in its accounts and reported earnings, which were then revealed, its banks would no longer continue their credit lines. It then filed for bankruptcy protection. In the meantime, Enron had stated in footnotes to its Annual Report that it had entered into derivative transactions with ‘counter-parties who are equivalent to investment grade’. In view of the lack of sufficient credit enhancement, SPEs of this nature hardly were such counterparties. If Enron stock had not fallen, all might have been well, but there was never any guarantee that it would not. Once it started to do so, it fed on itself in the unravelling of the protection scheme in which undisclosed dilutions of shareholders’ earnings and expectations had in fact been used as back-up of the put. 396 There may have been a criminal offence in so far as third-party equity holders necessary to deconsolidate Raptor from Enron were shielded from risk by Enron. The Raptor scheme itself, while being a likely form of whitecollar conceit, may remain difficult to characterise in terms of a traditional criminal offence against property: see also JE Murphy, ‘Enron, Ethics and its Lessons for Lawyers’ (2003) Jan/Feb Business Law Today 11. This proved an important issue in the criminal proceedings, and limited them.

Volume 5: Financial Products and Funding Techniques 253 issues market reaction can also be misguided. But it is an important key to the legitimate use of SPVs in complicated financial structures. Indeed, proper securitisation might have saved the scheme, as the put option would have been laid off on the capital markets, but it would have been costly, taken time, and might not have succeeded. But even that would have saved the company.

2.5.7. Covered Bonds In the meantime, covered bonds have appeared as some alternative or variant of securitisation.397 They had their origin in the German Pfandbriefe. As in risk layering, this alternative way of funding is concerned with the separation of a cash flow, subsequently used to support a class of bonds which the originator wishes to place with the public. To that extent, there is a close resemblance to CDOs in securitisations except that the originator itself remains primarily liable for payment on the bonds. The assets also remain in principle on its balance sheet. The originator is therefore the principal debtor, not an SPV which, however, may still be needed to capture the underlying assets and segregate the cash flow from the originator in order for it to be sufficiently set aside or ringfenced to provide extra security for the bonds. To that extent, it functions as guarantor. If there were no such segregation, this cash flow would continue to accrue to all creditors of the originator and not merely to the covered bond holders. In several countries, legislation may be necessary to achieve the proper ring-fencing here. Short of such legislation, legal structuring would be necessary to achieve a similar result, which, especially in non-common law countries, may create considerable uncertainty in terms of proper segregation. In other words, the proprietary rights of the bond holders in the back-up assets may be uncertain. Another common feature is that the cash flow or asset pool backing up these bonds may be topped up at the request of bond holders, normally to create a measure of overcollateralisation or to make sure that the quality of the back-up remains high (usually mortgages or government bonds). In England, there is a common variant under which the bank that issues the covered bonds lends the proceeds immediately to an SPV, which will not repay the bank until it has repaid all covered bond holders, who have direct access to the SPV’s assets. In the meantime, it purchases (often) mortgage loans or other consumer debt from the bank/issuer and may give them as security to a security trustee with the covered bond holders being the beneficiaries. It may be noted that a key concept of banking is here in the balance and may shift. Lenders to banks acquire direct rights in banking assets, or at least that is the idea. This could conceivably be extended to depositors, who may thus retain some proprietary interest in the money they gave to their bank. This is contrary to the basic concept of banking in which depositors do not retain any proprietary interests in their money. In countries like the US and Australia, this could require legislation. As just mentioned, something similar has long existed in German practice (Pfandbrief), where, as in Spain, there is (some) legislation.398 In 2010 alone, banks were estimated to have issued and sold around USD $350 billion equivalent of these products. The market dried up when further banking weakness appeared in Europe in view of the government funding problems after 2010 but covered bonds remain a major banking funding tool in the capital markets. 397 See Moody’s Investment Service, Structured Finance In Focus: A Short Guide to Covered Bonds (2010); SL Schwarcz, ‘The Conundrum of Covered Bonds’ (2011) 66 The Business Lawyer 561; R Burmeister et al, ‘Overview of Covered Bonds’ in W Kälberer et al (eds), ECBC European Covered Bond Factbook (2009). 398 In the US, this is also considered: see HR Bill 5823 (2010).

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2.5.8. The Recharacterisation Risk in Securitisations In section 2.1 above, the distinction between secured transactions and finance sales was discussed, and the dangers of recharacterisation in that connection. We have also seen that the US unitary functional approach of Article 9 UCC does not take into account different risk and reward structures and may well therefore distort the picture while converting all funding supported by assets of the party requiring the funding into secured transactions as a matter of principle, although exceptions had subsequently to be created, as there are now for equipment leases (Article 2A UCC), repos (section 559 Bankruptcy Code) and some forms of factoring or receivable financing (section 9-607 UCC). The essence remains that all structures ‘supporting payment or the performance of an obligation’ are considered secured transactions. Sales are now considered as alternatives in certain situations, but suggest a full transfer (see Section 9-318 UCC), and the special role of conditional transfers is not considered. Wherever there is a funding element, they are still likely to be transformed into a secured transaction. The use of SPVs or similar entities (with or without securitisation) to move assets off-balancesheet could be seen as another exception, but this has to be handled with similar care. Indeed, there could be a funding element, for example where protection providers also provide a loan, or in securitisation the originator becomes a loan creditor of the SPV, although in the latter case the proceeds of a bond issue are unlikely to be on-lent to the originator/protection buyer, but are used to pay for the assets transferred; in credit derivatives they are invested. There should never be an interest rate structure agreed, which would be indicative of a loan structure. Recharacterisation should not then normally be an issue, therefore if the transfer of any assets was outright and paid for (in credit derivatives there are no assets transferred anyway) and does not take the form of a conditional or temporary transfer either, which is less usual in the context of a securitisation of risk assets and should be avoided. The mere transfer of a class of assets to an SPV, which acquires them outright and pays for them, should therefore never be recharacterised as a secured transaction in which the purchase price could be recast as a loan secured on the assets transferred to the SPV.399 Loans should therefore not be transferred conditionally, meaning that they are returned if becoming non-performing, potentially to be replaced by others. Re-characterisation would mean that in the event of a default of an originator, there might have to be a disposition as the transferred assets would in principle be considered as having remained with the originator and, being part of its bankrupt estate, subject to a security interest of the SPV. This would be an extraordinary result, fatally undermining all asset securitisation. Re-characterisation could thus become a serious threat in securitisations as the buyers of the SPV’s bonds could find that the assets of the SPV may in fact still be owned by the originator, even if bond holders were given a security interest in them by the SPV.400 Altogether, it would make these structures unsafe for them. This whole recharacterisation debate is thus highly damaging and mis-focused, connected also with the more fundamental flaw in Article 9’s unitary approach. Post Enron, in which there was in fact no transfer of risk assets at all or any funding proper, this issue was revisited in the US (the Durbin-Delahunt Bankruptcy Code initiative).401 399 Doubts remained, however, in view of LTV Steel Co, Inc v US, 215 F3d 1275 (2000), a bankruptcy case in which it was argued that the transfer of assets to an SPV was not a true sale, and that the collections by the (now bankrupt) originator were its cash collateral which, pending a resolution of the sales issue, could be used during the bankruptcy if adequate protection was given. A settlement followed so that the basic issue was not determined. 400 This in itself could raise disposition questions and might prevent mere collection by the bond holders. 401 In 2002, a legislative proposal to amend the federal Bankruptcy Code (the Employee Abuse Prevention Act) was even introduced in Congress (the Durbin-Delahunt initiative) ostensibly to protect retirees and employees

Volume 5: Financial Products and Funding Techniques 255 Again, the characterisation issue should be solved by asking if there is an interest rate (structure) agreed between the originator and SPV. If not (and it would be highly unusual), there is no loan and there cannot be security supporting it. It has already been mentioned that normally, in an asset securitisation, the objective is not funding in the proper sense, but payment for the assets is irrevocably transferred. If properly structured, there is therefore also no finance sale or any repurchase implied. The last thing the originator/assignor wants back are the assets moved from its balance sheet.402 In fact, some States of the US, such as Delaware in 2002, had earlier introduced some special asset-backed securities facilitation statutes exactly in order to promote securitisations. These State laws make sure that asset sales in securitisations are true and final sales, and they may as such serve as clarification in the light of the functional approach of Article 9 UCC and, in the case of receivables, of all such transfers being generally covered by Article 9 (except if incidental or for collection purposes). They would, however, have been superseded by any federal (bankruptcy) legislation of the type just mentioned. It may well be, however, that in risk layering substantial risks remain with the originator, which ultimately may affect the off-balance-sheet nature of the scheme in respect of the originator or servicer, as we have seen. The transfer of risk in whatever form may not be complete and this might then leave some room for re-characterisation. There may in any event not be a transfer proper of loan assets, only the risk in respect of them. This could conceivably create recharacterisation risks depending on the nature of the scheme, which always has some funding elements, but if the recharacterisation is in the nature of a secured transaction, there should at least be a formal interest rate structure agreed. In 2002, the fear seems to have been that through securitisation valuable assets could be improperly taken from weak companies, thus contributing to their insolvency. But as long as the sale price paid by the SPV was normal or within a usual range and not a preferred transaction or fraudulent transfer (against which there is in any event ample protection in the US Bankruptcy Code, section 547), it is unclear what the true concern could be. The originator has an interest in being properly paid; it would incur a loss otherwise. Moreover, Enron was not a securitisation scandal (there were no publicly placed bonds) but rather an abuse of financial engineering, see section 2.5.5 above, and, in that context, of SPVs. In fact, the Durbin-Delahunt initiative also sought to strengthen the bankruptcy voiding powers (in section 103) in respect of the transfer of routine security interests in personal property.403 As suggested in the previous section, in the Enron case it would in fact have been safer if there had been proper securitisation because it would have invited the capital market’s judgement on the schemes. Indeed, successful securitisation might well be one of the possible and most obvious tests to determine whether the use of an SPV is proper. As such, securitisation of these schemes in the capital markets should be actively encouraged, but it takes time and is costly.404 while seeking in s 102 of the proposal to re-characterise as a secured loan any sale (with or without securitisation) of assets including those to SPVs if its material characteristics were substantially similar to the characteristics of a secured loan. No criteria were given. It was eventually withdrawn. See also SL Schwarcz, ‘Securitisation Post-Enron’ (2005) 25 Cardozo Law Review 1539. 402 It is hard to see what their employees or retirees would gain from it being considered otherwise by any (federal) statute (amending the federal Bankruptcy Code to this effect). Again, in the case of Enron, a sale of assets to obtain funding was not the objective. It wanted to shift market risk, much in the manner credit derivatives shift credit risk. In this context, there was a sale of Enron shares, but this was done in terms of backing up the put in the scheme, not to attract funding. It was therefore hardly in the nature of a substitute secured transaction to fund Enron itself. 403 See also SL Harris and CW Mooney, ‘The Unfortunate Life and Merciful Death of the Avoidance Powers under Section 103 of the Durbin-Delahunt Bill: What Were They Thinking?’ (2005) 25 Cardozo Law Review 1829. 404 There is a related move to keep the assets on the balance sheet of the originator, especially if the transaction is mainly motivated by accounting considerations, see US SEC Report and Recommendations Pursuant to

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2.5.9. The Characterisation Issue and Insurance Analogy in CDS Another indirect attack on securitised products, in particular CDS, has come from those who see it as an insurance product and argue that, in the case of naked CDS—that is CDS protection bought without exposure to the underlying risk it insures—there is no insurable interest so that these products must fail. It was thought by 2010 that 80 per cent of the activity in CDS was naked. It is in truth a form of short selling that has as such the benefit of increasing liquidity in the marketplace. Similar effects can be created through options, swaps and futures. The argument then goes to the practice of shorting itself as a normal market function. It is one thing to condemn CDS outright and forbid, for example, naked CDS. This could be a regulatory stand, unwise in the view of this book as it would be a form of market manipulation, but it is at least direct. To use what must be viewed as a rather contrived recharacterisation to undermine this product is less opportune, especially the insurance analogy. The basic point to make here is that insurance assumes a pooling of resources by several interested parties to meet a particular loss in one of them. There is no such pooling in CDS. This is reflected in the pricing, which, in the case of an insurance, is based on actuarial research and in the case of CDS determined by market forces. Another conceptual difference is that an insurance contract covers losses actually suffered while CDS provides for an agreed pay-out to all holders upon a credit event. Furthermore, insurance coverage is cancelled simply when premiums are not paid; cancellation of CDS does not automatically follow the non-payment of the protection fee. The better analogy is the guarantee which no one confuses with a guarantee.405 It is not normally opposed on the basis of similar arguments. In fact, insurance is an alternative protection: I can buy insurance against some risk or a guarantee which carries a very different credit risk for the protection buyer. In these debates, economic rather than legal arguments are often introduced, but these risks confusing everything: what looks economically the same might legally be very different. It certainly also confused the discussion on finance sales and secured transactions, which has also affected the status of finance leases and repos as we have seen in section 2.1.3 above. This was earlier rejected as un-useful. Economically, many financial products acquire aspects of others in certain circumstances, but this should not confound. There are here different risk and reward structures, which the law normally recognises and supports unless public policy dictates otherwise. Form is important, especially in professional dealings, because it denotes clarity in the division of risk, which is of paramount importance in all matters of risk management. There is no doubt that international practice accepts the status and legal effectiveness of CDS, even if naked. It is in England in particular supported by the so-called Potts opinion, an opinion of a QC, which in England is generally considered to have the status of an opinion of the court of first instance and stands as such until overturned by another court opinion of at least similar rank. It was sponsored by ISDA.406 The argument here is that the payment obligation is not Section 401(c) of the Sarbanes-Oxley Act of 2002 published in 2005. This is, however, not the same as terminating the legal segregation of the assets, which in the case of insolvency is a bankruptcy and not an accounting determination and hinges on the notion of ‘sale’. 405 See also N Leornard, ‘Credit Default Swaps, Guarantees and Insurance policies: same effect, different treatment?’ (2010) 25(11) Journal of International Banking and Financial Law 664. 406 Cf also O Juurikkala, ‘Credit Default Swaps and Insurance: against the Pott opinion’ (2011) 26 (3) Journal of International Banking Law and Regulation 128; MT Henderson, ‘Credit Derivatives are not “Insurance”’ (2009) Paper no 476 John Olin Program in Law and Economics; A Kimball-Stanley, ‘Insurance and Credit Default Swaps: Should Like Things be Treated Alike’ (2008) 15(1) Conn Insurance Law Journal 241; EA Posner and EG Wel, ‘An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets’ (2013) 107 NW U LR 1321.

Volume 5: Financial Products and Funding Techniques 257 conditional on the payee sustaining a loss or carrying the risk thereof. It does not seek to protect what could be called an insurable interest on the part of the payee and its right is not dependent on it. The Law Commissions of England and Scotland in a 2008 paper on Insurable Interests supported these views. Regulators may still not be wholly convinced.407 There is also a feeling that this activity needs special regulation,408 but the question for them is what insurance regulation as we know it would add and whether its application makes sufficient sense. Much insurance regulation is conduct of business-oriented and aims at the protection of unsophisticated individuals which may also cover pricing issues. This is clearly less needed and appropriate in professional dealings and also very costly. Another aspect of insurance regulation is that investments made by the insurers are sufficient to meet their potential long-term liabilities. In CDS the time span is normally quite short and risk evaluations are easier. Capital must be held by banks if engaging in this activity as protection sellers and to this end credit conversion factors can be used to produce credit equivalent amounts of what are in effect contingent liabilities: see section 2.5.8 below. Collateralisation and margining are ways to protect the protection buyer. Moral hazard can be reduced by keeping some skin in the game, not unusual in insurance either through deductibles. This is sometimes also introduced in CDS contracts. It depends on the parties. More in particular the incentive structure that CDS presents and may allow especially naked CDS to favour events of default (and not therefore cooperate in restructurings) may be another regulatory concern, but it was at least partly countered by ISDA in 2014 in eliminating as credit event restructurings substantially too far away from an insolvency situation. Whatever these special concerns may be, at least the insurance analogy and insurance regulation are unlikely to be here of much help either.

2.5.10. International Aspects Securitisations naturally create problems when assets outside the jurisdiction are meant to be included. As in assignments, this raises problems of the location of claims if a bank seeks to remove loans to foreign borrowers from its balance sheet. The assignment itself may mean on the other hand to transfer claims to a foreign SPV. Here the place of the claims may be clear (in the country of the bank/assignor, certainly if all the borrowers are in the same country), but the place of the SPV assignee may still give rise to questions about the applicable (domestic) law. The connected conflicts problems were summarised in section 2.3.5 above, in the EU covered by Article 14 of the 2008 Regulation on the Law Applicable to Contractual Obligations (Rome I); see also Volume 4, section 1.9.5. In the case of credit derivatives, only risk is removed, and this is in principle a purely contractual transaction under which a protection seller assumes the risk. Also, in the case of risk layering, there may not be a transfer of underlying assets, at most of future cash flows. Still their transfer will have proprietary effects, so has the trading of CDS, which must be assumed to be through assignment. Here the law applicable to the proprietary aspects of assignments will need to be considered and therefore the place of the location of these intangible assets or underlying contracts. In risk-layering schemes, short of transnationalisation, the applicable (domestic) law

407 See in the US Circular Letter No 19 Best Practices for Financial Guarantee Insurers from Eric Dinallo Superintendent NY Ins Dept (22 Sept 2008). 408 See BB Saunders, ‘Should Credit Default Swap Issuers be Subject to Prudential Regulation’ (2010) 10(2) Journal of Corporate Law Studies 428.

258 Volume 5: Financial Products and Funding Techniques is likely to be the law of the place of the party receiving the cash flow and assuming the risks connected with it. On the other hand, the contractual aspects of these assignments or transfers will acquire international aspects if parties are in different countries, to which ordinary conflicts rules concerning contractual obligations will in principle apply, in the EU therefore again the 2008 Regulation on the Law Applicable to Contractual Obligations, assuming always that there is no transnationalisation of the applicable law. It suggests the application of the law of the place where the most characteristic obligation is to be performed, which must be considered to be the law of the place of the protection seller, therefore in CDS often an SPV in some tax haven, barring a choice of law clause to the contrary in the contract itself. To repeat, in assignments, the contractual and proprietary aspects are often not distinguished, giving rise to the idea that also in the proprietary aspects there is room for party autonomy: see more particularly again Volume 4, section 1.9.3. Transnationalisation based on international market practices and general principle is here truly the answer: see the Conclusion in section 2.5.11 below.

2.5.11. Domestic and International Regulatory Aspects Apart from the legislative attempt discussed in section 2.5.9 above, in the US, the Sarbanes-Oxley Act of 2002 already concerned itself in section 401(c) with financial engineering and its potential excesses and asked for a Securities and Exchange Commission (SEC) report on the extent of the use of off-balance-sheet (derivative) transactions using SPVs. A report was published in 2005. It emphasised that the use of financial structuring merely for accounting and reporting purposes should be discouraged.409 In respect of CDS, earlier the federal Commodity Futures Modernization Act (CMFA) of 2000 aimed at creating greater certainty for CDS. It clarified that they are not regulated by the Commodity Futures Trading Commission (CFTC) if they are individually negotiated OTC transactions between sophisticated parties. The normal banking regulators remain competent, but because these contracts were between professionals, the regulators generally operated a hands-off approach. It meant that particularly the potential systemic risk implications were generally ignored.410 Securitisation came in for much more criticism during the 2008–09 crisis (see the discussion in section 2.5.4 above) but the International Monetary Fund (IMF) intervened in 2009 to explain the need for this type of risk management tool and the diversification of risk it achieves. Yet it is clear that especially in the credit derivative market (CDS), there is a problem with the popularity 409 See also n 401 above. In s 705 of the Sarbanes-Oxley Act of 2002, the Comptroller General of the US was asked to report on the role of investment banks in schemes of this nature. These issues were thus raised well before the 2007–09 financial crisis. On 7 January 2005 the SEC adopted new rules to address the registration, disclosure and reporting requirements for publicly offered asset-backed securities. They applied only to public offerings in the US and not to CDS. The difference between asset-backed securities and corporate securities was recognised. The accent was on transaction structure, disclosure of credit enhancements, quality of the asset pools, servicing and cash flow distribution. These new rules in essence summarised and streamlined the existing regulatory practices in this area. The use of SPVs and more generally the role and techniques of financial engineering did not come under similar scrutiny in Europe. The role of credit agencies was also reconsidered in the US: see D Coskun, ‘Credit Agencies in a Post-Enron World: Congress Revisits the NRSRO Concept’ (2008) 9(4) Journal of Banking Regulation 264. Again, their role in the events leading up to the 2007–09 crisis, in which they were much criticised, was therefore not a new issue and had been considered earlier. 410 See also Saunders, n 408, 429.

Volume 5: Financial Products and Funding Techniques 259 of these newer products, their proper documentation and assessment of the risk.411 Greater transparency may be needed as it would show when banks protected themselves against a credit risk, thus raising the temptation of neglecting (costly) oversight of borrowers. This is another instance of moral hazard. Other problems are over-protection, which may allow protection buyers to benefit more from a decline in values than from an increase. Capital adequacy concessions based on CDS may have to be reviewed on the basis of a better assessment of the credit of protection givers. However, although excess and abuse is much to be avoided, the concept of risk protection in this manner is sound. At the operational level, it was clear by 2005 that the paperwork handling infrastructure of securitised product trading and CDS was overwhelmed. Trade confirmations remained outstanding in large volumes and there was often no clear picture internally of the risk that each participant was taking, nor was there transparency in the risk position of the other participants. This led to early concern in the US where the Federal Reserve organised industry meetings to induce participants to get a better grip and co-ordinate responses in situations of financial stress. There is also the problem that risk may not be properly priced, especially likely in times of euphoria. Generally, CDS should be split from risk layering and CDO. Although closely related in origin, they give rise to different problems and concerns. The problems with risk layering, and especially the trading in the resulting products proper, raised particular regulatory concerns in 2008–09, also because of the gearing in the treasuries and investment portfolios of commercial banks connected with the trading and purchasing of these products and the risk concentrations that resulted as a consequence also in investment banks and in the insurance industry. The whole trading culture in banks and the operation of banks as if they were hedge funds in their proprietary trading activities became questionable. The proprietary and other trading activities of banks beyond merely squaring foreign exchange, repos, swap and securitisation books thus became the subject of review and proprietary trading in banks became another aspect of the regulatory reform in 2009. It could lead to some return of the former Glass-Steagall division, although not strictly along commercial and investment banking lines: see further the discussion in Volume 6, section 1.3.7. Quick turnover and the removal of all risk and cash flows from bank balance sheets through securitisation or similar structures, with the subsequently likely neglect of the underlying borrowers and the nature of the repacked products, led EU regulators as early as 2009 to decide that originating banks must retain at least a 5 per cent stake in these products.412 This was followed also in the US and makes great sense. Nowhere so far is it questioned that proper securitisation in the capital market is at least part of the answer and should be promoted in terms of transparency and pricing and judgement of the market on the quality of the product offered.

411 See D McIlroy, ‘The Regulatory Issues raised by Credit Default Swaps’ (2010) 11 Journal of Banking Regulation 303 and SK Henderson, ‘Regulation of Credit Derivatives: To What Effect and for Whose Benefit?’ Part 1–7, Butterworths Journal of International Banking and Financial Law (London, 2009) and ‘The New Regime for OTC Derivatives: Central Counterparties’, Part 1–3, Butterworths Journal of International Banking and Financial Law (London, 2011). See further also European Central Bank, Credit Default Swaps and Counterparty Risk (August 2009) and J Kiff et al, ‘Credit Derivative Systemic Risks and Policy Options’, IMF Working Paper WP/09/254 (2009). The ECB Report also went into the area of netting of opposite off-setting CDS trades (p 44) or ‘compression’/‘termination’/‘tear-up’; see further also the important IOSCO Report, The Credit Default Swap Market (June 2012). Their removal does not change the risk profile but reduces the notional value of a bank’s derivatives and hence the exposure to operational risk. TriOptima provides this service and runs quarterly termination cycles for single-name CDSs and monthly cycles for CDS indices. Perhaps the most important conclusion of these reports is that securitisation is legitimate, but that the practice can be improved. 412 See Vol 6, s 3.7.3.

260 Volume 5: Financial Products and Funding Techniques All the same, new regulation would likely affect the market activity and gearing in securitised instruments. In CDS, the concern is rather standardisation413 and transparency, but also accounting standards. At least part of the answer may be in some industry-wide organisation that sets rules and verifies trades. The creation of a central counterparty or CCP (see for their operation section 2.6.5 below) in this market, especially for CDS, is often believed to be useful and could at the same time allow for stronger forms of settlement netting, especially important between big-bank dealers among themselves.414 It should be understood in this connection, however, that centralised clearing does not necessarily mean a CCP acting as sole counterparty. There are lesser forms of centralisation, which simply concentrate on documentation and proper payments, including collateralisation and enforcement of margin. Yet even setting margin requires a valuation technique, which is difficult to develop for non-standardised products. Replacement cost assessment is one method but implies estimates. It remains a question whether CCPs that are private organisations are willing and able to do this: see further the discussion in section 2.6.5 below. It could be accompanied by a trading function, which would facilitate price formation and close-out netting: see for these netting concepts section 3.2 below. By organising these trades through clearing members, the settlement risk and solvency risk of the CCP could be substantially decreased at the same time (see further section 2.6.5 below) and the clearing system would no longer be dependent on the solvency of all its members, meaning that in practice all participants become liable for the failure of the weakest member(s)—see for this problem again the discussion in section 2.6.5 below. It is also relevant in payment systems: see section 3.1.6 below. On the other hand, allowing trading platforms to be built on these clearing facilities would allow the big operators to keep this business among themselves and might relax margin and other (collateral) requirements short of fuller regulation. In all cases, the operation of these clearing systems would require a substantial degree of standardisation, which may not be in the nature of the product, non- standardised products being, moreover, normally illiquid and therefore difficult to unwind or close out. That may apply especially to CDS and it remains unclear whether the drive in favour of more customised standard products can be successful; it may also be inefficient.415 But it could enhance proper documentation and record keeping as well as transparency, and provide a better-organised system of margin and collateralisation, although different clearers could start competing by offering lesser margin requirements. By connecting different products, for example trades in standard CDS with those in other derivatives, especially swaps, or even with repos and foreign exchange trades, the netting facility could usefully reduce risk even further. On the other hand, much would still depend on the solvency of the CCP and its (clearing) members, and too much risk may be put in one basket in this manner, especially undesirable when in financial crises these clearers may themselves be weakened. This is likely, as they tend to be the larger banks. Whatever the pros and cons, especially for CDS and interest rate swaps, clearing facilities of this nature became an important prong of the regulatory changes that were proposed during and after 2009: see also section 2.6.5 below and Volume 6, sections 1.3.9, 3.7.6 and 3.7.9. 413 See also n 386 above. 414 See further JP Braithwaite, ‘The Inherent Limits of “Legal Devices”, Lessons for the Public Sector’s Central Counterparty Prescription for the OTC Derivative Market’ (2011) 12 European Business Organization Law Review 87; SG Cecchetti, J Gyntelberg and M Hollanders, ‘Central Counterparties for OTC Derivatives’ (2009) BIS Quarterly Review 45. 415 TV Koeppl, ‘Time for Stability in Derivative Markets—A New Look at Central Counterparty Clearing for Securities Markets’ in CD Howe Institute Commentary (2011).

Volume 5: Financial Products and Funding Techniques 261 It was emphasised before that liquidity issues are also important, especially for layered products. How are the trading and investment positions financed if they result in illiquid (toxic) assets? Funding through deposits or other short-term forms of financing is not then appropriate. Another issue is that banks should not finance this type of activity in hedge funds either if these depend on short-term money for this loan activity. Capital adequacy concerns are another issue, in which connection the notion of off-balance-sheet risk, mark to market and self-assessment of risk for capital adequacy purposes may have to be reconsidered, but also the question whether 8 per cent capital is still meaningful. Assuming that it is not, capital requirements may have to be used in different ways, notably in an anticyclical manner: see again the discussion in Volume 6, sections 1.1.14 and 1.3.7. Mark to market would then also acquire a different meaning. Less capital might be needed to support the positions pending their more regular unwinding. Ill-targeted regulation or over-regulation as in Sarbanes-Oxley, may easily result however. Risk management may be curtailed in its progression or banking may shrink in unacceptable ways. Over-gearing of society at large is an important political issue and goes to the heart of how we wish to live, organise our economy, and what kind of growth levels we have come to expect. That is more properly a G-20 issue as is the whole notion of growth sustained in this manner, key problems much avoided in G-20 so far, which seems more interested in how yesterday’s crises can be avoided and growth restarted through more bank lending—a contradictory proposition as excessive gearing was earlier found to be the problem; see further the discussion in Volume 6, sections 1.3. These are key issues in which securitisation regulation plays only a secondary role. Under Dodd-Frank in the US and the European Market Infrastructure Regulation (EMIR) (see Volume 6, section 3.7.6), the CCP clearing in particular of CDS is encouraged and given capital adequacy relief as a major incentive. They present a framework and assume that CCPs as private institutions would be keen to engage in this activity and that its members would be willing to absorb any resulting losses from the default of other participants. This remains to be seen, but most appear to be content with the further concentration of risk and its management in these institutions. For the parties, the additional collateral requirements may be quite severe, however, and netting out the requirements or indeed the positions may not be a sufficient counterweight. It will probably take quite some time before we can see how these measures work out and what kind of effect they are going to have. The law of unintended consequences may be in full operation. In the EU in the meantime, further rules were introduced for securitisations, effective January 2019: see Volume 6, section 3.7.18. It demonstrated to some extent a change in sentiment in favour of the practice assuming it is sufficiently supervised. Under it, all originators and sponsors must ensure that there are sound and well-defined criteria for credit granting in respect of any exposures to be securitised and any originator or sponsor who buys such exposures for securitisation purposes must verify that the original lender also met such requirements. Notably the 5 per cent retention or skin in the game is maintained, but the disclosure requirements are relaxed, although there are sensible restrictions on selling to retail clients. Resecuritisation transactions are prohibited subject to certain carve outs to ensure the viability as a going concern of a credit institution or investment firm including the facilitation of their wind-up, or to preserve the interest of investors where the underlying exposures are non-performing. SPVs from certain jurisdictions are disqualified, notably those that are suspected of money laundering.

2.5.12. Concluding Remarks. Transnationalisation The modern possibility of removing whole classes of risk assets from bank balance sheets to SPVs and now even specific risks, qua risk, in credit derivatives or in risk layering and the facility

262 Volume 5: Financial Products and Funding Techniques (through securitisations) to lay these risks off on the capital markets in funding-connected schemes (which, in the case of credit derivatives, allow the cost of any matured risks to be deducted from the repayments) is of great importance in terms of risk management and an ingenious financial engineering facility that is rightly welcomed and admired. Credit derivatives in particular opened up major new vistas for moving all kinds of risk. They have the added advantage that they are much less inhibited by constraints derived from inadequate legal systems, notably in the area of assignment, precisely because these structures are wholly contractual rather than (partly) proprietary and therefore in the realm of party autonomy and ingenuity. But this ingenuity may lead to abuse; the Enron debacle was a vivid early illustration and risk-layering excess was an important contributory aspect of the confidence crisis in the financial markets in 2008. The use and especially abuse of SPVs and more particularly of financial engineering activities in which they are used rightly creates regulatory concerns in terms of proper disclosure and transparency of complex financial transactions and/or of the fiduciary duties of originating companies and their managements in respect of their investors. Conflicts of interest may abound. Indeed, in Enron, one of the vital issues may not have been so much the lack of disclosure itself— the existence and use of SPVs to manage risk were disclosed, at least in principle, but rather the nature and quality of the disclosure in an environment of conflicts of interest between management and investors. Discounting the unrealistic possibility of proscribing through regulation advanced financial engineering activity, the emphasis from a private law point of view must thus be on better disclosure and better education by, and greater openness of, management, underpinned by vigorously enforcing their fiduciary duties and their personal liability in this connection. Especially where financial engineering is used mainly as an accounting and reporting tool rather than as a prime means to manage risks, there is obvious danger, although the two are not always easy to distinguish. The bottom line is that dubious financial schemes must be avoided, and in case of doubt at least be properly explained. The responsibility of lawyers and accountants in this process has rightly been highlighted, and courts will have to enforce more than just the letter of the law. There is also a role for rating agencies. It was suggested above that successful securitisation in the capital markets might be a more powerful indication of the proper use of SPVs in terms of informed market judgement and true spreading of risk. If only for that reason, it should be greatly encouraged, although it is expensive and takes time, while cash flows might still have to be separated out through SPVs in schemes that remain private for entirely legitimate reasons. Against this background, private law issues might appear minor, but transnational law is likely to give better legal underpinnings, especially in terms of asset transfers where the same issues arise as discussed above in terms of bulk assignments: see sections 2.2.4 and 2.3.1 above. Where risk is transferred contractually, followed by the cash flow in respect of which the risk operates, the structure may be purely obligatory in terms of conditional payment obligations. This applicable law is also capable of transnationalisation, probably more easily so, and in fact follows the law concerning first demand guarantees. But when these products are traded there emerge unavoidably proprietary aspects as well, which in view of the indeterminate situs of these products is also best handled transnationally on the basis of evolving international practice and general principle. Although the regulatory issues are of a quite different nature, when expressed in terms of a concern for disclosure and observance of fiduciary duties, these remain in the realm of private law and its strengthening, which may as such also be subject to transnationalisation in terms of established industry practices or minimum international standards: for the hierarchy of norms this will present: see Volume 1, section 1.4.13. In such a more advanced approach, domestic law remains only the default rule.

Volume 5: Financial Products and Funding Techniques 263 As far as regulation is concerned, it presents special problems of application in international cases, as we have seen in Volume 2, sections 2.2.6ff, but could in finance be a matter of recognition of home country regulation elsewhere, again subject to international minimum standards, as is the EU approach, as we shall see in Volume 6, Part III. The situation and approach that arbitrators may take was discussed in Volume 2, sections 2.2, 2.3 and 2.4 as well as the likelihood of transnationalisation of the applicable law as was beginning to be demonstrated in the ‘purposive interpretation’ approach in the Lehman cases in the UK that followed the events of 2008: see Volume 2, section 2.4.3.

2.5.13. Impact of Fintech on Securitisation Securitisation is an area that could potentially benefit from the widespread utilisation of blockchain416 or a similar facility and smart contract technology.417 It can be envisaged that blockchain or similar technology may have a transformative effect on a securitisation’s entire lifecycle.418 Currently, loan data (contractual terms, borrower credit profiles, collateral information) is rarely standardised and sometimes not even centralised within the originator. Lenders use different formats to record data and digital records are often just scanned paper documents. They are stored in various servers and data warehouses all over the place. This increases the difficulty of access and reconciliation for all participants in the securitisation chain—originators, SPVs, rating agencies, investors and regulators. This results in significant inefficiencies with increased time lags, costs and opacity. Documentation may in fact be quite defective and hard to locate, as we have seen. The implementation of a solution based on blockchain and smart contracts at the stage of loan origination aims at efficiency gains throughout the entire securitisation cycle. The borrower could activate a loan agreement in the form of a smart contract by transmitting the necessary input to a blockchain (principal amount, repayment schedule, credit score, income verification, tax records etc). The lender/originator would validate the smart contract after which it would be placed on the blockchain in the form of a digital token that is owned by the lender/originator and contains in cryptographic form all input information and loan data. As a smart contract, the loan could be connected to the borrower’s cash account so that payments would be made automatically in accordance with the repayment schedule. If the borrower were to default on a repayment, the smart contract could automatically engage a special default servicer who would take over the recovery process. The repayment history would be imprinted on the loan token and recorded on the blockchain, which could be updated as appropriate. This information would be available to all downstream participants, which could vastly reduce downstream costs of due diligence. Downstream participants, including investors could in this manner easily follow a loan or pool of loans from issuance through to maturity, be alerted of modifications, and adjust servicing behaviour. On the same, or a different interlinked, blockchain, individual loan tokens could be bundled together into token pools or token blocks. Each token pool would have a unique signature that allows for the identification of all loan tokens contained in the pool, and therefore enables access 416 The following text is substantially taken from the King’s College Executive LLM organised by JH Dalhuisen, C Kletzer and M Schillig. 417 See for smart contracts s 2.6.12 below. 418 SFIG and Chamber of Digital Commerce, Applying blockchain in securitization: opportunities for reinvention (2017).

264 Volume 5: Financial Products and Funding Techniques to the loan data for each and every individual loan token within the pool. During structuring, a smart contract could be used to monitor new assets and automatically flag them for inclusion in a pool on the basis of pre-defined criteria. Each loan token and each token pool have a unique signature and is uniquely identifiable. A token pool, which itself would be represented as a new token, can be transferred to the SPV directly on the blockchain. Identifiability of all included loan tokens makes the ‘double-pledging’ of collateral impossible. Loan data would be available to the SPV and any servicing agent, whereas other nodes may only be informed of the fact that a transfer has taken place. This allows for an optimal balance between information sharing and confidentiality. Of course, structuring the pool transfer as a token transfer on a blockchain does not solve the legal issues associated with an assignment of debt receivables (effect of blocking clauses, bulk assignments, borrower notification etc). A robust legal framework would have to be in place, linking the off-blockchain IOUs to the loan tokens and supporting in legal terms the token transfer on the blockchain. However, given modern trends in the law of assignment (no debtor notification; blocking clauses ineffective; assignment by mere agreement between assignor and assignee) devising and implementing an appropriate legal framework which would be customary in the industry transnationally would not seem to be an insurmountable problem. When the structuring process begins, all parties involved could thus have seamless access to information about the available pool of underlying assets, with each asset’s modifications and payment history permanently linked to it. The securities to be issued by the SPV could be modelled as smart contracts also, recording the underlying collateral, tranches and payment distributions, and would become crypto-securities. Bespoke instruments could be constructed consisting of individual cash flows that meet precise needs in terms of timing and credit risk. In order to be activated and recorded on the blockchain, all parties would be deemed to have consented to the underlying model. This consensus could eliminate the duplication of efforts and the potential of misalignment of different parties’ models. Instead, there would be a single governing version of the ‘truth’ on the blockchain. Rating agencies, servicers, regulators and investors could also be granted access to the model, which they could use to run their own independent analysis. Regulatory compliance could become easier, as the blockchain could automatically share and analyse data in line with regulatory requirements. Thus, securities would be issued as crypto-securities in token form on to the blockchain. Imbedded smart contracts could automatically track loan-level payments, calculate and make distributions to investors and generate investor reports. They could collect the stream of payments emanating from loan servicing activity, could reference the consensus-verified waterfall model, channel cash flows to each security’s beneficiary investors, and automate many fiduciary and regulatory functions inherent in the security servicing process. Through the information available on the blockchain, investors could monitor whole asset classes with consistency. Where cash flow patterns significantly deviate from expectations, a ratings review may be triggered. The issued crypto-securities could be traded and transferred directly on the blockchain with near real-time clearing and settlement, possibly in crypto currencies also. Investors’ access to updated loan data and ratings could improve pricing and market efficiency and also deepen the market. Trading and transfer of tokens on the blockchain would enable to clearly identify the holder of a security at any given time. In combination with data on the underlying pool’s performance this would reduce opacity significantly. At a systemic level this may help to reduce the likelihood of fire sales during periods of acute market stress. In conclusion, blockchain technology’s potential to reinvent and facilitate securitisation is immense. By streamlining processes, lowering costs, increasing the speed of transactions and enhancing transparency significant efficiency gains could be achieved. The necessary

Volume 5: Financial Products and Funding Techniques 265 technology for completely rethinking the securitisation lifecycle may be available sooner than we think. Firms are already exploring opportunities for issuing and servicing loans on blockchains. NASDAQ has tested blockchain for private placements, and overstock.com has issued new equity shares through a blockchain. Securities can already be coded as smart contracts that automate much of the trading process, including payment processing, clearing and settlement. Bank of America Merrill Lynch, Citi, Credit Suisse and JP Morgan have tested a blockchain for trading credit default swaps. Symbiont has developed ‘smart securities’ to issue, manage, trade, clear, settle and transfer financial instruments on a blockchain. Moreover, a consortium led by JP Morgan, Barclays, Credit Suisse and Citi have tested equity swaps posttrade transactions using a blockchain from Axoni. The essential building blocks thus seem to be already in place. However, scalability currently remains an issue as do questions about data security and privacy. Many smart contracts and other blockchain applications have not yet reached a full proof level of reliability. The interlinkages between blockchain and off-blockchain assets and systems remain a source of risk. Standardisation and interoperability of various blockchains are other unresolved issues. Perhaps most importantly from a legal perspective, in order to operate efficiently and truly transform the securitisation cycle, a new transnational legal and regulatory framework needs to accommodate and support the creation and transfer of loan tokens and crypto-securities, allowing parties to ascertain how contract law, property law, insolvency law and securities regulation questions will be resolved. Innovative and transnational thinking will be required from the legal professions in order for the new technology to reach its full potential and become internationally operative.

2.6. Options, Futures and Swaps. Their Use and Transfers. The Operation of Derivatives Markets, Clearing and Settlement and the Function of Central Counterparties 2.6.1. Types of Financial Derivatives and Their Operation Derivatives in the present context are financial products that derive their value from the value of assets traded in other markets. Financial options and futures are the normal examples, but interest and currency swaps also figure. The credit derivative was dealt with in the previous sections. The difference is that options, futures and swaps deal with market or position risk, whereas credit derivatives deal with credit risk. Financial options can be calls or puts. A call option gives the buyer or owner of it the right, but does not impose a duty, to buy from the seller or writer of the option the underlying asset (often bonds or shares) at the agreed striking price during the time of the option (assuming the option is a US type of option that can be exercised at any time, which is now the more common type everywhere). A put option gives the option holder the right to sell this asset to the writer of the option at an agreed price (the striking price) during the time of the option. By writing a call or a put, the writer exposes himself to the option being exercised against him at the agreed price. S/he immediately receives a price or premium for his willingness to accept that risk. That is his/ her interest in this business. The option buyer, on the other hand, is likely to seek protection and hedge an outstanding position in this manner, especially in puts as we shall see, although s/he may also use the option as a speculative instrument and in covered calls as a way to create extra income.

266 Volume 5: Financial Products and Funding Techniques The futures contract419 is an agreement to buy or sell an asset at an agreed future moment for a fixed price, often the present market price (or relevant index). It should be noted in this connection that buying protection against future price movements may thus mean selling the asset forward at current prices.420 A future of this nature gives a seller the right and imposes on him the duty to sell and deliver the underlying asset to the buyer on the agreed date for the agreed price which (unless otherwise stated) will be paid at that time. At the same moment, the buyer under a future has the right and duty to acquire the underlying asset (which, in financial futures, may be certain types of bonds but could also be some time deposit) at that time and price. By entering into a future, both parties acquire rights and obligations in the nature of an ordinary sales agreement. The difference is that the delivery of the goods and payment will be delayed until a future date. This time frame allows the party entering into a future to manage its risk during this period by entering into opposite positions for the same delivery date. In the case of financial options and futures there is an important extra aspect or facility, at least in regular exchanges, as at the appointed date they may always be settled in money, as we shall see. In that sense, they are contracts for differences. During their period, regular exchanges that offer central counterparties (CCPs) clearing services, may offer a facility for the parties to get out of these contracts and settle the position, again in cash, either at a loss or a profit. Thus, a profit can be taken at any time or a loss may be fixed by getting out. For the uninitiated, this looks like a sale, but legally this is not the correct characterisation. Technically this is done by engaging in an opposite transaction with the same party for the same maturity date, where the transaction is netted out with the original one. This taking of opposite positions can of course also be done off-exchange (that is, OTC), but in that case there are likely to be different counterparties and there may be no netting out mechanism in place and no immediate payment of the difference. It should be borne in mind in this connection that options and futures are contracts and not transferable assets. Rather they are a bundle of rights and obligations. Counterparty substitution in principle requires consent of the other party who therefore has a veto (see also the discussion in section 2.3 above). Getting out means normally unwinding these contracts with consent and may require substantial concessions. As we shall see, regular exchanges commonly provide a mechanism to overcome this in respect of standardised transactions, especially by interposing a CCP with whom all the participants deal, allowing in particular for a netting out of these opposite transactions (known as ‘multilateral netting’), now between the same counterparties. A future may provide the readiest example of what is at stake here. An owner of an underlying asset may worry about its price going down. This owner could sell the asset immediately but doing so under a futures contract gives flexibility at the same time. While the underlying asset was sold at a fixed price at a future date, the market price of that asset may now be lower. It means that there is a profit in the future that could be protected by buying the underlying asset back (or similar securities in the case of investment securities of the fungible type) at the lower price in another future for delivery and payment at the same date as the earlier one. It substitutes market 419 The US Bankruptcy Code defines forward contracts in s 101(25) in respect of all commodities but requires a maturity date exceeding two days. Only merchants and financial parties are covered. For them, this particularly protects any ipso facto netting clauses, exempts these clauses from automatic stays and from preferential payment provisions, see s 561. Forward contracts of this nature, including a reprocessing facility in the underlying assets, are covered by the Bankruptcy Code (and its benefits) if their primary purpose is not the reprocessing but the management of risk. 420 A distinction is usually made between futures and forward contracts. The concept is the same, but futures, if financial, are usually contracts for differences associated with a market infrastructure, especially the operation of clearing through CCPs. Historically in the US, it gave rise to the question which regulation applied and who was the competent regulator, issues that are not here further considered.

Volume 5: Financial Products and Funding Techniques 267 risk for counterparty or settlement risk. There is a doubling of it on the appointed date unless both transactions are entered into with the same counterparty. Indeed, to make a close-out possible, both contracts need to be with the same counterparty and it must be agreed in advance. It is for this reason that most regular exchanges offer the services of a CCPs in standardised transactions of this nature in the manner explained below in section 2.6.4. In regular exchanges, the financial option and future periods are normally brief (three months, six months or nine months), but could be longer. There may be some particularities in their regular trading. For example, one financial option contract usually covers 100 of the underlying investment securities. A future is often on a (share) index and may then cover 200 times the difference between the index as it develops during the time of the future contract. It means that if one buys 100 future contracts of this nature, one is exposed for 20,000 times the difference and may win or lose accordingly. Interest rate swaps are the other traditional example of derivatives. The term ‘swap’ does not in itself denote any particular legal structure except some kind of exchange. In modern finance, it is common to find an exchange of accruing cash flows, normally resulting from different interest rate (fixed or floating) structures. Thus, a fixed-rate cash flow arising out of a bond portfolio may be exchanged for a floating-rate cash flow arising out of another bond portfolio of a similar size and maturity. The owners of the respective bond portfolios do this because they have a different view as to the interest rate movements. The owner of the fixed stream fears an increase of which s/he would benefit if in floating. The other fears a decrease against which s/he wants to protect by opting for fixed. The result is an interest rate swap. They could also be in different currencies (that is a cross-currency or cocktail swap, mostly called currency swap), in which there are two possible variables. Their value depends on the relative value of the accruing cash flows that have been temporarily exchanged, see section 2.6.3 below. For swaps, at first, parties who want to enter into a currency swap had to find a counterparty, which was not easy, and banks were often used as brokers. Eventually banks started to operate as counterparties. This is often called swap warehousing, but is in truth a market-making function in swaps. It immediately doubled the number of outstanding swaps, as, instead of one swap between two end-users, they would now each enter into a swap with a bank. Like any market maker, banks quote a spread between bid and offer prices for these swaps and will also enter into them if they cannot immediately find an offsetting one. This greatly facilitated the operation of the swap market and allowed further development, especially towards more specialised swap types based on purely fictitious cash flows. Again, as in futures and options, the ‘trading’ in these swaps, which are contracts, normally takes the form of parties entering into mirror swaps to offset their positions, thus locking in certain gains or losses.421 Here again, a simple example may demonstrate the point: a person entitled to a five-year cash flow at a fixed interest rate of 8 per cent expects a rise in interest rates and swaps into a floating rate for the period. After two years the interest rate is 10 per cent. Now a fall in interest rates is expected and the party concerned may swap back into a fixed rate at 10 per cent through a new swap for the remaining period. The result of both swaps is that this party has locked in a 2 per cent increase for three years while having had the benefit of the rising interest rate during 421 Warehousing banks are not CCPs subject to close-out netting demands—see s 2.6.4 below. A bank as counterparty may nevertheless be willing to unwind a swap deal and take or make payment for the accrued differences in cash flow values. Bilateral netting of outstanding swaps between the same parties is the next step. This was very much promoted by the ISDA Master Agreements as we shall see in s 2.6.8 below. No regular markets developed in swaps, although there had been calls for it—and it is much the drift of regulation since 2010, both in the EU and US as we shall see in s 2.6.5 below, but LCH.Clearnet already provided a similar service on a more limited scale.

268 Volume 5: Financial Products and Funding Techniques the first two years. As just mentioned, in modern swaps, the underlying amounts may be purely fictitious and there may be no exchange of any flows at all. Only the difference is paid at agreed regular intervals. In such swaps, there is a new financial instrument created, structured as the difference between two fictitious cash flows in the form of a set-off agreement, which nets out the accruing theoretical cash flows during each period at the end of it. This is often referred to as (a form of) novation netting: see also section 3.2.3 and section 2.6.7 below.422 It provides further flexibility in terms of interest rates and maturities, while there are no funding needs and physical transfers at the beginning. It has already been said that financial derivatives may be used to make a profit by playing markets in this manner, but they are often more important to quickly change market or position risk and are therefore of great importance as hedging instruments or risk management tools, especially for banks, thus neutralising this type of interest rate risk promptly. These financial derivatives developed rapidly in the fast-changing inflation, interest and currency environment in the early 1970s after the end of the fixed exchange rates regime earlier established at Bretton Woods (in 1944). Their development was much helped by the modern computerised calculation and information storage facilities. Swaps, futures and options change market or position risk in the underlying assets but are not appropriate to change credit risk and are more likely to add to it (in the form of settlement risk) as additional relationships are created. To reduce credit risk, so-called credit derivatives (credit default swaps or CDS) may now be used, as we have seen. They are in fact a type of third-party guarantee of performance or a sui generis form of insurance, as we have seen in section 2.5.3 above. Other ways are the diversification in the loan portfolio, security (collateral), more traditional guarantees of third parties (such as parent companies), cross-default covenants in the loan agreements, set-off and netting, and asset securitisations (which remove the asset from the balance sheet altogether). Asset securitisations are also likely to reduce market risk when moving the risk assets into a special purpose vehicle (SPV): see section 2.5.1 above.

2.6.2. The Use of Derivatives. Hedging. Derivatives and Share Ownership As was shown, derivatives are important instruments for parties (particularly banks) to change their market or position risk exposure, often in a relatively quick and cheap manner depending on their view of future market movements. This is the essence of hedging. As mentioned in the previous section, in these cases, there will be added settlement risk as the hedge assumes that the other party will perform on the future date. In that sense it can be said that market risk is exchanged for credit risk. Again, as we shall see, regular exchanges mean to minimise that risk especially through (a) the interposition of CCPs, (b) the use of clearing members which whom CCPs exclusively deal, and (c) the notion of margin (that is, collateral). Thus, buying a put option in certain shares protects the buyer against the shares falling below the striking price. It therefore reduces the risk of holding them. It comes at a cost, however (the price or premium of the option plus settlement risk). By selling assets (such as foreign exchange) forward into domestic currency at a fixed price under a future, the position risk regarding that

422 Again, these swaps should be distinguished from credit swaps as discussed above in s 2.5.3. They concern especially credit default swaps (CDS) under which a sum will be due when a certain party goes bankrupt or total return swaps (TRS), when payments may be made depending on the market behaviour of a portfolio of securities.

Volume 5: Financial Products and Funding Techniques 269 asset will be eliminated (assuming the future buyer will perform). By choosing an alternative cash flow under a swap, an uncertain floating rate cash flow may be exchanged for a fixed rate cash flow. In this way, risk on either the asset or liability side of a balance sheet (through an asset or liability swap as we shall see) may be managed, although of course only history can tell whether it was a good decision. Again, it increases settlement risk. Again, parties could of course unwind their long or short positions in the underlying assets, but it is more likely that they will use derivatives to hedge their existing positions in the indicated manner by effectively taking (particularly in futures) opposite positions to those which they already have. It is likely to be quicker and cheaper and makes it possible to correct the hedge by undoing it later when the risk position is clearer. Thus, if a party is long in a market-sensitive asset, it may go short through a standard futures sales contract. That hedge may not exactly mirror the underlying position and may as such not be perfect because a contract in the underlying asset may not be readily available in the derivatives market, but a similar contract may protect sufficiently. In this manner, an underwriter of securities who is long in corporate US dollar bonds may try to hedge the position by selling US Treasury futures because these hedge instruments are more readily available and therefore easier, faster and cheaper to obtain. Yet the Treasury and corporate bond market may not always move in tandem and there may therefore remain an exposure under this imperfect hedge. Similarly, to protect against an interest rate rise in a floating rate outstanding debt or borrowing, the party seeking protection may buy a corresponding floating interest rate (term-deposit) future. A swap into a fixed income stream would have the advantage of being able to go out much longer in time than standard futures usually do. It is a more versatile instrument. However, it may take longer to organise, which, in a heavily fluctuating market, may prove a considerable disadvantage. The time element will largely determine whether a futures hedge is preferred to a swap. The difference between protection through a put option or through a futures hedge may be more fundamental, and the choice will depend on whether the hedging party seeks to become indifferent to market movement altogether or whether it wants to retain upside potential. Thus, an investor may seek to protect the value of its portfolio of shares by buying a put, which gives the right to sell that portfolio at the agreed striking price to the writer of the put. Should the price rise, the put does not oblige the investor to sell anything to the writer and the investor could sell the assets at a higher price to someone else while letting the put expire. An option contract gives more flexibility than a futures contract (which would likely be a stock index future), but is also more expensive. The normal use of a derivative is as (a) a speculative instrument (like buying a call option), (b) an instrument to create extra income (as in the case of writing covered calls), or (c) a hedge like buying a put (to limit exposure in underlying assets). In fact, all kind of plays become possible. One is the straddle, under which an investor buys a put and a call in the same underlying asset at the same time. This may be costly, but may serve a purpose in times of extreme volatility, as it creates a possibility to make a profit either way. One may do the opposite and write a put and call at the same time if one thinks that the market may not move and cash in on a double premium. It is a very common technique. Also common is the synthetic future when an investor buys a call and sells (or writes) a put in the same underlying asset at the same time (thus reducing substantially the net price of the call option), usually but not necessarily at the same striking price. It simulates a long holding in the underlying asset while eliminating much of the funding costs (but there is no dividend or coupon income either). The result is that, if the market moves up, the investor will exercise the call; if the market moves down, the put will be exercised against him. In either case s/he will end up with the securities as if s/he were long, hence the idea of a future (purchase). It minimises immediate costs and avoids them altogether if there is no appreciable movement in the market value of the underlying assets so that no option will be exercised.

270 Volume 5: Financial Products and Funding Techniques As just mentioned, rather than as risk-switching instruments or hedges, derivatives may of course also be used as pure investments to enhance income. Thus, writing or selling a call option in a share portfolio exercisable at a striking price at or above the market price of the underlying shares gives the writer of the option a premium income. Doing so without such a portfolio (a naked call option) will expose the writer to substantial (unlimited) risk when the share price rises above the striking price. Similar risk is incurred when a future contract is sold in assets the seller of the future does not have. This seller will only do so if s/he believes that the price of the underlying assets will go down. The risk under a put, on the other hand, is limited to the striking price and naked puts are therefore less risky than naked calls. To hedge, the writer could create a short position in the underlying asset which may be obtainable under a future. In that case the put would no longer be naked. In a swap, other kinds of plays are available. A party may enter a swap, for example, without any right to the underlying exchanged cash flow. In fact, as already mentioned, these underlying flows now may be entirely fictitious and parties may agree only to pay or receive the difference in the simulated accruing flows on the appointed payment dates. This makes them better hedge instruments because they can be tailor made and are more flexible. Except if used as a hedge, the stakes are raised in currency swaps, which carry both interest rate and currency differential risk. The stakes are higher still if the assets out of which the cash flows arise are also swapped, particularly in (liability) currency swaps, as large amounts of money may have to be returned in a currency that may have increased in value in the meantime. It requires the risks in these swaps to be actively managed. To repeat, asset swaps are here to be understood in the sense that an asset is swapped or that the swap takes place on the asset side of the balance sheet. A liability swap takes place on the liability or funding side of the balance sheet. A liability swap in which the underlying assets are also swapped may be entered into as an arbitrage or currency play between two different bond issuers who are each better placed to issue bonds in currencies that they do not really need. One party may thus end up with large yen proceeds and the other with US dollar proceeds, although the first one has a need for dollars and the latter for yen. A swap is then the obvious solution, and many international bond issues are swap driven in this manner. Under such an arrangement, the relative advantage accrues to the parties operating in the most favourable markets. The result would be an exchange of principal as well as the attached interest rate payment obligations. Naked foreign exchange positions for each party would result, as they are short in, and must repurchase respectively, yen and US dollars on the agreed payment dates of the coupons and on the repayment date of the principal amounts at the then prevailing exchange rates between the currencies, or settle the difference between them. As just mentioned, this may mean a great deal of currency risk beside interest rate risk, which are risks that the parties may hedge from time to time during the swap period depending on their view of the development in currency and interest rates. It is a question of risk management, which is greatly important here, as the risks may be large when currencies and interest rates are volatile.423 423 A more recent development is the use of derivatives to hedge against volatility in the crypto-currency markets (eg, Bitcoin). Crypto-currencies are a novel financial creation that are typically decentralised (in the sense that they are not backed by a government or central bank) and can be traded OTC, meaning that they do not need to (but may) be traded on a crypto-exchange. They have received large investments from speculators around the globe, many whom are making profits by buying a crypto-currency when the price is low and selling it when the price is high. This speculative activity, arbitrage, and the fact that the largest crypto-currencies are decentralised, has resulted in significant volatility in these markets. This has seen the emergence of a market for crypto derivatives, whereby an investor can enter into a future, option, or swap in order to manage the risk of violent swings in the price of a particular crypto-currency. By 2020, the crypto derivatives market reached a volume of $600 billion, see Alex Axelrod, Crypto Derivatives Might Drive a New Cycle of Mass Adoption (June 28, 2020) Cointelegraph. https://cointelegraph.com/news/crypto-derivatives-might-drive-a-new-cycle-of-mass-adoption.

Volume 5: Financial Products and Funding Techniques 271 The swap may thus play at various levels: (a) as an actual exchange at the level of the principal; (b) as an actual exchange at the level of the coupon or cash flows, or both; or it may (c) simply be a contract for differences between two fictitious underlying asset pools and/or accruing or outgoing income streams in them. The latter type can be freely structured by parties and may incorporate a series of succeeding payment dates during the swap. As already mentioned in the previous section, this type of synthetic swap, which has become the most common, at the same time avoids problems with the underlying credit risk when the cash flows and payment dates do not exactly match. But even in the principal and coupon swaps, especially in the Eurobond bond market or loan markets, in practice, the swap parties are unlikely effectively to exchange the amounts or flows involved. In asset swaps—for example, US student loans in dollars against English mortgages in pounds sterling—there could be a cross assignment, but each party would become dependent on the credit risk of a third party, being the issuers of the (euro)bonds or the borrowers under the loans swapped into. In liability swaps, there would be a delegation of principal and coupon payment duties through which the swap parties would force themselves on bond holders or lenders as new debtors, which could not be done without their consent. In these principal and coupon swaps, both parties will therefore normally cross-lend similar amounts to each other and only assume the credit risk of the other. They will thus continue their normal relationship with the bond issuers or borrowers to whom they may have lent the principal (subject to an asset swap) or from whom they may have borrowed the principal (subject to the liability swap), including the interest payments on these amounts. The swap partner will not become involved in the administration of these bond issues or loans and payments. Further developments have led to a number of hybrids such as floors, collars, swap-options or swaptions and forward rate agreements or FRAs. Caps are instruments under which the seller (of the cap), usually a professional investor or a bank, at a fee payable immediately, guarantees a maximum interest level to a borrower in paying him any excess s/he may incur in his floating rate obligation during the period in question. Floors do the opposite in guaranteeing a lender with a floating rate a minimum return. Caps and floors can even be introduced in modern floating rate bonds. Collars combine both and will allow the buyer of a cap (the borrower) to function at the same time as a seller of a floor to his lender (the seller of the cap). It reduces the cost of his cap to the extent of the value of the floor, giving him a protection as to the maximum borrowing cost while s/he guarantees a minimum. Swaptions allow the other party, for a fee to be paid immediately, to enter into a preagreed swap at a specific later date (usually exchanging a fixed rate bond for a floater). The fee will serve as reward for the risk of the option being exercised and can be used towards the cost. There are some variations: in extendable swaps, the party benefiting from the option may extend the swap period to a specified later date; in callable swaps, the recipient of the fixed income may shorten the swap period to a specific prior date; in puttable swaps, the payor of the fixed rate may do so. FRAs, finally, are agreements under which parties agree a swap during an agreed future period leading to a single net payment, usually on the first day of the period concerned. Other types of arbitrage plays may be encouraged by the existence of derivatives. Most of them take advantage of small differences in price between the derivative and the underlying (cash) markets. Thus, in stock index futures, there may be a fictitious underlying basket of shares and arbitrage between the index future and the basket stocks is a popular activity among professionals, facilitated by computer monitoring (program trading). It may create large volume flows in the basket assets and has as such been identified as a source of potential instability in stock markets. For the participants, there is a risk of distortion. The underlying basket assets are quoted at their latest bid and offer prices. In times of high market volatility, they may not reflect the actual values correctly, because trade in some of the basket assets may have dried up. Hedge funds are also known to have entered this field.

272 Volume 5: Financial Products and Funding Techniques As we shall see in section 2.6.4 below, standardised tradable options and futures are likely to exist in major shares and bonds and form the substance of regular derivative market activity. Options may also exist in stock exchange indexes and in some futures and swaps (swaptions). Standard futures are less likely in individual shares but do exist in stock exchange indexes as just mentioned. They are also common in foreign exchange contracts and likely to exist in major government bonds or bills and in certain standard time-deposits of short duration. Forward contracts, of which financial futures are a further evolution, have themselves existed for a long time and remain common, particularly in agriculture to sell crops (or pork bellies) forward to guarantee a certain income. They also became common also for other types of commodities, particularly crude oil. These forward agreements were intended to lead to delivery of the underlying commodity, and were as such different from the modern financial futures as contracts for differences developed as exchange quoted financial instruments since 1974; but the principle is the same. Derivatives and share ownership present a different picture in which ownership of public companies can be obscured even though that may not be the prime objective.424 Stock index swaps may be one example. The incentive may be to circumvent local withholding taxes payable by foreign investors.425 Another feature may be to allow the stock index holder to acquire the actual shares in an option structure through which a takeover campaign can be conducted in secret.426 Insider trading and market abuse laws, even monopoly laws may be subverted in a similar way.427 In the EU, the Second Transparency Directive of 2013 (Recital 9) now requires disclosure.

2.6.3. The Valuation of Derivatives The value of options or futures depends on the present market value (‘cash market’) of the underlying assets (or indexes) in which an option is given or which, in futures, are subject to delayed transfer and payment. In futures, there is a direct correlation between the cash and futures value; if the price of the underlying asset rises, so does proportionally the price of the future. In the option, the relationship (or Delta) is usually less than direct and the option price may change less than the price in the underlying assets. This can be demonstrated through a mathematical formula in which not only the cash value of the underlying asset figures but also the diminishing time value of the option and the volatility of the market (this is the Black and Scholes model). Thus, in futures, if the market price of the underlying assets rises above the agreed sale price of the asset, the buyer wins and the seller loses the difference. The next day, it may be the other way around. The value of the future (the right and duty for the seller to sell or for the buyer to buy an asset at an agreed price on an agreed future date) rises and falls accordingly. So, it happens in term-deposit futures (although it may be affected by the buyer/seller spread and by the interest rates). If interest rates rise, the value of the underlying (future) fixed deposit falls; the future buyer loses and the seller wins. New contracts for the same deposit will be cheaper. In the option, similarly, the buyer of a call wins when the value of the asset rises above the striking price. The buyer of a put wins when the value of the underlying asset falls below the striking price. As just said, because of the time and volatility factors, they may not rise or fall in 424 See AP Salonen, Transnational Law of the Over-the-Counter Derivatives Market, A Study on the Interactions between Finance and Law (Helsinki, 2019) 69. 425 DP Harito, ‘Equity Derivatives, Inbound Capital and Outbound Withholding Tax’ (2007) 60 Tax Law 313. 426 E Khasina, ‘Disclosure of Beneficial Ownership of Synthetic Positions in Takeover Campaigns’ (2009) Colum Bus LR 904. 427 Y Yadav, ‘Insider Trading in Derivative Markets’ (2014/15) 103 Geo LJ 381.

Volume 5: Financial Products and Funding Techniques 273 the same way as the underlying assets. Price fluctuations in the underlying asset will nevertheless have a substantial impact on the call or put price. Accordingly, the option may move in the money or out of the money even though it may be more difficult to determine by how much. The price of the option and future thus changes all the time depending on the values of the underlying assets in relation to the agreed striking price in the option or sales price in the future. Options and futures are bought or sold in the markets at a price reflecting this difference. It is important to remember that although the modern financial option (like the future) is often called a contract for differences, the underlying assets must still be delivered and paid for when the option is exercised or delivery under a future is requested. That price (and the commissions payable) is not part of the option or future itself. But in reality, modern financial options and futures, especially when traded as standard contracts on regular option and futures exchanges, are often not exercised in the sense that the underlying assets are delivered. As was mentioned above, normally only the difference (that is, the options or futures price prevailing at the time) will be cashed in, but it is usually for the winning party to decide. That is the essence of contracts for differences, which modern financial futures and options normally are. In the American option, the buyer may exercise the option at any time during the period (important when dividend and coupons are going to be paid), not so in the European option, which can be exercised only on the agreed option date. To win, the buyer of the option will have to be lucky on that day. In the American option, there is on the other hand a continuous window to exercise the option or claim the difference. It affects the value of the option and the calculation thereof. Note in this connection that the regular European option exchanges normally use the American option. European options are OTC instruments and much less common. Under a financial future, the underlying assets can be acquired only on the agreed future date and the party being in the money normally has the right to claim the difference between the market price and the forward price on the date of settlement. In the meantime, any party in the money may attempt to cash in by transferring its position to others (including the counterparty). As already mentioned, this is much facilitated by the regular futures and option exchanges, although for some futures contracts, notably those concerning time-deposits, the buyer has in fact only an entitlement to the difference on the contract date, as a deposit contract is not normally transferable without the depositors’ consent. In the case of stock index futures, there is an entitlement only to a cash settlement and not to the underlying basket assets. Interest rate swaps are by far the largest segment of the derivatives market. Using the gross nominal value of all payments under these swaps, by the end of 2014 the total was about $600 trillion, a decline of 9 per cent on the previous year. It has remained at this level and is the largest market in the world. Up to almost 30 per cent may now be transacted and cleared centrally through CCPs. Another measure is the gross market value of these swaps being the difference from time to time between the value of the exchanged cash flows as they develop (before bilateral netting). It determines which party is in the money and for how much: if market interest rates rise, the party entitled to the floating rate cash flow is winning as its (Libor or Euribor) cash flow rises with the increased interest rate. The party with the fixed rate interest stream loses and would have been better off to stay in floating. In a cross-currency swap the difference may be accentuated or corrected by the development in the exchange rate between the differing currencies of both cash flows. The totals are here much lower, about $16 trillion at the end of 2016. Upon bilateral netting, the outstanding total was thought to be in the region of $3.3 trillion.428

428 See BIS, ‘Statistical release OTC derivatives statistics at end Dec 2016’, Monetary and Economics Dept (BIS Statistics 2017) Annex A.

274 Volume 5: Financial Products and Funding Techniques As already noted, where swaps are structured on the basis of fictitious cash flows, they are synthetic contracts for differences. No exchanges and returns of cash flows (or assets out of which they arise, such as principal loan amounts) are involved. In such swaps, different pay dates during the swap period may be agreed, and this is quite common. Where exchanges of principal amounts and coupon are still supposed to take place, they are in fact cross-borrowings of the swap partners, as we have seen in the previous section, but also in those cases, in the nature of contracts for differences, only the differences in values will normally be settled. The valuation of swaps acquires a particular meaning and urgency in a close out upon an event of default in a swap relationship. This became clear in particular in the interaction between ISDA and the UK courts under the 1992 Master Agreement text as subsequently amended in 2002. In principle there are two methods: either to ask market makers for quotes for replacement swaps, which may vary greatly in times of stress and even outside it for complicated products. The alternative is a loss assessment by the affected party itself on the basis of a fair evaluation by the non-defaulting party, such party acting reasonably and in good faith. This is obviously more subjective but may be reasonable in abnormal times or for unusual products. These methods are also referred to as the market quotation and loss methods, bankruptcy courts having here the last word regardless of the contractual language in master agreements. They may be inclined to a more objective approach if feasible, but may also consider whether the cost of the transaction is reasonable when an actual replacement has been made regardless of the precise wording of the master agreement requiring several quotes in respect of a close out calculation.429 The ISDA language was adapted in the 2002 text under which the replacement value of terminated transactions was to be determined in good faith using commercially reasonable procedures in order to produce a better result, but it requires ever greater sophistication and leaves a great deal of power with the non-defaulting party and eventually courts or arbitrators to determine the correct interpretation and application of the ISDA Master in these matters.430

2.6.4. Derivatives Markets and Their Operations. Clearing and Settlement, CCPs, Clearing Members and the Notion of Margin It has already been said that all three—options, futures and swaps—are contracts, not negotiable instruments or (transferable) securities as such, even if for regulatory purposes, they may be considered securities, or at least investments. Being contracts, they are not easily transferable and could as a consequence not be traded on exchanges, although in recent times an exception has been made for some standardised options and futures contracts and regular options and futures exchanges now operate in many countries. This was not the case for swaps, which remained typical OTC products although as we shall see, since the financial crisis, there is regulatory pressure for this to change for swaps that can be standardised. It raises the important issue of what ‘standardisation’ means in this connection, see section 2.6.5 below.

429 See for the English Courts, Fondazione Enasarco v Lehman Brothers Finance SA, [2015] EWHC 1307 (Ch). It concerned the 1992 text, replaced by the ISDA in 2002 with reference to ‘commercially reasonable procedures’ to find the replacement costs or the economic equivalent of the terminated transactions. It is clear that there is here, probably unavoidably, in a vital aspect of the termination, a weak component in terms of legal certainty. See also the discussion in Vol 2, s 2.4.3. 430 See for a critical comment, R Zepeda, ‘The ISDA Master Agreement 2012: A Missed Opportunity?’ (2013) 28 JIBLR 308.

Volume 5: Financial Products and Funding Techniques 275 The most important modern exchange for financial options and futures in the US is the Chicago Mercantile Exchange (CME), with which the Chicago Board of Trade (CBOT) merged in 2007. In London there is LIFFE, in Frankfurt the Deutsche Terminbörse (DTB) and, in Paris, the Matif. Except for the DTB, they traditionally all applied the open outcry system – that is where a group of market makers on a trading floor (that is, in a ‘pit’) shout prices to floor brokers who communicate with them through a set of hand gestures. Electronic trading is now taking the upper hand everywhere, as it is cheaper while doing away with the floor and many of its personnel. The argument for open outcry was always that it was quicker (approximately six seconds), but it became doubtful whether this was really so while the communication facilities on the floor remained unavoidably cumbersome and subject to human error. The US exchanges held out the longest, but they have also abandoned the open outcry system. Future and option exchanges may have their own clearing and settlement systems (known as the vertically integrated model), or they may use an external clearing and settlement system (known as a horizontal model) (for example, the LIFFE exchange in London uses the London Clearing House (LCH.Clearnet) for the clearing process, which is a separate organisation). These are likely to be quite different from the ones in the securities markets, where the emphasis in clearing is on managing transfer and settlement risk, which requires special services in terms of brokers, custodians, transfer agents, verification and the like. Clearing and settlement is then an issue of transaction and payment finality. For derivatives, there may also be a ‘transfer’ in terms of a close-out, but it is not considered the essence and the clearing function in this connection is foremost centred on the management of the contractual positions, their proper recording, the timely payments thereunder and forms of collateralisation (margin as explained below) which are connected with heightened counterparty or credit risk over an extended period of time. This is the result of these contracts incorporating a time factor during which the parties may go in or out of the money as explained above. At regular intervals, payment may have to be made to the party in the money, while margin calls will be made on a continuing basis. Regular derivative markets are likely to be regulated, at least in some of their more essential functions such as post-trade processing, but also for the publication of quotes and done prices. This is now common in all exchanges, whether formal or informal. If some or all of these functions are left to outside clearing houses, they may also be regulated, but probably only lightly and only in certain specific aspects. It depends on the country of their location. They may compete and their efficiency and internal safeguards (for clearing and settlement) will determine their success. This may provide better protection of the public at the same time. OTC markets have so far remained largely unregulated (except sometimes for the pre- and post-trading price reporting, depending on the product). The swap market is the most important example where individual banks make markets and take a position with a host of counterparties. The clearing and settlement processes are conducted in-house and on an informal basis by each individual bank. Regulations in the US (Dodd-Frank Act) and in Europe (the EMIR) meant to change this at least for standardised products (see Volume 6, section 3.7.4). It is felt that this makes this business safer as it will be better and more professionally administered. It may also be better monitored. According to the BIS, by the end of 2014, almost 30 per cent of the OTC derivatives were centrally cleared using a CCP. The percentage of OTC derivates being centrally cleared is presently much higher, with ISDA reporting that 76.6 per cent of interest rate derivatives (a market with a notional value of $344 trillion) were cleared in the second half of 2019.431 431 ISDA, Key Trends in the Size and Composition of OTC Derivatives Markets in the Second Half of 2019 (June, 2020), at 7: www.isda.org/a/BAQTE/Key-Trends-in-Size-and-Composition-of-OTC-Derivatives-Marketsin-2H-2019.pdf.

276 Volume 5: Financial Products and Funding Techniques While discussing the ‘trading’ of derivatives, even on regular derivatives markets, again it should be borne in mind that these derivatives are contractual positions, and that in law the transfer of such positions is generally not easy as it means a transfer of rights and duties. Especially the latter are not transferable without consent of the original counterparty, who would thus acquire a veto. It is a question of credit or counterparty risk and concerns the question of proper performance, which cannot unilaterally be shifted to others. The simplest way to achieve it is by assignment, which, without consent of the counterparty, can thus only be effective for contractual benefits or rights, not for the contractual duties (unless closely related)—see also the discussion in sections 2.2.4, 2.3.1 and 2.5.1 above. It could still be feasible for options (which by their very nature only confer rights) but an assignment may still entail all kinds of formalities (in terms of notification and documentation) and may therefore still not be very suitable, even for options. In any event, normally, there are rights and duties under most contracts (certainly in sales contracts such as futures, and in cash flow exchange contracts such as swaps) and consent of the counterparty in the derivative would then be necessary for a full transfer. This could amount to novation as a tripartite agreement under which the old contract disappears and is replaced by a new one.432 Again, it gives the original counterparty a very strong position as it can block the transfer. In law, a simple transfer of one’s (net) position under a derivative to a third party is thus not a likely facility; a contract is not ordinarily transferable and tradable. This is a great disadvantage in derivative dealing and is particular to the traditional OTC transactions. Successful derivative exchanges have to overcome these difficulties. (a) They do this by narrowing the field while offering only a limited number of standardised types of (financial) derivatives, which can be created, ‘transferred’ or rather extinguished through the exchange. This means standardisation in documentation as well as operationally, the latter meaning in the case of options and futures that only derivatives with a specific time frame and price will be offered (operational standardisation may be different for swaps and is a crucial issue as we shall see in the next section). (b) These regular exchanges will provide a clearing and especially settlement and payment facility at the same time, which are the key to the whole operation. In the process, they also allow for a better verification of the positions and management of risk. (c) Clearing in this context concerns foremost the payments that will have to be made under the relevant contracts, which, in the case of swaps, may mean multiple payments over long periods. It also concerns their collateralisation through margin collection. (d) Although options and futures may be exercised (the US options at any time during the period), and the clearing and settlement facilities in regular exchanges may deal with that also, normally settlement in respect of financial derivatives is in the nature of contract for differences and regular exchanges will operate on that basis. (e) The idea is still that the party wishing to get out enters the opposite position for the same date at present prices. In this sense, there is no transfer, but a hedge created as was explained before, although it may become subject to an immediate close-out facility.

432 There is room for considerable confusion in the reference to novation in the context of derivative trading. It is often thought that by interposing a CCP and breaking the contract up into two, there is at the start of the transaction a form of novation. However, CCPs in some jurisdictions use a mechanism called ‘open offer’ for the counterparty substitution process instead of the traditional mechanism of novation. See C Chamorro-Courtland, ‘Counterparty Substitution in Central Counterparty (CCP) Systems’ (2012) 26 Banking & Finance Law Review 519.

Volume 5: Financial Products and Funding Techniques 277 (f) To facilitate the finding of a ‘buyer’ or ‘seller’ as the case may be, therefore someone who will take an opposite position, these exchanges are likely not only to rely on public demand, but also to organise market makers who will take positions if public investors do not do so, or do so insufficiently. (g) Importantly, these exchanges may at the same time become the parties’ counterparties in all transactions (or CCPs). In that case, there are no longer connections between end-investors. All transactions are cut into two, with the CCP entering in between through a process called ‘counterparty substitution’. The counterparty substitution process is often explained as a ‘novation’. (h) This novation process is considered to occur where end-investors enter into a contract with each other by executing a derivatives contract on an exchange. This contract is then considered terminated, and an identical set of mirroring contracts are assumed to be entered between the buyer of the derivative and the CCP, and the seller of the derivative and the CCP. However, as we shall see, CCPs in some jurisdictions use a process known as ‘open offer’ to substitute end-investors with the CCP, which is an agency construction that permits the CCP to create a direct relation with the end-investors as soon as they enter into a derivatives contract on the particular exchange.433 (i) The interposition of CCPs in this manner (whether through novation or open offer) makes an instant or immediate close-out of opposite contractual positions on the exchange possible through the technique of close-out netting, thereby eliminating the transactions, paying out or collecting the difference and ending the attending counterparty or settlement risk. (j) The position of the CCP is secured by strong guarantees of the main supporters of the system (often large banks) who operate at the same time as so-called clearing members and are legally the only entities the exchange deals with.434 (k) It means that all activity is directed through these clearing members. They stand in for the end-investors and market makers, who activate them but cannot directly transact with the CCP. (l) This set-up is supplemented by the concept of margin as a prime risk management tool based on a continuous mark to market of all positions. It is conceivable that it is substituted or supplemented by other forms of collateralisation. (m) For risk management purposes, CCPs are likely also to maintain a multilateral novation netting system among all clearing members under which at each moment there results a net exposure of each clearing member to the CCP in respect of new transactions. This is meant to limit further the exposure of the CCP in the case of an intervening bankruptcy of a clearing member and may then also limit the margin requirement or collateralisation needed. (n) It is also conceivable that there are netting facilities within each clearing member for all these transactions currently entered into through its intermediation. To take a futures contract as an example, it means that instead of there being one contract between a seller and a buyer in the underlying asset to be bought or sold in a future, in exchange-traded futures, there are in reality two contracts: in the case of a sale, one sales contract between the seller of the underlying assets and the exchange or CCP (which is then the buyer under the

433 That is to say, the end-investors never actually enter into a contract with each other. The CCP is immediately interposed between the end investors upon completion of the trading stage. Therefore, the end-investors will never owe each other contractual obligations, with the CCP acting as the main counterparty to all of their obligations. 434 See for CCPs and their functioning in particular, J Huang, The Law and Regulation of Central Counterparties (Oxford, 2010).

278 Volume 5: Financial Products and Funding Techniques future) backed up by one purchase contract for the underlying assets between the end-buyer or investor on the one hand, and the exchange on the other, the latter then being the seller of the same position. As already mentioned, there is a further twist in that these contracts are not between end-investors or market makers and the exchange but between the exchange and clearing members who stand in for them. By doing this, the exchange is able to guarantee termination of the future if a party, the original buyer under the future for example, wanting to ‘sell’ his long futures position before the expiry date presents a willing ‘buyer’ (who could be a market maker) of the same position (but for a different market price). It allows an opposite chain of two contracts to be organised through the CCP. This is of immediate importance for the party wanting to get out of the original future. The ‘sale’ is in this manner no longer at the mercy of the original individual counterparty who now has a contract with the exchange also, which remains in place and will not be affected. In fact, there is no transfer of a futures position at all. A ‘buyer’ found by the ‘seller’ of the future (who was the original buyer of the position) on the exchange enters into a new futures contract with the exchange (always through the clearing member), and this contract will be backed up by a purchase contract between the exchange and the ‘seller’ (being the original buyer of the position which the latter now wants to liquidate). The consequence is that the original ‘buyer’ under the future now enters a similar ‘sales’ contract with the exchange, but for a different price. If that party wants a close-out, both contracts will be netted out by the exchange so that a nil-delivery obligation results under which the exchange either pays to or receives payment from the ‘seller’, depending on whether the latter had a positive or negative position under the original future. That is a form of netting (close-out netting outside a situation of default) and eliminates counterparty and settlement risk. In practice, the margin requirement system may already have taken care of the payments, as we shall see. The key is that in this system the exchange is committed to co-operate by entering the necessary contracts (which are all standardised) and, if so requested, by closing them out. In fact, under applicable exchange rules, this close-out may be automatic. The arrangement is thus that the exchange cannot refuse to act in this manner and must close out the position if a buyer is found and the seller of the position wants this. The result is that the investor can transfer its position and realise its gain or limit its loss at any time. That is the great virtue of this system for this party. The practical steps are as follows. Normally, a client wishing to open a futures or option position will do so by approaching its securities broker. This broker will contact a floor broker on the exchange and lay in the order. The floor broker will subsequently approach other floor brokers who may have a mirror requirement, or will approach a market maker, who will take positions and operates against a spread. Subsequently, there will have to be a system in which the orders of either party are confirmed and verified. There could even be a form of netting of orders between them; market makers or floor brokers involved may also have the same clearing member who may net at that level. Then follows settlement, therefore payment under any original transaction or otherwise, and the close-out netting with the CCP. Within the clearing there may be a further netting mechanism in the nature of a settlement netting at the end of a given period (usually one day) among all participants, both in respect of their future positions and payments. As already mentioned, this may even become a system of multilateral novation netting, which determines the overall netted-out position of each clearing member at all times vis-à-vis the system. If properly set up, it may protect the CCP further if a clearing member becomes insolvent.435

435 See for the particulars and conditions for novation netting, s 3.2 below.

Volume 5: Financial Products and Funding Techniques 279 The foregoing offers the broadest description of what happens, but in the official derivative exchanges, this process acquires a typical legal form that is quite distinct and has to do with the risk management in the exchange. The floor broker and market makers while dealing may operate on the exchange only if backed up by a so-called clearing member of the exchange. The clearing member so activated by each acting broker/market maker in the transaction in fact becomes the party to the transaction on behalf of the ‘buyer’ or ‘seller’ and enters into the necessary ‘purchase’ or ‘sale’ agreement with the CCP (which may be outside the exchange as the LCH.Clearnet is in LIFFE in London). This role is becoming the essence of all modern clearing systems.436 In short, in the regular derivatives markets, the CCP or clearing house operates as seller to the buyer and as buyer to the seller, both represented by clearing members, and nets out the positions on either side if a close-out is required. It may be automatic. This system, supported by strong clearing members, guarantees substantial safety for the ‘buyers’ and ‘sellers’, who are the end-users (clients) operating through an exchange but not themselves directly connected with the exchange or each other. This is a key issue, as large amounts of money may have to be paid out to investors who would not dare to use the exchange if they could not be sure of safe settlement. As already mentioned, in such a system, the clearing members step into the shoes of ‘buyers’ and ‘sellers’ through a series of agency agreements and instructions, although this is sometimes also seen as a novation, but there may never have been a contractual relationship between the original parties, it being immediately expressed in terms of a relationship between the CCP and the relevant clearing members through the law of agency. Indeed, the original broker of the ‘buyer’ or ‘seller’ has an agency relationship with its client, under which the broker acts in its own name but at the risk and on account of the buyer/client. The floor broker takes instructions from this house broker of the buyer/client and acts for the latter under a service or agency contract between them. However, while acting with another floor broker or a market maker to finalise the transaction, the floor broker does so not in its own name, but in the name of the clearing member supporting this broker. The clearing member, through this chain, ultimately acts in its own name (but ultimately on behalf and for the risk and account of the original client) with the clearing organisation or CCP, towards which the clearing member accepts full liability for the transaction. The same goes for market makers. As far as the exchange is concerned, the transaction is therefore always principal to principal in which the clients (or end sellers or buyers) do not play a legal role except indirectly as activators.437 Although the clearing members, albeit always acting in their own name with the CCP, may thus still be considered some kind of agent from the perspective of the floor broker or market maker, the latter will notably not be able to enter in their place through disclosure of the agency. That possibility will be specifically excluded under the prevailing rules. The floor brokers and market makers (or traders) have a general power of attorney to commit and activate their clearing member in this way. It follows that the clearing members will only know at the end of the day how many deals are done for which they must accept responsibility (on a netted basis) vis-à-vis the CCP, including those of any rogue trader. That is their risk. Vis-à-vis

436 This system is not yet typical for all clearing as we shall see, particularly not yet in payment clearing under modern payment systems, see s 3.1.6 below, or even in clearing systems for investment securities in Euroclear or Clearstream, where the central party only makes the necessary calculations and arranges the net payments or transfers of securities as the case may be but is not a counterparty and therefore takes no market risk. 437 The CCP is likely, however, to have several accounts with its clearing members in which a distinction is habitually made between the client business and the clearing member’s own business. This is meant to segregate client business and therefore to give clients special protection against clearing members but also against claims of the CCP on these members.

280 Volume 5: Financial Products and Funding Techniques the CCP, the clearing members will be responsible for the implementation of all the deals entered into by the floor brokers and market makers supported by them. While the clearing member is de facto bound by the floor broker vis-à-vis the counterparty’s floor broker or the market maker, who themselves only operate for another clearing member, both clearing members involved in the transaction implement their obligations by entering into a contract with the CCP. It clears, settles and nets out the transaction pursuant to which the necessary payments are made, the (clearing member for the end-)seller is released and a new contract is entered into with the (clearing member for the end-)buyer. It may be asked in this connection who is the agent for whom or what? Who is the principal and who is the third party? Under the general power given by clearing members, they are the principals, to be bound to the CCPs in accordance with the end-investors’ needs, who are the third parties. The floor brokers are the agents. The details of this system, in which the CCP may never know the names of the end-users (the ‘seller’ and ‘buyer’) may differ between futures markets and option markets in different countries, but the principles are similar everywhere. The result of this system is that all futures contracts are split into two agreements, with each party having only an indirect relationship with the CCP through its own broker and the floor broker acting through a clearing member of the exchange. Thus, while the first broker contacts the floor broker, they activate at the same time an agency relationship between their client and the clearing member of the floor broker, which leads to the latter irrevocably binding the clearing member vis-à-vis the CCP (now as principal) if a transaction is concluded. There is here neither an assignment nor a novation, or at least there need not be. It was already mentioned that novation terminology is often used in this connection, but as mentioned above, the counterparty substitution stage may take place through the process of ‘open offer’. The essence is rather that by putting a CCP in between the original parties to a financial future, a mechanism is found in which the one party is not dependent on the other for the transfer of its position, which takes the form of a close-out of the positions once the original party has been able to organise an opposite position in the manner explained. The clearing organisation is bound at all times to enter into an offsetting contract as soon as a ‘buyer’ of the original position is found. Through this mechanism, a party (a clearing member, and through it an end-investor) can be released while it pays to the CCP any negative value of a contract and may claim any positive value from that organisation, assuming there is anyone interested in a like position. The result is that the original contract is closed out and replaced by a new contract with a new party (clearing member). This result can be achieved by parties to a derivative at any time of their choosing during the contract period and is an extremely valuable aspect of the operation of regular derivative exchanges. If there is going to be a payment by the exchange, it will often have this money already paid through the margin account as it may already have paid the party ‘in the money’ the difference on a daily basis through this mechanism. This system is supplemented by the concept of margin to provide further protection. As already mentioned, when a futures or options contract turns negative for the party concerned, the CCP will normally be able to request margin from the relevant clearing member, which will debit it to the client.438 To this end, a clearing member will want its floor brokers and market makers, whom it supervises, to keep a minimum balance with it. In turn, floor brokers will ask the house brokers, with whom they deal, to keep a balance with them and the floor broker will 438 Margin in this connection is normally thought of as cash payments but it may also be provided in the form of financial collateral, usually eligible government bonds. This creates a raft of other problems, including the possibility of the CCP currently selling or repledging these assets with an obligation to repurchase them if (eventually) they must be given back. See, for these problems, the discussion in s 4.1.3 below.

Volume 5: Financial Products and Funding Techniques 281 verify this or will hold the house broker responsible for protecting its clearing member further and may be required by the latter to do so. Vis-à-vis the CCP, this part of the arrangement is irrelevant, however, as the clearing member is first liable for the margin. The margin will go up and down on a daily basis (or will sometimes be assessed intra-day) and gives rise to payment to the client when the contract turns positive (a process known as marking-to-market). Thus, upon the occurrence of a close-out event (for example, the insolvency of one of the counterparties), there is usually little counterparty risk because all of the parties are continuously settling their outstanding obligations on a daily basis. The system of close-out payments is then subsumed into the margin payment system. To repeat, the objective of the involvement of clearing members standing in for their clients in this manner is that strong intermediaries accept responsibility for the creation, performance and termination of futures and option contracts and this is reinforced by the margin requirements. These clearing members are vetted and supervised by the exchanges for their continued solvency and margin is closely supervised. Bankruptcy of end-investors in a futures contract is therefore no problem for the exchange. The bankruptcy of a clearing member would still be a serious matter; but these institutions are carefully selected before they can participate as clearing members. In fact, this method of clearing and settlement has also been adopted in ordinary stock exchanges (that is, securities markets where investors can buy and sell shares and bonds), to minimise the risk to the system through the operation of well-capitalised clearing members who take over the liabilities of individual investors. Some stock markets use CCPs because transactions for shares and bonds are not settled immediately after trade execution. In most stock markets, delivery of a share or bond and the corresponding payment typically occurs two days after the trade was first executed (known as T+2). This means that the buyers and the sellers of shares and bonds are exposed to each other’s counterparty risk for a two-day period.439 Therefore, the CCP provides a guarantee that the shares or bonds will be delivered and that the corresponding payments will be made if one of the counterparties defaults in the two-day period before the settlement is finalised. Moreover, CCPs have been used for clearing and transferring foreign exchange (FX) transactions and the OTC swaps market (known as ‘cleared swaps’). Indeed, in London, LCH.Clearnet started to provide that service also for swaps even before the 2008 crisis.

2.6.5. The Concept of Central Clearing and the Issue of Standardisation in the Swap Markets It has already been mentioned that the swap market was, at least until recently,440 an informal OTC market in which there were no general rules for clearing and settlement, set-off or margin

439 Although the technology already exists for performing ‘instantaneous settlement’ (that is, settlement occurs immediately after a trade is executed on an exchange), participants in the securities industry have preferred to have delayed settlement (ie, T+2 or T+3) because this delay provides the parties with more time to obtain the necessary shares and cash to perform their obligations on the settlement date and also to go short without a need for security borrowing. At least in the context of the securities markets, the role of the CCP is likely to become redundant once exchanges begin to offer instantaneous settlement of shares and bonds, as there will no longer be any counterparty risk. 440 See in the EU for the EMIR Regulation favouring central clearing, Vol 6, s 3.7.

282 Volume 5: Financial Products and Funding Techniques (and other collateral) requirements.441 There is then no close-out facility either unless especially agreed. In principle, there is therefore an endless doubling up of counterparty risk. This is all a matter between the client and the swap dealer concerned, in which connection bilateral netting becomes important and may be introduced between them. That was the aim and essence of ISDA’s Swap Master Agreements and is especially important for market makers in swaps who are likely to deal directly with each other all the time. It concentrates on events of default which it defines and seeks a full netting out of all mutual positions at such moments.442 It limits a close-out of transactions to such events of default. As we have seen, modern clearing systems may now start providing a central swap clearing service through CCPs, which in such cases interpose443 themselves between the counterparties.444 This is promoted by modern regulation and would logically entail (some) supervision of documentation, enforcement of margin requirements, verification of trades and price reporting. The intended result is a more professional handling of this business with a more sophisticated infrastructure. But there is also the issue of a more reliable counterparty and the facility of continuous close-out netting at least if the transactions are sufficiently standardised,445 although such a regular close-out may not be the prime purpose here, and may be less opportune where the exposures are tailor-made or bespoke, although market makers might still be willing to create opposite positions.446 Fungibility is also an issue, as we shall see. Another key is reliable pricing and there must be some transparent and accessible valuation system in respect of spot sales in the underlying assets (mark-to-market), also to underpin margin calls. There are thus important issues of transparency, liquidity and stability. When clearing houses supported by clearing members start providing this service, there arise more in particular issues of ‘standardisation’, relevant for close-out and novation netting, but here perhaps more generally for risk management purposes. As (synthetic) swaps are often bespoke or tailor-made products with very different time horizons (see section 2.6.1 above)447 there may be problems, although again under the ISDA Master they can and are dealt with, more in particular in situations of default in the OTC or informal markets, as we have seen. In regular derivative 441 According to the IMF Global Stability Report (2010), Chapter 3: Making Over-the-Counter Derivatives Safer, already in 2009, 45 per cent of all interest rate derivatives were centrally cleared by LCH.Clearnet. 442 See for further details sections 2.6.8 and 3.2.5 below. 443 In the case of an interest rate swap, it means that it will pay fixed or floating backed up by a similar payment to it by the other party. Margin will be the main risk management too, as already explained. In the case of Credit Default Swaps (CDS) in its simplest form, the seller of the protection for a premium will buy the underlying asset at face value if a credit event occurs, see further s 2.5.3 above. The interposition of a CCP means that the latter will give the protection, backed up by the other party selling the same protection to it (the CCP). 444 See Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties (CCPs) and Trade Repositories (TRs), also referred to as EMIR, see Vol 6, s 3.7.4. Art 2(3) explains that the clearing is ‘the process of establishing positions, including the calculation of net obligations, and ensuring that financial instruments, cash, or both, are available to secure the exposure arising from these positions’. 445 Close-out netting is indeed often defined as the process ‘involving termination of obligations under a contract with a defaulting party and subsequent combining of positive and negative replacement values into a single net payable or receivable’, see ISDA Research Note, The Importance of Close Out netting, no 1 (2010). In the previous section, we have already seen that the close-out may also follow an opposite trade and is not necessarily connected with a default in regular derivative markets where CCPs operate. 446 S Cechetti, J Gyntelberg, and M Hollanders, ‘Central Counterparties for Over-the Counter Derivatives’ (September 2009) BIS Quarterly Review, note three advantages of central clearing: better management of counterparty risk, close-out netting (reducing counterparty risk further and earlier), and transparency. 447 The G-20 Pittsburgh Summit Leaders Statement, September 2009 required all standard derivative contracts to be traded on exchanges or electronic trading platforms to be cleared through CCPs. It raises the issue when a derivative is standardised. Non-centrally cleared contracts were to be subject to higher capital requirements.

Volume 5: Financial Products and Funding Techniques 283 markets where CCPs operate, it was noted that these operate in certain standardised contracts only, although LCH.Clearnet in testimony in London before the House of Lords EU Committee in 2010,448 explained that standardisation of this type may not be truly the key for central clearing of swaps. Rather standardisation must be seen primarily in terms of risk management of the ongoing positions in view of a possible default of a participant (clearing member) and not therefore in view of a regular close-out.449 Swap clearing then concentrates on four different aspects: (a) liquidity, (b) transparency, (c) reliability of market prices and (d) cost. CCPs operating here as clearers will fashion their default management procedures and standards in swap clearing accordingly. In the same hearings, the Future and Options Association (FOA) also put emphasis on price transparency, liquidity, volatility, risk complexity, valuation capability and the risk management capacity of CCPs to determine clearing eligibility, rather than on the narrower issue of standardisation. ‘Fungibility’ in terms of ease of transferability and replacement was also identified as an important issue, which suggests that the derivatives contract can then be more easily netted. The ISDA Masters and practices developed thereunder remain of great importance also in these clearing operations and may be incorporated in these clearing systems,450 whilst margin calls become the essential protection. Progressive standardisation may still help as the more a product is standardised, the easier it is to access clearing and to lower risk, which is the reason why standardisation tends to encourage further standardisation and a convergence in risk management and valuation models.451 Again, that also leads into more properly calculating the margin requirement. In fact, it may be necessary to understand the notion of standardisation in this context better. Is it merely in (a) the legal terms or documentation, of which ISDA often takes care, or is it also in (b) the risks, currencies and maturities covered? This suggests operational standardisation. The EU financial stability board (called the European Systemic Risk Board or ESRB, see Volume 6, section 3.7.2)452 puts emphasis on the contractual terms and operational processes, on the depth and liquidity of the market for the product in question, and on the availability of fair, reliable and generally accepted pricing sources. Thus, when determining whether a particular product is sufficiently ‘standardised’, meaning that the contract it is somewhat fungible and made suitable for central clearing (‘clearing eligibility’), authorities consider whether the risk characteristics of the product can be measured, financially modelled, and managed by a central clearer with appropriate expertise. It may mean that even standardised products can still not be cleared because they are not sufficiently liquid, demonstrating that at least for swaps, formal standardisation may 448 The Future Regulation of Derivatives Market, HL Paper 93, 42 (2010). 449 This type of standardisation is thus more typical for the regular option and future exchanges and is then a special feature of CCPs operating in that context, which allows regular users to net out settlement risk in futures and options when closing a transaction by engaging in a counter-position or hedge. 450 C Monnet, ‘Let Us Make It Clear: How Central Counterparties Saved the Day’ (First Quarter 2010) Federal Reserve Bank Philadelphia, Business Review notes that all positions of Lehman’s that were centrally cleared were settled very quickly. All counterparties were paid on the basis of Lehman’s margin held by LCH.Clearnet. 451 Whilst regulators started demanding that ‘standardised’ derivative contracts were to be cleared through CCPs, another seemingly more objective notion was introduced to make these contracts ‘clearing eligible’, but it was not clear what the criterion was and it raised the question whether CCPs still have the last word. Again, for them that is essentially a question of risk management. Private law concepts are here used by regulators, but they may present problems, see JP Braithwaite, ‘Private Law and the Public Sector’s Central Counter Party Prescription for the Derivative Markets’, LSE Law, Society and Economy Workshop Papers 2/2011; JP Braithwaite, ‘Legal Perspectives on Client Clearing’, LSE Legal Studies Working Paper No 14/2015, available at http://papers.ssrn.com/sol3/papers. cfm?abstract_id=2629193. 452 See its 2010 paper Implementing OTC Derivatives Market Reforms, 13.

284 Volume 5: Financial Products and Funding Techniques indeed not always be the issue. It requires a certain level of judgement, which it would appear must ultimately be left to these CCPs or clearing institutions as a question of their own financial standing and solvency. Thus, whether subsequently the positions can be netted out (short of an event of default) may not be the essence, although achieving it is normally a major aim in standardisation and may be a powerful risk management tool by itself. Operational standardisation also remains an important concept in this connection. For futures and options operational standardisation was shown in the previous section to mean that only derivatives with a specific time frame and price were considered for central clearing in regular derivative markets. For swaps, the situation is more complicated, and operational standardisation is here rather concerned with, and may be measured by, the extent to which product trade, processing, and life cycle events are managed in a common manner to a widely agreed-upon timetable. Firms may be given permission to perform them in the contract. Common life cycle events are in this connection coupon payments and rate re-sets, but they may also involve buy/ sell issues, such as increases, decreases, novations and trade compressions. One can see here economic standardisation revolving around valuation, payment structures, and dates. Life cycle events then include more in particular trade capture and revision, confirmation, settlement, and close-out or termination. Common handling of life cycle events indicates that a derivative market may be suitable for central clearing because the clearing process incorporates many of these practices as a matter of course. Nevertheless, bespoke products may still complicate the picture and often remain required especially by non-financial end-users such as airlines, insurance companies, hedge funds and institutional investors. Derivatives dealers may themselves have these bespoke requirements.453 These products may range from very simple products to products that are more complex. Customised features of bespoke products may include, among other things special consideration of: (a) underlying assets; (b) strike prices; (c) pay-outs; (d) currencies; (e) caps and floors; and (f) exercise dates. Some products may be so customised, that they require a day or more to price (and weeks to negotiate the governing documents). As there may not be secondary market pricing sources for many of these bespoke derivative products, margin in particular may be difficult to determine and this then becomes the more crucial issue.454 There may be no sufficient market liquidity to determine the exposure. These problems may make central clearing of bespoke products even unadvisable. If bespoke products use some sufficiently standardised terms such as exercise dates, they may still lend themselves, however, to some level of operational standardisation. Bespoke products that reach such a level may then still be clearable and deemed appropriate for trading on organised platforms, but to repeat, CCPs may not be interested or willing as these products may be too risky for them because they may not be liquid enough and are not fungible enough to be closed-out. Again, within reason, CCPs have to have the last word here as their own survival may be at stake. There are thus limits to what regulators can impose as objective standards for derivative clearing. The facility is further restricted by the limitations innate in private law structures, notably in the concept of set-off, even if one allows for more party autonomy in the creation of set-off facilities or similar preferences between professionals among themselves through netting agreements. In the EU, under the relevant regulation (EMIR, see Volume 6, section 3.7.4 below), much of this

453 EU Financial Stability Board, Implementing OTC Derivatives Market Reforms (October 2010). 454 See Basel Committee and IOSCO, Second consultative document on margin requirements for non-centrally cleared derivatives (2013). Especially the determination of the initial margin has proved difficult and is contested, see ISDA Letter to Basle Committee and IOSCO of April 2013.

Volume 5: Financial Products and Funding Techniques 285 is now left to negotiation between the securities regulator, ESMA, and the CCPs, with ESMA compiling a list of ‘classes of derivatives … which are eligible for the clearing obligation’. It also includes a mechanism to add to the list. The issue is also dealt with in Title VII of the Dodd-Frank Act in the US, much to be left here also to regulators, but it is better recognised in this Act that the CCPs must retain ultimate control of what they clear. The catch is that if swaps are not centrally cleared, capital adequacy penalties may be imposed, reflecting higher risks in terms of transparency and stability and require the posting of initial and variation margin (which is also normal for cleared derivatives, but it may be much more difficult to calculate). Where regulators may be more effective is in lifting certain restrictions or impediments like stay provisions under bankruptcy acts or limitations on set-off, and the operations particularly of swaps and repos in this connection, as we see under the US Bankruptcy Code. Considerable challenges also exist in the credit derivative market (CDS).455 A final observation may be in order. Moving swap trading to clearing houses means detracting from major banks’ business as market makers in this area. Of course, they may still be clearing members and market makers in exchanges but these may be more open and price transparent, reducing in this manner profitability but also enhancing market confidence. There is here clearly a conflict of interest. Furthermore, the exchanges or clearing institutions will have a larger volume and probably sounder infrastructure and systems to check on proper documentation and margin calls, additional reasons why regulators may support their intermediation, and end-users’ confidence will be further increased. On the other hand, it should be accepted that the operation of the swap markets was not really at the heart of the 2008 financial crisis and regulatory concern in this connection probably misdirected. In the absence of clear ideas, it was already mentioned that much regulatory concern in this area subsequently dissolved in further negotiations with participants.

2.6.6. The Concept of the CCP and its Potential The facility of the CCP has reached maturity in the regular markets for standardised options and futures. It will also be briefly mentioned in connection with payments and investment securities trading where it is not yet common (see sections 3.1.6 and 4.1.4 below). For swaps the situation remains in the balance as we have seen and the concept of standardisation as well as central clearing is more complex. The non-standardised OTC markets in many derivatives remain large, and operate especially when tailor made and replacement values are difficult to come by. It continues to raise important issues of fungibility, liquidity, valuation and netting as we have seen. The key is that, at least in the simpler regular options and futures exchanges, instead of a direct relation existing between two end-parties, one central counterparty is created, which acts as counterparty to the seller and the buyer of a derivatives contract in all cases. It immediately doubles all transactions, which remain related but only in the sense that the relationship of the one is backed up by that of the other. There is no longer a direct legal connection between the seller and the buyer. An important immediate effect is that if someone long on derivatives (acquired from the CCP) wants to close its position, there will be a counter-transaction with the same CCP (backed up by an outsider), who will net both the original contract and the new opposite contract out and pay the seller the difference if positive or demand that the latter pay any loss that is now crystallised (if these payments have not already been taken care of in margin 455 See for standardisation in this area, s 2.5.4 and n 386 above.

286 Volume 5: Financial Products and Funding Techniques payments). At the same time, there will be a new agreement in place with the new party (probably a market maker), who will have paid the CCP for the position. The CCP system usually goes together with ‘clearing’ (among the clearing members, which stand in for the end-investors in the manner explained in section 2.6.4 above) and ‘settlement’, in which the same CCP acts as the central organiser. Of course, the participating end-investors take the credit and settlement risk concerning the CCP, which could go bankrupt, but is normally guaranteed through the interposition of financially strong clearing members (activated by brokers or market makers who are approved by them) and who are the only intermediaries that the CCP deals with. Margin will further protect the operations in these markets, as will any early close-out and netting facility. In fact, it may be a great advantage to have a single CCP as counterparty rather than many other participants whose risk may be difficult to assess. This may well be the true reason for the success of the CCP concept. But additional benefits arise from the sophistication in the clearing and settlement facilities of CCPs and their systems expertise. From a legal point of view, there is also the standardisation of documentation and there are further substantial benefits from any operational standardisation, which allows what amounts in effect to a transfer of positions. This is important because derivatives are contracts (and not negotiable instruments), which means that traditionally they have been harder to transfer from one party to another as we have seen. Historically, CCPs were used to manage the counterparty risk associated with the prolonged settlement period for performing under a derivatives contract, which can remain executory for months or even years (for example, a futures contract for a barrel of oil for $50 with a delivery date of 18 months). In other words, counterparty risk is significant because one of the parties to a derivatives contract may become insolvent before the performance (or ‘settlement’) date, which could be months or years from the time that the derivatives contract was first executed on the exchange. The CCP manages counterparty risk by providing a sui generis form of insurance in the event that one of the counterparties is unable to performs their contractual obligations on the settlement date of the derivatives contract. As mentioned, CCPs reduce risks by requiring the counterparties to post margin and reduce exposures with multilateral netting. The CCP also facilitates the ‘transfer’ of contractual positions through the close-out facilities. It may be recalled that ‘transfers’ (of contractual positions) in the derivative markets, for example in the case of interest rate swaps, happens through taking counter positions. With the same counterparty, positions may be netted out on a continuous basis, but both remain in place in principle unless there is also a close-out agreed. That may be done under bilateral netting agreements, as under the ISDA Master Agreements, but is facilitated through CCPs. Again, the close-out is not then the sole or may not even be the major concern in the central clearing of swaps, which foremost tends to introduce greater order, especially in terms of documentation and margin calls. It also provides transparency, which may then also affect OTC markets in these instruments. That is what is happening with swaps upon regulatory prodding by G-20. The EU has long been concerned about the lack of consolidation in the clearing facilities in Europe where the costs of clearing and settlement remain high and the industry itself appeared to be comfortable with this situation. There is a need for consolidation, which, however, at the same time increases the possibility of monopolisation. One possibility is to create a single pan-European CCP in the nature of a public utility, much as the Depositary Trust and Clearing Corporation (DTCC) is already in the US. Another idea prefers market forces. The EU Commission appeared to favour the latter but now promotes clearing through regular exchanges and therefore also the CCP process. As mentioned earlier, in 2010 the EU came up with a proposed Regulation in this area of OTC derivatives, CCPs and Trade Repositories (EMIR), after substantial modifications put before the Parliament in 2011; it became effective in 2012, see further Volume 6,

Volume 5: Financial Products and Funding Techniques 287 section 3.7.4. In the US, there is the Dodd-Frank Act, which also promoted the policies of the G-20 in this regard. Thus, in the aftermath of the 2008–09 financial crisis, this area of clearing and settlement including greater transparency of the markets received much greater attention, at first especially in connection with the practices concerning CDS; see also the comments in section 2.5.10 above. The risk is that on the one hand regulation may upset participants’ own risk management facilities, even their own netting and close-out arrangements under the ISDA Master while there is no guarantee for anything better, and on the other that CCPs or other central clearers are forced to take more risk than they should. Again, this may have to do with the fact that in many OTC derivatives the risk is unlimited and the call for collateral is based on statistical findings as mark to market may only be partly available and not up to date. It has already been said that it could seriously endanger central clearers in bad times, problems that would be compounded if consolidation were forced upon them. On the other hand, profit depends on volume. CCPs are typical market creations that derive their success from market forces, and they generally compete with each other. That makes them vulnerable, which means that they have to perform a balancing act. Forcing the pace through regulatory intervention may destroy their credibility. In other words, if politicians and regulators want to introduce more regulations, they may have to provide a state-backed guarantee in the event that a CCP were to fail. In this case, there must be determination of whether the central bank has the legal authority to provide a bail-out to a CCP that is considered too-big or toointerconnected to fail.456 There are other forces: banks continue to have much influence over CCPs and may resent the transparency in pricing that they bring, especially in OTC products in which they trade. This was shown when after the 2008 financial crisis when the CME started to clear CDS. It follows that there are here serious conflicts of interest that good regulation must overcome. As mentioned above, the securities markets have also begun to use CCPs to manage the shorter period of counterparty exposure that arises in many securities exchanges around the world, where the settlement occurs two or three days after the execution date for the purchase or sale of a bond or share.457 However, the role of the CCP may soon be reduced (or even be made redundant) with the introduction of technology (such as distributed ledger technology) that permits instantaneous settlement of securities transactions. This will essentially eliminate counterparty risk, as the settlement (that is, delivery versus payment) will occur within minutes or even seconds after execution for a particular share or bond takes place on a securities exchange. The buyer will immediately receive the securities that they have purchased (that is, the securities will be immediately credited to the buyer’s securities account), and the seller will immediately receive payment for the securities that they have sold (that is, they will receive an immediate credit to their cash account with their broker or in their bank account). There are already securities exchanges around the world moving toward this model of instantaneous settlement. For example, the ASX in Australia will permit one leg of a transfer (that is, the securities leg or the cash leg) to be settled instantaneously as of 2021, with a plan of permitting instantaneous settlement of both legs of a transaction in the near future. 456 See C Chamorro-Courtland, ‘The Trillion Dollar Question: Can a Central Bank Bail-Out a Central Counterparty (CCP) Clearing House which is “Too Big to Fail”?’ 6 Brooklyn Journal of Corporate, Financial & Commercial Law 433 (2012). 457 In securities markets, the position is in fact simplified as there is no need for regular payments during a certain time frame. The only issues are the verification of the transactions and the transfer of and payment for the securities (or commodities) in question. The accent is here on prompt and reliable settlement.

288 Volume 5: Financial Products and Funding Techniques Another recent development is the ongoing debate over the impact that Brexit will have on Europe’s clearing and settlement infrastructure in the near future.458 Policy-makers in the EU have been concerned for several years that large volumes of euro-denominated transactions are cleared by CCPs located outside of the eurozone, in particular in the UK. For example, the majority of euro-denominated interest rate derivative contracts are cleared by CCPs located in the UK. The ECB has reported that ‘[a]pproximately 99% of total cleared euro-denominated cleared interest rate swaps (IRS) transactions and 50% of total cleared euro-denominated repurchase agreement (repo) transactions currently take place outside the euro area’.459 London is home to some of the largest CCPs in the world: LCH, CME, the Intercontinental Exchange (ICE) and the London Metal Exchange. These four CCPs are responsible for clearing a notional €877 billion a day in euro-denominated swaps contracts and are overseen by the Bank of England as systemically important infrastructures. EU policy-makers are particularly concerned that these systemically important infrastructures will be beyond the reach of EMIR after Brexit. In response to this uncertainty, the EU has proposed amending the European Markets and Infrastructure Regulation (EMIR) to provide the European Central Bank (ECB) and the European Securities and Markets Authority (ESMA) with enhanced supervisory powers over CCPs, in particular with respect to third-country CCPs—that is, CCPs located in non-EU jurisdictions. The reforms provide for the participation of multiple regulators at the national and the EU level for the regulation and supervision of systemically important CCPs with the goal of reducing systemic risk in the EU. Under the proposed ‘comparable compliance’ regime, CCPs will be classified as either being non-systemically risky (Tier 1) or systemically risky (Tier 2) and supervised accordingly. The new regime may prove to be controversial among foreign regulators (that is, non-EU regulators), as it may sometimes require the extra-territorial application of EU law in a third-country. Therefore, the proposed regime will only work if the relevant thirdcountries and their National Competent Authorities (NCA) agree to recognise and enforce the relevant provisions of EMIR. The proposed reforms also revive and update the ‘location policy’ for CCPs that are considered too systemically important to provide clearing services to EU market participants from a third-country (for example from the UK). The location policy is workable in practice, as there are financial centres in the EU (or potentially even the US) that could handle the business of a CCP that relocates from a third-country such as the UK. Therefore, it will be seen in the near future whether the UK will comply with the requirements of EMIR, or whether systemically important CCPs such as LCH will voluntarily or whether they will be forced to relocate from London to a financial centre in the Eurozone such as Frankfurt, Paris, Amsterdam or Dublin.

2.6.7. Derivatives Risk and Netting for Swaps Derivatives are traditionally off-balance-sheet items. As they may go in and out of the money, they are contingent in value, which value can only be determined from time to time by marking them to market or otherwise statistically.460 They may carry substantial risk, especially the naked options and uncovered future sales. In swaps, if principal and/or cash flows are exchanged,

458 See C Chamorro-Courtland, ‘Brexit Scenarios: The Future of Clearing in Europe’ (2019) 25(2) Columbia Journal of European Law 169. 459 European Central Bank, The International Role of the Euro (July 2017). 460 See further also the discussion in s 2.6.3 above.

Volume 5: Financial Products and Funding Techniques 289 the one party may not receive the return of these amounts in a bankruptcy of the other, while it may still have to perform its own return duty. If the swap is a question of cross-loans in different currencies, it means that the non-bankrupt party may not receive back its principal, while it may still have to repay the bankrupt unless there is a reliable system of set-off or contractual netting acceptable to the bankruptcy court (which may also allow a set-off between claims in different currencies, which may not otherwise be possible under the applicable law of set-off). Equally, it may still have to pay interest to the bankrupt until the end of the loan period while it gets nothing in return under the swap. Thus, even within one swap, the risk may be substantial unless the netting principle is fully accepted. For the modern (synthetic) swap, based on fictitious amounts and structured as a contract for differences, this may be easy. There is here so-called novation netting, which starts from the beginning of the transaction as the essence of this structure in which both parties have agreed from the outset a single net payment for cross-claims. It might be simpler to refer here to a contract for differences, and the term ‘novation netting’ may not add much.461 Swaps of this kind are then considered financial products in their own right under which the result is that only one amount will be due on the payment date (that is, the net debtor will pay the net creditor to perform final settlement). If cash flows are exchanged, or in currency swaps even the underlying principle amounts of bond issues or loans out of which they arise, the exposure is much larger. When such amounts are physically swapped, there may still be settlement netting, however, that is, netting on the settlement date. This netting may be more contentious when the maturities and currencies are not the same (or non-monetary claims are also involved, for example when bond issues must be returned). The essence here is that the netting contract might introduce formulae to deal with different maturities and interest rates. That is the aim of the ISDA Master Agreements. As already mentioned above in section 2.6.2, although we speak of the exchange of underlying cash flows and principal payments, they are in fact more likely to take the form of new cross-loans when principal is also exchanged; the original arrangements remain in place and continue to be served in the ordinary manner. Bondholders in particular need not be worried that they have a new debtor. The situation becomes more acute in the case of an intervening bankruptcy of the parties when there may be added complications. If there is merely a contract for differences based on the exchange of fictitious cash flows, the risk is not large, and a replacement swap may fill the void if the swap was used as a hedge. Any extra cost is then easy to establish and may figure in a claim against the bankrupt party. If there were cross-borrowings, the situation is more dangerous, and a proper netting of all outstanding positions becomes a key facility so that at least the large amounts due to the bankrupt are reduced by any counterclaim on the bankrupt. The essence is that whatever is owed to the bankrupt is then reduced by whatever was owed by the bankrupt to the non-bankrupt party. No cherry-picking should occur in which the non-bankrupt party is asked to perform but the liquidator of the bankrupt party will only do so if it is advantageous to the estate. In this situation, settlement netting may be contractually brought forward through acceleration in a close-out (close-out netting). The question is whether in bankruptcy this can still be effective. Regular derivative markets may deal with these issues, but in the OTC markets the emphasis in this connection is the ISDA netting agreement, especially the full bilateral netting of all outstanding swap positions between two regular swap partners when one defaults or cross-defaults or goes bankrupt, or when other 461 See for this concept s 3.2.3 below.

290 Volume 5: Financial Products and Funding Techniques events occur that from a legal or tax point of view may make termination desirable (together called ‘close-out events’ as defined in the swap netting agreement). To avoid any bankruptcy limitation of the set-off, in the draftsman ship an attempt is often made at a form of contractual novation netting.462 What would appear to be settlement netting is then also crafted as a continuous process so that there is only one net balance at any given time (even though not continuously calculated). But effectively, bankruptcy acts often needed to come to the rescue to avoid uncertainty. As we have seen in section 2.6.3 above, swap netting in the OTC markets may make an enormous difference (just as CCPs make an enormous difference in regular markets in terms of total exposures).

2.6.8. Legal Aspects of Swaps. Integration and Conditionality, Acceleration and Close-out in the OTC Markets. The ISDA Swap Master Agreement As we have seen, the swap is an exchange mostly of cash flows, sometimes also of the assets out of which these flows arise, such as underlying loans or bond issues (on the asset or especially liability side of the balance sheet). In fact, even then, legally they normally amount to cross-loans between the partners, as has already been mentioned in section 2.6.2 above, and the positions under the loan agreements or bonds are not themselves swapped. The result is that in swaps, even if principal or coupons are exchanged, only the counterparty or credit risk of the swap partner is relevant. As shown in the previous section, settlement netting that survives a bankruptcy petition becomes a key risk management tool here. Hence the idea of novation netting. On the other hand, in the swap as a contract for differences based on fictitious cash flows, there is (a form of novation) netting from the beginning, and there is therefore, no exchange of cross-claims, as explained above. It is a contract or financial product of its own kind. This means that at any given point in time, there is only one net obligation owing from the net debtor to the net creditor. The position of the net creditor the net debtor may reverse throughout the day, depending on any fluctuations in the value of the ‘underlying’ on which the swaps contract is based. Therefore, if a counterparty’s position moves out of the money, they will be the net debtor. If that counterparty’s position subsequently moves into the money, they will become the net creditor, and the counterparty who was previously the net creditor will become the net debtor. The legal characterisation of swaps itself is not of the greatest interest. The only characterisation to avoid is that of a speculative or gaming contract, which could lead to a void agreement in jurisdictions where gaming contracts are not allowed. The law in many countries has now been clarified to prevent this, at least where these products are used for hedging purposes. The other crucial issue is indeed the possibility, status, and effect of close-out netting in insolvency, which itself is now often cast in a form of (contractual) novation netting to avoid any bankruptcy limitations on the set-off. Whether such a protection can indeed be effectively achieved by contract (that is, contractual netting) is another matter, and depends on the applicable (bankruptcy) law. Thus, the legal community has been largely concentrating on the close-out netting aspect of swaps. As just mentioned, novation netting is not problematic where netting is the very structure of the contract producing a financial instrument of its own. For other types of swaps, it may be different and there could be obstacles, particularly if the currencies of the exchanged amounts

462 See for the complications, s 3.2.3 below.

Volume 5: Financial Products and Funding Techniques 291 were not the same or the maturity dates differed, especially important for interest rate payments in cross-currency swaps. For full bilateral netting there may also be connexity problems.463 Outside of a bankruptcy scenario, some countries (especially common law jurisdictions) still require connexity as a prerequisite for any set-off. As a consequence, in full bilateral netting there may be a need to bring (as a minimum) all swaps between the same counterparties within one (master) framework in order to demonstrate that there is dependency or mutuality.464 Again, the drafting was much helped by ISDA, which first produced a swap master agreement in 1987.465 It has already been mentioned several times that the typical bankruptcy complications in a close-out are connected with the fact that the counterparty, if bankrupt, can no longer legally act and that the set-off as a pure bankruptcy law facility tends to be limited. In fact, legal drafting concentrates in this connection primarily on the principles of integration and conditionality to achieve a form of ‘continuous novation netting’ between regular swap partners. First, the idea is to integrate all aspects of each swap (if not already a synthetic swap) within one legal structure and show their interdependence or conditionality. Thus, in a bankruptcy situation, there should not be a question of the non-bankrupt party having to return cross-loans or pay interest (in due course) without risking receiving nothing in return. Interest rate and currency formulae will be inserted to take care of shortened maturities and currency differences between the various amounts, so that one total amount either due to or owed by the non-bankrupt party (depending on whether they are the net creditor or the net debtor) could easily be calculated upon default. Second, all mutually outstanding swaps would also be integrated into one single balance payable at all times to the net gaining party (at that moment). As mentioned above, this means that there is only ever one outstanding obligation owed by the net debtor to the net creditor upon the insolvency of one of the counterparties. It is the principle of the running score; netting then results automatically in respect of each and any (new) swap without much difficulty, followed by full (bilateral) close-out (settlement) netting if envisaged in the swap agreement. It assumes a continuous acceleration and the acceptance of that principle. This may remain contentious. Also, it would do away with the requirement of notice innate in the netting concept—it might be deemed to have been given once and for all and therefore no longer subject to being non-effective or inadequate in post-bankruptcy situations. There is also the question of proper booking, which should show that it is only the netted-out score that counts. The burden of proof would be on the party invoking the close-out, normally the non-bankrupt party. Indeed, short of a statutory netting recognition in the relevant legislation, the effectiveness of a novation netting facility is particularly important in the case of a bankruptcy (and then most contentious, probably less in other situations of default of the counterparty or in any other closeout event as defined). In this connection, it would help of course if the applicable bankruptcy law itself were willing to consider some form of integration of contracts to support the economic reality between regular swap parties. It is thus possible that the applicable law itself groups some contracts together and makes them mutually dependent. The applicable bankruptcy law may

463 See also s 3.2 below. 464 There may be reason to distinguish between connexity and mutuality: ‘connexity’ refers to both claims arising out of the same relationship (important in England in a set-off outside litigation), while ‘mutuality’ concerns the true ownership of the claims and guards particularly against trustees and agents claiming set-off rights against the funds or other assets they hold for their clients. 465 See for the history of ISDA, further s 3.2.5 below.

292 Volume 5: Financial Products and Funding Techniques at least accept that much (again short of it having a special regime for netting). Naturally, there would still be the potential loss of any net balances due to the non-bankrupt party. In full bilateral netting of all swaps between two parties, the integration is often less clear, however, no matter how the contract has been framed, and may well be considered artificial. Moreover, the idea of a continuous acceleration may be considered artificial also, as may be the notion of advance notice. Hence the continuing preference for an ipso facto set-off in most bankruptcies, which is normally a statutory facility. The problem earlier identified is here that, depending on the country of the bankruptcy, any such ipso facto (statutory) set-off in bankruptcy may still not go so far as to accept the contractual netting expansions if going beyond it. The danger is then that, regardless of the close-out netting clause with full bilateral netting, the ipso facto set-off in bankruptcy is not expanded. The risk therefore is that such a clause would still not give extra protection when it matters most (in bankruptcy). There may indeed continue to be justified doubt in this aspect, and one may not be sure. It is the particular concern of ISDA, whose approach is based on one single master agreement between two swap parties in which all their swap deals are considered integrated on a continuous basis (and not only upon a default). Yet again, whether this can overcome the problems of connexity and ipso facto bankruptcy law, set-off limitations still depend on national (bankruptcy) laws. In the UK, it is assumed that there is no problem, and contractual netting clauses are given much scope. In countries like the US and France, where there is moreover a reorganisation philosophy in bankruptcy, there was an additional problem in that all close-outs and similar measures were stayed pending a decision on reorganisation or liquidation.466 This required legislative amendments to save bilateral netting for swaps (and repos). They also recognised the validity of close-out netting.467 Another issue is here the characterisation of a swap as an ‘executory contract’468 which can be repudiated in bankruptcy subject to a competing claim for damages only, an issue which proved of particular importance under the US Bankruptcy Code. In bankruptcy, there may be other problems. The non-bankrupt party is not only likely to see any net balances due him being reduced to an unsecured claim, but may also lose the future (contingent) profits under the swap. These future profits are, however, impossible to predict and may also turn into losses. They could thus be considered not only contingent, but also purely speculative. It is only possible to put a present value on them assuming the situation does not itself change. Instead of losing a future (contingent) profit, the non-bankrupt party may also lose a hedge when it risks renewed exposure in a neutralised position and incurs the cost of a replacement swap (known as ‘replacement cost risk’). As already mentioned, it may, however, give a better clue to the real future loss. To resume the simple example given above towards the end of section 2.6.1: if through an offsetting swap at 10 per cent, a spread of 2 per cent for three years was locked in, which lock-in is now endangered, a new offsetting swap at 9 per cent with two years left would present a loss of 1 per cent per annum for two years on the amount of the swap. This can be calculated, and the loss at least claimed as a competing claim in the bankruptcy. If now a fixed interest were obtainable at 11 per cent, that benefit would likely accrue to the non-defaulting party. It might, however, also induce the trustee in bankruptcy to honour the swap. 466 See s 365(e)(1) of the US Bankruptcy Code and Art 37 of the French Bankruptcy Act 1985, now Art L621-28 Code de Commerce 2001. 467 See in the US, ss 101(53B) and 560, 561 of the Bankruptcy Code, and, in France, Art 8 of Loi 93-1444, now Art L431-7 CMF (2000). 468 For a comparative analysis of the treatment of executory contracts in an insolvency situation, see Jason Chuah and Eugenio Vaccari, Treatment of Executory Contracts in Insolvency Law: A Comparative Study (Cheltenham, 2019).

Volume 5: Financial Products and Funding Techniques 293 As regards the close-out bilateral netting itself, there is a further issue whether the nonbankrupt party needs to pay any amount due from it under the netting clause in view of the fact that it is deprived of its future opportunity. There is here the aspect that a bankrupt should not benefit from its bankruptcy and force (early) payments in this manner. A one-way (pro-rata) payment by the bankrupt estate only and a walk-away option for the non-bankrupt should it owe a net payment, have been advocated in these circumstances, but are not always considered fair, may lead to further pressure on the netting principle itself, and have been progressively abandoned. In any event they could not obtain when there is a termination for non-default reasons, for example where tax or legal reasons required termination when there is always a two-way payment. Two-way payment is now generally the norm.

2.6.9. International Aspects In the traditional view, the law applicable to derivatives depends on the type of derivative when the place of any regular market on which it is traded may also have to be considered. But to repeat, options, futures and swaps are in principle ordinary contracts, in the traditional perceptions subject to a conflicts of laws approach looking for some domestic law when there are international aspects, notably when the parties to the relevant agreements are in different countries. In the EU, in the ordinary courts, it invites application of the 2008 Regulation on the Law Applicable to Contractual Obligations (Rome I). For swaps, the emphasis is then in particular on the netting agreement, the validity of any contractual choice of law in this respect, and the consequences in a bankruptcy wherever it may be opened. The situation compares to the one under repo master agreements.469 There are here many problems and great differences in view as we shall see: this is the reason why a transnational legal approach increasingly imposes itself, centring on customary law and general principle in the marketplaces it concerns, as will be discussed further in section 2.6.11 below.

2.6.10. Domestic and International Regulatory Aspects Eventually, bank regulators had to deal with derivatives, at first especially for the effects of netting and its admission in the context of regulatory capital adequacy standards and the determination of the reduction in capital that it allows. Since 1993, the BIS has allowed close-out netting in the manner of novation netting on the basis of its interpretation of the 1988 Basel Accord, provided one amount results and this type of netting is accepted: (a) under the law of the country of the other party (his residence or corporate seat); (b) under the law of the country of the branch through which that party acted (if not the same); and (c) under the law governing the swap. Legal opinions to the effect must be presented.470 In the more recent 2008–09 financial crisis, a host of other regulatory issues arose, which were highlighted above in section 2.5.9 in the context of securitisation and the use of CDS. Introducing central clearing systems, often at the level of CCPs, also for OTC derivatives, especially swaps, became a regulatory objective, as was seen in section 2.6.5 above. Better documentation,

469 See s 4.2.6 below and for the law applicable to set-off and netting, also in the context of swaps, s 3.2.6 below. 470 The ‘value at risk’ or VaR approach may lead to further refinement: see for this approach Vol 6, ss 2.5.5 and 2.5.13.

294 Volume 5: Financial Products and Funding Techniques transparency, proper margin requirements and better collateralisation and netting facilities were considered related benefits. But it also became clear that not all can be standardised, and, where this was not possible to achieve proper risk management, clearing of this nature remained less powerful, but is nevertheless still important. This was also discussed in section 2.6.5 above. The trading culture in banks, at least beyond proper risk management, itself subsequently became another issue. The regulatory response will be discussed further in Volume 6, sections 1.3.7 and 3.7.4. One way of promoting central clearing through official facilities is to impose greater capital requirements on non-cleared derivatives. In the US, another was to suspend the waiver of the ‘stay provisions’ under the Bankruptcy Code in respect of them.

2.6.11. Concluding Remarks. Transnationalisation It should be clear that financial derivatives like options, futures and swaps are important hedging instruments in respect of market risk. Credit derivatives, on the other hand, particularly guard against counterparty credit risk as we have seen above in section 2.5.3. Asset securitisations aim at removing assets completely from the balance sheet, and thus, all risk connected with the holding of them. In practice, financial derivatives are often considered investment securities, at least for regulatory purposes, but it may be repeated that legally they are mere contractual facilities and do not acquire the status of negotiable instruments. Their transferability is therefore limited as it would entail the transfer of contractual positions, which would require the consent of the other party, at least for any connected obligation or duty. An assignment (with its formalities), only transfers contractual rights, and not obligations. Thus, under traditional theories of contract law and the law of assignment, the writer of a call option is essentially stuck with its position until the end of the option period. Moreover, the seller under a future is bound to deliver the underlying asset on the delivery date at the agreed price (or in financial futures can claim or must pay the difference between the future price and the market price in the underlying asset). Also, in a swap, the parties are bound until the end of the swap period, never mind whether they are in the money or out of the money. As we have seen, taking an opposite position will protect them if they wish to limit their risk in the meantime. That is tantamount to the hedging of or reduction of position risk. It means that the counterparty has two opposite positions until the end of the period, and therefore, more credit (and settlement risk). Also, they may not easily find a party who would be willing to offer such a facility. Here regular derivatives market help, at least in the contracts that they have standardised, which is common in the regular options and futures markets, although there may also remain many non-standardised OTC options and futures. The facility of CCPs in these regular markets means that all contracts are with the exchange acting as the main counterparty to all transactions executing on the exchange, backed by similar contracts with other end-users (who are often market makers). It makes possible close-out netting, in which counter positions once entered into may be immediately netted off with the exchange (CCP), giving rise to an immediate payment should one of the counterparties decide to close-out their position. In the swap market, the non-standardisation (that is, non-fungibility) of many swap contracts has meant that regular markets have not developed to the same extent. Hence, the continuing importance of the swap master agreement aiming at bilateral netting between end-users, including banks as swap warehouses. Yet CCPs, in particular clearing and settlement companies, which are used to acting as such for regular (that is, standardised and fungible) option and futures exchanges, are also starting to act as CCPs for swaps. This is the

Volume 5: Financial Products and Funding Techniques 295 regulatory preference since the onset of the global financial crisis, as we have seen, at least in respect of clearing the payments under them. When supplemented with a trading facility, they would start substituting for the present system where swap warehouses, therefore mostly the large banks, act as the main market makers. It has been pointed out that as a consequence the role of CCPs is acquiring greater importance and may even transfer to payment systems, investment securities, and commodities markets (also called the horizontal function of CCPs). It is commonly combined with clearing and netting functions (also called the vertical functions of CCPs). Cross-market activities and netting-out facilities (that is, cross-product netting) may thus also become possible. Central to the system is then the margin requirement or other forms of collateralisation, but the protection may be extended by the set-off facility enhanced by netting agreements, even if it may be less the objective of swap clearing, as we have seen. Although it is the principal aim of the ISDA Master Agreement, this agreement is limited to close-out events, notably situations of default and bankruptcy, which are unlikely to arise in the case of CCPs, but they may still affect their counterparties (which are, however, always clearing members). The intended effect of the increased use of CCPs is the substantial reduction of liquidity and settlement risk across markets, but also the creation of greater discipline, better documentation and records, and transparency, enhancing in this way the stability of the entire financial system. After 2008, it became as such a regulatory priority and assumes that the risk concentration in CCPs itself can be properly handled. Again, the operation of clearing or similar system members as sole counterparties of the CCPs (acting on behalf of the end-users but always only in their own capacity although for the end-users’ account) and especially the notion of margin is of prime importance in this connection. Whether, as a consequence, financial derivatives acquire a different legal status and rise beyond mere contractual rights (and obligations) is a question that may then usefully be considered. For options and futures, the close-out netting facility in regular exchanges through the interposition of CCPs may suggest new financial products, in the same way as the novation netting has done for the synthetic swap. The interposition of CCPs may do so for all swaps that are so cleared. Indeed, all financial derivatives in this way acquire aspects of transferable securities. This can be seen as an important modern alternative to the more traditional approach in negotiable instruments, which, because of their disadvantages as paper instruments requiring physical handling, are gradually losing their attraction even in areas where they commonly operated, including investment securities, bills of exchanges, and now probably also bills of lading (as transferable documents of title).471 For security entitlements this will be further discussed in section 4.1.1 below. These are important developments taking place at the transnational level which are having an effect on the law, first on the status of the netting contracts and related master agreements (of ISDA and the TBMA/ISMA – now ICMA – respectively for swaps and repos), which may usefully be considered transnationalised, but also on the way derivative exchanges are organised and operate (CCPs especially follow a transnationalised model), which then also affects clearing and settlement. Transnational customs and practices thus become dominant as part of the modern lex mercatoria. This will probably foremost be tested in international arbitrations, see more in particular Volume 2, sections 2.2, 2.3 and 2.4, where, within the EU, the 2008 Regulation (Rome I) does not

471 See Vol 4, s 2.3.2. If connected with a proper clearing and settlement facility it could make the documentary letter of credit and its needs for proper documentation obsolete. Furthermore, this area is ripe for reform. There are already projects for making documentary letters of credit digital and storing them on a distributed ledger.

296 Volume 5: Financial Products and Funding Techniques hold sway and there may therefore be greater room for the transnational approach even in the EU. The Lehman Brothers cases in the UK may be seen as having started this recognition in ordinary court proceedings, at least to some extent, especially in determining (some of) the proprietary, segregation, and set-off/netting aspects of derivative activities and facilities in insolvency situations in the UK.472 But it was also said that the last word remains with local bankruptcy courts that might acquire jurisdiction in these matters in a bankruptcy of any of the parties. If there is an arbitral award it will become an issue of recognition and enforcement under the New York Convention. If there is none, it will be a matter of transnational custom and practices being recognised (at first probably in terms of nearest equivalent) or rejected in local bankruptcies. But for all those countries that claim the benefit of globalisation, it was also noted that it is increasingly likely that transnational practices in this regard will be more readily accepted even in local bankruptcies. Two more recent issues and incidents in ISDA may make the point and concern the discussion about the ‘condition precedent’ clause in Section 2(a)(iii) of the Master Agreement (‘Each obligation of each party … is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect the other party has occurred and is continuing, …’) and the ‘manufactured defaults’ issue in CDS transactions. In the first instance there was a different approach between the New York and the English courts in the Lehman cases under respective New York and English law; in the second instance the SDNY court came to a contentious decision against an ISDA expert opinion. In the first instance, the issue was opportunistic behaviour of the non-defaulting party following an event of default. In that case, under Section 6(a), only the non-defaulting party has the option to immediately terminate the agreement, but the party may not want to do so when s/he is out of the money and owes the defaulter a payment as the situation might reverse itself in due course. In these cases, there will not be a close-out netting for the time being, even though in practice this appears to be rare, since mostly whole portfolios of positions are involved. The reason for this flexibility is that without it the defaulter could engineer the default for him at the most favourable moment. It is in fact the opportunism of the one against the other where the Master Agreement gives the non-defaulter the advantage; but is it unfettered? And how does New York and English law react? English courts held it to be unlimited and effective even in bankruptcy (regardless of pari passu notions and the asset deprivation principle, see also Volume 2, section 2.4.2).473 New York courts, on the other hand, held it not to be unlimited, with a potential detrimental effect in bankruptcy for lack of sufficient intent of early termination (this undermining the ipso fact nature of the set-off).474 In the second instance, the issue was the meaning and impact of a credit event in the CDS market. ISDA provided the legal and practical framework: the ‘ISDA Credit Derivatives Definitions’ set forth the contractual framework for credit derivatives and the ‘ISDA Determinations Committee’ determines if and when the ‘Credit Event’ occurs and the protection seller must make payment. If so, it conducts an auction to determine the loss. This framework had worked well until revelations about ‘manufactured defaults’, or, according to ISDA, ‘narrowly

472 The EU now covers under its EMIR regulation especially record keeping, transfer of positions of defaulting clearing members, orderly liquidation, and return of excess assets as collateral or margin (Recital 64), see for EMIR further Vol 6, s 3.7.6 and L van Setten, The Law of Financial Advice, Investment Management, and Trading, (Oxford, 2019) 129 for the safeguarding of cleared contracts and collateral. It is a (regional) harmonisation of standards that conforms to international practices and needs. 473 Lomas v JFB Firth Rixson, [2012] EWCA Civ 419. 474 In re Lehman Brothers Holdings Inc, et al (Metavante) Case No.08-13555 (2009).

Volume 5: Financial Products and Funding Techniques 297 tailored credit events’ were claimed in 2017, when allegations were made that a buyer of protection collaborated with the Reference Entity in the CDSs it bought, to intentionally miss the due date for interest payments, thereby manufacturing a ‘Failure to Pay’, which resulted in a Credit Event. The SDNY district court held that ‘irrecoverable loss’, which was the requirement for the petitioned preliminary injunction, was not proven,475 against the testimony of the ISDA expert witness to the effect that (a) the CDS market assumes that a Reference Entity would do its best to prevent the occurrence of Credit Events to protect its reputation, and (2) investigating the inner most intentions of a Reference Entity, which would be needed to curb such manufactured defaults, is very hard and burdensome for market participants or the ISDA Determinations Committee. The court disagreed and believed that under NY law, ISDA would be deemed to have enough ability to prevent manufactured defaults through amending the Credit Derivatives Definitions framework.476 ISDA’s view, however, is that the amendment to the Definitions made to the effect in 2019 is not sufficient to curb collaboration of this nature. Relying on local laws leads to these unconvincing and unhelpful differences or results which would be less likely if transnational law was recognised to prevail as it is with regards to the set-off and netting mechanism. It means that as between all professional participants the custom of their trade must be investigated as the applicable law.

2.6.12. Impact of Fintech. Smart Contracts and the Potential Operation of a Permissioned Distributed Ledger Network Many commentators believe that the impact of distributed ledger technology (DLT)477 will have a significant impact in the context of derivative transactions.478 On a blockchain, derivatives may be created as coded smart contracts, capturing the obligations of the two counterparties. In the US, the Depository Trust and Clearing Corporation (DTCC) is in the process of developing such a blockchain-based post-trade framework for derivatives processing in collaboration with tech firms R3, IBM and Axoni. The project has been developed with input and guidance from a number of leading market participants including Barclays, Citi, Credit Suisse, Deutsche Bank, JP Morgan, UBS and Wells Fargo, and infrastructure providers HIS Markit and Intercontinental Exchange. The present goal of the project is to develop a permissioned distributed ledger network for derivatives, governed by the DTCC, with peer nodes at participating firms and regulators. Smaller DTCC clients will have the option to access the network through DTCC’s own node.479 The new system may be of special significance for OTC derivatives, especially swaps, as DLT could be used to replace trade repositories to store swap contracts on a distributed ledger. A smart contract may be defined in this connection as an automatable and enforceable agreement. Its essence is the automation and self-execution of a pre-set conditional action. Automatable means in this connection ‘automated by a computer program’, although some parts may still require human input and control. Enforceable means ‘execution’, either by legal enforcement of 475 Solus Alternative Asset Mgmt LP v GSO Capital Partners LP, No 18 CV 232-LTS-BCM, 2018 WL 620490 (SDNY 29 January 2018). 476 Solus v GSO, 2018 WL 620490. 477 Although ‘blockchain’ is a type of DLT, the literature uses these terms interchangeably. 478 The following text is substantially taken from the King’s College Executive LLM organised by JH Dalhuisen, C Kletzer and M Schillig. 479 C De Meijer, Blockchain and derivatives: reimagining the industry (Treasury XL Panel 6 February 2017).

298 Volume 5: Financial Products and Funding Techniques rights and obligations, or via tamper-proof execution of computer code.480 Thus, smart contracts allow for the transposing of the contractual obligations imposed on users the distributed ledger. It is the ultimum in standardisation, through which all provisions can be complied with and enforced by means of automatic updates to the users’ accounts. A smart contract may then also have access to a number of accounts and can transfer assets according to the terms of the contract as soon as an event—outside the distributed ledger or within—triggers the application of these terms. In this way, smart contracts can provide for automatic transactions to take place on the ledger (for example, crediting a dividend or coupon payment, issuing and reacting to margin calls, optimising the use of collateral) in response to specific corporate or market events.481 In the context of derivatives, a smart contract can automatically recalculate exposures with reference to agreed external data sources in order to recalculate variation margin. Interoperable derivative and collateral ledgers would automatically allow the contract to call additional collateral units to asset ledgers. In the nature of all contracts for differences, on maturity dates, a net obligation is computed by the smart contract, and a payment instruction automatically generated in the cash ledger, effectuating regular payments or closing out the deal.482 Based on Ethereum’s public blockchain, developers have been able to simulate the full life cycle of derivatives and their execution through smart contracts. Their work gives a good indication as to how a future blockchain-based framework could operate.483 This may be best demonstrated by a simple call option. A key challenge is that financial smart contracts need some mechanism to refer to market and reference data external to the blockchain in order to get the prices of the underlying assets. Currently, there are no market data publishers that are capable of reliably pushing data on to the blockchain. The developers built a mock price feed that randomly and periodically mutates the values of popular financial symbols (S&P 500 etc), with the smart contracts accessing the price feed for margin calculation and option exercises. In public blockchains, market data access through so-called oracles has a centralising effect: reputed centralised authorities are required to push price information on to the blockchain, which renders the entire system vulnerable where the oracle lacks in resilience or supplies inaccurate or false information (that is, ‘fake news’). In private blockchains, standard market and reference data interfaces could be defined and then plugged into industry-standard feeds by identifiable and accountable network participants. This reduces vulnerability and would allow for standardisation. Sellers and buyers would be represented on the blockchain by their respective trading accounts. The installation of a trading account on the blockchain is therefore a necessary precondition for participation in the blockchain financial system. Trading accounts must be sufficiently funded to meet margin calls and to make cash settlements. The creation and activation of any smart financial contract implicitly authorises the interaction with the counterparties’ trading accounts, which allows for the transfer of funds whenever required. In this system, a simple call option contract on any of the underlying assets supported by the price feed can be initialised by either the seller or the buyer. The contract is initialised (using a private key) by providing it with the address of the seller’s or buyer’s trading account (that is, the public key), the underlying asset, the strike price, notional and date of maturity. Initialisation automatically authorises the contract 480 ISDA and Linklaters, Whitepaper: Smart Contracts and Distributed Ledger—A Legal Perspective (August 2017) 5. 481 A Pinna, and W Ruttenberg, ‘Distributed Ledger Technologies in Securities Post-trading’, ECB Occasional Paper Series No 172/April 2016, 18. 482 Euroclear and Oliver Wyman, Blockchain in Capital Markets (February 2016) 10. 483 https://medium.com/@vishakh/a-deeper-look-into-a-financial-derivative-on-the-ethereum-blockchain47497bd64744.

Volume 5: Financial Products and Funding Techniques 299 to interact with the initialiser’s trading account. Following transmission of the option contract’s address to the counterparty through an external channel, the counterparty must validate the contract, which entails the authorisation to interact with the counterparty’s trading account. Once active, the option contract cannot be interrupted as long as the blockchain remains resilient. If upon maturity the underlier exceeds the strike price, the buyer may exercise the option. Exercising the option initiates automatic cash flows between buyer (notional and strike price) and seller (underlier’s market price) through their trading accounts. The smart contract may also be coded so that the mutual cash flows are netted out, resulting in a single cash flow. During the simulation, cash settlement was effectuated in ‘ether’, the crypto-currency supported by the Ethereum blockchain. Moving on from this very simple option contract, developers were able to simulate the lifecycle of a more complex call spread over a single underlier using a combination of smart contracts. The call spread contract manages two call options as its legs and interfaces with them on behalf of the counterparties. The call spread also maintains a margin account, which it rebalances at regular intervals as the value of the underlying security changes. The call spread may be initialised by either seller or buyer in the same way as the simple call option. In addition to the simple call’s input, initialisation requires input of the addresses of two uninitialised call options, their respective strike prices and a parameter for the amount of margin collected from the seller. The call spread then initialises the call options to represent a long option and a short option (for the latter, the roles of seller and buyer are reversed). At the same time, the legs are authorised to interact with the initialiser’s trading account, as is the call spread for margining purposes. After the call spread has been initialised, the counterparty must then validate the call spread to activate it. This will be transmitted to the legs and all three contracts are authorised to interact with the counterparties’ trading accounts. Prior to maturity, any party may induce the call spread to check the value of the underlier and rebalance the margin it holds. In order to ensure that margin is rebalanced regularly, the developers created a ‘contract pinger’ off-blockchain that would ‘wake up’ the call spread periodically. Private blockchains can simply ping every resident smart contract regularly. Upon maturity, the buyer and seller may be eligible to exercise their respective legs based upon the market value of the underlier and their respective strike prices. The buyer may exercise the long option, which also returns the seller’s margin to their trading account, and the seller may exercise the short option independently from the buyer. The financial industry has high expectations in the area of derivatives, and it has been said that blockchain and smart contract technology will allow buyers, sellers and central clearing houses of derivative trades to share information in real time across various distributed ledger platforms and thereby unleash greater efficiencies. Peer-to-peer networks that secure digital assets would allow parties to identify, transact and settle with each other in expedited workflows. DLT could speed up and automate the process for posting cash and securities margin with the CCP. Furthermore, the costs associated with reconciliation, settlement and security may be significantly reduced. A regulatory node could give competent authorities access to real-time data about transactions, instead of having to wait for reports from market participants. Risk management may be significantly improved: parties may consider cash flow exchanges every 30 seconds instead of every 30 days, reducing counterparty or credit risk. The improvement in fund settlement and counterparty risk assessment in a blockchain environment may shorten the liquidity cycle for various derivative positions, allowing banks to inject liquidity into the system for other transactions more quickly.484 484 De Meijer (n 479).

300 Volume 5: Financial Products and Funding Techniques Significant challenges remain, however. In addition to a lack of scalability, common standards, an adequate legal and regulatory framework and the risk of fragmentation through multiple distributed ledgers, DLT is still in its infancy. The running of complex mathematical formulae (Black Scholes), although theoretically possible, is currently expensive and difficult. Reliance on off-blockchain pingers and oracles for market data access creates a risk of centralisation and vulnerabilities.485 The latter issues may be more easily resolved in private/permissioned blockchains. The DTCC supported platform was meant to go live in 2018. In a phased approach it will run alongside traditional settlement systems. It is possible that DLT will have a more significant impact on the clearing and settlement of securities (that is, shares and bonds). Although it is already possible with existing technology for clearing and settlement systems to offer instantaneous settlement, DLT (in combination with smart contracts) could be used to permit the counterparties to a particular trade to customise the time for settling their securities trades (for example, T+1, or T+6 hours). There is already a major DLT project in the works, with the ASX in Australia updating its main CCP (CHESS) and implementing a private DLT system for the clearing and settlement of securities. This new system will begin operation in 2021. Moreover, the DTCC in the US has also proposed creating a DLT system that uses the Ethereum network (codenamed ‘Project Whitney’) for the clearing and settlement of securities issued by private companies (that is, for non-publicly traded/unlisted securities). The goal is to maintain a decentralised record and facilitate the transfer of these privately issued securities (where this is permitted under the law). Time will tell whether DLT will be able to meet the high expectations in the context of the derivatives markets, and in particular, in the context of the securities markets.

2.7. Institutional Investment Management, Funds, Fund Management and Prime Brokerage 2.7.1. Investment Management It may be said that, ultimately, all investments or indeed all assets are held either by private households or governmental agencies, but it is a fact that there are many intermediate holdings such as those of insurance companies, pension funds, banks and collective investment schemes or funds. Investments in securities, or related products, are a particular type of these holdings; their definition was discussed in Volume 4, section 3.1. They all require some management. Investors may do that themselves or may seek professional advice. In the latter case, investment managers provide this service. They are as such subject to contractual and fiduciary duties as well as to the law of negligence. The ambit of these fiduciary duties will be discussed further in Volume 6, section 1.5.9. In respect of institutional investors such as pension funds, insurance companies or collective investment schemes, investment management is likely to acquire a different dimension in terms of scale and expertise. This is the business of institutional investment management. Its service may also be used by government agencies such as public pension funds that also have large investment holdings. Banks, including central banks, might also be mentioned as important (institutional)

485 These vulnerabilities could be compared to the financial industry’s over-reliance on a handful of credit rating agencies for rating certain securitised assets before and during the global financial crisis.

Volume 5: Financial Products and Funding Techniques 301 investors, but they normally make it their business to manage these investments themselves, as well as their trading books. They do not depend on others and are likely to maintain an elaborate system of liquidity and risk management to that effect and their own staff. The essence of all professional risk management is selection and diversification of risk, limitation of transaction costs and tax efficiency. Investment management for private household investors is normally distinguished because the factual, legal and regulatory aspects are likely to be quite different, not least in the kind of expertise and professionalism that is or may be expected. This is not sinister: institutional investors simply have other aims. There is likely to be special concern in that the expected returns must meet future liabilities, obvious in the case of pension funds and life insurance companies. These may be more urgent liquidity issues, which may also impact on the type of underlying investments and the strategy. It commonly gives rise to asset and liability modelling (ALM) or similar facilities that may then move to the heart of the agreed strategy. Although investment management is subject to regulation, these aspects are more likely to be a matter of contract and are likely to be at the core of the professional investment agreement. Beyond this, regulation may accept that institutional investors are entitled to less protection from institutional investment managers in terms of private law protection (especially fiduciary duties) and it may be less strict. It follows that in particular the interpretation of the investment agreement and of fiduciary duties may be quite different in situations of institutional as distinguished from private asset management. In legal terms, we are concerned here primarily with the scope of skill and care, assessment of the performance and its quality, and the determination of quantum of damages in the case of a breach of contract or fiduciary duty for both types of investors. It has already been suggested that negligence may also be an issue, although recourse and damages need not be very different. In the execution of the investment transactions, another important aspect to be considered is the relationships that the investment manager creates for its clients (both professional and private) with third parties.486 They result from the manager accessing the marketplace for its clients. This raises questions of agency law in its proprietary and contractual aspects: see further Volume 6, section 1.5.9. Again, in respect of private investors, there may be scope for differences as compared with the situation for institutional investors. The latter’s special position in clearing and settlement, for example in terms of the delivery of investments and their payment, may have to be considered. For these various reasons, the definition of institutional investment is of importance, but so also is the distinction from mere investment advice. The institutional investment manager invests according to its professional judgement and acts as such within the agreed investment policies or objectives in respect of investments as defined, but there is an important discretionary element exercised on a client-by-client basis, both in respect of private and institutional clients, although likely in different ways as just explained and always within the agreed investment policy. If this discretionary element in the selection and execution of investments is altogether missing, the clients’ instructions are followed but there may still be investment advice, although the liability is likely to be different.487 In such cases, the advice is often given randomly in regular information sheets. The key is that the client takes the final investment decision, but reasonable care remains the standard for the adviser, who could still be sued in negligence. However, unless its advice is directed towards a special investment or the adviser acts in the exclusive interest of the investor 486 See L van Setten, The Law of Institutional Investment Management (Oxford, 2009) 1.57. 487 See Lord Hoffmann in South Australia Asset Management Corp v York Montague Ltd [1997] AC 191; Lord Millet in Aneco Reinsurance Underwriting Ltd v Johnson & Higgins Ltd [2002] 1 Lloyd’s Rep 157; and Lord Roskill in Caparo Industries Plc v Dickman [1990] 2 AC 605, 628.

302 Volume 5: Financial Products and Funding Techniques who relies on this advice, there are no special fiduciary duties while there may also be no contract proper, at least not in respect of the advisory function; such advice is also likely to be unregulated. If there is specific advice, however, protection of the investor becomes a matter of justified reliance on special skills and information in the nature of liability for any other investment management activity. Such advice may then also become the subject of regulation, as investment management generally does, which is likely to be primarily expressed in reinforced fiduciary duties (‘know your customer’ and ‘suitability’) but there may in such cases also be an implied or express agreement. Again, these duties are likely to be less strict for institutional investors.

2.7.2. Investment Funds or Collective Investment Schemes. Exchange Traded Funds (ETFs) Vast amounts of money are invested in collective investment schemes, also referred to as investment funds. As mentioned in the previous section, they are normally run by institutional investment managers, often investment banks who may (a) advise investors directly in their investments, (b) discretionarily manage their investments, or (c) instead offer them collective investment schemes which they usually organise and market as investment alternatives and run themselves as investment managers (for a fee). They are often quoted on exchanges and may then take the form of so-called exchange-traded funds (ETFs). Investment funds are typically targeted at retail customers, but in the case of hedge funds or private equity, may be limited to a smaller group of wealthier investors, although umbrella funds of them (which are funds of funds) may reach retail customers also. Intrinsically, spreading or diversification of investments is guaranteed in these collective schemes, which then also benefit from professional management and larger scale so that risk may be better managed and exploited. The investment managers are often investment banking divisions operating as institutional investment managers, who themselves create these funds, although they may also be commercial banking subsidiaries or independent companies. These funds may be of the open- or closed-end type. In the case that these funds are open, new investors can join at all times and old ones may leave the fund at any moment of their choosing. In principle, they will be entitled to join and leave (or acquire or sell participation certificates) on the basis of the intrinsic value of the fund in respect of which the managers may quote a spread (or bid and offer price). These open-ended investment companies (OEIC) or funds are the more normal type and often more suited to the public for their easier exit facilities, even if the spread may be large, and management may have the facility to close them at any time. Joining or getting out of closed funds is often much more difficult and may be more costly. They are mostly wound up and distributed after a fixed period of time (and investment). In the UK, funds of these types are called collective investment schemes. When solely invested in stocks they are often also called mutual funds. They may indeed be open or closed and come in several legal forms. They may basically be organised in the form of (a) a trust (called a ‘unit’ trust), (b) an investment company, or (c) a (limited) partnership. In a trust, the investors will operate as beneficial owners, in an investment company as shareholders, and in partnerships as unlimited or limited partners. It may be asked in all these schemes what the true nature of the investor’s interest is and in particular whether there are any direct (equitable) rights of participants to the underlying securities of the fund, an important issue especially in a bankruptcy of the entity. It may be more difficult where the corporate form is being chosen, shareholders not normally being

Volume 5: Financial Products and Funding Techniques 303 considered to own the corporate assets. In the UK, the Financial Services and Markets Act 2000 (section 235) defines the generic notion of a collective investment scheme as an arrangement with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income. Under section 237(1) of the Act, a unit trust scheme means a collective investment scheme under which the property is held in trust for participants. Section 236(1) defines an investment company. It is a collective investment scheme that satisfies two conditions: (a) the property condition and (b) the investment condition. The implications are similar to those for unit trusts in the sense that the property condition allows the scheme’s property to belong to and be managed by a body corporate having as its purpose the investment of its funds with the aim of spreading the investment risk and giving its members the benefit of the results of the management of the funds. The investment condition means that an investor may reasonably expect to be able to realise its investment in the scheme after a reasonable period on the basis of the value of the property in respect of which the scheme is set up and makes arrangements. This corporate form of investment scheme was set up in the UK in order to appeal more to foreign investors who might be less familiar and comfortable with the trust concept inherent in unit trusts.488 They can also be open or closed. In the UK, regulation of investment companies is largely left to special orders of the Treasury, which track the situation for unit trusts (since 1997 the Financial Services (Open-ended Investment Companies) Regulations). In respect of limited partnerships as collective investment schemes, in the UK, a distinction must be made between limited partnerships and limited liability partnerships. The latter are organised under the Limited Liability Partnership Act 2000 and operate like companies. In the UK, partnerships proper operate under the Partnership Act 1890. Limited partnerships operate under an Act of 1907. They are still partnerships in the proper sense; the difference is that the limited partners are mere investors and do not become involved in the running of the business, which is left to the general partners who have full liability. The result is that the limited partners have no direct rights in the underlying assets. The limited liability partnership is more particularly suitable to be used as a collective investment scheme. Partners are entitled to a share in the profits of the business and to the assets available upon dissolution, but it is often assumed that in the meantime no limited partner has a true proprietary interest in the assets of the partnership itself. Limited Liability Partnerships (LLPs) under the Act of 2000 were particularly created to protect professionals, mainly lawyers and accountants, in professional partnership, against

488 The distinction was explained in Charles v Federal Commission of Taxation [1954] 90 CLR 598, where it was said that a unit in a unit trust is fundamentally different from a share in a company. A share confers upon the holder no legal or equitable interest in the assets of the company; it is a separate piece of property, and if a portion of the company’s assets is distributed among the shareholders the question whether it comes to them as income or capital depends on whether the corpus of the property (their shares) remains intact despite the distribution. But a unit confers a proprietary interest in all property, which for the time being is subject, however, to the trust deed, so that the question whether moneys distributed to unit holders under the trust form part of their income or of their capital must be answered by considering the character of those moneys in the hands of the trustees before the distribution is made. It should be noted, however, that by defining the rights of investors in a corporate scheme more precisely (whilst approximating them to that of unit trust holders), the differences here outlined might become more blurred.

304 Volume 5: Financial Products and Funding Techniques negligence claims against other partners, but may also be used as investment vehicles. They do not need to have members, are incorporated by registration, and need not have capital nor directors. In the area of investments, they are used in particular as open-ended investment vehicles (according to Article 21 of the Collective Investment Schemes Order 2001). As collective investment schemes of the various types are normally subject to strict regulatory supervision if marketed to the public, this may give problems in cross-border investments supervision as it could lead to double regulation. In the EU, for funds of the open type, this gave rise to an early division of labour between home and host regulators in the UCITS (Undertakings for the Collective Investment in Transferable Securities) Directive of 1985, amended and expanded by two further Directives in 2001: see Volume 6, sections 3.2.5 and 3.5.14 and further also section 2.7.7 below. As part of an EU passport for these funds, the original 1985 Directive set out harmonised rules for authorisation and prudential supervision throughout the EU, which subsequently served as a model for banking and investment services in all EU countries: see Volume 6, section 3.3. There are also some harmonised rules concerning the investments themselves and the spreading of risk. Hence the limitation of these schemes to certain authorised products that were expanded in the 2001 (Products) Directive. There are also provisions for prospectuses and regular information supply. Host country rule remains particularly relevant in the area of investors’ protection in terms of cold calling, marketing and advertising. Since 2009, all UCITS Directives have been consolidated in what is now called UCITS IV. ETFs are a newer phenomenon and appeared first in the US in 1993 and in Europe in 1999. They commonly track an index but there are also Stock, Bond, Commodity, and Currency ETFs. There may even be Actively Managed and Leveraged ETFs. Unlike collective investment schemes, they trade as common stocks on stock exchanges and this trading does not depend on valuations although obviously the pricing is connected. In practice, ETFs try to avoid the problems of only end of day trading in mutual funds or intraday trading of such funds at more or less than book values. They offer also lower transaction costs. In these ETFs, so-called creation units are typically bought from the ETF itself by large distributors, often in exchange for baskets of the underlying shares in the fund. The essence is that these participants can create and redeem share in the fund itself in kind and it allows them to make a profit by arbitraging small discrepancies between the price of the fund and the underlying investment securities. This then substitutes for fees. These distributors, usually high frequency traders, may act in turn as market makers for smaller investors using further their ability to buy or redeem underlying shares or creation units as a means of liquidity and way of approximating in their spreads the net asset value of the underlying assets at all times. In the case of strong demand, the price may still rise above the intrinsic value, however, but there will be instant arbitrage and these deviations should not become large. These funds have become very popular because they are competitive and cost effective. Millions have been saved in fees. They attracted US$ equivalent of 660 trillion in the first half of 2021, almost as much as in all of 2020. For many, stock picking is not worth it and there is solid evidence that it seldom beats the index. It is more expensive and riskier, now increasingly the realm of the professional, largely hedge funds. There are special risks, however, and these new structures are still not fully tested, although they proved resistant in the pandemic crisis and the early sharp contraction of the markets. In that instance, they did not contribute to the panic or prevent investors to get out in an orderly manner, but especially when leveraged or representing untransparent underlying assets like bank debt or future contracts being rolled over, they may present stability issues and be inappropriate for retail investors without sufficient disclosure. This activity is largely captured by three operators, of which Vanguard is the most significant and successful, trading trillions with potentially also a large impact on board rooms.

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2.7.3. Hedge Funds and Their Operation The operation of hedge funds has raised many questions in recent years. They have been around far longer than is often realised and started to operate in the US for wealthy private individuals at least as early as the 1950s. There are many definitions of hedge funds, several entirely circular. As so often in the financial services industry, the name is a misnomer. They very seldom hedge anything, quite the opposite. The issue is notably not that they remained unregulated as is often suggested. That is something that remains to be seen, but as they are usually only offered to a small circle of insiders, this has traditionally mitigated the need for regulation. Many other funds are not regulated either; regulation generally only limits their advertising to the public and sometimes excludes inexperienced investors from their activity. The key is also not that these hedge funds are highly leveraged. They often are, but need not be. It is not necessary for this activity to take the legal form of a fund either; there are many related or other structures possible. Thus, they may be funds or types of partnerships. The essence is rather that they are identified by the type of investment management or investment strategy for professional or private clients. That means that risks are sought out ad hoc, not on the basis of a pre-set strategy or asset class. It follows that it may not be useful to distinguish between hedge funds and similar activities of investment banks, investment managers, or even ordinary banks— in this sense, it is often said that the treasuries of large banks are operated as a hedge fund. Fees being what they are in this business, many managers want to join in one form or another attracting investors’ money for this activity. They may also enter this activity for their own account, and this is now often at the heart of proprietary trading in banks. Funds of this nature may also remain limited to a small group of traders; they may invite also outsiders but equally be able to exclude them at any time. Their special nature is thus not necessarily in the investors’ class at which they are targeted either. As just mentioned, investors used to be high-net-worth individuals but are now equally institutional investors and increasingly may involve also retail investors, at least to the extent they are properly advised by professional brokers, advisers or managers. Funds of hedge funds, also called umbrella funds, may be more suitable for them, although it should be considered that these umbrella funds are often highly geared in their own right, and so borrow money to invest in more hedge funds, which results in double gearing as the latter are often also highly leveraged (but need not be), which again may make them less suitable for the retail investor. Beyond this, the reason to allow newer classes of investors also to participate is obvious: why should any class of investors be excluded from a type of professional investment management that has often been shown to be good at creating extra value, has persistently outperformed other classes of investments and is, as the financial turbulence in the summer of 2007 showed, not as risky as many had thought? Even the collapse of some hedge funds in 2008 was not directly connected with the sub-prime mortgage crisis of that year, but rather with the difficulty of refinancing their often highly geared operations in the banking climate of those days, which forced many to liquidate their positions. Temporary restrictions on short selling did not help either. Again, the key is rather that, unlike most other types of funds that have a particular strategy and are advertised and marketed as such, hedge funds usually adopt any investment strategy they believe in for the time being, and invest in any type of investment or other asset they like, including derivatives, commodities and currencies. They may thus engage in unrestricted short selling or hold concentrated positions. There is usually no limit on leverage either. In fact, the essence is always freedom in the investments and a more sophisticated investment strategy, therefore an atypical investment profile to seek out a special profit-maximising opportunity as may be

306 Volume 5: Financial Products and Funding Techniques spotted from time to time. As such it is best to include all types of investment activity that seeks such opportunity. It could then also include private equity or venture capital, although usually considered other classes of funds/investments. Market risk is here compounded by management or operational risk in terms of dependence on the ingenuity of (often) only one or two people. So-called quants are special types, which maintain mathematical trading strategies based on small market inefficiencies that they spot and expect to correct, often coupled with very high gearing. In fact, the underlying strategy may be, and often is, quite conservative but high gearing and the continuation of the inefficiency or even its increase for the time being may cause sudden death. That was the situation with LTCM in 1998.489 In the end, LTCM was saved through an industry support scheme or lifeboat (of US$3.6 billion in recapitalisation) at the behest of the Federal Reserve in the US in order to limit collateral damage or systemic risk through the banking system, which included the main lenders. With this breathing space, eventually LTCM managed to ride out much of the storm.

2.7.4. Hedge Funds and Their Regulation From a banking regulatory (systemic risk) point of view, a particular concern may be that commercial banks in their Treasury operations may follow similar speculative policies or lend excessively to hedge funds, therefore indirectly assuming their risk. For banks it concerns foremost proprietary trading of this nature, which came in for regulatory review after the 2007–09 financial crisis: see further Volume 6, section 1.3.10. For hedge funds proper, regulatory concern may arise from the point of view of suitability of the investment, especially for retail investors. Another concern may be that hedge funds in fact hold themselves out as deposit takers, although they must segregate. Even so, they may legally solicit participations, although usually address themselves mainly to investors who understand at least some risk and are able to take a substantial loss. It is not in the interest of hedge funds that it should be otherwise. Specially regulating these hedge funds is often demanded, but is mostly unfocused. Their history seems not to suggest an urgent need, and regulation is in any event likely to be less successful as these funds may easily move to other countries. Most of them are already offshore. In the summer of 2007, the Island of Jersey, for example, relaxed its rules to attract them in the event that more regulation should result onshore in the UK. The Cayman Islands were considering a zero-regulation regime altogether, as was the Island of Guernsey. The amounts in offshore centres were even then considered already to have reached US$1.17 trillion equivalent. If disclosure of strategy is the aim, it may endanger the very schemes that these funds set up and it would lag in time. In any event, it is neither possible nor desirable to regulate all types of speculation, which is a normal market function and smooths markets out. Although contagion and systemic risk may follow their failure, this will largely be so because such failures affect banks that have lent (too much) money to them. From a regulatory or stability point of view it is this lending that should then be primarily scrutinised and, if necessary, curtailed. As we shall see, it often results from prime brokerage activity in investment banks, in turn often financed by commercial banks. Even so, some form of rating of hedge funds is sometimes proposed and, if there is sufficient confidentiality in the rating exercise itself, it could at least counter the problem with disclosure 489 In the US, part of the problem may be that in derivative transactions there is no automatic stay under the US Bankruptcy Act 1978. This may lead to immediate termination of the transactions upon default where favourable to the counterparty subject to a netting-out regime of mutual obligations. That is a considered policy choice.

Volume 5: Financial Products and Funding Techniques 307 of strategy. The US Treasury Department by 2007 made a distinction in this connection between aspects of systemic risk and disclosure (or investment protection). The Financial Services Authority (FSA) in the UK at the time required filing of trades and risk management strategy, but only in public funds. Valuations, in particular, remain a matter for the funds themselves, however. This is an important aspect where there can be much uncertainty and wishful thinking on the part of management. Hedge funds and their regulation are old topics that received renewed attention in the financial crisis of 2007–09, at first not least in connection with the rewards of managers and the tax treatment of their remuneration. These last issues will not be discussed further here. It is clear that hedge funds have long been of interest, especially in terms of innovation of investment strategies, although many proved not to be particularly successful or even innovative. Nevertheless, as such they have an important function and fulfil a legitimate need. As just mentioned, the call for their regulation is often inarticulate because, beyond general unease, it seldom specifies sufficiently the risks we should be concerned about. It follows that there is no clear indication what kind of regulatory approach should be taken. In 2008 it was at first thought that hedge funds were contributing to the financial instability that had appeared in the summer of 2007, but when the dust settled that proved not to be the case. Some hedge funds were damaged as should be expected, but they were hardly the proximate cause of the trouble, which was more properly the mispricing of risk especially in sub-prime lending and connected structured finance, and the over-leveraging of society as a whole, especially in developed countries. Banks proved to be in the front line, also as investors, underscoring the fact that the hedge fund problem, if there was any in terms of financial stability, is in truth foremost a commercial banking problem. Again, this is clear for those banks that lent to hedge funds, which, through prime brokerage (see next section below), is sometimes also an investment banking problem. But this problem is enhanced in those banks that aggressively indulge in special strategies as part of their proprietary trading and investment operations, hence the idea that banks themselves often operate like hedge funds in their investment strategies. In terms of financial regulation, the key is always the risks these activities (in whatever form) assume, the nature of these risks, and what the regulatory response to each of these risks should be. If we want to regulate, they should be identified and clearly defined. That there is so much fuzziness in the subject is caused by the lack of this focus. The consequence is that the discussion seldom rises beyond the journalistic. One natural and obvious concern is the stability of the financial system. Again, that is particularly relevant when these funds are highly leveraged, therefore heavily indebted to the banking system, and is then chiefly a banking problem, as we have seen, in which connection the sudden death scenario has already been mentioned. Lifeboat schemes could be institutionalised, but this is not a regulatory response in the traditional sense. More importantly, it may create serious moral hazard. The answer here is better banking supervision and concern about large exposures. Hedge fund regulation would seem unfocused and therefore unjustified from this perspective. Problems may be longer term and affect large parts of the industry, but that is often the result of monetary policy and strongly rising interest rates as we saw in 1992–94. Funding itself became an acute problem in 2008. Hedge funds and their banks may thus become squeezed for reasons not directly of their doing, although there was likely misjudgement of future trends, including the continued availability of short-term funding. There may arise here a stability problem for the whole financial system in the form of liquidity, which may lead to precipitous liquidation of positions with a depressed mark-to-market effect on the holdings of others, which may thus get the banks into trouble. This liquidity issue may then also become a legitimate regulatory concern. The special position of small investors and the need for their protection has already been mentioned as another potential concern, which only becomes relevant if they should be allowed to

308 Volume 5: Financial Products and Funding Techniques participate also, and this may put greater pressure on regulators. Trust in the managers is important and retail clients mostly do not have the expertise and information to judge: their brokers may. It is also clear that atypical strategies could favour hedge fund managers greatly. They may, for example, organise a scheme that yields high profits up front of which they would receive 20 per cent in fees, while there may be great losses in later years or at least the possibility thereof. A simple example may be aggressively writing naked options. That gives a high premium and fee income up front, but the investor might carry large risks later. One could also think of a scheme in which there is a 10 per cent chance of losing the entire investment but substantial profits otherwise. Statistically it is clear that the investment will be completely lost if there is a 10-year time frame. Yet for nine years there may be substantial profits of which the manager receives 20 per cent in fees, but there may be sudden death in the tenth year. Much aggressive investment management intends to manage these schemes and this type of risk, but it is often hard to say whether they are managed or simply float on luck. These funds should therefore disappear as untrustworthy (bad lemons), but they do not truly do so, which is an argument for their regulation. Protection of retail investors is then necessary, and there are a number of traditional techniques. One way is to exclude them from more risky investments altogether, including those in hedge funds. It is likely in this connection that hedge funds themselves require large minimum participations that cut most retailer investors out. It is a rough measure and, as already mentioned, excludes these investors also from the benefit of more sophisticated strategies. Another way is to allow only investment managers or brokers to advise retail investors on these products, meaning that less wealthy investors will not be allowed to participate directly. These intermediaries are themselves regulated, which also applies to fund managers who directly market to the public. So far, no special regulatory category of hedge fund brokers or managers has been created. It could give the retail investor the benefit of special fiduciary duty protections, including suitability and best execution protection, although it must be understood that the fund itself typically trades suitability for a specialised strategy that may only be partially disclosed, as we have seen. Another protection may be in asset allocation. A rule could, for example, be considered that retail portfolios may have no more than X per cent in any of these funds or similar investment strategy, or at most Y per cent of their assets in all such funds or strategies together. This is of course also the normal approach of institutional investment/pension funds, albeit in that case adopted voluntarily as a matter of proper asset allocation and risk management. As already mentioned, funds of hedge funds may be attractive to retail investors also for diversification reasons and would from that point of view need lesser restrictions too. Another matter is the fee structure itself,490 especially the total cost ratio of these funds. It is often of prime interest to the smaller investor and often hard to come by. Fees may have to be much more clearly marked in advertising and other sales efforts. Also, intermediaries should better explain at what price investors are allowed to enter these funds, which raises the issue of best execution where there are few market makers. They should also explain what premium they pay for instant dealing or size. Furthermore, did the fund managers acquire the underlying assets for realistic prices? That is an obvious concern in private equity funds where at least there is public knowledge in the bigger deals. That is unlikely to be the case in most investments of hedge funds. Yet again, it is not necessary for this matter to be sorted out through regulation. It is the very essence of the business. Valuations remain here a key aspect, however, and their credibility could be another justified regulatory concern as already mentioned.

490 The so-called 2–20 rule gives managers 2 per cent of the assets and 20 per cent of the profits per annum, which may seem excessive as later losses are not discounted over the cycle.

Volume 5: Financial Products and Funding Techniques 309 Of course, hedge funds themselves (rather than their managers or intermediaries selling these products) could be made subject to an authorisation and prudential supervision regime in all cases, therefore also if not offered to the public. In fact, in the EU the UCITS Directives already referred to assume some initial supervision in the contexts of funds operating cross-border in the EU, but they are public funds. It was not typical for hedge funds and only applied to openended funds of the simpler type offered to the public, extended to more sophisticated products in UCITS III, when the liberalisation (and not regulatory) ethos of UCITS also became of interest to hedge funds, again always of the public and open-ended type. This is well documented and is at the origin of the greater interest of institutional investors in this new trans-border facility. Most importantly, the UCITS certificate has found recognition outside the EU, and it has been said that it has led to 60 per cent of these funds being sold in Asia on the strength of it. UCITS being a liberalisation measure would, however, hardly appear to be the proper framework for hedge fund regulation, although some special attention was given to these funds in some EU countries when implementing the UCITS Directives into their national legislation. Nevertheless, Member State (or domestic) prior authorisation may be a way to alleviate fears, especially in respect of retail investors. In that case there would be regulation not only of intermediaries selling these products, but, in the case of hedge funds, also of the product itself, assuming that retail investors would be allowed to participate. In the UK, the Financial Services and Markets Act 2000 distinguishes here between regulated and unregulated collective investment schemes, the latter being marketable only to a limited class of investors. No special regime was provided for hedge funds. Regulation in terms of authorisation assumes some conditions and a system of prudential supervision, making sure that the original conditions remain in place. Following commercial and investment banking regulation, one may think for public funds in terms of a proper risk management system, fit and proper managers, limits to gearing and some minimum capital while managers would not be able to take out their own capital at will (long notice periods are even now mostly in place), and a proper business plan. It would be a system of governmental or administrative law intervention. Problems would still be the great diversity in hedge funds, the difficulty in saying what kind of risk management system is appropriate, and what proper management and a proper business plan for them would be. As in commercial and investment banking, regulators would not want to go into, and thereby become responsible for, the management of the activity itself. That is not their task at all. It could also create serious moral hazard. Authorisation and supervision of this nature must therefore remain a system of rules, or at least of objective principles. More than the minimum may therefore never be likely or workable. As in the case of investment banking activity, authorisation and prudential supervision could, however, be coupled with special conduct of business and product rules which, if not respected, could give rise to civil damages claims of harmed investors, usually in the nature of extended or reinforced fiduciary duties of their intermediaries, at least in respect of retail investors. This possibility has already been mentioned before in terms of retail investor protection, including proper disclosure of and transparency in fee structures and valuations, but it was also pointed out that there may be better or additional protections in terms of mandatory asset-allocation rules and better supervision of brokers. A great deal of additional regulation would not then seem necessary nor indeed helpful from this perspective. Bureaucracy and systems cost may be held to a more realistic minimum. Another regulatory approach could be borrowed from new issuers in the primary markets in terms of disclosure in prospectuses and regular information supply, applicable in any event when these funds go public. Here the new Regulations and Directives in this area in the EU also spring to mind. Again, the problem is that exposure of the strategy could kill its advantages and lead to immediate copying in a competitive climate, and it would as such be inappropriate. A better system of valuations and their publication may, however, be entirely appropriate.

310 Volume 5: Financial Products and Funding Techniques Important and necessary as these disclosures may be, we would be regulating at the margin, and a true case for special regulation of hedge funds or similar activity per se is not made, especially if they are not offered to the public. It could increase the cost without obvious benefits and only yield to the basic feeling often found on the European Continent and in academic circles that anything that is not regulated is not safe or even reputable. All innovation here becomes suspect. Quite apart from the already mentioned practical aspect that these funds need not be funds at all, but simple strategies, and could, especially if private, easily be managed offshore or on the telephone and therefore move to more favourable regulatory climates, it was already said that the prime warning must be against unfocused debate. In the US, the SEC tried to regulate hedge funds by requiring registration and by conducting routine inspections and examinations. That was the Hedge Fund Rule of 2004. A federal appeals court threw this out in 2006 on technical grounds.491 The Dodd-Frank Act (sections 401–10) tried again and ordered that virtually all hedge funds be subject to federal disclosure and enforcement requirements. It distinguished three types of funds for these purposes: those subject to disclosure, those subject to enforcement, and those subject to both. The SEC implementing rules date from 2011. Records must be kept for the protection of investors and the assessment of systemic risk. They must cover information on assets under management, use of leverage, counterparty risk exposure, trading and investment positions, valuation policies and practices, types of assets, side-arrangements, and trading practices. Inspections by the FDIC and Federal Stability Oversights Council (FSOC) are subject to strict confidentiality requirements. In the UK, an industry group under Sir Andrew Large started work in 2007 to consider forms of self-regulation for both public and private funds. It centred on disclosure of holdings of complex, hard-to-value investments and the valuation method, risk management, including liquidity risk, and clear policies to avoid or deal with conflicts of interest between managers and investors. Companies should also be able to identify hedge funds with large stakes in them especially if they hold mere voting rights having sold on the economic interest. In June 2009, the International Organization of Securities Commissions (IOSCO) published a list of principles based on registration of managers and prime brokers, who would also be required to provide regulators with information on systemic risk including its identification, analysis and mitigation. Regulators would share this information. A move by Germany in the G-8 in 2007 to come to a comprehensive set of rules was defeated. In the meantime, France continued to ask for a tax on speculative movement of capital by financial groups, especially hedge funds. The G-20 in April 2009 required registration of hedge fund managers and disclosure of information, including leverage, necessary for assessment of systemic risk. After the financial crisis of 2008, some in the EU resurrected the idea of a comprehensive set of rules, and at the end of April 2009, the EU published a draft proposal for a Directive on Alternative Investment Fund Managers (AIFM) (see Volume 6, section 3.7.7) amending also the Pension Directive of 2003.492 The proposal covered all funds not under UCITS and included in particular also all closed and private hedge and private equity funds. The idea was that all managers require authorisation, that leverage is supervised, that transparency is enforced for all in terms 491 Goldstein v Securities and Exchange Commission, DC Cir 23 June 2006 451 F3d 873. The decision hinged on the meaning of the term ‘client’ in the Investment Advisors Act 1940, which had been interpreted to hold that any fund manager with more than 15 funds under management needed to register. In 2004, the SEC under its hedge fund rule changed this by requiring registration of all funds with more than 15 investors. The court rejected the argument that the SEC could put any interpretation on the term ‘client’ and held that its change of interpretation had been arbitrary and exceeded its authority. 492 Directive 2003/41/EC [2003] OJ L235/10, on the Activities and Supervision of Institutions for Occupational Retirement Provision, see Vol 6, s 3.6.4.

Volume 5: Financial Products and Funding Techniques 311 of regular disclosure to regulators of products, exposure, performance and concentrated risk, that depositaries are regulated beyond what UCITS requires, and that sales into the EU of products from outside were to be curtailed or at least also supervised. There is a new potential danger over the horizon. It has been observed that hedge fund managers are increasingly turning to artificial intelligence (AI), and more specifically, machine learning to meet investor’s needs and to obtain more diversified sources of income. ‘Machine learning is a subset of AI utilized to build predictive rules based on the identification of complex patterns.493 Although this technology has the potential to provide hedge fund managers with deeper and faster analysis of market data, automate the analysis process, and provide more persistent and diversified alpha streams, it also introduces cyber and operational risks into the decision-making process. For instance, the machine learning software might have coding errors, thus causing the software to malfunction and enter into undesirable trades or initiate a mass sell-off of a particular share, bond or derivatives contract. Furthermore, the algorithm used in the machine learning software may not be able to properly identify patterns in scenarios that it has not previously experienced. There is also the risk that cyber-criminals will be able to hack into the hedge funds using this software and hijack the program for their own purposes, thus potentially bringing trading to halt for the affected institutions and parties until the problem is resolved. Therefore, careful consideration and appreciation must be had of the potential benefits and the potential risks that machine learning software can introduce before there is a mass adoption of this technology in the hedge fund industry. Regulators must also open the channels of communication with hedge fund manager to determine whether these machine learning programs have the potential to cause systemic risk during periods of market turmoil, as it foreseeable that various hedge funds (through the machine learning software) could simultaneously begin a mass sell-off of certain shares, bonds and derivatives, thus sparking a downward spiral in prices and causing a financial market panic.

2.7.5. Prime Brokerage Since shorting is a normal activity of hedge funds, they need access to a securities lending facility. It is an activity that will be further discussed in section 4.2 below where the close connection with and differences from the repurchase agreement (‘repo’) will also be explained. An important aspect of securities lending (as in repos) is that the borrower may sell the securities and only has a redelivery duty in respect of fungible assets of the same sort. It would therefore appear that the securities borrower obtains some ownership rights in the assets and that there is some kind of sale, but this may not be a proper legal characterisation and a sui generis structure is often assumed under which the borrower pays a fee for the facility and the lender takes the risk that in a bankruptcy of the borrower the securities cannot be located, so that the lender becomes a mere competing creditor. This is a risk that also affects the repo seller of fungible assets, for whom netting may, however, provide some relief: see sections 4.2.4–4.2.5 below. As a consequence, the securities lender will often require security (that is, collateral) to cover the redelivery risk. Prime brokerage refers to a number of activities that originated with the facilitating of short selling, in which securities lending is likely to play an important role, as it is a way for the short seller to meet any delivery requirement in respect of securities that s/he has sold but does not have. The prime broker may also provide credit, foreign exchange and custody facilities in this 493 https://am.jpmorgan.com/au/en/asset-management/institutional/insights/portfolio-insights/machine-learningin-hedge-fund-investing/.

312 Volume 5: Financial Products and Funding Techniques connection and normally benefits from a contractual close-out facility in respect of a defaulting client that will provide for bilateral netting in respect of all outstanding transactions or balances with that particular client. According the UK FCA Handbook prime brokerage provides a package of services under which the prime broker also has a right to use safe custody assets for its own account. As just mentioned, the prime brokerage function is of particular importance to hedge funds and is then usually carried on by investment banks who execute the trades, hold hedge fund’s assets, finance them, if necessary, may engage in margin financing and stock-lending services facilities for their client, provide risk management, clearance and settlement services and all kind of back-office or administrative support, and may also handle subscriptions and redemptions. It means in practice that the hedge fund only takes the decisions of strategy, but the prime broker does all the rest. This close connection suggests a form of oversight of hedge fund activities by their prime brokers, who do not want to become over-exposed, therefore oversight through private interests. Prime brokerage activity of investment banks then also allows for a form of indirect regulatory monitoring of hedge fund activity through investment bank supervision, and could even mean some form of regulatory control, while regulators supervise, or regulation may limit the activities of investment banks, here especially through capital adequacy requirements in respect of exposure to hedge funds. Prime brokerage activity of investment banks has not so far been regulated as a separate function with a special regulatory regime, either in the UK or elsewhere. Any investment bank authorised to engage in securities activities may commonly operate as a prime broker, although IOSCO suggested special treatment, as we have seen. That reflects a similar attitude to intermediaries in the hedge fund business itself, as discussed in the previous section. Special problems may arise when prime brokers fail. In the US this is a matter of SEC (rr 15 c3-2 and 15c3-3), bankruptcy (chapter 7, subchapter 3 of the Bankruptcy Code), and securities investor protection rules under the Securities Investor Protection Act (SIPA 1970), which alternatively allows the Securities Investor Protection Corporation (SIPC) to initiate liquidation proceedings. The proceedings under the Bankruptcy Code and SIPA are different in that SIPA favours the return of securities in custody to the customers while the Bankruptcy Code requires the trustee to sell and distribute the cash to the customers. In both cases there is segregation and it becomes a question of timing and delay. Any deficit is pooled on the basis of the customers’ net equity claims.

2.7.6. Private Equity Finally, it is necessary also to say something about private equity, already mentioned in connection with hedge fund activity. The term may also be misleading here. It concerns the activity of entrepreneurs in taking companies private, that is removing them from official markets and infusing new management. Often, they use a fund structure to induce a wider range of investors to provide the financing, but they themselves, and also investment banks, may participate directly. As in hedge fund activity, there is therefore a difference between the activity itself and it being conducted through funds. Sometimes private equity activity is equated with asset stripping, that is selling off the better parts of a business in order to provide a quick profit for investors, wrecking the company in the process. In fact, private equity is a longer-term game and is intent on providing better management that can concentrate on a longer perspective, commonly seven or eight years. It is not driven by venture capital, which is meant for start-up companies and is a different kind of investment activity altogether. Although the activities of private equity should therefore be benign and rational, they have nevertheless become associated in the public mind with predatory tactics.

Volume 5: Financial Products and Funding Techniques 313 Regulation is thus demanded, but again it is less clear on what it should focus unless killing off the activity itself. A difference should be made between the activity and fund structures. The true worry should be the private investor in these activities, the initiators paying too much for the companies they buy up, taking more risk than they should, and being paid too much. There may also be taxation questions in respect of the profits these initiators or private equity fund managers make. It has already been said that these latter questions are outside the scope of the discussion in this book proper. Here again going offshore may solve the problem for the fund, which is usually the choice if privately held. Another typical concern is the hold these private equity operators may get over the market. Small initial participations of them in public companies may create great unease and may lead to a sudden sale and break up of large companies as in the 2007 ABNAmro demise. Shareholders’ activism is certainly strengthened in this manner and inefficient or unresourceful management is at risk, probably rightly so, and no reason for regulation per se. From a stability point of view, the funding may concern regulators in the sense that, in private equity schemes, long-term assets may be bought against shorter-term funding, so that there may be a refinancing need at inopportune moments in terms of availability of financing. This may seriously weaken the scheme and even lead to its early demise. It is a matter of liquidity management. In the UK the industry itself set up a special study group under Sir David Walker, which reported in July 2007, looking for some kind of voluntary code. Annual reports were proposed for companies owned by private equity operators and they would report every six months. Financial planning and job cuts would be disclosed when buyouts occur. It would amount to some disclosure of strategy. ‘Outside’ directors may be another possibility. As one of the virtues of private equity is that it cuts out the layer of executives that are likely to look after their own interests instead of shareholder’s interests—the so-called agency problem in public companies, which should not be resurrected—these outsiders would therefore need to be industry professionals who could work with management on turn-around situations, although again the operation of private equity and the inner structure of the funds should be clearly distinguished. In 2009 the EU got involved in a review of all fund activity, which led to a draft proposal for a Directive on Alternative Investment Fund Managers (AIFM), already mentioned above in connection with hedge funds, even though neither hedge fund nor private equity activity was at the heart of the 2008 financial crisis. Again, the idea is that even in private funds of this nature all managers need authorisation, that leverage may be curtailed, that transparency must be enforced in terms of regular disclosure to regulators of products, exposure, performance and concentrated risk, that depositories must be regulated beyond what UCITS requires, and that sales into the EU of products from outside must be curtailed or at least supervised in order not to undercut the whole new approach. It confirms a strand of thinking that rejects the underlying activity and wants it curtailed per se rather than being concerned about the fund structure itself.

2.7.7. Domestic and International Regulatory Aspects, UCITS The regulatory aspects and concerns in respect of modern investment management and fund management were already noted in the foregoing and need not be repeated. Also, UCITS has been mentioned several times as a way in which regulation is handled in the EU in respect of certain types of open-ended funds offered to the public that may acquire a passport to do business EU-wide under home-country supervision. Even then, host-country rule remains relevant

314 Volume 5: Financial Products and Funding Techniques in the area of investors’ protection in terms of cold calling, marketing and advertising. It was the first example of passporting of this nature in the EU and assumes a minimum supervision standard, structure and authorisation at home. But it was also pointed out that this type of regulation was for open-ended public funds of certain products only, extended by UCITS III, which also allowed the use of derivatives for investment rather than hedging purposes. It made this passporting facility of interest to some hedge funds, but UCITS is not normally applicable to them or to private equity funds of the closed and non-public type. Since 2009, all UCITS Directives have been consolidated in what is now known as UCITS IV: see Volume 6, section 3.5.14. The regulation of hedge funds in particular was the aim of the 2009 EU proposals for a Directive on AIFM, already discussed before (see further Volume 6, section 3.7.7) and looking for a comprehensive set of rules covering all funds operating cross-border, not under UCITS. It included a passporting facility but gave rise to much debate and amended proposals. The issue ultimately became largely one of access by EU investors to non-EU (US and offshore tax haven) funds. At one stage during these discussions, a blacklist was proposed in respect of some tax havens, which would forbid EU investors from sending funds. It implied the curtailment of hedge fund activity in London, where much of the management of these offshore funds is located. To avoid the list, these countries would have to comply with certain standards and conditions, of which disclosure and a tax agreement based on the OECD guidelines would be a main one. Even then, they would not benefit from the passport. The result was that small and medium-sized companies could be hurt as they may depend for funding on private equity or other more innovative funding activities. As mentioned earlier, in the end the debate largely came down to the access by EU investors to non-EU (US and offshore tax haven) funds. They can do so actively but only by way of private placement and subject to its rules in each Member State. The marketing of non-EU funds in the EU by EU fund managers is now also to be treated as private placements in any Member State where they are marketed subject to its rules unless unsolicited by the manager, therefore bought on the investor’s own initiative, which is not therefore subject to the same restriction.

2.7.8. Concluding Remarks. Transnationalisation It may be clear from the above that regulatory issues dominate the debate in investment and fund management; private law issues do not get the same type of attention but nevertheless remain of great importance, for example where investors’ protections are reinforced by regulatory intervention through private law, as in the area of fiduciary duties, which may lead to special private law protections especially for the smaller investor. It is the regulatory area of conduct of business. But there are other areas of private law which are important, notably the structures through which investments are held by managers for their investors or through which funds operate, and the true nature of the rights of investors in them. There is also the issue of how investors may be bound by their managers when it comes to execution, clearing and settlement and gain direct access to their assets, avoiding their intermediaries if needed (in the latter’s bankruptcies, for example). Here practices may start to converge and transnationalisation then becomes a potent option of simplification and limitation of transaction costs, legal risk and promotion of transactional and payment finality. This may come partly through the transnationalisation of the clearing and settlement functions themselves and the way in which securities and cash are held in modern securities entitlement and payment systems, which will be the subject of the next sections, but it is also likely that an independent impulse in that direction will issue from the investment management industry and fund business itself.

Part III Payments, Modern Payment Methods and Systems. Set-off and Netting as Ways of Payment. International Payments. Money Laundering 3.1. Payments, Payment Systems. Money and Bank Accounts 3.1.1. The Notion and Modes of Payment All acts of performance are a kind of payment in the sense of giving satisfaction, but payment in the more technical sense is associated with the fulfilment or extinction of pre-existing monetary obligations, which are obligations reduced to money as expressed in the unit of account of the relevant currency. The issue is therefore when and how such a monetary obligation can be and is extinguished. That suggests payment proper and liberates the payor or debtor at the same time. Paying seems to be simple, but legally it is quite complicated. First it should be realised that normally a liberating payment cannot happen unilaterally before the due date. Even then, it must still be legally made, which goes to issues of capacity, intent and disposition rights in the money, and requires further that the relevant amount is unconditionally transferred and put at the free disposition of the creditor. Upon proper acceptance it extinguishes the debt, but this acceptance is itself another legal act, which has similar requirements in terms of capacity and intent. A valid payment is the result and constitutes the way monetary obligations are fulfilled and extinguished once they become firm and mature. That is what a liberating payment means. The result may be cash or, in modern times, more likely a credit to a bank account.494 Only in the case of a set-off, a novation, or release may a monetary obligation be extinguished in other ways. As to these different forms of ‘payment’, they may indeed be achieved in the following manner: (a) in cash in the agreed currency or in the currency of any judgment or award by handing over coins or banknotes of that currency—notes are in this connection promissory notes issued by a bank (now mostly the central bank of the currency);495

494 See also van Setten (n 486), 6.63 ff. 495 Technically speaking, it is also possible for the payment to be made through the transfer of assets other than money, eg, through the transfer of chattels other than coins or banknotes. This barter, a possibility not considered any further, would make the payment subject to the formalities concerning the proper transfer of such an asset. However, it points to the fact that payment in cash is also a transfer of assets in its own right and payment through a bank transfer no less of an asset, in this case a transfer of (part of) a bank balance of a payor to a payee, as we shall see below.

316 Volume 5: Payments, Modern Payment Methods and Systems (b) through a bank transfer (known as ‘commercial bank money’) where money assumes the form of a transferable money claim on a bank in the agreed currency and the payee receives the immediate and unconditional disposition rights in the money claim so transferred496—it will normally entail the substitution of a money claim of the payor on its bank by a money claim of the payee on its bank (which may, but need not, be the same bank); (c) through a central bank digital currency (CBDC), which is a new form of digital central bank money, to be used at least for retail users (and some wholesale users); (d) through a set-off, which means that the payment obligation is extinguished (in whole or in part) through the deduction of a counterclaim of the debtor (which normally must also be monetary, in the same currency and be mature) against its creditor; (e) through novation, which is the replacement of the payment obligation by another obligation which may be a new payment obligation between the same parties or a tripartite agreement under which someone else will make the payment to the creditor in the same or another currency, as in the case of the negotiation of a promissory note or bill of exchange (which is now much less common); or (f) through a release by the creditor by way of a gift or similar type of contractual arrangement. Payment is normally achieved through voluntary performance of the payment obligation (even if a money judgment) in one of the first two ways, therefore in cash or through a bank transfer, but may also be enforced (therefore be involuntary) through court action leading to an attachment and execution sale of a sufficient number of the debtor’s assets and a set-off of the proceeds against the payment obligation, with a return of any overvalue to the debtor. Thus, the set-off is a key element of all involuntary payments, but it is also a normal way of payment outside enforcement action. In most modern legal systems, it is considered a unilateral right of a debtor, with a counterclaim on its creditor, not therefore subject to consent or acceptance of the payee. The debtor must invoke it, usually as a defence. In cash and bank payments, the debtor also normally takes the initiative. Novation, on the other hand, requires the co-operation of all parties and could therefore be proposed by anyone, although as a way of payment the debtor is probably again the initiator. A release, on the other hand, is entirely dependent on the creditor and is a unilateral act on their part. Payment proper—in cash, through a bank transfer, by set-off, novation, or through a release by the creditor—should be clearly distinguished from a payment promise, payment instruction, or tender to pay in any particular form, such as signing a cheque, drawing a bill of exchange in favour of a payee, or issuing a promissory note (as distinguished from handing over a bank note) or letter of credit, or allowing a credit card imprint. These are not payments themselves, but only actions eventually leading to payment in the above sense of extinguishing a payment obligation, unless of course by contract these actions themselves are accepted as full payment. This is not likely in the case of the writing of a cheque, which normally depends for its effectiveness on sufficient debtor funds being in place in the bank on which the debtor drew the cheque, which can only be determined at that time. Nor is the endorsement of a bill of exchange likely to be accepted as payment, as its effectiveness depends on the acceptance and creditworthiness of the drawee. However, it is possible that the issuance of a letter of credit is accepted as full payment in a sales contract and extinguishes the debtor’s payment obligation; this may also be the case in the issuance of a promissory note of a bank to the creditor (or the latter’s order).

496 The nature of the bank account, especially the current account, and the framework for netting it entails, as well as the legal status of deposits, will not be discussed here, but is the subject of Vol 6, s 1.4.9.

Volume 5: Payments, Modern Payment Methods and Systems 317 Payment in cash is now largely limited to smaller consumer transactions, especially minor cash sales, or payment for minor services. In commerce, it has become exceptional and is no longer assumed to be the normal manner of payment. In these transactions, payment is normally through a bank transfer initiated by an (electronic) payment instruction of the debtor/payor, and, if nothing more is said, the payor may be assumed to have a right to pay in that manner and be liberated upon such payment once completed. This means that if in commerce a cash payment is still required by the payee, it should be clearly agreed, although, unless specifically stipulated otherwise, the payor may still have the option to pay in cash under their own law,497 at least if the payment is in their own country and in the currency of that country. That may be the consequence of this currency being legal tender. The debtor may have more rights and more options than the creditor here. What happens here in truth is that the more traditional payments though banknotes, there the transfer of claims upon the central bank embodied in promissory notes, is replaced or supplemented by payment through the transfer of claims on banks, the particular legal characterisation of which is discussed in section 3.1.5 below. The issue of and shift towards money creation through the banking system in this manner, its meaning, and regulatory limitations are briefly dealt with in the next Volume, section 1.1.1 and the stability of this activity and its macro-prudential supervision in section 1.1.13/14 of the same Volume. CBDCs are a novel invention that may soon permit retail investors to make instantaneous electronic payments using their digital devices (that is, smart phones and computers) by transferring a digital central bank currency (tantamount to digital cash). See section 3.1.11 below for its operation. As already mentioned, payment through set-off depends on the existence of a counterclaim, which must normally also be monetary, in the same currency, and mature. Under modern law a set-off outside bankruptcy is normally not automatic and must be properly notified to the creditor/payee if the debtor/payor wishes to use this form of payment, but the creditor’s consent is not required, and there is therefore no creditor’s veto right. In some countries some connexity between both claims is still necessary, although all these requirements may be waivable by the parties in advance. If notification is necessary, which is now the more normal procedure (except in countries like France where it remains automatic), it makes the set-off a juristic or legal act, which confirms that the parties may in principle vary the conditions or may waive them as they often do in modern netting arrangements. Depending on applicable law in terms of mandatory public policy, which generally has become ever more flexible and accommodating in this area of the law, they may even be able to expand the scope of the set-off to include non-mature claims and claims in other currencies, or to other assets, or to lift other restrictions (such as the one of connexity). Set-off is a way of payment, but in its various forms it has become of greater importance in terms of risk management in banks (these aspects will be discussed in greater detail in section 3.2 below). Payment by novation is on the other hand exceptional and involves the termination of the old obligation in exchange for a new one. This cannot be done without the creditor’s consent and is often a tripartite agreement under which a third party undertakes to pay in lieu of the debtor. In that case, it leads to debtor substitution. It usually comes about because the first debtor

497 In order to deter black market activities and money laundering, some countries may have legislation that limits the amount of cash that can be used to make a payment. For example, the Australian legislature recently passed a bill that proposes to make it a criminal offence (with imprisonment of up to two years and a fine) for anyone who makes a cash payment above AUD $10,000 (see Currency (Restrictions on the Use of Cash) Bill 2019).

318 Volume 5: Payments, Modern Payment Methods and Systems has a claim on the second debtor, which is settled in this manner (but only with the creditor’s consent). It is notably not a form of assignment, which results in creditor substitution. Assignment does not require the other party’s (debtor’s) consent either, but does not extinguish the existing payment obligation. This is all very different in novation. See for the difference more p articularly Volume 4, section 1.5.7. Payment by set-off and payment by novation may be combined in novation netting: see for this important facility, especially in interest rate swaps, section 3.2.3 below. Payment by novation will not be discussed here any further. The same goes for a payment through a release by the creditor. It should be distinguished from a payment through novation as nothing is put in the place of the payment obligation proper. In common law, both may be similar in so far as the concept of consideration (see Volume 3, section 1.2.2) is a problem in either in common law countries, and a release in particular may not therefore be binding except if arranged in a special form (by deed).

3.1.2. The Notion of Money as Unit of Account or Unit of Payment. Money as Store of Value Before going any further, it may be useful to say something about money itself. In all payments of monetary obligations, we see the importance of money.498 In payment in cash or through a bank transfer, money figures both as unit of account and as unit of payment. In the set-off, novation or creditor’s release, it only figures as unit of account. Money as unit of account identifies the currency of the monetary obligation and the amount of money owed as expressed in that currency. Thus, a unit of account figures in all types of payment, but money as unit of payment figures only if it effectively changes hands. That is therefore only relevant for cash payments and payments through a bank transfer, which is, technically speaking, the substitution (by the payor) of a claim on the latter’s bank for a claim on the payee’s bank (if a different bank) in favour of the payee and replaces or supplements the payment, which means in essence the transfer of claims on central banks embodied in promissory or bank notes. Particularly important aspects of money as unit of payment (and therefore not relevant in set-offs, novations and creditor’s releases) are that: (a) the creditor must accept the payment in the agreed currency; and (b) the origin of the money is irrelevant whether it is in the form of coins, of promissory notes of (central) banks, or of bank balances. This means that even if the money was originally stolen, this has no effect on the payment once the origin of relevant money can no longer be identified. This is normally the case when it becomes irreversibly commingled with other money of the payor of the same currency, either physically or in his bank account.499 In respect of all payments, there remain in principle all the normal transfer requirements in terms of capacity of the parties and an underlying intent. Only in respect of units of payment are they joined by the requirement of actual delivery, at least in countries that require it for the

498 See, for the nature of money in a legal sense, the classic treatise by FA Mann, The Legal Aspects of Money, 5th edn (Oxford, 1992). 499 In any event, the notion of the protection of bona fide payees is at least in the case of bank notes an old one: see Lord Mansfield in Miller v Pace (1758) 1 Burr 452.

Volume 5: Payments, Modern Payment Methods and Systems 319 transfer of title in chattels500 and in any event for notes. It has already been mentioned that there is also the need for disposition rights in the case of transfers of cash or bank transfers. Money is, besides a unit of account and a unit of payment, also a store of value. Under the old gold standard, the emphasis was principally on this aspect of money, which was not difficult to grasp, as it meant gold. In that system, paper money was always convertible into it. Thus a (central) bank issuing banknotes promised to pay gold upon their presentation against a fixed exchange rate. In that system, the unit of account indicated how much gold was to be given in payment of a monetary obligation. If currencies rather than gold were used, it would indicate how many notes in the indicated currency were required to achieve payment in full. In truth, it was not of great interest in which currency the notes as units of accounts were expressed—such as dollars, sterling, marks or francs—as long as central banks strove to maintain the intrinsic (gold) value of their notes, which they normally did (although they could technically devalue the paper currency in relation to gold). As they were all convertible into gold, they were in fact also interchangeable with each other on the basis of gold at a fixed rate. In modern paper money systems, the central bank that issues the money only promises to replace paper for paper. This is known as ‘fiat’ money. The value of money is no longer supported by gold, only by government, and thus became subject to political and inflation pressures. As such it has lost an important support for its status as store of value. The other risks inherent in a system of paper currencies or fiat money in terms of convertibility and transferability, especially relevant in international transactions, will be further discussed in section 3.3.3 below. Use of claims on banks as a means of payment further presupposes confidence in the banking system as a matter of counterparty risk. These claims may be supported by deposits, themselves mostly resulting from the transfer of claims on banks by others, for example, employers paying wages, or from overdraft facilities. For claimants, the facility to require the bank to pay out upon such claims in cash, meaning in notes drawn on central banks, may be some comfort and enhance the confidence in this system, assuming of course that the bank has unlimited access to its central bank for such notes in times of crisis. This is a question of liquidity and access to its lender of last resort which may in such situations not be assured and will be much the subject of the next Volume.

3.1.3. Legal Aspects of Payment. Completeness and the Need for Finality To repeat, a payment in whichever of the above-distinguished ways is effective—therefore may be considered to have extinguished the payment obligation of the debtor—only if it is properly made, but is then also likely to achieve a full discharge of the latter and is therefore liberating. For this to happen, payment first needs to be complete and unconditional. It must also be legally made. Completeness is normally easily verifiable in cash payments. In the case of a bank transfer, the payment is notably not complete and therefore not fully effective: (a) when it is subject to a later value date (except if agreed) or release notice of the debtor, (b) when it does not give the creditor/payee full disposal rights of the money (therefore an unconditional credit in his own account), 500 Care is here required for the chattel analogy, even in respect of coins. It has already been said that the promise to pay is not payment and some act of delivery would appear to be required, even in countries like France where chattels are transferred upon the mere conclusion of a sales agreement. Payment would not appear to be in that nature and is more like barter, which also in France requires a physical act of title transfer to conclude the transaction.

320 Volume 5: Payments, Modern Payment Methods and Systems (c) when it does not allow the payee to receive interest on the money, and (d) in an international setting, when there is no full convertibility and transferability of the (foreign) currency, unless that risk was clearly taken by the payee. Thus, unless otherwise agreed, payment needs to be legally made and must give the creditor unconditional disposition rights in the money. Altogether this is likely to lead to the extinction of the payment obligation of the debtor, therefore payment proper, and achieves liberating effect, although this is strictly speaking still a separate aspect that needs to be clearly distinguished, concerns primarily the creditor, and may have its own requirements in terms of the capacity and intent to receive and give a release (and legally to receive the money), although the liberating effect could be considered implied, as we shall see, if all is done and the payment is unconditionally received. The result is otherwise a defective payment, the importance of which is that if such a payment is made and the due date has passed, a default of the debtor/payor results. Another related key requirement of a valid payment is its finality, meaning that it cannot be revoked or invalidated later by the payor merely because there were formal defects. It also underpins the liberating effect. That does not mean that an erroneous or defective payment cannot be reclaimed by the payor, but that is a separate issue and a different legal act or cause of action, for example, on the basis of mistake or unjust enrichment if too much was paid. Even then, as we shall see, the payee may still be protected and keep the money regardless of what went wrong to the extent the payee was somehow owed the money and assuming the latter was in good faith and had not contributed to the mistake. The key is that a payment once made should not itself become invalid and reversible merely because of some legal sophistry in terms of capacity, intent, disposition right, delivery, or acceptance (assuming always that the money was owed and indeed received). That is the concept of ‘finality’. Again, it does not mean that the money cannot be claimed back, but the payment is not automatically reversed and there is a need for a new cause of action. There are a number of aspects here, both contractual and proprietary, on the part of both the creditor and debtor. As we have seen, payment implies a transfer of an asset for which (as for any other) there must in principle be a valid reason, intent and capacity, while the formalities associated with a transfer of assets must also be complied with. As for the reasons, there may or may not be a payment duty. If in retrospect there was no valid reason, this could conceivably undermine the validity of the payment. Again, it is a finality issue. More important may be the conditions of the transfer in terms of handing over (or giving payment instructions) and receipt, and the necessary legal capacity and intent. There may also be the question of disposition rights, for example in a thief, but also in a husband or father using the account or money of a wife or child. This may work out differently for the different forms of payment. Thus, a difference may exist between payment in cash (even between coins and notes) or through a bank transfer. It is not uncommon in this connection to see a cash payment as a mere act in fact. This would dispense with legal niceties such as capacity and the intent of the payor to transfer and of the payee to receive. It may also dispense with the formalities of a transfer in terms of proper delivery (in a legal sense, at least in countries such as Germany that require an act of delivery for any title transfer, therefore in principle not different in the case of a transfer of cash).501 It may even dispense with disposition rights in the cash as long as the payee was bona fide. That would at least be the normal rule for coins and notes. 501 See in Germany, K Lahrenz, Lehrbuch des Schuldrechts, Band I, Allgemeiner Teil, 14th edn (Munich, 1987) 237. Payment in Germany is often not considered a legal act subject to the requirements of capacity and intent. It means that if payment is made in the agreed manner it cannot be undermined by legal considerations and a

Volume 5: Payments, Modern Payment Methods and Systems 321 For bank transfers, it would be much harder, however, to follow the act-in-fact approach and to deny that there is—in German terms—a legal act or a series of them: instructions are given by the payor to his bank; there may be interbank transfers subsequently to reach the bank of the payee. Thus, credit transfers are being made, which must also be accepted. The creditor must (explicitly or implicitly) also give a release, which needs, at least in principle, to be accepted as well (either directly or indirectly). It follows that capacity and intent to transfer, receive and release are relevant in such transfers in regard to both transferor and transferee in the various intermediate transfers necessary to reach the creditor in his own bank, and there may also be disposition and delivery requirements. Legal defects in payments may thus easily result: for example, too much was transferred, errors were made, there may have been no intent or sufficient capacity (for example, when minors make payments), proper disposition rights, or there may have been fraud. The end result may be that the payment is defective, even if the payee received the money and may have been owed it. This is not good news from the perspective of payment finality and the requirements of capacity and intent are therefore normally de-emphasised. A debtor must give a valid instruction to its bank to make the transfer through the system, but the validity of the instruction might be assumed, at least if there was a sufficient bank balance, and impliedly any lack of capacity and intent may then be considered waived by a payor or the latter’s representatives as grounds to invoke invalidity. Similarly, the instruction could be deemed accepted by the bank if it was put sufficiently in funds by the debtor.502 So it goes down the chain503 until the payment reaches the creditor who may be deemed to have accepted the payment and granted a release by receiving the money on the proper date and right amount in his account. S/he could not then invoke later any lack of capacity or intent on his part, or on the part of anyone in the system, to deny the release, at least as long as the amount was correct. In such an approach the simple implementation of the agreed payment steps could thus be considered to achieve full payment regardless of any further act of acceptance on the part of the creditor. As already mentioned, even the handing over of a cheque could then suffice as full payment and discharge the debtor, provided the contract is clear on this. Certainly, putting in

liberating payment will follow regardless of the parties’ intent and proper acceptance. But if the payment itself requires further acts, as in the case of a bank transfer, the situation might be more complicated and the solution may be that, even though further legal acts are required, the requirement of capacity and intent are largely ignored in the tendering, instructing and accepting payments, as they now appear to be ignored also under statutory law in the US. See for the situation in the UK, Momm v Barclays Bank International Ltd [1977] QB 790. 502 In the US, ss 4A-209 and 211 UCC set a standard by dealing with this point in electronic payments. 503 The promise or obligation of each successor in the chain to act on the instruction of the predecessor in this manner is not strictly speaking an undertaking towards the payee, perhaps not even in the case of his/her own bank. It means that there is here no joint or several liability. The payee may be no more than a third-party beneficiary of these undertakings unless each bank could be seen as the agent of the successor bank in the payment chain and ultimately of the payee, a less common view. In fact, even the crediting of the payee’s bank by a central or correspondent bank seems not itself to create the obligation of the payee’s bank to credit the payee’s account and the payee then has no automatic right to this credit either. This is an issue quite separate from the receipt of the funds by the payee’s bank. S 4A-405 UCC in the US introduces another important statutory clarification and sees the obligation created by the acceptance of the money by the payee’s bank as being for the benefit of the creditor. In this approach, the creditor’s bank’s duty to credit the creditor’s account does not necessarily derive from the creditor’s bank’s acceptance of the instruction of the prior bank in the chain, but is statutory. Art 4A UCC is also specific in determining: (a) the other duties of participants in the payment circuit; (b) to whom they are owed; (c) the time at which each bank involved is deemed to have accepted its duties in this connection; and (d) until when any acceptance of instructions can be revoked or how it can be made conditional (notably upon receiving adequate funds).

322 Volume 5: Payments, Modern Payment Methods and Systems place a letter of credit could be so considered. The analogy with cash payments may not be far away: there the acceptance may be implied even if cash is left on the doorstep and not promptly returned. For bank transfers, that translates in their not being promptly protested. Depending on the circumstances, at least in cash payments the debtor/payor could even be seen as agent for the creditor/payee in the aspect of the acceptance of the payment, for example when it is unsuccessfully tendered on the maturity date and subsequently kept apart for the creditor to collect. Modern payment systems, to the extent they have received statutory backing, will confirm this approach to finality, at least in bank transfers, meaning that defects in the transfer will generally be ignored except in the case of outright fraud, when the payment may even be stopped in the system. At least the payee bank may be prevailed upon not to credit the payee’s account if on the face of it the latter was involved in the fraudulent payment. Whatever the approach, bona fide payees who are owed the amount should be protected against any reclaiming rights and also against any lack of disposition right in the payor or any intermediate banks. It may even be a matter of justified reliance. That is what finality means to them and it is enormously important. In order to promote finality, there are in fact a number of established legal techniques which have been mentioned before and may be summarised as follows: (a) We may use the analogy of acts in fact, so that capacity, intent, disposition rights and transfer requirements may be de-emphasised or diluted. This would also apply to the release. The easiest way to do this is by simply assuming that they have been present or in the case of intent by maintaining an objective notion or presumption in the sense that the debtor must have had the intent to transfer as long as the amount was owed. The creditor may similarly be assumed to have intended a release if the money was unconditionally received. These issues and this reasoning may show a greater civil law than common law concern, but in common law these issues cannot truly be ignored either. (b) It is also possible, in the German manner, to consider any transfer of assets complete in its proprietary aspects once it is made regardless of defects in the underlying steps leading up to it, unless there was fraud. That is the abstract system of title transfer: see more particularly Volume 4, section 1.4.6. (c) Analogies derived from the notion of independence in the case of negotiable instruments and letters of credit (and the modern receivable) and the payment obligations and payments made under them may also be used here. (d) That also leads into the protection of bona fide payees, perhaps on the analogy of the protection of bona fide assignees (where accepted) or of holders in due course of negotiable instruments. It traditionally protects especially against a lack of disposition rights in the payor. The payee needs therefore not be concerned that the money received was tainted unless the payee was in the plot. (e) It can also be explained as justified reliance by the creditor/payee, assuming always that the amount was legally owed, although it may be for reasons other than motivating the transfer. Different legal systems may take different approaches (or even a combination) or put the emphasis differently, but the objective is always finality, which in essence means the closest possible approximation to a cash payment. In the US the matter is the subject of statutory law in Article 4A UCC. It appears to rely on a combination of (a), (b) and (d) (see also Comment section 4A-303). In France the emphasis is on (d), see Articles 1238ff Cc. The Germans may rely more on (b). In other countries, statutory law may be patchy or non-existent and the matter is left to case law. It is obvious that there is here a more subjective or more objective view of payments possible, and there may be legitimate controversy in this area, but there is growing unanimity that the effectiveness of payments should not be undermined by subtle legal reasoning, both at the level

Volume 5: Payments, Modern Payment Methods and Systems 323 of the payment method and intermediaries or systems used and not at the level of the liberating effect either. So, the objective approach is the preferred one. It is not a matter of principle, but one of necessity. In terms of finality, there are also important practical issues especially as to whether and how payments in the pipeline (that is, for bank transfers in the banking system) may still be stopped or automatically reversed, especially in the case of human or system error (or fraud). Again, whatever the legal arguments, the modern approach is that that should not happen lightly (and only under special rules). It bears out that payments, once set in motion, should be seen as independent from their origin and from the defects that may attach to the original instructions and intent. This is a public policy choice and economic necessity to which the law must conform. Whether, when and how such payments may be still reclaimed is then another issue. It was already said that this is not normally done through an automatic reversal in the system but through a new action, probably based on unjust enrichment, that will result in a new set of payment instructions. The former payment will not then itself be undone. In other words, once payment is set in motion and is so to speak in the pipeline, it must be unhindered as it is in no one’s interest to throw sand in the machine. Again, this is an underlying public policy objective in the operation of payment systems. Another one is that money is presumed to be untainted. So, the ultimate receiver might consider it clean, again, unless the payee was in the plot itself. That goes for cash, but also for credits in banks. This is the purpose and importance of the concept of finality in transfers or payments.

3.1.4. Bank Transfers and Payment Systems. Pull and Push Systems, Credit and Debit Transfers It cannot be repeated often enough that promising payment, writing a cheque, giving a payment instruction to the bank, or even tendering payment is not the same as payment unless the relevant contract directly or indirectly so provides, which may become a matter of interpretation, especially relevant as to letters of credit. Neither are swiping or tapping a credit card or debit card at a payment terminal (EFTPOS) likely to be sufficient. Thus normally the writing of a cheque, the drawing or even acceptance of a bill of exchange in favour of a payee, the issuing of a promissory note or even a letter of credit, using a payment terminal, let alone the giving of a payment (or giro) instruction by the debtor to its bank, are not in themselves payment, as they do not effectively result in the unconditional and complete cash or bank transfers to the creditor (giving the latter full disposition rights in the money), thereby entitling the payor to a release and a final discharge extinguishing the relevant payment obligation. It may well be that a creditor is dilatory in cashing a cheque. That delays the payment but does not substitute for it. What it is likely to do is to shift the responsibility for the default to the payee, giving the payor a valid defence. If the cheque is promptly presented but bounces, that defence would obviously not be valid. A key issue is therefore always to determine when payment has happened, and that is often less clear than it may appear. As has been pointed out all along, the key is that the payee has acquired by the maturity date the unconditional and immediate disposition right in the money received. That may then also imply a release, which is, however, still a different legal act. Thus, in bank transfers, a cheque, using a credit card or bank (giro) instruction directed by a debtor to its bank do not in themselves implement and extinguish the original promise to pay money. However, if acted upon by the bank, this could technically be considered to substitute

324 Volume 5: Payments, Modern Payment Methods and Systems (vis-à-vis the creditor) a promise of the bank for the original payment promise of the debtor (which could thereby be considered extinguished). Legally this is normally not the proper analysis however (for lack of the creditor’s consent to what in effect would be debtor substitution). As we have already seen, under applicable law, it is likely that the payment is only deemed concluded by the unconditional crediting of the payee’s account by his own bank. The other side of this coin is the ensuing release of the debtor only at that moment. A direct debit should be similarly analysed, and even using a credit card guaranteed or accepted by the debtor’s bank may not in itself produce full payment effect and a release of the debtor. Payment instructions to banks technically vary, and this affects the initiative in the chain of transfers. It may lead to some legal distinctions. If by cheque, the initial instruction to the banking system will be given by the payee/creditor, who will normally send the cheque s/he received from his payor/debtor to his own bank, which will present it (through clearing) to the payor’s bank (if a different bank) on which the cheque was drawn. The reason is one of convenience. The creditor may not have an account at the debtor’s bank on which the cheque was drawn, and may want his account to be credited rather than to receive cash. His own bank will then normally handle the matter as a special service (for which it may or may not charge). It is sometimes thought that in such cases the initiative of the creditor’s bank will give rise to an interbank transfer at the initiative of the creditor’s bank as a ‘pull’ system of payment, based on a chain of debit transfers starting with the creditor’s bank and working its way up to the debtor’s bank. This is also thought to result from direct debit instructions of the debtor, which are usually also handled (or ‘pulled’) by the creditor’s bank. Bank giro instructions or credit card through a payment terminal, on the other hand, give rise to a ‘push’ system of payment (or credit transfers) because payment is then initiated by the debtor’s bank.504 Modern law may maintain somewhat different approaches in respect of either system. The 1989 Article 4A UCC in the US and the 1992 UNCITRAL Model Law on Credit Transfers only cover the credit or ‘push’ systems and exclude more generally consumer payments of any kind (section 4A-108 UCC). In the US, consumer transfers are mostly covered by the Federal Consumer Protection Act and their electronic banking by the federal Electronic Fund Transfer Act (EFTA) and Fed Regulation E. Article 4 UCC, on the other hand, covers the handling of cheques in the payment system and assumes here a pull mechanism or debit transfer system while ignoring the fact that these cheques are usually presented by the creditor’s bank to the debtor’s bank, which will subsequently push the funds through the system (if it still owes something after the clearing). The terminology is confusing. It would appear that in fact there are never debit transfers, not therefore in a ‘pull’ system either, unless specially authorised by statute. Without such authorisation, debits (being obligations) cannot be transferred unilaterally and pushed up through the banking system from the creditor’s bank to the debtor’s bank. The intermediary doing the pushing would in any event remain a guarantor of the obligation. A debit transfer system suggests at best that the creditor’s bank, upon (provisionally) crediting its client’s account, seeks reimbursement from the debtor’s bank by provisionally debiting that bank and crediting its own account in it (or in any intermediary bank in the payment circuit). Legally, this would still require a system of consents between the banks involved, as nobody can be forced into a reimbursement or assume a debit function against its will even if only provisionally. It would not discharge the intermediary bank either vis-à-vis its own client.

504 Note that such credit transfers should not be characterised as assignments or novations, see the discussion in the next session.

Volume 5: Payments, Modern Payment Methods and Systems 325 Failing a stronger statutory base, this need for consent(s) complicates the pull system. Again, it results at best in a series of provisional debits and credits through the banking system up to the debtor’s bank, while a provisional credit to the creditor precedes the ultimate debit to the debtor. It is therefore strictly speaking not ‘payment’ as it is not complete and does not unconditionally give the creditor the free disposition of the money. In a ‘push’ system or system of credit transfers, on the other hand, a debit to the payor will precede the credit to the payee, and it is the debtor’s bank that subsequently credits other banks. Here at least no consents are necessary, as only credits are transferred when these consents may be implied.

3.1.5. The Legal Nature and Characterisation of Modern Bank Transfers. Their Sui Generis Character Although superficially payment through a bank transfer in a push system has some aspects of an assignment, it is ordinarily not viewed as an assignment by the payor/debtor of his claim on his bank to his payee/creditor, even when both payor and payee have accounts at the same bank. The creditor is no assignee proper, if only for lack of his approval, and the bank is not his agent in this aspect even though payment through a bank transfer is accepted by the creditor. It is in any event more difficult if the creditor is at another bank so that there is a chain, as the assignor/debtor does not then select or even know the immediate assignee (being the next bank in the chain). The significance is that the characterisation of an assignment would at the same time make the debtor’s bank the new debtor of the ultimate creditor under the contract demanding the payment, often a contract for sale or delivery of services. That would amount to debtor substitution under that contract, which can hardly be achieved without the ultimate creditor’s consent. It means that the payor is no longer liable for the pipeline and the ultimate payment. Of course, it should be realised that for an assignee there is always a new debtor, but that depends on the assignee’s consent, and the assignment itself demonstrates that s/he agrees. The debtor (bank) cannot object to the assignment if that is what is wanted, but the payee/potential assignee needs to consent. It is all the same true that a credit is transferred (from the debtor at first to his own bank, which transfers it further through the banking system until the creditor/payee is reached in the same bank or another) but this does not regard the payee and does not convert the debtor’s bank (upon the debiting of the debtor’s account) into the new debtor, subsequently responsible for the payment. To repeat, a credit transfer of this nature does not result in or imply a debtor substitution. Although, as already mentioned, the approval or acceptance by the creditor could be implied through an agency construction in which each bank accepts on behalf of the next one and ultimately the receiving bank on behalf of its client/payee (easier when both payor and payee use the same bank), the characterisation of the transfer as an assignment remains inadequate and incomplete. In any event, the inherent assignment formalities are here avoided. Indeed, from a practical point of view, the assignment analogy is especially unsuitable in legal systems that subject it for its validity to special formalities in terms of documentation and notification (see for these requirements Volume 4, section 1.5.1). The assignment route can be specifically chosen by the parties in their contract if they see a need to do so, and the payee bank would then likely act as agent for the payee, but again it appears uncommon.505 505 In England, the assignment and novation characterisation was firmly rejected in Lybian Arab Foreign Bank v Banker’s Trust Co [1988] QB 728. Lord Millett in Foskett v McKeown [2001] 1 AC 102, 128, observed that there is simply a series of debits and credits which are causally and transactionally linked. That means a chained system of transfers.

326 Volume 5: Payments, Modern Payment Methods and Systems Another particular aspect is that the instructed bank as debtor is not passive, as it would be in an assignment proper. In fact, the initial credit transfer by the debtor puts its bank in the money for it to credit the creditor/payee if a client of the same bank or otherwise the bank next in the chain. This pushes the bank (being the bank account debtor of the debtor/ payee) into an active role, which goes quite beyond what an assignment would suggest. A novation or series of novations could here be implied. If it is thought that the payee receives a new claim on its own bank in exchange for the (old) claim of the payor on the latter’s bank, as would any intermediary bank in respect of the previous one, this would indeed look like novation (in every part of the chain). However, this characterisation is normally also avoided. Here again the lack of clear approval of the payee is often cited as preventing it. Yet, as in the assignment construction, consent could still be deemed implied. It would, however, change the nature of all payments by way of bank transfers and suggest a chain of debtor substitutions through novations. This does not correspond sufficiently to reality. Also, all security interests backing up the payment obligation would lapse and would have to be renegotiated, resulting possibly in a lower rank as a later security interest. Still, payment may be made in the form of a novation if the parties so choose, but again this appears exceptional and is normally avoided.506 While these two characterisations (assignment and novation) are commonly avoided, the payment through a bank transfer is now mostly considered to have its own (sui generis) legal nature. That does not in itself solve the problem of its legal structure, however, and payment of this nature would still have to be characterised as a bilateral or unilateral legal act, an act in fact, or a series of acts in this connection, and the rules defined. Some of the main options, their consequences and their effect on the notion of finality were discussed in section 3.1.3 above. Another important aspect is that the bank uses its own credit with the next bank in the chain subject to its further instructions as to the ultimate payment. And so it continues, until the payee is reached. This is the nature of a chained transaction. The sui generis character of the payment transfer does help in this connection by placing the facility outside the system, particularly important in civil law countries, but must still be clearly explained in both the obligatory and proprietary aspects. It notably allows the issues of capacity and intent, of payment instruction, acceptance and moment of payment, of finality, and of the proprietary aspects of the transfer to be approached and determined independently and therefore separately from the more conventional notions of obligatory and proprietary law. This may in fact create extra room for deprecating capacity and intent notions, for a more abstract approach to the title transfer inherent in all payments, for emphasis on the independence of the payment, and for a reasonable protection of bona fide payees. As has already been noted in section 3.1.1 above, this may be of particular importance in civil law with its on the whole unitary systematic approach per country, and might indicate at the same time a proprietary transfer and structure outside its closed system of proprietary rights. In common law, this is less of an issue. Indeed, Article 4A UCC in the US maintains an approach that foremost serves participants in the payment process, defines the proprietary aspects accordingly, and is not concerned with systematic coherence. While on the other hand putting emphasis on the active role of the payor’s bank, it may be of interest to identify in this connection the French notion of délégation and the German notion of Anweisung. This is not delegation in a common law sense, which is a transfer to a third party of

506 It should also be considered that if the payments through the banking system were assignments or novations, it would become absolutely unavoidable for these payments to become juristic or legal acts subject to the legal requirement for them in terms of proper offer and acceptance, capacity, intent or even delivery.

Volume 5: Payments, Modern Payment Methods and Systems 327 one’s contractual duty, for example to pay a creditor. As we have seen, that would lead to debtor’s substitution and would normally require the creditor’s consent (contrary to the transfer of a right to payment from a debtor which could be transferred to a third party in an assignment without the consent of the debtor). A délégation in the civil law sense presents a more complicated legal structure and is operative in a situation like the present one, in which I instruct my debtor not to pay me but someone else to whom I owe a payment duty. It is a tripartite arrangement short of novation, and may capture the situation of the modern bank transfer better, in which I ask my bank (who is my debtor) to debit me and pay (for its own account and not as my agent) C, who is my creditor (instead of my doing so directly). Although the bank will use its own money or credit, it notably does not discharge me vis-à-vis C until C receives the money unconditionally in his own account. One problem is that this civil law legal structure of délégation, which derives from Roman law, does not find great elucidation in the modern civil law codes.507 The consequences of its use in the payment circuit are therefore not fully clear either, especially when there are defects in the relationship (or instructions) between the payor/delegans and its instructed or delegated bank or in the relationship between the payor and payee/delegataris in the chain of instructions, or when there are other defects in the transfers (for example in terms of capacity and intent of some in the chain), and when the question arises whether the payee may still be protected as bona fide receiver of the money, even if it is clear that it should not have been sent to him or if there are other reasons why it should perhaps be returned. To repeat, we are concerned here primarily with finality of the payment, in which connection the key concepts were identified as: (a) the deprecating of notions of capacity and intent upon the analogy of cash payments; (b) the abstract nature of the transfer itself; (c) the independence of the payment (like payment obligations under promissory notes and letters of credit); and (d) the protection of the bona fides of the beneficiary/payee where there may be the analogy of the bona fide assignee or holders in due course or rather (e) the protection of justified reliance. The payee must have had at least some claim on the payor (for goods or services rendered) in the particular amount and must not have been involved in the making of the wrongful payment to him or caused the defect. It may, on the other hand, also be that the debtor’s instruction was simply erroneous as the debtor never owed the indicated creditor anything, and the payor may seek no more than a correction. More frequent is the misplacement of decimal points in the instruction so that much larger amounts are paid than were due. This goes to the aspect of intent. The mistake may be due to the payor, but may also be internal in the instructing banks. Again, once the payment has been set in motion there would not seem to be a way to correct the flow. The creditor/payee has

507 There is, however, increasingly more modern literature on this structure in civil law: for the Netherlands see HCF Schoordijk, Beschouwingen over driepartijenverhoudingen van obligatoire aard (Zwolle, 1958) 222, and HCF Schoordijk, Onverschuldigde betaling en ongegronde verijking bij zogenaamde driehoeksverhoudingen (Deventer, 1999) 83; for France, M Billiau, La délégation de créance: Essai d’une théorie juridique de la délégation en droit des obligations (Paris, 1989); L Aynes, La cession de contrat et les opérations à trois personnes (Paris, 1984). The notion was introduced in the eighteenth century in France by R-J Pothier, Traité des obligations, no 602. On the other hand, there are French authors who do not apply the notion of délégation to bank transfers: see S Piedelièvre, Droit bancaire, no 333 (Paris, 2002). The problem seems to be that a bank transfer is here not considered a payment (against the clear wording of L-311-3 Code de Commerce). Others signal problems when other banks come into the chain, but further delegations would simply ensue between each bank in the chain. In Germany C-W Canaris, Bankvertragsrecht (Berlin, 1988), I prefer the notion of ‘abstraktes Schuldversprechen’ (rather than an Anweisung) in connection with bank payments, which suggests a sui generis legal structure, but the analogy of the Anweisung is accepted.

328 Volume 5: Payments, Modern Payment Methods and Systems a legitimate interest in knowing that the payment through the chain of instructions is safe once the necessary initial instructions have been given by the debtor. From this perspective, the payee is likely to maintain that the payment was his, once the mechanism for payment was activated (assuming his good faith and reliance on the independence of the process). Indeed, modern systems are likely to provide that a payor’s bank cannot adjust the account of its client once debited, having in the meantime discharged its own obligation to proceed with the payment and the same would go for all intermediary banks once they have followed instructions. General banking conditions might still change this, however, at least in the case of an obvious mistake of the payor bank itself, and the German banking conditions (number 8), which each banking client is deemed to have accepted, contain language to that effect. There may also be special correcting procedures in banking systems, but the payment cannot simply be reversed. Again, once the banking system is properly engaged and the payment set into motion, such a recall of the instruction would not appear to be feasible. It has already been said that it acts like sand in the payment machine which is to be avoided. That is necessity and a public policy issue. Correction is not excluded but it does not mean the simple reversal of payments or instructions received from clients or other banks in situations in which the bank accepted a mistaken instruction and acted upon it. Instead, it was noted that clients would have to start a separate action for recovery against the relevant account holder if the latter were receiving too much, probably on the basis of unjust enrichment, as already mentioned above. The adjustments that banks may still be able to make may be those concerning mistakes by the payor/client and between the intermediary banks themselves within the interbank payment system as long as the payment has not gone any further down the chain. It was noted above that there may be a broader exception in situations of clear fraud in which the payee was involved when payment to him may also be interrupted, at least in the last part of the chain (therefore between the fraudulent payee and his bank once the latter is credited by the system).508 As a consequence of the foregoing, it may be possible and appropriate to reconsider the nature of the bank account and to re-characterise the rights in a bank account as a particular (sui generis) proprietary right. It is supported by the sui generis character of the payment transfer itself. This is altogether clearer in investment security accounts as we shall see in section 4.1.2 below. It means that the traditional view that a balance in a bank account is merely a contractual right against a bank may require some adjustment. Of course, a bank balance is always a monetary claim and as such an asset like any other in respect of anyone else, but at least in the manner of transfer of the right within the banking system, different rules apply to this type of claim, which may well be indicative of the fact that we have a different type of right or entitlement altogether, that is to say in its proprietary as well as its contractual aspects and effects. This is an important insight as it has an effect on the relationship between a bank and its customers. It does not mean that in a bankruptcy of the bank the account holders are better placed, but it may have an impact if during the payment period either the payor, the payee or any intermediary bank becomes insolvent, and the question becomes: who has got what?

508 Art 4A UCC deals with fraud problems in the sense that payment instructions may be fraudulently given to the detriment of third-party accounts but for the benefit of the instructing parties: see s 4A-204. The question here is what kind of precautions the debtor’s bank needs to take to protect its client. S 4A-207 deals with non-existing or unidentifiable beneficiaries. The issue is here one of due diligence in trying to identify the real beneficiary. For consumers these issues are dealt with under the federal Electronic Funds Transfer Act 1978 and Regulation E, which implements it.

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3.1.6. Clearing and Settlement of Payments in the Banking System Modern developments have made electronic payments through the banking system possible. If we leave the payor and payee out of this for the moment, in these systems, orders will be given between banks by telephone or rather through electronic means, therefore between professional banking institutions, which is the key modern communication element. The interbank orders are then no longer paper-based but are paperless and may as such be on-line or off-line. As a further elaboration in terms of settlement, the emphasis is on real-time gross settlement (RTGS) and designated-time net settlement (DNS) systems. The on-line orders (RTGS) commonly concern individual payments, usually of large amounts, conveyed through special telecommunication lines between the banks, which are in immediate and during banking hours continuous communication with each other for payment purposes. The online method achieves instantaneous debiting and crediting of the relevant accounts between banks. It thereby makes immediate payment to clients possible. There is here no clearing but a gross settlement system. Only such a system can be real time. But it creates credit risk and liquidity issues, which are closely connected and also raise the spectre of systemic risk given the interdependency of all banks in the payment system: in each step in the chain the paying bank must be sure of sufficient funds at its disposal, although it will practice bilateral netting, but may not exactly know what is coming in and out at every moment, hence also credit risk. For its liquidity it must depend on (intraday) credit lines, hence more credit risk in the system. In practice, it will be done foremost at the level of each bank’s credit line with the central bank. It will not take over the obligations, however, and may want security for its funding, usually also intraday (in terms of collateral or repos). Off-line orders, on the other hand, may be stored in magnetic form and netted out in a clearing system between the member banks. The result is a net settlement system (DNS), which will be all the more effective if it is multilateral, therefore between as many banks as possible. It may result in later payment to clients and usually requires a number of (settlement) days, often two, or a shorter cycle, same-day settlement becoming more and more an option. It has also become increasingly the practice that banks will credit the relevant amounts to the relevant accounts ahead of clearing and will notify the payee accordingly, although settlement between the banks will still take place at the end of each business day or other agreed period or cycle. It is an important development in terms of efficiency and cost and also reduces appreciably the settlement risk for the participants in the system as we shall see. It is the essence of modern payment clearing systems. Indeed, many modern countries now have both (a) their own paperless on-line wholesale fund transfer and gross settlement systems, and (b) an off-line net settlement or clearing system. Apart from these two systems, they are likely to continue for the time being also a (c) paper-based clearing system for cheques and sometimes a special bank giro payment instruction clearing for retail customers. In the US, the most important online electronic system is Fedwire, which maintains a gross settlement system. It operates between the 12 US Federal Reserve Banks for the benefit of those banks holding accounts at the Federal Reserve. In the US, CHIPS (Clearing House Interbank Payment System) maintains the off-line net settlement system. In the UK, there is CHAPS (Clearing House Automatic Payment System). CHIPS and CHAPS have also proved useful for (domestic) payments in which foreign banks are involved. They operate on a net basis, include a multilateral clearing system, except that in the UK in CHAPS large-value transfers may now also be settled gross on a real-time basis through the Bank of England (provided it is put in funds) to limit day-time exposure.

330 Volume 5: Payments, Modern Payment Methods and Systems In the EU, there also exists a euro clearing and settlement service (Euro-1) operated by the Euro Banking Association (EBA) as a privately owned, multilateral, cross-border net payment system providing same-day value. It receives its messages through SWIFT (the UK is connected through CHAPS-Euro). Larger payments normally go through real-time gross settlement systems for which in the Eurozone there now is TARGET operated through the European System of Central Banks (ESCB). In TARGET 2, all the Euro national central bank systems were integrated at the level of the ECB in a RTGS, under which the ECB grants an intraday interest-free facility against eligible collateral to manage liquidity risk in this system. Non-EU country central banks from Bulgaria, Croatia, Denmark, Poland and Romania are participating. The UK and Sweden are notably absent and depend on other arrangements for euro payments as there are for all non-euro payments. The EU concern is in fact not so much with these systems or with the setting up of one pan-European clearing house (which could also make domestic transfers cheaper through greater netting facilities), but rather with the cost of smaller bank transfers cross-border for retail where the Transparency Directive now at least insists on proper disclosure of the charges. As of July 2003, these charges are supervised; see further also for the developments in the Single Euro Payments Area (SEPA), Volume 6, section 3.6.12 below. To demonstrate the clearing methods: in the US, under CHIPS, for example, once a day the settling participants are given a settlement report indicating their net debit or credit positions. They reflect the net positions on the basis of all payments made to or received from the other participants in the system so far during the day. If the net debtor does not have sufficient funds in its reserve account with the system it will draw down balances or lines of credit held at other banks or at the Federal Reserve as central bank so as to clear the deficit. This is also done daily and there should be no overnight debt positions in the system. Payments processed during the day are finally settled only when a participant has cleared any overall net debit position. This means that if banks are notified of payments during the day while making funds available to their customers, they incur the risk that the settlement will not take place because the bank from which the funds came may have a debit balance at the end of the day. There is here a liquidity risk to the system, which may turn into a credit risk in the case of the intervening insolvency of a bank that has a net debit position which it can no longer cover. There may also be systemic risk in the sense that the default of one bank may affect the settlement capability of others. To prevent this from happening in multilateral net settlement systems, there are normally certain risk-control mechanisms which centre on: (a) the prior screening of all participants; (b) bilateral credit limits, restricting between two participants the volume of payments received to those of the payments sent (or allowing only a limited overshoot); and (c) limits on net debt positions (which requires monitoring during the day). All the same defaults in settlement by members of the clearing may happen and then lead in principle to recasts and unwinds. In a recast, the defaulting parties’ payments (received and sent) are deleted from the settlement while the net positions of the other participants are recalculated. A unwind undoes the entire netting and requires participants to settle all positions individually. It may create liquidity and even systemic risk problems as it removes the netting benefits from all participants. It does not exclude bilateral netting with bankrupt counterparties, but it may expose participants to large gross settlements on which they did not count and for which they may not have the required liquidity, nor indeed the staff any longer to handle this. To avoid such a situation, members of the system may well guarantee the operation of the system in advance, effectively taking over the defaulting party’s settlement obligations. To avoid liquidity problems for one of them, they may then also provide mutual lines of credit. There may even be some collateral in the case of weaker members to facilitate the obtaining of overnight funds by them. If the costs of support are not

Volume 5: Payments, Modern Payment Methods and Systems 331 retrievable from the defaulting member, the participants may operate a pre-agreed cost-sharing formula system. It has already been said that clearing tends to be product specific and is not any particular defined concept: see sections 2.6.4 above and 4.1.4 below and also Volume 6, sections 1.5.7, 3.5.8 and 3.6.14. Here it means in essence the set-off of all mutual claims between the participants in the payment system, although it may extend to other functions like the verification of all entries during the period. Clearing of this nature is then a form of settlement netting: see for this type of netting, which may also imply a novation netting, section 3.2.3 below. So far netting systems of this nature still practise decentralised controls under which each participant remains subject to the risks deriving from the behaviour of other participants. It is conceivable, however, to centralise this risk control and transfer all positions to the clearing agent when a new total position arises between him and each participant. That could be novation netting. In fact, attempts may be made to introduce the concept of continuous novation netting in clearing systems that have a longer cycle so that at least in theory there is always one netted outstanding amount between each participant and the system; that is, at any point in time there is single net amount owing from the net debtor to the net creditor. It is meant to better protect against any participant becoming insolvent during the clearing period. In such systems, a central body or counterparty (CCP) might take over all contracts and become the party to each transaction engaged in by participants with each other. This is now common in the futures and options markets, where the market organisation itself provides this facility and therefore operates a centralised clearing infrastructure: see again section 2.6.4 above. This type of centralised risk control in which the CCP takes over all payment obligations and becomes liable for payment of all of them is not so far common in payment clearing systems, however. Even though central banks are sometimes called central counterparties in these clearing systems, it does not mean that they take the full credit and settlement risk. They only act as agents for the system to make or receive each participant’s settlement balance. ‘Settlement’, in this context, means the making of the final (netted) payments after clearing. The benefits of multilateral clearing in terms of liquidity and cost may be demonstrated in a simple example. If Bank A receives daily 100 payments from 50 banks, each for US$100 and makes 50 payments to 100 banks for US$100 per payment, it is clear that in a gross settlement there will be 10,000 payments (5,000 to and 5,000 by bank A) of US$100 each for a total of US$1,000,000. It has an ultimate nil net effect on Bank A as its total incoming and outgoing payments balance. In a bilateral netting system, Bank A and each other member would only net out the payments they made or received between each other. Assuming that the 100 payments from each of the 50 banks to Bank A were balanced by 50 payments made by Bank A to each of them, all payments being for US$100, the effect would be that only 50 payments would be made by each of these banks to Bank A. It would reduce the total payments by 2,500 and halve the net exposure of Bank A to each of these banks. In a full multilateral netting system, no payments would be made by and to Bank A at all, even if the 100 banks paying to A were all different from the 50 banks A must pay, provided they were all part of the same system. All payments of Bank A would be redirected to satisfy the other banks. If a net overall payment had to be paid by or to Bank A taking them all together, this would be paid to or be received from the operator of the system as common agent for the system. As just mentioned, this is sometimes called the central counterparty, but that is strictly speaking confusing as the common agent does not act as central assignee – in other words, there is no counterparty substitution (through novation or open offer) as in the case of a CCP operating in the derivatives or securities markets. A simpler example may demonstrate the

332 Volume 5: Payments, Modern Payment Methods and Systems same point: if in full multilateral netting A owes B 70 units, while B owes A 40 units and C 20 units, while C owes A 20 units, there would be only one payment (instead of four) under which A would pay B 10 units.509

3.1.7. International Aspects of Payment The private international law aspects of payments do not commonly receive a great deal of attention. At least in modern bank transfers they do not seem to give rise to many legal problems, although it is conceivable that in chained transactions through the banking system in terms of credit transfers, proprietary and finality issues arise when the chain goes through banks in different countries. The transfer, being of a sui generis character, may not be characterised in the same way everywhere. Also, the level of finality may change. Whether payment in foreign currency is proper payment is another important issue in this connection of which English case law may give the most prominent demonstration.510 This problem also arises when foreign money judgments are recognised in another country and there may be redenomination of the payment obligation.511 The practices of international payments will be discussed in section 3.3 below, including ways to avoid currency, convertibility and transferability risk. As to the applicable law, to determine whether payment has properly been made, this issue is mostly considered covered by the law of the payee unless there are special contractual provisions. In a chained transaction that would mean that in respect of each step, the law of the payee per chain would be decisive. In an international payment, the applicable law may thus vary in each step, although overall the payor would 509 See for CHAPS also Goode (n 203) 464, and for CHIPS, HS Scott and PA Wellons, International Finance, 8th edn (New York, 2001) 616. See in respect of payment systems also the work of the BIS Committee on Payment and Settlement Systems of January 2001, which also includes a useful glossary of the terms used in payment and settlement systems. 510 In England, the currency of all common law judgments had to be pounds sterling until 1975, cf Miliangos v George Frank (Textiles) Ltd [1975] 3 All ER 801 reversing prior case law, and Re United Railways of Havana and Regla Warehouses Ltd [1961] AC 1007. Cf however also the earlier arbitration case of The Kozara [1974] Journal of Business Law 46, allowing the currency of the obligation to stand. The emphasis now is on the proper currency of the contract or loss and on what would work better justice or on what most truly expresses the plaintiff ’s loss, thus giving the court greater freedom in this respect: Kraut v Albany Fabrics Ltd [1976] Journal of Business Law 110; Barclays Bank v Levin Brothers [1976] 3 All ER 900; Service Europe Atlantique v Stockholm Rederiaktiebolog Svea, The Folias [1977] 1 Lloyd’s Rep 39; The Despina R [1977] 3 All ER 374, House of Lords (1978) TLR 19 October. See also G White, ‘Judgments in Foreign Currency and the EEC Treaty’ [1976] Journal of Business Law 7; J Becker, ‘The Currency of Judgment’ (1977) 25 American Journal of Comparative Law 152 and J Marshall, ‘Judgments and Awards in Foreign Currency, Working out the Miliangos Rule’ [1977] Journal of Business Law 225. See for a conversion clause reflecting the older practice, Art VIII(7) UK-Italian Full Faith and Credit Treaty (1973). 511 See in France, Tribunal de la Seine, 30 May 1958, R 731 (1958); 18 December 1967, G.1-2.108 (1968). It would appear, however, that any devaluation loss is claimable in France if the foreign debtor is an unwilling payor and caused a delay during which devaluation took place, cf also (in the Netherlands) HR 8 December 1972, NJ 377 (1973), 22 Ars Aequi 509 (1973) note Stein. In Germany, it appears that the foreign currency is respected in principle, but judgment and other debts expressed in such currency may in the case of enforcement be converted into local currency at the option of the debtor, cf s 244(2) BGB, except if the currency is of the essence of the obligation. The exchange rate of the place of payment prevails if the option is exercised and the original date of payment is controlling in this respect. Foreign exchange losses pending enforcement appear to be in principle for the account of the creditor, cf OLG Cologne, 2 February 1971, 47 NJW 2128 (1971), although for equitable reasons some adjustment may follow if actual damage is suffered, cf also Oertman, Kommentar Zum BGB, § 244 Anm.3 (Berlin, 1901–27). In the US, the foreign currency of foreign judgments will in particular not bar recognition and the rate of exchange prevailing on the date of entry of the foreign judgment will apply, Competex SA v La Bow, reported in [1984] International Financial Law Review 40.

Volume 5: Payments, Modern Payment Methods and Systems 333 remain responsible for the timely arrival of the money and the completion of the payment, also presumably under the law of the payee. At the practical level, international payments have long presented a number of problems and special risks, in terms of collection but also currency exposure and transferability and convertibility issues. In section 3.3.3 below, a number of instruments developed to deal with these risks will be discussed. There are special risks in other areas. In currency trading, for example, it is normal to expect deliveries of two different currencies between the same counterparties. As there may be different currency and therefore time zones involved, the payments may not be concurrent, which creates a special form of settlement risk, also called Herstatt risk.512 Here a (multi-currency) net settlement system through a single counterparty linked to central banks may be the answer.

3.1.8. Regulatory Aspects of Domestic and International Payments The proper functioning of the payment system is a major issue in each country and usually an immediate concern for central banks. Hence their involvement in payment systems and in their proper functioning and their role as organiser of the on-line and off-line clearing systems. The safety of the payment system was also a major concern after the financial crisis in 2008. This concern also rises to the level of international payments and the stability of the international financial system. Importantly, direct central bank involvement and organisation is here preferred to regulation. Within the EU there are more particular concerns with the details of the free movement of money and payments cross-border as a policy issue. It was already mentioned that practical problems arose with payments in other Member States and with the delays this often caused. There is further the issue of proper exchange rates to be applied in what are often small transactions in or from Member States that are not yet members of the euro and in respect of payments among such countries themselves. In 2007, the EU issued a Directive in this area: see also Volume 6, section 3.6.12 for the Single Euro Payments Area (SEPA). It is concerned more in particular with consumer protection in cross-border transactions within the EU and also deals with issues of finality in that context.

3.1.9. Concluding Remarks and Transnationalisation It was noted that at the international level, the private law aspects of payments through the banking system remain largely unexplored but may give rise to very different views under national laws. This is again an argument for transnationalisation of the law in this area, leading to a unitary system under the modern lex mercatoria. Indeed, the nature of bank accounts, transferability of balances (credit transfers), and especially the concept of finality may even now better be seen as transnationalised concepts, therefore conforming to a transnational normativity in terms of practices, custom and general principle. 512 This risk was first identified when the Herstatt Bank in Cologne went bankrupt in 1972 during banking hours. Some of those who had already delivered deutschmarks to Herstatt in Germany were still awaiting US dollars in return from Herstatt in New York when the bank went out of business. This is a major risk in foreign exchange transactions, each link of which will normally be settled through the settlement systems of the country of the currency. They are separate and operate in different time zones. US dollars will therefore normally be the last to settle during the day. These technical aspects prevent simultaneity in practice or delivery against payment (DVP) when engaging in cross border transactions, see further also Vol 6, s 1.4.4, n 237. This issue could be resolved if central banks around the world operated around the clock and offered their services on a 24/7 basis.

334 Volume 5: Payments, Modern Payment Methods and Systems In respect of bank transfers, the practice shows a sui generis way of transfer, which itself may also suggest a sui generis type of right and asset where bank accounts are held and balances are used for payment. This is counter to the traditional view that bank balances are no more than contractual claims, see section 3.1.5 in fine above. Upon proper analysis that may not be the entire truth, and if this were to be accepted, it is likely that there would arise a special (even if weak) proprietary interest instead, which needs further legal characterisation. It presents at the same time an opening of the proprietary system in civil law terms. Another important aspect is the finality of such transfers, which is also greatly enhanced, another indication perhaps that we are not talking here about the transfer of purely contractual rights but instead have a commodity product that is governed by further rules. Transnationalisation of the law in this area would bring this out as it allows us to abstract from traditional domestic concepts and also to depend on market practice and custom. Again, within the modern lex mercatoria we must think in new terms along the lines indicated. In international payment transactions, new concepts and insights would then prevail over the application of domestic laws which, within the modern lex mercatoria, would only retain a function as the default rules: see Volume 1, section 1.4.13 for the hierarchy of rules within this modern lex mercatoria.

3.1.10. The Impact of Fintech. Permissionless and Permissioned Blockchain Payment Systems with or without the Use of Cryptocurrencies. Promises and Perils Payment systems and in particular international payments are often considered to present a significant prospective application of blockchain technology, perhaps in combination with cryptocurrencies. As we have seen, payment systems can take various forms and are technically and legally complex. In order to get a better idea of the promises and challenges that blockchain technology may hold in store in this context we may resume the above model of a fairly typical international payment by way of an inter-bank funds transfer across borders.513 In this example, debtor D in Country A owes a sum of money to our creditor C in Country B, in exchange for, say the delivery of goods or the provision of services. Payment is to be made in the currency of C’s country, which is Country B. D, as the originator of the inter-bank ‘funds transfer’, sends a payment order to its bank DB in country A in electronic form, specifying the beneficiary’s account details and the amount and currency to be sent. DB checks whether D’s account with DB holds sufficient funds and performs other ‘know your customer’ and anti-money laundering duties. Assume that DB and CB do not maintain accounts with each other, and are also not members of the same clearing system and that there is also no common correspondent bank. This makes it necessary to go through further intermediary banks. To this effect, DB will send a payment order to an intermediary bank of its choosing, likely in Country B which has CB as its client. It will verify whether DB’s account with it contains sufficient funds or that there is a credit line. If that is the case, it will credit CB with the required amount. CB can then credit the funds to C’s account with CB. Clearing will be effectuated through the clearing system of Country B as the country in the currency of which payment is to be made.

513 The following text is substantially taken from the King’s College Executive LLM organised by JH Dalhuisen, C Kletzer and M Schillig.

Volume 5: Payments, Modern Payment Methods and Systems 335 In section 3.1.5 above, it was already explained that in legal terms, the process does not involve the transfer to C of D’s claim on DB. There is no assignment of claim. Rather, debiting D’s account with DB leads to a transfer of payment commitments passing through a chain of intermediaries, which enable CB to decide on an unconditional credit to C’s account. Depending on the rules of the relevant payment system likely consisting of an interbank electronic communications network as well as clearing and settlement facilities between the various banks in the chain, a payment instruction will normally become irrevocable when entered into the system and the respective member bank’s account is debited. This is a system of credit transfers in a push system, and any errors or mistakes cannot be undone by debit transfers within the chain but have to be dealt with by a reverse payment. As between D and DB, any revocability of payment orders will be dealt with under their respective contract. C receives payment—payment is complete only when CB unconditionally accepts C as its creditor for the amount in question. This system is generally perceived as lengthy and costly. From D’s payment order to C’s account being credited may require many steps and may take several days. The intermediaries involved may charge additional fees for their services; holding funds in the system may result in opportunity costs. There are credit risk and liquidity issues. The validation of information at the stage of each intermediary is also costly and prone to errors. System improvement through blockchain technology may easily be envisaged. In accordance with various versions of distributed ledger systems, we may envisage different payment systems that deviate more or less radically from the status quo. Perhaps the most radical innovation would be a permissionless distributed ledger system in combination with a cryptocurrency, say Bitcoin or Ripple’s XRP. To this effect, let’s assume that D and C have agreed in a contract for sale or the provision of services that D may effectuate payment in a virtual currency, say Bitcoin. Both D and C have Bitcoin wallets. With these they can connect to the Bitcoin system, as well as store, transfer and receive funds in Bitcoin. When payment is due, D enters into their wallet (using their private key) the destination address generated by C’s wallet (their public key) as an input together with the amount of Bitcoin to be sent. Upon pressing the send button on their wallet, D broadcasts the transaction message to the peer-to-peer network (that is, the Bitcoin network). Within seconds the message will have been picked up by most well-connected nodes within the network. The validator nodes (that is, ‘miners’) verify that the transaction message is valid, notably whether the amount to be sent to C can be attributed to D’s wallet address on the basis of previous transactions. The first node to solve a complex mathematical problem (which essentially proves that the transaction was validly sent) will immediately notify the other nodes in the network. Within seconds, C’s wallet will identify the transaction as an incoming payment. However, at this stage, the transaction has not been verified (that is, cleared) and is not yet part of the blockchain. The other nodes in the network will first verify that that the node has actually solved the mathematical problem, and then the majority will have to agree (using a consensus mechanism called ‘proofof-work’) to add the transaction to the network. If the majority of the nodes agree to update the distributed ledger (that is, the Bitcoin blockchain), the transaction will be bundled in to a ‘block’ with all of the other transactions that were cleared at the same point in time. This new block is then added to the blockchain. The block, which contains D’s transaction, is evidence that that the transaction has been verified and settled.514 Unlike a traditional fund transfer using a bank, the 514 There is the (small) risk that the new block may become an ‘orphaned block’—rendering any transactions contained therein unverified—if the blockchain has grown longer with additional blocks added to an alternative block solved at the same time as the block that contained D’s transaction. It is considered that only after six confirmations (five additional blocks on top of the one that contains the transaction) that the risk of ‘orphanage’ becomes negligible.

336 Volume 5: Payments, Modern Payment Methods and Systems entire validation and transfer process on the Bitcoin blockchain is generally performed within a matter of minutes.515 That is to say, there is near-instantaneous and final settlement516 within a matter of minutes from the moment that the transfer instruction is first submitted to the network, thereby virtually eliminating counterparty risk. In this system there are no intermediaries (in the traditional sense). There is no need for banks or central banks. The transaction message is broadcast to the peer-to-peer system as such and can be picked up by any node around the world. The transaction message becomes irreversible as soon as D enters their private key and presses the send button. The rectification of any mistakes depends on the willingness of C to effectuate a re-transfer. When payment becomes effective and when D’s obligation is discharged is currently not clearly determined in a legal sense. The parties could agree on either the transaction appearing in C’s wallet as ‘unconfirmed’ (within seconds when it has been broadcast to the network as a valid transaction); as ‘confirmed’ (when it has been added to the blockchain within a new block of transactions, which on average takes 10 minutes); or when the transaction becomes for all practical purposes irreversible (when five additional blocks have been added to the blockchain on top of the one containing the transaction, thus approximately 60 minutes after the transaction message was sent). For the latter to be practical D and/or C have to operate a full node that contains the entire blockchain, otherwise they will not be able to verify exactly at what point payment has occurred (at least not without enlisting the help of a full node). This process is mostly believed to be faster and cheaper than a traditional bank transfer despite the transaction fees that have to be paid to incentivise the miners. However, currently cryptocurrencies are neither a medium of exchange (they are not widely accepted) nor a store of value (as they are too volatile). Their value is quoted in traditional fiat currencies (as they are not a unit of account). Although transactions as envisaged in our example have become frequent across the world, overall, in terms of sheer volume they remain currently insignificant. To become more effective, it is possible to combine the permissionless system with fiat rather than cryptocurrencies. To understand this better, we can modify our example somewhat. Now D owes payment in the currency of Country B, a fiat currency issued by a government. In order to speed up the transaction and to reduce international payment fees, D could open a bank account with C’s bank in Country B. D exchanges Bitcoin at an international crypto-exchange, say Coinbase, for Country B’s currency. This involves (I) transferring bitcoin to the exchange (using the bitcoin payment process as discussed) and (ii) transferring Country B’s currency to D’s bank account with DB (using the status quo domestic payment process). Thereafter, D can pay C using the 515 The average settlement time for a Bitcoin was 12.74 minutes in October 2020. 516 It has been questioned whether settlement is ever truly ‘final’ in a decentralised network with a distributed ledger. For example, where two groups of nodes have disagreed with certain changes that have been made to the distributed ledger (eg where there has been a massive theft of crypto assets on the system due to a vulnerability in the code used by the network, or due to the activities of cyber-criminals), this could lead to a situation where the two groups begin to follow two different versions of the distributed ledger (ie, one group will follow the version that reflects that certain crypto assets were stolen, whereas the other group will follow a version that ignores that certain crypto assets were stolen). This is known as a ‘hard fork’, and it is exactly what happened to the Ethereum network in 2016 when a hacker stole US$50 million worth of ether from participants in the DAO (Decentralised Autonomous Organisation) due to a vulnerability in the DAO’s code. This led to a hard fork at the Ethereum network, where some of the nodes argued that the distributed ledger should continue to reflect that the ether had been stolen (ie, that the transaction should not be unwound), and where the other nodes argued that the distributed ledger should be updated to reflect the theft had never occurred (ie, that the theft should be ignored by unwinding the transaction). This led to the creation of two types of ether – Ethereum classic (ETC), for the nodes who did not want to amend the distributed ledger, and the new Ethereum (ETH), for the nodes who amended the distributed ledger.

Volume 5: Payments, Modern Payment Methods and Systems 337 normal payment process, perhaps by way of an in-house transfer if D has an account with the same bank as C. This type of transaction is thus a combination of the traditional process (twice) with the bitcoin payment process. It may make sense if the contract between D and C is an on-going relationship and D has to pay C repeatedly. As said before, it may reduce international payment fees and speed up the process, but is essentially embedded in the traditional payment system, although the number of intermediaries in international payments may be reduced. Perhaps the more realistic future is a permissioned network of participating banks, which may use either crypto or fiat currency. Here participating banks have formed a peer-to-peer network that maintains the blockchain as a decentralised ledger recording all transactions that occur within the network, which is closed or ‘permissioned’. Joining the network, downloading the blockchain and being able to add transactions to it require admission to the network, subject to certain conditions. As a result, network participants are identifiable and accountable; they may be subject to capital requirements, risk management requirements and requirements in terms of the resilience and security of their IT systems. Given that the network is closed and its participants identifiable, the entire network can be overseen by regulators who may also be in control of the admissions process. Because of the participants being identifiable and accountable, the network does not require an extensive proof-of-work validation process similar to Bitcoin. Instead, permissioned networks can rely on proof-of-identity consensus mechanisms which make it much cheaper. The network thus consists of trusted and identifiable counterparties; transaction validation may be based on each individual validator’s reputation. In addition, a ‘proof-of-stake’ validation process may be in place where validation rights are assigned in accordance with collateral held off-ledger and/or the number of native tokens owned by a participant, which may serve as a buffer if things go wrong. This system can be envisaged as functioning on the basis of a cryptocurrency that has state backing (fiat cryptocurrency, or central bank digital currency (CBDC)) and replaces traditional currencies and electronic money. It may be issued by the central bank and commercial banks directly into the distributed ledger in the form of tokens native to the ledger. Similar to Bitcoin, these tokens would be represented only by their cryptographic signatures. Customers would hold these tokens in their wallets provided by their respective banks (DB and CB). In order to make a payment, D would insert C’s cryptographic wallet address and the amount to be sent into his device; by hitting the send button the transaction message would go out to the network. DB (and any other network participant) could verify that D owns the required amount and add the transaction to the ledger. C’s wallet will show the transfer initially as unconfirmed and upon adding the transaction to the blockchain as confirmed. Importantly, the transfer would take place directly between C and D. The banks and the network that they are members of would operate only as validators and not as intermediaries in the traditional sense. This would remove credit risk and liquidity risk inherent in traditional payments systems. D’s payment instruction may become irreversible as soon as D enters their private key and hits the send button. However, it is also possible to envisage a system where DB has a mechanism in place under which D would have some time to reconsider, for example, by structuring the wallet in such a way that the message would not be immediately broadcast to the network so that D could retract it within a certain period of time. Payment will be complete, depending on the agreement between the parties, when the transaction appears in C’s wallet as confirmed. In an international context, this system of a direct transfer between D and C can operate only where Country A and Country B both back the same cryptocurrency, for example in the Eurozone. Otherwise, the differences are marginal as compared to a permissioned system that still relies on traditional fiat currencies. When fiat currency is used, customers maintain traditional accounts with their respective banks. In order to pay C, D sends a payment order to DB.

338 Volume 5: Payments, Modern Payment Methods and Systems Upon receipt DB will debit D’s account. DB will then issue a transfer message to the network that specifies the amount in the relevant currency, the relevant network participant (CB) and the recipient (C). Upon validation in accordance with the network’s validation mechanism, a token transfer takes place directly between DB and CB. A smart contract may convert Currency A into crypto-tokens and at the other end into Currency B. As soon as the transaction has been added to the ledger and is as such visible by CB, CB can credit C’s account in the currency of Country B. The transaction can take place in almost real time. The number of intermediaries is significantly reduced and therefore credit risk and liquidity risk. Both risks have not been eliminated completely however. Set-off and netting as between DB and CB could be also achieved through a smart contract.517 What are the promises and perils? Blockchain technology might be able to realise its greatest potential in a permissionless network that relies on a universally accepted cryptocurrency. Transfers would take place peer-to-peer and almost in real time. There would be no intermediaries that could charge fees or default within the payment system. Credit and liquidity risk and concerns would be a thing of the past. On the other hand, the validation and consensus mechanism in a permissionless system has to be extensive and elaborate. The Bitcoin proof-of-work mechanism is costly in terms of computing power and energy consumption and might be unsustainable in the long run.518 Furthermore, cryptocurrencies such as Bitcoin that use a proofof-work consensus mechanism to validate trades are subject to a ’51 per cent attack’.519 Also, in order to replace the current payment systems on a large scale, banks may have to be on board, and they have no incentive to facilitate a development that limits and eventually removes their own role and importance within the system. It could dramatically affect their deposit-taking function and therefore their cheap funding facility. A large-scale permissionless payment system is therefore unlikely to emerge soon, but the diversification away from the banking system may provide greater stability, which would become clear if a future financial crisis would more seriously affect the banking system and thereby also its payment function. On the other hand, the use of such a system, which would be entirely unsupervised, might help money launderers, tax evaders and criminals (although it must be admitted that the present system is not full proof in this regard either, in particular with respect to the anonymity that cash provides, but at least there are some means of checking). These concerns are clearly legitimate but are not a decisive argument against innovation of this nature. On the other hand, there remain checking points in the entry and exit to the system. Tokens must be bought with fiat currencies, and there is a market in bitcoins and its derivative trading (usually expressed in fiat money), which could be regulated. Thus, this payment system can never be completely self-contained, but it is clear that the more creditors that accept to be paid in this manner and do not themselves wish or have to exit the system (meaning that most of their own payments are also in the cryptocurrency), the more the system gains in strength in terms of 517 Smart contracts present a form of standardisation that allows complete computerisation of the contract formation and enforcement process and blockchain technology may become usable in this process, see also Vol 3, s 1.1.10. It could be followed by a transfer and storage of assets. 518 It was reported in 2018 that bitcoin mining consumes at least as much electricity in a year as all of Ireland (about 24 TWh). 519 Bitcoin is vulnerable to a so-called ‘51 per cent attack’. Parties who control at least 51 per cent of the computing power that the Bitcoin system uses to validate transactions can theoretically rewrite the public ledger and control which transactions are validated and added to the blockchain. In this way, an attacker could divert bitcoin transfers to itself or could double-spend its own bitcoins. It is possible, and has already occurred, that large mining pools hit the 51 per cent threshold. For example, GHash.IO—a mining pool that operated from 2013–16—briefly controlled more than 51 per cent of bitcoin’s computer power in 2014.

Volume 5: Payments, Modern Payment Methods and Systems 339 autonomy. Lacking so far sufficient support as a payment system, many cryptocurrencies have become a speculative tool. Although all payment systems have a store of value aspect, when it becomes dominant, they are likely to become distorted, and their meaning as a payment facility undermined. It is often said in this connection that the real problem is that there is no intrinsic value, but neither is there in paper or fiat currencies. One can say that they are backed up by legislation and government, but they will never give back more than the face value that is printed on the note. The issue for both crypto and paper currencies is whether they are accepted by the public as a means of exchange or payment, no more. Fiat currencies were never good as investment vehicles and may as such better be avoided. Or to put it differently, if they become so, they would lose their effectiveness as a payment facility. Again, what may be more likely to emerge and scalable in the near future is a permissioned distributed ledger system maintained by participating banks. For example, a group of banks could create a payment system that uses Ripple’s XRP to speed up international transfers. Although largely based on traditional fiat currencies, such a system could still reduce intermediation and the associated costs as well as credit and liquidity risks. International payments in particular may be effectuated faster and cheaper. By storing an identical version of the ledger at each participating institution, the system may be less prone to error and transaction validation can be more accurate. However, operational risk remains relevant and may even increase. This is because even blockchain technology is based on software. There is no such thing as flawless software; there are always errors and ‘bugs’ that negatively affect the performance and make it vulnerable to attacks, whether it is a permissioned network or a permissionless network. In conclusion it might be said that blockchain has the potential of significantly enhancing current payment systems, in particular with respect to reducing settlement times for international payments, but the technology is still in its infancy. It will have to be significantly improved in order to be able to process huge volumes of transactions as current payment systems do on a daily basis. For example, the Bitcoin blockchain only processes 4.6 bitcoin transactions per second, which is a miniscule amount compared to the 1,700 transactions that Visa processes per second. In order for there to be a mass adoption of bitcoin and other cryptocurrencies for making international payments, these novel technologies would have to demonstrate that they are scalable to a size where they can supplement or compete with existing payment systems. A blockchain-based permissioned system may be more immediately feasible as an alternative, but would require a globally accepted legal framework for its frictionless operation.

3.1.11. Central Bank Digital Currencies (CBDC) Payment in CBDC is a new form of digital central bank money, mentioned before but not so far discussed in its legal aspects. It is becoming significant at least for general retail users, although not necessarily for wholesale entities such as the commercial banks, which traditionally have accounts directly with central banks (central banks already provide digital money in the form of settlement accounts balances or reserves to commercial banks and certain other critical financial infrastructures such as clearing and settlement systems). A CBDC is a central bank liability, denominated in an existing unit of account, which serves both as a medium of exchange and a store of value. The Bank of England has described a CBDC as electronic central bank money that: (I) can be accessed more broadly than reserves, (ii) potentially has much greater functionality for retail transactions than cash, (iii) has a separate operational structure to other forms of central bank money, allowing it to potentially serve a different core purpose, and (iv) can be interest bearing.

340 Volume 5: Payments, Modern Payment Methods and Systems Governments around the world have demonstrated an interest in developing their own CBDCs for various reasons. First, many governments have been concerned about the rise of ‘privately’ issued cryptocurrencies such as bitcoin and ether. As of February 2019, there were 2520 cryptocurrencies with a market capitalisation of US$ 113 billion. Due to the pseudo-anonymity that cryptocurrencies issued on a permissionless DLT network provide their users, many governments and regulatory agencies around the world have raised concerns that cryptocurrencies can be used for committing international financial crimes such as money laundering, tax evasion, bribery of foreign officials and terrorist financing. Second, as cryptocurrencies are privately issued, but are not issued by any particular identifiable person or organisation, users are often left without any legal recourse if there are problems. Therefore, users are left in a particularly vulnerable position. Third, many governments are concerned that cryptocurrencies pose a threat to a country’s monetary sovereignty, as they have the potential to take away influence from the nation state. This influence can be restored by providing households and businesses with access to a digital form of domestic currency such as. CBDC. Fourth, CBDC’s have the potential to make transfers more secure, lower transaction costs, and increase transfer speeds. Fifth, many countries have seen a downward trend in the amount of cash that is used, particularly in the past couple of decades, where alternative payment mechanisms such as cards, bank transfers, apps, and contactless payment have emerged. In some instances, this downward trend has been supported by governments, which have taken the initiative to stop printing and phasing out large denomination notes (egg the EUR 500 note) in order to reduce the risk of money laundering and tax evasion. The Covid-19 global pandemic has seen a further reduction in the usage of cash in various jurisdictions due to a fear of transmitting the virus on the physical notes. A CBDC ensures that the public have access to legal tender if for some reason cash were no longer widely available. Moreover, there is a large cost for governments in replacing their cash inventories when coins and notes are damaged and from wear and tear,520 and a large cost for banks in installing and maintaining ATMs.521 It is for these reasons that several governments have pushed for a CBDC. There are various types of CBDC that have been proposed, and not all of them will have the same features. A CBDC may be offered to retail consumers (known as a ‘general purpose CBDC’), which would be a digital version of cash that is universally accessible. Alternatively, a CBDC may only be offered to wholesale/sophisticated entities (known as ‘wholesale CBDC’), which would only be accessible to a more limited range of institutions but would include some institutions that do not currently have access to accounts at the central bank (for example, large multinational companies in sectors such as telecoms, technology, energy, transportation, etc). Although there has not been much excitement with respect to wholesale CBDCs due to the limited change that they are proposing to the current banking infrastructure, general purpose CBDCs have the potential to transform the landscape for making payments. A CBDC may be either ‘token-based’ or ‘account-based’. A token-based CBDC system would involve a type of digital token issued by and representing a claim on the central bank, and would effectively function as the digital equivalent of a banknote that could be transferred electronically from one holder to another. The tokens would – like banknotes – be bearer instruments, meaning that whoever ‘holds’ the tokens at a given point in time would be presumed to own them, rather than there being a record of account balances. Transactions in token-based CBDC might 520 Eg, the US, which has USD 1.5 trillion of cash in circulation, has to replace $100 notes every 15 years, and $1 notes every 5.9 years. It costs the Federal Reserve 4 cents to print a new note (depending on the denomination). 521 Eg, Deloitte has reported that a new ATM costs between $15,000 to $65,000, depending on how sophisticated the technology is, with a maintenance cost of around $165 per month.

Volume 5: Payments, Modern Payment Methods and Systems 341 only depend on the ability to verify the authenticity of the token (to avoid counterfeits) rather than establishing the account holder’s identity. The CBDC tokens could be stored on devices such as mobile phones or some kind of chip-based card, and move from one device to another when there is a transaction. A possible implication of a token-based CBDC is that it would allow payments to occur without the involvement of an intermediary such as a bank, which might be an advantage in an offline environment. Therefore, this type of CBDC would be the equivalent of holding digital banknotes. Conversely, an account-based CBDC system would require the keeping of a record of balances and transactions of all holders of the CBDC. Transactions would involve transferring CBDC balances from one account to another and would depend on the ability to verify that a payer had the authority to use the account and that they had a sufficient balance in their account. Because the balance in a retail CBDC account would be a claim on the central bank, this model can be thought of as the equivalent of every citizen being offered a deposit account with the central bank, even though the central bank might not be responsible for user-facing and account-servicing functions. Therefore, this type of CBDC would be the equivalent of having a bank account, but the account would be with the central bank instead of with a commercial bank. An account-based CBDC would permit the government to inject cash directly into people’s accounts (known as ‘helicopter money’) for the purposes of economic stimulus and to avoid deflation of the national currency. The structure for holding a CBDC may also vary. A one-tier CBDC system would be one where the central bank was responsible for all aspects of the system, including the issuance of the CBDC, account-keeping (in an account-based CBDC system), transaction verification, and any Know Your Customer (KYC) and AML/CTF security checks. In a two-tier or ‘intermediated’ system the central bank would develop the technology to issue CBDC to private sector entities (such as commercial banks or technology companies), with those entities then being responsible for all interactions with customers.522 CBDCs have several potential benefits, including providing the public with access to legal tender in countries where cash stockpiles are diminishing, the potential to make instantaneous payments on a 24/7 basis, the potential for the government to provide helicopter money to the public during a financial crisis and to avoid deflation, and to provide people and businesses with a safe-haven for depositing their wealth that is free of credit risk, as commercial banks have the risk of becoming bankrupt, in particular during periods of financial turmoil.523 Although it is theoretically possible for a central bank (and the respective government) to take actions which devalue a country’s currency (as in the cases of Zimbabwe and Venezuela), this is less likely to occur in practice than the failure of a particular commercial bank. There are also potential negative consequences of introducing a CBDC. Especially the transfer of deposits from commercial banks to CBDC would have implications for bank funding and liquidity. The impact of this would be a reduction in the aggregate size of the banking sector’s balance sheet, which threatens the sustainability of current bank business models. The presence 522 See Committee on Payments and Market Infrastructures, ‘Central Bank Digital Currencies’ (March, 2018) Bank for International Settlements, and O Ward & S Rochement, ‘Understanding Central Bank Digital Currencies (CBDB)’ (March 2019) Institute and Faculty of Actuaries. 523 Although many governments provide a state-backed guarantee to depositors (ie, deposit insurance) if their bank becomes bankrupt, this is usually capped at a certain amount; eg, depositors in the US are covered up to USD 250,000 by the Federal Deposit Insurance Corporation; depositors in most EU countries are covered up to EUR 100,000 by their respective local government funds. However, any losses above these amounts are borne by the depositors themselves. Therefore, there is credit risk for depositors who have deposited their savings at a commercial bank in excess of the insured amounts.

342 Volume 5: Payments, Modern Payment Methods and Systems of an attractive CBDC would put pressure on commercial banks to raise their retail deposit rates to avoid losing retail funding. Currently, commercial banks source about 60 per cent of their funding from deposits, with about two-thirds of that being at-call deposits. If banks were to experience an outflow of deposits, they would have to fund more of their lending in capital markets or from equity. The loss of deposit funding and greater reliance on other funding sources could result in some increase in banks’ cost of funds and result in a reduction in the size of their balance sheets and in the amount of financial intermediation. Furthermore, a CBDC introduces the risk of a ‘digital run’ to a CBDC during a financial crisis. Depositors at commercial banks could switch to a CBDC during a financial panic, which also would affect commercial banks negatively. It could get to the point where a central bank would have to bail-out some of the larger commercial banks that are negatively affected by a digital run, in order to prevent systemic risk. Therefore, the introduction of a CBDC could have a negative effect on financial stability and on the economy of a particular country. Moreover, a CBDC could open up the potential for political interference. It is also unclear how a CBDC would affect seignorage. In some countries, there will be legal considerations in implementing a CBDC. Not all central banks have the authority to issue digital currencies and expand account access, and issuance may require legislative changes, which might not be feasible, at least in the short term. Other questions include whether a CBDC is ‘legal tender’ (that is, a legally recognised payment instrument to fulfil financial obligations) and whether existing laws pertaining to instructions, transfers of value, and finality are applicable. At the time of writing, researchers at the IMF have observed that ‘close to 80 percent of the world’s central banks are either not allowed to issue a digital currency under their existing laws, or the legal framework is not clear’. The researchers reviewed the central bank laws of 174 IMF members and found that only around 40 are legally allowed to issue a CBDC.524 The researchers also noted that only 10 central banks would currently be allowed to hold accounts directly for members of the general public (that is, retail customers) in order to provide access to a retail CBDC. Therefore, it will not be possible for central banks in many countries to issue a CBDC (in particular to retail customers) until their domestic laws are updated. There are also questions with respect to KYC and AML/CTF checks in systems that are tokenbased, as it is unclear whether it will be possible to trace transfers of tokens that are made on the system and whether it will be possible to make transfers with complete anonymity (as in the case of cash transfers). If it is possible to make transfers with complete anonymity, it becomes very difficult for the government to combat against financial crimes such as money laundering, terrorist financing and tax evasion. Moreover, in the case of a one-tiered system, it is unlikely that central banks would have the capacity to perform the necessary KYC and AML/CTF checks on their own for each individual customer, and it is more likely that they would have to use intermediaries (for example, commercial banks) to perform these background checks. Furthermore, a CBDC will introduce cyber risks; therefore, central banks will have to ensure that they have the latest cyber security measures in place to be able to combat against cyber-attacks and potential cyber forgeries, whereby cyber criminals attempt to replicate tokens that have been issued (this is analogous to criminals trying to forge and print fake bank notes). It is also unclear whether central banks will be using distributed ledger technology (DLT) in the design of their respective CBDCs. If DLT is used, the designers of the CBDC will have to recognise that this novel technology is still in its infancy and it has certain shortcomings with respect to its scalability, confidentiality, resilience and processing speeds.

524 C Margulis, A Rossi, Legally Speaking, is Digital Money Really Money? Jan 14, 2021, IMF Blog: https://blogs. imf.org/2021/01/14/legally-speaking-is-digital-money-really-money/.

Volume 5: Payments, Modern Payment Methods and Systems 343 At the time of writing, around 50 countries have demonstrated an interest and recognised the value of implementing a CBDC (including Canada, the UK, Singapore, China and Sweden). There are even some countries that already have their own CBDCs (Iran, Marshall Islands, Senegal, Tunisia and Venezuela). The most significant CBDC pilot scheme was being tested in parts of China at the end of 2020, where the Chinese government plans to introduce a CBDC (a ‘digital Yuan’) on a nationwide basis by 2022. The available reports indicate that China’s CBDC will operate a two-tier model: The People’s Bank of China will issue the CBDC and distributed it to the local commercial banks and other payment providers, which will then redistribute the CBDC to the public. It is unclear from the reports whether the Chinese CBDC will be ‘accountbased’ or ‘token-based’, although the presumption is that it will be account-based in order for the government to be able to closely monitor for criminal activities. The monitoring of financial activities is of particular importance to the Chinese government, as the country has strict ‘currency control’ laws that restrict citizens from remitting more than USD 50,000 worth of RMB per year to other countries. Hence, a CBDC that provides full anonymity would easily permit citizens to remit a (potentially) unlimited amount of CBDC holdings abroad by merely using a smart device with an internet connection (and possibly a Virtual Private Network). It is also unclear whether the Chinese government will pay the holders of CBDC any interest on their deposits. It is presumed that the government will have to pay customers interest on their CBCD deposits, as the government will be competing with private mobile payment providers such as Alibaba’s Alipay, which pays up to 4 per cent interest annually through their money market fund—Yue Bao—on customer deposits held in a digital wallet. The Chinese government has accelerated the development of this CBDC project because they are concerned about the large market share that private sector digital payments providers (such as Alipay and WeChat Pay) currently have; for example, in 2019, consumers made USD 8.16 trillion worth of mobile payments in China, with Alipay alone having 54 per cent of the market share for these digital payments. The government wants to reclaim its monetary sovereignty and be able to provide the public with an alternative option for making digital payments that are considered ‘legal tender’. Therefore, if China—as the world’s second largest economy—is successful in introducing a CBDC, there will be pressure on the governments of other major economies around the world to follow suit.

3.2. The Principles and Importance of Set-off and Netting 3.2.1. Set-off as a Form of Payment and Risk Management Tool Set-off is an alternative way of extinguishing a debt, or more particularly, a monetary obligation, and therefore an alternative manner of fulfilling a payment obligation, that is payment proper. At least that is the traditional view in civil law and is here followed, although as a risk management tool, as we shall see, it may acquire other features, especially in novation netting.525 Set-off can be described as follows: if A owes money to B, but B at the same time owes money to A, it is only logical, convenient and efficient that the party owing the larger sum merely pays the difference. 525 See for a comparative study mainly of the laws of England, France and Germany, P Pichonnaz and L Gullifer, Set-off in Arbitration and Commercial Transactions (Oxford, 2014). See for a comparative study of the laws of England, France and the US, B Muscat, Insolvency Close Out Netting: A comparative study of English, French and US laws in a global perspective (EM Meijers Institute 2021).

344 Volume 5: Payments, Modern Payment Methods and Systems There may also be an element of natural justice. To the extent that the claim is eliminated, there results a mutual payment. Convenience has long given rise to a right and sometimes even to an obligation (especially of bankruptcy administrators or trustees) to offset reciprocal monetary claims and settle them in this manner. The facility is particularly important in the bankruptcy of one of the parties as the set-off generally allows the non-bankrupt party to reduce its own competing claim by any amount it owes the bankrupt debtor so that this party will be a competing creditor only for the excess indebtedness (if any). The result and essence is that a preference is created, but there are connected or other advantages: credit, settlement, liquidity, and systemic risks are likely to be reduced526 or better managed in this manner whilst payment finality is also promoted. In insolvencies, the lex concursus commonly takes over, however, and then determines the ultimate effect under its mandatory rules of priority. Outside bankruptcy in countries that consider the set-off subject to notification and a legal act, set-off is a contractual issue, either under a national law or increasingly in international transactions the lex mercatoria, chosen or implied.527 Particularly relevant in bankruptcy, the set-off thus gives the non-bankrupt party an implicit preference to the extent of its own debt because this party recovers fully from the bankrupt estate to the extent of its own claim and it is no longer a competing creditor for that amount. Perhaps somewhat surprisingly, this preference, which can make a great difference, has as such been long and generally accepted as automatic in insolvencies. The approach appears to be: why should the creditor pay if the bankrupt party is not paying? It is a major contract principle and excuse and is then also considered a key feature that spills over into bankruptcies as we shall see; it may indeed allow the set-off to be promoted as a main risk management tool, especially between banks or more generally in the financial services sector, as will be extensively discussed below. In bankruptcy, commonly payment through set-off is considered not then only a right of a creditor, who is at the same time a debtor of the estate, but may then also be some kind of duty of the bankruptcy trustee or, putting it differently, is automatic or happens ipso facto, that is without any election by the non-bankrupt party.528 This is important as such an election would risk being no longer effective in a bankruptcy of the other party as the opening of insolvency proceedings freezes the bankrupt estate and the exercise of all personal rights against it. It puts the legal effect or validity of notices or elections of any sort against the bankrupt party in doubt. That would also affect any set-off notice—hence the (often) statutory automaticity of the set-off in such cases to retain its full effect. Again, it is of long standing and seems universally accepted, although its extension or broadening in contractual netting clauses and thus through party autonomy may still be controversial. Creating preferences like proprietary rights cannot be left to party autonomy alone as it detrimentally affects third parties and it must be supported by the law or more in particular public policy. It is a key challenge of risk management and a central theme in this discussion and may be presented as a policy conflict. Which creditors are to be preferred and why? Again, better risk management and the limitation of systemic risk may be one issue which favours the automatic set-off even for its contractual enhancements, all at the expense of common 526 More recently, it has been argued that systemic risk may also be increased, see the Cross-Border Bank Resolution Group of the BIS Basel Committee on Banking Supervision Recommendation 9 (2010), worried about a sudden close out of very large positions in financial crises or situations leading up to them thereby undermining an orderly resolution of failing financial institutions and further weakening the stability of the financial system. A rush to the exit may thus develop. 527 This freedom has not remained uncontested especially after the 2009 financial crisis, see eg, K Ayotte and SA Skeel, ‘Bankruptcy or Bail-outs’ (2009) 35 Journal of Corporate Law 469. 528 For a comparative analysis of the treatment of executory contracts in an insolvency situation, see Chuah and Vaccari (n 468).

Volume 5: Payments, Modern Payment Methods and Systems 345 creditors who are increasingly postponed, see section 1.1.11 above, but more recently it is being realised that at least in the financial service industry, these preferences may need postponement to give reorganisation or banking resolution a better chance. One of the traditional issues in the set-off is thus first the question of its automaticity, and in this respect the law outside bankruptcy and in bankruptcy may be different within one legal system, as is the case for example in England, Germany and the Netherlands, although even then in different ways. In England outside bankruptcy,529 the set-off must be especially invoked, which in that case can only be done in litigation and therefore requires judicial sanction except if both claims were closely connected, which means that they must arise out of the same legal relationship, or if parties have agreed otherwise in advance. The set-off is then a procedural tool, a convenient way to settle accounts, or a defence. It makes connexity an important issue. In France, on the other hand, the Code Civil (Cc) traditionally accepted the automaticity of the set-off also outside bankruptcy (Articles 1289ff Cc (old)) and was limited thereby, enhancements and contractual extensions being contentious, but was amended in 2016 in Articles 1347/8 suggesting notification also in bankruptcy but remaining obscure as to its nature and effect and any automaticity if no notification is or could any longer be effectively given, its retroactivity, and the status of contractual extensions or enhancements as well as the position of third parties on whose vested rights it is not supposed to have any effect (Article 1347-7), which could hardly be said in respect of common creditors. Automaticity outside bankruptcy with its limitations is still the situation in Italy, but this is now becoming less common. The new Dutch Civil Code (Article 6.127) deviates in this respect from old French law, which it used to follow and is now much like section 388 BGB in Germany. Outside bankruptcy, both the German and Dutch legal systems require the notification of the party availing itself of the benefit. The difference from the common law approach in which, as just mentioned, the set-off is foremost procedural, is that upon notification, the set-off is retroactive to the time the set-off possibility arose. Payment is therefore considered to have been made and then obligation extinguished as of that date, and there is no default as of that moment (should the maturity date have passed), although as already mentioned it can also be made retroactive in England by agreement of the parties. The second theme is then the validity of contractual extension and the effect especially in bankruptcy. The importance of the ‘election’ or ‘notification’ requirement is here that, at least in civil law jurisdictions, it suggests that the set-off is a legal act. The disadvantage is that it becomes subject to requirements of capacity and intent (on both sides), but it may thereby also become subject to party autonomy. It means that parties need not avail themselves of it, or in their contracts may make other arrangements imposing additional requirements or excluding the facility altogether. More importantly, it also means that they could try to extend the facility by contract, although under new Dutch law, this freedom may be limited in consumer contracts: see Articles 6.236(f) and 6.237(g) CC. This contractual extension is often called ‘netting’.530 It may notably attempt to cover claims in other currencies or non-mature claims as we shall see in the ISDA Swap Master and the ICMA/SIFMA Global Repo Master Agreements (GRMA), not normally part of set-off which requires maturity of claims and the same currency or other asset class. It may also allow parties to choose the applicable law, but, as already mentioned, the effectiveness of party autonomy will find its limits where a preference is invoked, which is likely

529 See for a discussion Stein v Blake [1995] 2 WLR 710. 530 It started as a mere commercial term which appears to have been first used more officially in the BIS 1989 Angell Report, 6, 14.

346 Volume 5: Payments, Modern Payment Methods and Systems to be subject to the mandatory rules of the applicable bankruptcy or other enforcement laws that concern the effect on third parties and public policy, notably common creditors. There may also be a danger of repudiation if such contract can be characterised as executory in an insolvency. It may not permit the extension to be operative and in any event not be automatic in bankruptcy, further impeded by the fact that no valid notifications can any longer be given. There may also be a problem under the rules concerning preferential conveyances. Another option is to keep the setoff and especially its contractual enhancements at least within the stay provisions of bankruptcy acts. Altogether this may limit the risk management aspect of the netting beyond what the automatic set-off itself allows but has, as we shall also see, many legislators induced to accept them in bankruptcies also. Again, this is motivated by and especially proves important in the stabilisation of banking risk. In the EU, the Collateral, Settlement Finality, and Banks Winding-up Directives have in particular dealt with the promotion of this facility as we shall see, with amendments later, however, in the Bank Recovery and Resolution (BRRD) Directive (Articles 68–71) after 2014, making netting potentially subject to stay provisions but only in bank resolution situations. Article 68 BRRD does no longer see here an enforcement event per se. Article 69 allows for a suspension of payment and delivery obligations. Article 70 covers the restriction of enforcement of security interests and Article 71 deals with the temporary suspension of termination rights. As mentioned, at least in civil law, the fact that the notification as a juristic or legal act requires capacity and intent of the party giving it, and perhaps also of the party subject to it in the manner of an acceptance constitute further impediments. It must in this narrower sense be legally valid, and as a consequence becomes vulnerable not only in a bankruptcy of one of the parties, but even outside it to defects, which may affect the finality of the payment which the set-off implies. It is also to avoid the complications in this connection in bankruptcy that the automaticity is retained and that outside it, just as in the case of other types of payment, the impact of the requirements of capacity and intent tends to be construed in a restrictive manner in order to promote the finality of the inherent cross-payments. For greater detail on the issue of finality, which is a proprietary matter, reference may be made to section 3.1.3 above. Set-off is a way of payment, but not all claims may be eligible for payment through a set-off and there are also inherent constraints. Problems may arise when (a) claims are highly personal, such as those for alimony, child support, and often also for wages, and the payor of these moneys may not be able to reduce its payments by unilaterally offsetting counterclaims. Other questions that commonly arise in the context of the set-off are (b) whether both debts must be connected, in other words must arise out of the same contract or legal relationship (which could be a tort when there may be a duty for the tort victim to contribute in the case of negligence). As already mentioned, this is the element of connexity. It is traditionally more particularly required in common law jurisdictions (outside bankruptcy or other litigation), except where there was a contractual provision doing away with the requirement, and in countries like France, Belgium and Luxembourg it is still necessary in a bankruptcy set-off. Belgian and Luxembourg law may be relevant in this aspect, especially in repo dealings of investment securities held in Euroclear or Clear stream (formerly Cedel). Mutuality, also known as the issue of reciprocity or privity, should here be distinguished from connexity, and refers more particularly to there being a direct creditor/debtor relationship between the relevant parties, which excludes, in particular, claims held through trustees or collecting agents.531 It is not a question of the claims arising out of the same transaction or relationship. Problems with mutuality of this kind may arise particularly in connection with client accounts. 531 See for this notion in particular, P Wood, Set-off and Netting, Derivatives, Clearing Systems, 2nd edn (London, 2007) paras 2-006 and 4-001.

Volume 5: Payments, Modern Payment Methods and Systems 347 Brokers or lawyers who maintain them for their clients may be tempted to set off their claims for services against such accounts. It should be realised that (in a modern legal system) these accounts do not belong to the broker or lawyer but that their client is the owner of the moneys which they (the broker or lawyer) only administer (in the manner of trustees). No mutuality in claims should then be expected. One could even say that the claim of the broker or lawyer is only administrative for the release of the money and not monetary in nature. Naturally, it does not leave the broker or lawyer without redress. They may be able to claim a lien in the account or request an attachment, but that means that recourse will be obtained only under the rules pertaining to liens or attachments, and not (although more convenient) under a set-off. Furthermore, the set-off normally only applies to (c) monetary claims, although French law traditionally also allows a set-off between obligations to deliver goods of the same sort (Article 1291 CC old, Article 1374 -1 new). That facility might also be contractually introduced and has now become more widespread, as we shall see in the next section. It is of importance particularly for the trading and clearing of investment securities. The need for the assets being at least of the same sort was often interpreted to mean that, even in monetary claims, the set-off was only possible if they were in the same currency, a restriction that could also be lifted by contract (in countries that have the notification requirement and where this is a legal act). Another setoff issue is (d) whether both debts must be mature, also a traditional requirement of French law so that future or contingent debts, including un-adjudicated claims or claims for damages, could not qualify for a set-off against a mature claim. The consequence is that if the creditor’s claim is mature but the debtor’s claim is not, the former must pay even if s/he has no expectation of payment by the latter, a reason why bankruptcy law is here again often more lenient than non-bankruptcy law. It may follow from the principle that in bankruptcy all claims against the bankrupt mature immediately. It may still leave problems with (e) contingent debt. In many common law countries, the set-off of contingent debts of the bankrupt, including damages, is allowed in bankruptcy provided they are provable in the sense of being capable of reasonable estimation under applicable bankruptcy law. It may still exclude tort claims (in England, but not in the US and Canada), but normally not damages for breach of contract, promise or trust, which will then be reasonably assessed. In England there was still a problem in that Rules 4.86 and 12.3(1) of the Bankruptcy Rules 1986 only assessed the contingent debts of the bankrupt in this manner but not the ones of the solvent party, which may therefore remain excluded from the set-off. Finally, (f) the question of retroactivity arises. It is a more complicated issuer that has a meaning in several different ways. In the case of full retroactivity of the set-off, it may be argued that interest payments cease on both claims from the date they become capable of set-off, even if the election (in systems requiring it) is only made later. It would also fix the date for conversion if one of the debts were in a foreign currency (unless other provisions were made between the parties). To the extent debts are retroactively set off and therefore extinguished, there would be no default, and therefore, no repudiation possibility or penalty as at the date the set-off became possible, as we have seen. Any intervening insolvency restricting the set-off would also have no effect. Article 3.129 of the new Dutch Civil Code specifically allows the retroactivity; see also section 389 BGB in Germany. In the traditional French system of an automatic set-off (even outside bankruptcy), the retroactivity was implicit, it is not clear from the present Article 1347 whether it still so. English law traditionally did not have automatic set-off, but, again, it can be negotiated. A last more general remark may be in order. Although the expansion of the set-off in contractual netting clauses is now also accepted in principle in civil law countries, at least in those that consider set-off a legal act, party autonomy in these matters sits easier and is of longer standing in

348 Volume 5: Payments, Modern Payment Methods and Systems common law countries, more in particular in equity which is then also more accommodating in respect of maturity and currency or valuation clauses operating in bankruptcy, which itself is an equitable jurisdiction. This may be underpinned by a greater bias in favour of creditors protection at least in professional dealings, relevant especially in swaps and repo or foreign exchange transactions, and it may follow that relevant bankruptcy laws in these countries are therefore also more accommodating (at the expense of common creditors, see again section 1.1.11 above), although even in these countries this might still find its limit in temporary stay provisions, more especially in bank resolution proceedings.

3.2.2. The Evolution and Use of the Set-off Principle It may not truly be useful to start with history. The Roman law of set-off or compensatio remained incidental and fragmentary.532 It was mostly a procedural device depending therefore on the type of procedure in which it was invoked. In the more common of them, the iudicia bonae fidei, there was judicial discretion (except in the case of bankers or bankruptcy/similar enforcement proceedings to the extent developed). For it to be given, there was a need for connexity, but it did not matter what type of performances or obligations were set off as in litigation all types were reduced to money, see also Gaius 4.61ff. The Justinian compilation (D 16.2 and C.4.31.14) remained confused in the matter.533 The ius commune concentrated at first mainly on the nature of the set-off as an instrument of party autonomy expressed in the requirement of notice, or, alternatively, on its automaticity or ipso facto nature. The first approach remained generally speaking the German one, which is believed to have had its origins in the writings of Azo.534 The other approach, roughly embodied in French law and in many bankruptcies, statutes following its lead in the nineteenth century, also had its origin in the writings of the thirteenth-century glossators. Opinion remained divided in the Dutch seventeenth-century school of Voet and others and still is in South Africa. In modern civil law, section 388 BGB in Germany stands at the one end, Article 1289 (old) CC in France stood at the other. Common law presents a mixed picture. It was probably more practical but with its rigid set of original actions, it could not easily accommodate the set-off.535 At first, it depended mostly on statutory law in set-off statutes, especially an Act of 1705.536 In Green v Farmer,537 Lord Mansfield summarised the position and, whatever natural equity said, held that at law apart from statutory relief, each party had to continue to recover separately in separate actions. Outside bankruptcy or other statutory law, the impact of the will of the parties is now accepted, however, allowing in principle contractual set-off. Without such a clause, which is often deemed implied on very slight grounds, there are still problems in England, however. It has already been said that outside litigation, the set-off is, for 532 See P Pichonnaz, La Compensation (Freiburg, 2001) 9ff; WI Burdick, Principles of Roman Law and their Relation to Modern Law (Lawbook Exchange 1938), 541; WH Lloyd, ‘The Development of the Set-off ’ (1916) 64 U Pen LR 541. 533 See also Inst 4.6.30 and R Zimmermann, The Law of Obligations (Cape Town, 1990) 760. 534 Summa Codicis, Lib IV, De Compensationibus Rubrica. 535 See ‘Comment, Automatic Extinction of Cross-Demands: Compensation from Rome to California’ (1965) 53 California Law Review 224. 536 Temporary Insolvency Act, 4 Anne, c 17, sec. II (1705), followed by an Act for the Relief of Debtors of 1729, 2 Geo II, c. 22, sec 13, amended in 1735, 8 Geo II, c 24, sec. 5. The facility was limited to debts at law and they had to be liquid, cf S McCracken, The Banker’s Remedy of Set-off 3rd edn (London, 2010) 57. 537 Green v Farmer (1768) 98 ER 154 (KB).

Volume 5: Payments, Modern Payment Methods and Systems 349 example, normal only between claims which are connected, that is, have their origin in the same contract or legal relationship. This is also called transactional set-off and is equitable, operating like a special type of defence rather in the form of an injunction, in this manner preventing the main claim from proceeding. In this set-off as a self-help remedy based on connexity, one of the claims may be unliquidated. Courts may overcome this also, and it is then often referred to as another form of equitable set-off. The common law set-off is, barring contractual stipulation or bankruptcy situations, thus still considered a procedural device at least in England, which can only be invoked in the manner of a defence in litigation as a way of settling accounts and depends therefore ultimately on a court order. Moreover, even in litigation there is only a set-off of mature claims, except again in equity, but it is then by its very nature subject to a measure of discretion of the courts. This type of setoff might create problems in an arbitration, although international arbitrators are now mostly considered in charge of procedure and could then handle these aspects also. It has no meaning outside litigation (including arbitration), except where specifically induced by contract or in the case of connexity. It means that mere payment of the difference is normally not sufficient payment in England.538 In insolvency, the situation is different, also in the UK. There is no need for connexity, and the set-off is then automatic or ipso facto, but it does not go any further than allowed by statute or the bankruptcy rules: see section 323 of the UK Insolvency Act 1986, and for company liquidation, Rule 4.90 of the Insolvency Rules 1986 (see also section 382 and Rule 13.12), although it was very broad. It was replaced in 2016, (Rule 14.25). These Rules are considered mandatory. Under Rule 14.25, it is immaterial whether the debts are present or future.539 Regardless of this basic attitude, it may still be questioned, however, in how far contractual enhancements of the set-off principle are effective in bankruptcy, especially in reorganisations (called ‘administration’ in the UK). At least an acceleration clause survives bankruptcy,540 and a bankruptcy trustee’s option to repudiate contracts under section 178 of the Insolvency Act 1986 does not appear to prevent it, but there may remain doubt about the validity of other contractual enhancements of the set-off principle.541 There is no full clarity, especially on close out netting, and opinion remains divided on the limits to the contractual enhancements of the set-off facility in bankruptcy and administration.542 In particular, further expansion of the set-off facility could be considered to violate the principle of equality of creditors, now expressed in section 107 of the Insolvency Act 1986,543 which never excluded, however, ranking in respect of senior claims and the operation of other preferences. It was already said that bankruptcy is about equitable distribution, not equal distribution.544 It would appear that the anti-deprivation rule which guards 538 See for terminology and further comment the comparative study by PR Wood, English and International Set-off (London, 1989). 539 See Stein v Blake [1995] 2 WLR 710. 540 See Shipton, Anderson & Co (1927) Ltd v Micks Lambert & Co [1936] 2 All ER 1032. 541 In England in bankruptcy contractual netting appears accepted only as long as it does not give better rights, that is better than those provided by r 4.90 of the Bankruptcy Rules 1986, now Rule 14.25, cf Carreras Rothmans Ltd v Freeman Matthew Treasure Ltd [1985] 1 Ch 207 and also Derham, n 227 and his The Law of Set-off, 3rd edn (Oxford, 2003). See further the Paper of the British Bankers Association of 13 August 1993, BBA Circular 93 (56) on the validity of bilateral close-out netting under English law; see also the guidance note of the City of London Financial Law Panel on Netting of Counterparty Exposure of 19 November 1993, BBA Circular 93 (82). 542 See S Firth, Derivatives Law and Practice (London, 2013), para 5.060, who favours the ‘flawed asset’ theory, see s 3.2.5 below, and RJ Mokal, Corporate Insolvency Law. Theory and Application (Oxford, 2005), 108, who puts emphasis rather on respect for the collective nature of the bankruptcy regime. 543 See Carreras Rothmans Ltd v Freeman Mathews Treasure Ltd [1985] 1 Ch 207. 544 See s 1.1.2 above.

350 Volume 5: Payments, Modern Payment Methods and Systems against improperly removing assets from the estate, is no bar either,545 nor is the rule against preferential transfers. The implementation in the UK of the EU Collateral Directive in the FCAR brought further support (see for a more structural definition, its regulation 3(1)) and was extended from the financial service industry to all corporate reorganisations.546 Clearly English law favoured the risk management aspect. It may also have clarified the situation in particular with regard to executory contracts and their possible repudiation. Another issue is here the elimination of the stay of enforcement action under sections 126 and 130 (2) of the 1986 Act pending an evaluation of the chances of a reorganisation of a company, which the Collateral Directive also pushed back. However, the Banking Act of 2009 dealt with banking resolution more in particular, well ahead of the EU 2014 Bank Recovery and Resolution Directive (BRRD). When the public interest so requires, it is meant to be an alternative to the established insolvency procedures and distributes power between the Bank of England, Treasury, Prudential Regulatory Authority, and Financial Conduct Authority. It has a more generic netting definition in section 48(1)(d) without any valuation method or clarity how termination and acceleration are to be handled, probably to provide maximum flexibility. The Treasury under sections 47 and 48 has power to make orders and impose restrictions. Implementation of the BRRD in 2014 brought some further changes and more finetuning took place under the Bank Recovery and Resolution Order 2016. The main effect was that under section 48Z termination clauses could no longer be activated by resolution measures, but they could still be enforced if there was a substantial breach by the party under resolution especially of delivery and payment obligations and the provision of collateral and margin. In the meantime, especially in the UK with London as major financial centre in mind, documentation has commonly tried to increase the chances of acceptance of netting clauses. In close-out netting, it seeks to make it effective as at the date of the close-out event as defined, which may be even before a bankruptcy petition. It is the essence of the swap and repo master agreements, often covered by English law, which is then supposed to be especially favourable to them. As already mentioned, it may particularly seek to protect set-off and netting arrangements through the notion that parties accepted this type of net payment as from the beginning of the contract, while sometimes defining it in terms of novation of the claims into one net obligation of the net debtor as of that moment on a continuous basis as we shall see, mainly to avoid any notification requirements, complications and difficulties, this promoting the automaticity. Modern law also avoids penalties like one-way or limited two-way payments to make the netting more palatable. In France, the situation in and outside bankruptcy is now also different, more so after the changes in the Civil code in 2016, which depend on notice already mentioned in the previous section and a distinction may now be made between contractual, judicial, and statutory set-off. Yet for bankruptcy, there is no special statutory regime provided,547 L 622-7 Cde Com explains that pre-insolvency claims must be connected (meaning that they derive from the same contract or are part of a global relationship)548 in order to be set-off so that it is still depending

545 See Belmont Park Investments PTY Ltd v BNY Trustee Services Ltd, [2012] 1 All ER 505, one of the Lehman cases, on the basis of commercial sense and absence of intention to avoid the insolvency laws, the netting being meant to also operate outside bankruptcies. It was further observed that there is a particular strong case for party autonomy to prevail in complex financial instruments. 546 LC Ho, ‘Practitioners’ Perspective: The Financial Collateral Directive’ in D Prentice and A Reisberg (eds), Corporate Finance Law in the UK and EU (Oxford, 2012). 547 See Muscat (n 525), 145 see also L Andreu, ‘LExtension de l’Obligation’ (2016) Droit et Patrimoine 86. 548 Cour de Cass, April 5 1994, Bull. Civ IV, no 142, and May 9 1995, Bull Civ IV, no 130.

Volume 5: Payments, Modern Payment Methods and Systems 351 on connexity,549 but it may then be considered automatic as notices can no longer be validly given after bankruptcy. Like elsewhere in the EU, for the financial sector, it was further refined by the EU Settlement Finality, Collateral, and Bank Winding-up Directives, favouring netting also in insolvencies, for banks amended, however, following the BRRD in 2014 notably introducing the possibility of a stay as we have seen in the previous section. For netting, the basic rule, limited to financial instruments and obligations (as listed) is now in L 211-36-1 Code Monetaire et Financier which incorporated the Collateral Directive but was extended also to non-collateralised agreements. In L 211-40, the Code Monetaire and Financier provides that the bankruptcy laws under Book VI of the Commercial Code should not hinder its application. It does notably not deal with events of default or acceleration issues (which may be left to master agreements under L 211-36-1, II) and, in view of the connexity requirement, still appears to avoid multilateral netting agreements, but it allows cross product netting under master agreements which suggests at least a relaxation of the connexity requirement in favour of contractual linking. In the US, the set-off outside bankruptcy is a matter of State law. In most States, particularly in New York, the set-off is no longer merely a defence in litigation and generally does not depend upon a court order. The early non-bankruptcy case was Greene v Darling,550 in which Justice Story allowed the set-off, but only in the case of connexity. It is now generally a self-help remedy, at least for banks. It developed as such in a more general way particularly through the bank current account practice, which grouped all outstanding claims between a bank and its customer together.551 Case law confirms, however, that the claims must be mature552 if only upon acceleration under a contractual clause to the effect.553 In (federal) bankruptcy, section 553 of the Bankruptcy Code applies. It is not an original grant of bankruptcy set-off rights but it limits the reach of the set-off under State laws if exercised within 90 days before the petition. The automatic stay provision of section 362 also applies (section 362(a)(7)) while section 365 allows the termination of all executory contracts and section 365(e) renders contractual acceleration clauses ineffectual in bankruptcy, although, importantly, through amendments of the Bankruptcy Code relief was given in repo and swap situations, also against the stay, see section 559 for repos and section 560 for swaps since the 2005 amendments for netting agreements in these products (defined in Section 101 (38A)), further elaborated in sections 561 and 562.554 Derivative counterparties could henceforth substantially circumscribe the Bankruptcy Code’s automatic stay and preference rules. Further expansion happened in 2006 through the Financial Netting Improvements Act.555 For financial institutions special procedures are enacted, however, one for insured deposit 549 There may also be problems in respect of a set-off of pre- and post-insolvency claims, see G Ripert and R Roblot, 2 Droit Commercial, 16th edn (Paris, 2000) nos 2842, 3039ff and 3217. 550 Greene v Darling 10 Fed Cas 1141 (DRI 1828). See also SLSepunick, ‘The Problems with Set-off: A Proposed Legislative Solution’ (1988) 30 W&M LR 51, 53. 551 See Otto v Lincoln Savings Bank 51 NYS 2nd 561 (1944). 552 See Jordan v National Shoe and Leather Bank 74 NY 467 (1878). 553 See also PM Mortimer, ‘The Law of Set-off in New York’, International Financial Law Review (24 May 1983). 554 In the US, netting is now allowed in the context of settlement payments, but was limited to transactions executed on recognised exchanges, although a statutory amendment of 1990 more generally allowed the integration and acceleration in the case of standard swaps: see ss 101 and 560 of the US Bankruptcy Code (and similar provisions in the laws covering institutions such as banks, insurance companies and the like, not subject to the US Bankruptcy Code). They were amplified in the amendments of 2005. 555 Part of Sec 362 was reworded and Secs 546 (e) and (j) were expanded better to protect transfers made by protected parties from the avoidance powers. The inroads of party autonomy on the ordinary bankruptcy process in this manner could be considered excessive and it could be questioned how private parties could arrogate to themselves in this manner so much protection at the expense of others. Again, it is done in the interest of better

352 Volume 5: Payments, Modern Payment Methods and Systems institutions under the Federal Deposit Insurance Act and Federal Deposit Insurance Corporation Improvement Act (FDICIA) when the Federal Deposit Insurance Corporation (FDIC) acts as receiver with broad powers to continue the operation, and another under the Dodd Frank Act for systematically significant financial institutions that are not federally insured (all other financial institutions are covered by the Bankruptcy Code). The Dodd Frank Act created the Orderly Liquidation Authority (OLA) authorising in appropriate cases the Secretary of the Treasury to appoint the FDIC as receiver, when these issues must be dealt with separately. Provisions concerning the automaticity or ipso facto nature of the set-off in insolvency proceedings,556 type of claims, automatic stay, preferential treatment and executory contract repudiation need then also consideration, but except for temporary stays which leaves the netting itself intact, they are generally in line with the Bankruptcy Code and its exemptions or safe harbours for special types of protected creditors, again notably in swaps and repos, but they may also be commodity brokers, forward contract merchants, stockbrokers, or security clearing agencies. Netting is defined in Section 402(14) FDICIA and is protected in section 403 ‘in accordance with its terms’. It may be noted that the temporary stay is now also a BRRD facility in the EU and the coordination in this aspect was a G-20 initiative further supported by the Basel Committee of the BIS which became increasingly concerned about financial stability and wary of the more liquidation oriented safe harbours increasingly favouring and protecting set-off and netting arrangements. On the other hand, it was in nobody’s interests to unsettle the derivatives and repos markets either. In Germany, the set-off is at the request of the party invoking it and is not ipso facto outside bankruptcy: see section 388 BGB. It has two purposes.557 It is (a) a settlement, payment or discharge of mutual debt; and (b) a self-help measure for the notifying creditor, giving the latter a preference. It has also been viewed as a charge-back or a lien on debt. The debts must be mutual and mature, homogeneous, therefore of the same sort, enforceable, therefore not time-barred, but may apparently be in different currencies. In bankruptcy, the trustee operates under the BGB provisions, but the creditor has special facilities under sections 94 and 96 of the Insolvency Act 1999 (formerly section 54 of the German Bankruptcy Act (KO)): in bankruptcy the claims to be set off need not yet be mature or unconditional, and the claims need not be homogeneous, in which case estimated monetary values are used.558 But it would appear that the claim of the creditor must become payable before the claim of the bankrupt (except that instructions into systems governed by the EU Settlement Finality Directive are subject to the same-day rule). Contractual modifications or enhancements of the set-off principle are not necessarily upheld in bankruptcy, in any event not any contractual exclusion of the benefit.559 Section 104(2) of the Insolvency Act 1999 elaborates on the close-out netting of financial transactions under master agreements and specifically accepts the conversion of the outstanding obligations between the parties into a single claim, for which section 104(3) gives a calculation method. Although integration and acceleration through master agreements have thus been accepted in the US and even in France especially in bankruptcy by statutory amendment, which was not risk management and supposedly contributes to less systemic risk by spreading financial risk more broadly. It may have proved a high point in this development, now reined in by more modern bank resolution regimes for systemically important institutions. 556 The effect of contractual ipso facto clauses was limited by the federal courts in Lehman Bros. Special Financing Inc v BNY Corporate Transaction Services Ltd, 422 BR 407 (SDNY 2010) if not specifically set forth in swap agreements. 557 See BGH, 24 November 1954, [1955] NJW 339. 558 See E Jaeger, Kommentar zur Konkursordnung, 8th edn (Berlin, 1958) s 54. 559 See BGH, 6 July 1978, [1981] NJW 2244.

Volume 5: Payments, Modern Payment Methods and Systems 353 believed necessary in the UK, they may still not be accepted in other countries or be subject to temporary stay or even repudiation provisions.560 Like all contractual set-off enhancements, acceleration is in general more vulnerable in the case of a full bilateral netting than in the context of integration and damages calculation within each particular swap. As suggested before, conditionality and connexity-creating contract language may help, but appears to need some base in economic reality, and may therefore only be an expression and reinforcement of a more objective principle, see also section 3.2.5 below.

3.2.3. The Expansion of Set-off Through Contractual Netting Clauses. Different Types of Netting. Special Importance in Clearing and Settlement and in Bankruptcy In countries that characterise the set-off as a legal act and subject it to notification and thereby potentially to party autonomy, parties may in principle correct and expand the concept by contract, relevant particularly in the aspect of (a) connexity, (b) acceleration of maturity, (c) set-off of non-monetary obligations (like claims for delivery of commodities or investment securities) or of obligations in different currencies, and (d) retroactivity, which would at the same time eliminate any adverse effect of an intervening bankruptcy. This is confirmed in the equitable assignment in England and under State law in the US. Thus, in such a system, parties in their agreements could elaborate and, for example, delete the connexity requirement where in principle upheld outside bankruptcy as is the case in the UK. Absent connexity, they could also abandon the need for a court order to achieve the set-off of other debts, allow acceleration of immature debt, include contingent debt and unliquidated claims, and provide for the set-off of other than monetary claims or of monetary claims in different currencies. In the latter three cases, it would require valuation or translation formulae to make the set-off possible without further argument. Retroactivity could also be negotiated. The shaping of the set-off principle in this manner may in fact give rise to (netting) structures that could become separate from the set-off in the more traditional sense, but it may still retain an important support function in the matter of the preferences created and to be accepted even in a bankruptcy of one of the parties. It was already said that agreements expanding on the set-off facility in this manner are commonly called netting agreements and have become particularly important in financial 560 In Switzerland, there was considerable doubt: see M Affentranger and U Schenker, ‘Swiss Law Puts Master Agreement in Question’ (1995) International Financial Law Review 35, now alleviated by a change in the Swiss Bankruptcy Act 1997. In Ireland, special legislation was introduced through the Netting of Financial Contracts Act 1995: see R Molony and J Lawless, ‘Irish Legislation Validates Close-out Netting’ (1995) International Financial Law Review 15. See for the history of the amending legislation in the US, SK Henderson and JAM Price, Currency and Interest Rate Swaps (London, 1988) 144ff. Under prior US law, the contractual integration created only a presumption, which could be defeated when there remained too many individual elements of the different transactions. In this connection, the addition of new swaps and the termination or transfer, and thereby elimination, of others remained a problem. Differences in currencies were also problematic so that different master agreements per currency were not uncommon. Other authors emphasised, however, the existence of material circumstances favouring the integration concept. In their view, an interrelationship was to be assumed when there was the same contractual framework, a close-out netting clause for all, a consolidated credit risk approach, mirror swaps or swap hedges, etc: see DP Cunningham and WP Rodgers Jr, ‘The Status of Swap Agreements in Bankruptcy’ in WP Rodgers Jr (ed), Interest Rates and Currency Swaps (1989) 229. This reasoning was somewhat circular but nevertheless taken seriously.

354 Volume 5: Payments, Modern Payment Methods and Systems derivatives (like swaps) and in repos: see sections 2.6.6 above and 4.2.4 below. As already mentioned also, any contractual variations on the set-off principle so introduced are likely to curry more favour in countries where the set-off is subject to notification and considered a legal act, which may imply the parties having a say in the set-off method. This is different therefore in principle in countries where the set-off is still automatic, even outside bankruptcy. The true issue is always the effect on third parties, notably common creditors who are likely to come short, on what is in fact a preference extended through party autonomy beyond tie set-off facility and goes therefore beyond privity and there may be the issue bona fide creditors’ or pari passu protection, see section 1.1.11 above. There could even be question of a voidable preferential transfer or repudiations of such contracts as being executory. It was already said that giving notice upon bankruptcy may itself prove no longer effective. These issues are thus particularly relevant for the status of netting agreements in bankruptcy. Are they valid in that case even if the netting they introduce goes beyond the scope of the automatic bankruptcy set-off? Can the contractual netting so introduced also benefit from the automaticity and how should it be structured to that effect? If not, it would be extra vulnerable to notices being no longer effective in bankruptcy. Often statutory intervention has been needed to achieve the effect of an extended set-off in bankruptcy. Common law here makes further distinctions, and at least in England, there is an effort in legal writings to differentiate between (a) settlement netting, (b) netting by novation, and (c) close-out netting.561 Settlement netting is the netting of monetary obligations in the same currency whether or not connected or of goods of the same sort as in the set-off of non-monetary obligations like those to deliver fungible assets, notably bonds and shares of the same sort deliverable on the same day, sometimes also called ‘position netting’, ‘delivery netting’ or ‘payment netting’. It is important in bilateral and especially in multilateral clearing and settlement systems (short of the operation of CCPs) and then takes place at the end of the processing cycle. In England, it is particularly used to avoid the connexity problem outside bankruptcy, and it may then also seek to deal with maturity and currency differences. It is considered to take place only at the moment of payment or delivery, which still raises the issue of its effectiveness in an intervening bankruptcy of the counterparty. Whether it is possible to have an effective set-off in a bankruptcy situation before the netting and payment processes have been completed (sometimes through clearing agencies) will then be a matter to be determined under the ordinarily applicable bankruptcy laws. The notion of retroactivity of any netting could acquire here a special meaning and importance. To create greater certainty, other structures have been tried, especially netting by novation. This is any netting in which parties agree to substitute a single net payment for two cross-claims, normally as soon as the relevant accounting entries have been made, even if payment is deferred until an agreed payment or settlement date. It is sometimes also called ‘obligation netting’. It often assumes a continuing process in which each new transaction is automatically consolidated with the earlier ones. The result is a running score. This means that at any particular point in time, there

561 See Derham (n 227) above. These various distinctions between the types of netting were foremost inspired by the typical limitations of common law in respect of the set-off (notably in England) and may be much less relevant in other legal systems. Thus, in Germany, no contractual enhancement would appear necessary to obtain a broad netting of mutual claims (if mature and in the same currency) as (unlike in England) the issue of connexity does not arise, even outside bankruptcy where a court order is also not necessary either. Much of the English effort in this connection is therefore centred on creating a form of contractual dependency of claims through bilateral netting clauses, but no less so in multilateral netting schemes, by interjecting a single party who may assume all rights and obligations of the participants in the system and net them out, first bilaterally and then among all participants in a clearing system, thus creating one debt or credit (possibly in the nature of a novation netting) for each member of the system in respect of claims accruing during an agreed period.

Volume 5: Payments, Modern Payment Methods and Systems 355 will only be a single net obligation owing by the net debtor to the net creditor. It may also be seen as a confirmation of the notion of retroactivity, particularly in a common law environment that is less familiar with that notion.562 In a bilateral manner, novation netting may be useful in swap and foreign exchange transactions producing single outstanding balances to be settled (but not created) at the settlement date. A special and obvious form of novation netting may be found in contracts for differences when, as in modern interest rate swaps,563 theoretical cash flows are netted out on a bilateral but continuous basis, and the resulting benefit or loss constitutes the true obligation between the parties, even if only settled on specific dates. Probably the set-off has here altogether lost its character as a means of payment, and the netting then constitutes the essence of a new financial instrument. The normal rules of set-off (and their limitations) may not apply. Indeed, it could be said that, unlike when swaps were still back-to-back agreements, there are here only contracts for differences, and there is no set-off in the more traditional sense, not therefore true legal novation either. In a multilateral way, novation netting is often considered to happen in a clearing system that has a central counterparty (CCP). It suggests an immediate transfer of all claims of participants in exchange for a net right or obligation of each of them in respect of the system. The novation itself could then be seen as not being part of the clearing, but rather, the prelude to it, followed by a net payment at the close out of transactions.564 If a novation netting system can thus be construed and maintained, it is likely to be more reliable and effective in a bankruptcy of one of the counterparties, as there are ever only net outstanding balances or contracts for differences (ordinarily secured by margin). In multilateral clearing systems without a CCP, there may still result a contractual netting also, but more likely only on a provisional basis as a book-keeping effort (in the nature of a settlement netting) subject to all participants ultimately being able and willing to pay whatever is due from them. This is also called a net settlement system as we have seen in section 3.1.6 above for payment systems. It is another form of settlement netting that is not complete until all the net debtors have paid their net contribution at the end of the settlement cycle.

562 When novation netting is combined with a clearing function, it is also referred to as ‘netting by novation and substitution’. This is even conceivable for swaps and would lead to a swap clearing facility, which has been offered for some time by the London Clearing House. The result is a kind of swap exchange, now favoured by regulators, as we have seen in s 2.6.5 above. An example of it may also be found for foreign exchange transactions in the multilateral netting facility between a number of banks in the Exchange Clearing House Organisation Ltd (ECHO), operating in London since 1995. The idea is that ECHO is inserted in all foreign exchange transactions between the member banks in the same way as an exchange is in futures and option dealings. In the case of the bankruptcy of any bank in the system, ECHO is the counterparty and the other banks will not directly be affected. ECHO nets all outstanding positions so that there remains one contract. If under it ECHO is the creditor and remains in whole or in part unpaid, the other member banks must support it according to a certain formula. To protect ECHO further, strict limits are imposed on the total outstanding with any bank, and additional security may be requested in terms of margin. For swaps, the idea obtained early support from ISDA, but as it would also give weaker swap parties ready access to the market and deprive the stronger banks of their credit rating advantage, it was not implemented at the time. ECHO is followed by a similar system in New York called Multinet. 563 Swaps of cash flows have become very popular as financial tools, see s 2.6.1 above. They allow flexibility to investors and borrowers who may in this way swap their investment income or borrowing cost, therefore their incoming or outgoing cash flows, for others with other interest rate structures or in other currencies to protect themselves against undesirable movements in interest or currency rates. 564 It has already been said in s 2.6.4 above that the novation of all contracts into the CCP, which should be distinguished, may not happen as they may from the outset be vested in the CCP through an agency construction or the exercise of a general power of attorney by the relevant floor broker or market maker.

356 Volume 5: Payments, Modern Payment Methods and Systems Close-out netting is a netting that becomes operative only upon a default or other close-out event by a counterparty as defined. It is sometimes also called ‘default netting’, ‘open contract netting’, or ‘replacement contract netting’. It nets bilaterally all outstanding positions between both parties at the moment of default or upon another agreed close-out event and accelerates or matures all outstanding obligations as off that moment. It is commonly provided for in the swap and repo master agreements. In a multilateral close-out netting, other parties are also roped in. Again, the issue arises whether upon a default in bankruptcy, this type of netting may still prevail. It might be cast in terms of a novation netting at the same time, as we have seen, and may then be more bankruptcy resistant. It is sometimes thought that the close out distinguished this type of netting more fundamentally from set-off but the latter does no less terminate relationships as all payments do. The practical difference is probably more in the likelihood of whole classes of claims coming to their early end at the same time. It may be clear that whether there is in these situations a form of novation netting or not may be a key issue in a bankruptcy of the counterparty, and is often a question of contract interpretation and may be combined with settlement and close-out netting to overcome their vulnerability in bankruptcy situations. Yet novation netting most certainly is not implied in every netting, even if there is a resultant net obligation which may be simply an accounting matter. Indeed, one indication may be in the actual booking practices of the parties. In other words, it may depend on whether the transactions are immediately booked in a netted way. Even in a clear novation netting that may still create problems where the netting is perceived as a continuing process. To be effective in bankruptcy, it may have to precede it, while balances may have to be continuously notified (although payment may be postponed) and could still not be effective in a bankruptcy unless it was also retroactive.565 Another danger is that, in the nature of all novations, there are extra requirements in terms of capacity and consent of the parties, although of course any relevant netting agreement also needs capacity and sufficient consent for its mere validity, but not necessarily (or to the same extent) that is required for a set-off, which may stretch out into a bankruptcy of one of the parties, who may no longer have that capacity. Capacity and intent are then issues of payment finality. It is sometimes said that close out netting process goes in three steps: termination, valuation, and determination of the net balance to be paid either way.566 This may be so, as long as it is understood that these steps are coterminous and are all crystallised at the moment of the event of default. As already noted, bankruptcy laws have often had to adapt to recognise these extended forms of set-off, creating substantial preferences for the beneficiaries at the expense of common creditors. See the next section for the various steps taken in different countries567 and the more 565 See British Eagle International Airlines Ltd v Compagnie Nationale Air France [1975] 2 All ER 390, in respect of mutual airline claims resulting from passenger cancellations and ticket changes for which IATA served as a non-financial CCP. Public policy was invoked to preserve the integrity of the insolvency rules and limiting the effect of opting out through a netting agreement, but perceptions may have changed: see in this connection in particular the more recent Australian (Victoria) cases in IATA v Ansett [2005] VSC 113, [2006] VSCA 242, and [2008] HCA 38, in which ultimately the Australian High Court accepted that this internationally accepted form of clearing and settlement and set-off trumped the Australian bankruptcy laws. This is a significant development. See C Chamorro-Courtland, ‘The Legal Aspects of Non-Financial Market Central Counterparties (CCP)’ (2012) 27(4) Banking & Finance Law Review 553. For Germany see CG Paulus, ‘Rechtspolitisches und Rechtspraktisches zur Insolvenzfestigkeit von Aufrechnungsvereinbarungen’ in CW Canaris et al (eds), 50 Jahre Bundesgerichtshof (Munich, 2000) 765. 566 I Annett and E Murray, ‘Set-off, Netting, and Alternatives to Security’ in D Prentice and A Reisberg (eds), Corporate Finance in the UK and EU (Oxford, 2012) 289. 567 For the 2005 US Bankruptcy Code amendments see S Vasser, ‘Derivatives in Bankruptcy’ (2006) 60 The Business Lawyer 1507.

Volume 5: Payments, Modern Payment Methods and Systems 357 recent trend to at least retain temporary stay provisions, especially in corporate reorganisation and banking resolution schemes. A special form of close out netting may be found in cross-product netting, which may take the form of a bridge agreement, as in the ISDA 2001 Cross Agreement Bridge, a single master agreement, as in the 2004 European Master Agreement of the European Banking Federation, or an overarching master-master netting agreement which links different master agreements and their close out facilities for different financial products.568

3.2.4. Use of Contractual Netting Clauses in Swaps and Repos: Contractual Netting and Bankruptcy. The EU Settlement Finality Directive The expansion of the set-off principle through the netting agreements have made set-off and netting a major risk management tool between parties that are intimately connected as banks usually are and guards then especially against systemic risk. It means to strengthen the stability of the financial system and transcends in such cases the notion of set-off as merely a way of payment. If properly done and recognised in bankruptcies, it means that banks owe each other only netted-out amounts which are likely to be small. It prevents especially a situation where the solvent banks would be forced to pay all they owe to the bankrupt banks, and risk only receiving a small percentage back (the bankruptcy dividend) on all the bankrupt banks owes them in each transaction. It is clear that the netting clauses acquire here a special significance and may indeed create an extended preference which is the purpose. Contractual netting clauses have in recent years particularly developed for swaps and repos in terms of a novation close-out netting, although (depending on the precise contractual terms) probably in somewhat different ways. In swaps there may be emphasis more on novation netting and in repos more on close-out netting; see also sections 2.6.6 above and 4.2.4 below. They are supported by regulators and are now favoured in most bankruptcy acts as already noted. Again, the reason is the promotion of financial stability be it at the expense of common creditors. The justification is that they commonly receive very little anyway. The modern swap contracts may make use of the netting concepts basically in three different ways. As mentioned in the previous section, (a) in most modern interest rate swap structures, there is now an inherent netting of both cash flows, leading to the swap’s modern form of a contract for differences with payment only of the difference between two theoretical cash flows on certain agreed dates. Practically, there is a form of novation entered into at the very beginning of the transaction. It is its essence so that most interest rate swaps now no longer involve any exchange of physical cash flows or of the underlying assets or liabilities out of which the cash flows arise, each of which would have given rise to settlement or close-out netting. As mentioned in section 3.2.3 above, this type of novation at the practical rather than legal level may lead to a different financial instrument altogether. Importantly, it means that there is no longer a true set-off and no need to net the amounts out on the payment or close-out dates, although this is what modern swap documentation is still likely to want to achieve for other types of swaps, such as (b) currency swaps, where the underlying

568 T Keijser, The European Collateral Directive from a Property and Insolvency Law Perspective (Alphen aan den Rijn, 2006) 40.

358 Volume 5: Payments, Modern Payment Methods and Systems assets are still likely to be exchanged, at least in the case of liability swaps (although as we have seen there may be cross-loans instead), and (c) in respect of whole swap portfolios between the same parties in a bilateral netting. Especially in the latter case, this is done by means of integrating all swap aspects on the appointed day under a pre-existing swap master agreement or framework, which in close-out netting may also provide for acceleration. As was explained above, that does not, strictly speaking, need to mean novation netting, even if this is often the preferred route of the banking industry, especially in bankruptcy situations, for the reasons explained before. In achieving these results, swap documentation uses a number of concepts, such as integration, conditionality, acceleration and retroactivity (the latter to achieve automaticity, promote the ipso facto effect, and avoid notification after bankruptcy), which under applicable law may be deemed implied, but are here made explicit to clarify the situation for countries like England, where it may be less clear whether they are implicit. It is relevant if the entity against which the set-off is invoked resides in such a country. As may be seen from the previous discussion, these concepts are especially put to the test in bankruptcy, especially its reorganisation variant, for which they are primarily devised. Again, one aspect of this is the emergence of the swap as a contract for differences; another is the integration of all swaps between the same parties in a single balance through bilateral netting. Multilateral netting and clearing may be yet others. The problem is always the same: preferences, like property rights, cannot be created by mere contract because of their third-party effect, while these contracts, if executory would still be subject to repudiation by the bankruptcy trustee. There could also result impermissible preferential transfers. Support of the positive law in terms of legislation (or treaty law, or EU law in the European Union) is therefore necessary, or otherwise customary law, or general principle. That is what was achieved early in the set-off and it remains therefore the basic support structure. Through notions of integration, conditionality, acceleration, and retroactivity, contractual enhancements may obtain further support but it remains fragile. Even then there may still be a stay at least in respect of these contractual extensions, even if at first the UNIDROIT Principles (7(1)(a), the EU Settlement Finality, and Collateral Directives did away with it,569 and the Banks Winding -up Directive also provided for a special regime, a policy now reversed in the EU under the Bank Recovery and Resolution Directive (BRRD) (Articles 68 and 71) and in the Dodd Frank Act in the US, at least for banking resolution, usually initiated when statutory solvency or capital adequacy levels can or are no longer being met. This is considered to engage the wider public interest more profoundly and then to justify greater administrative intervention and possibly discretion, especially the imposition of a temporary stay.570 Beyond this it remains a question of Member States’ (insolvency) law. The aim is always to expand the netting facility, thereby minimising risk for the bankrupt’s counterparty (often a bank) in such a manner that it can survive the scrutiny of any applicable bankruptcy law which may still use the narrower set-off concept and at the same time avoid 569 On the other hand, the World Bank Principles for Effective Creditor Rights and Insolvency Systems (2001) paras 136 and 137, favoured the stay, the argument being that attempts at rescuing businesses might fail without a temporary stay, whilst in a liquidation a stay might maximise value. This was maintained in its 2005 Insolvency and Creditors Rights or ICR Standards formulated by the Expert Working Group of the Insolvency Creditor/Debtor Regimes Task Force (C10.4 which also considered exceptionally a short stay)) in coordination with the work of the 2004 UNCITRAL Legislative Guide, see also s 3.2.9 below. In the 2009 IMF and World Bank Insolvency Report, 16, which further updated the 2001 Worldbank Report, the special situation of banks was more in particular highlighted in terms of financial stability, smooth functioning of the payment and settlement systems, the protection of the depositing public, and the preservation of the credit intermediation function. 570 Thus the 2010 IMF Report on the Resolution of Cross-Border Banks, Box 7 at 22, considers in such cases the overruling of ordinary private property and contractual rights.

Volume 5: Payments, Modern Payment Methods and Systems 359 further legal acts having to be performed after bankruptcy (in terms of notice), and issues of intent and capacity, which could no less interfere with its effectiveness, or any contract repudiation facility of the bankruptcy trustee, also not favoured by the UNIDROIT 2013 Close Out Netting Principles (7(1)(b)), which did not favour the avoidance of netting agreements as preferential transfers either (7(1)(c)), all to promote better risk management. There may be further uncertainty, however, because the applicable bankruptcy law may not always be easy to predict. It depends on the place where the proceedings are opened, which could be in several countries, or at least in a country away from the swap partner in trouble. At the same time, it raises the issue of extraterritoriality of such bankruptcy proceedings, and therefore the issue whether they would still be effective in the country of the troubled swap party upon recognition (and under what conditions). Indeed, in practice, any resulting foreign bankruptcy law limitation of the set-off may not always be effective against such a bankrupt swap partner if the latter has its centre of affairs elsewhere, therefore not in the country where the bankruptcy was opened and whose bankruptcy law applies (while not itself making amends to accommodate the netting against the bankrupt party if allowed under its own bankruptcy laws). In the context of a recognition of such foreign bankruptcy proceedings, if at all possible, in the country of the relevant swap party, the bankrupt swap party might still be considered subject to its own law for any effects of the netting on the swap. Thus, while the bankruptcy law concerning a branch may limit the effect of netting clauses, that need not necessarily affect the recovery from the company itself if headquartered elsewhere.571 In this connection, it may of course greatly help if the applicable (bankruptcy) law itself is willing to consider the principle of integration of the swap contract (regardless of contractual clauses to the effect). It is even conceivable that the applicable bankruptcy law groups certain contracts together and makes them mutually dependent. It is against the notion of privity of contract, but this notion is not as absolute as it is sometimes considered to be in common law countries: see Volume 3, section 1.5.3.572 Parallel loan agreements and swaps may present special examples in the financial services industry. Integration of the contracts on the basis of economic reality may be all the easier here, as this type of integration of contracts does not (directly) involve third parties and is mostly on a bilateral basis only. The effect is likely to be felt in the formation, performance, and especially termination of the arrangement. There may be interdependence at all three levels. Definitions, interpretation and applicable law may then also become connected. It is likely, however, and was already noted that there must also be some more objective cause for the integration and 571 In terms of bankruptcy law policies, the limit is usually that no extra preference is created for the non-bankrupt party at the expense of the other creditors. As suggested above, by introducing integration, conditionality, and acceleration notions creating contractual connexity, the acceptance of a broader set-off may become more readily acceptable, even in bankruptcy. That is certainly the aim of the modern swap and repo documentation, which for this reason may even prefer to avoid the set-off characterisation altogether. Another aim is to reduce the capital adequacy requirements for financial institutions as their swap risks become more limited because of the netting facility (see for this aspect Vol 6, s 2.5.5). Yet it remains true all the same that extra privately preferences are created which may offend applicable bankruptcy laws. That is the challenge. 572 In the financial area, the modern example is the finance lease under which the supply agreement of the goods to the lessor/owner often creates certain rights and obligations in the lessee as user of the goods and normally the instigator of the deal. Article 2A UCC in the US expresses this approach quite clearly, and it is also taken up in the UNIDROIT Convention on International Finance Leasing: see s 2.4.10 above. Economic interdependence may sometimes have a sequel in law and may even create trilateral relationships. Other examples are subcontracting, reinsurance and chain sales. See in France, where there is a special academic interest in the subject of economically connected contracts, B Teyssie, Les groupes de contrats (Paris, 1975). See for swaps earlier also P Goris, Swaps (PhD Dissertation, Leuven, 1992) 177ff.

360 Volume 5: Payments, Modern Payment Methods and Systems interdependence in such cases, which may have to be found in economic realities. The importance of the integration, conditionality, acceleration and retroactivity language in modern swap agreements in the context of the contractual close-out and netting provisions may thus be enhanced when there are also signs of a more objective interdependence. If so, these concepts could even be considered to have been implicitly included in the contract by the parties. But absent special statutory support, the real impact of netting clauses in bankruptcy is likely to remain dependent on a generally receptive attitude of the applicable law to the concept of contract grouping and integration in the case of economic interdependence, which may be more contentious in multilateral netting. The result as already mentioned is better risk management, now generally favoured by regulators in the financial services industry, see also the figures given in section 2.6.7 in fine although, as we shall see, temporary stays are increasingly accepted in respect of netting clauses, if not set-offs also. It is in this manner that modern contractual netting clauses are likely to attempt to tie all swap deals at least between the same parties, together. This is so especially for bilateral close-out netting. It is very much the objective of the ISDA Swap Master Agreements (see also section 2.6.7 above and 3.2.5 below). In each swap and between the various swaps, this may require a system of valuations which depends on conversion formulae for foreign exchange and non-monetary exposures as the redelivery of bonds, especially important if underlying assets or liabilities are also exchanged. The contractual acceleration, close-out and netting are increasingly typical if a default occurs in any financial dealings between the same parties (which need not be confined to their swap transactions), especially if they are banks. Repos spring then also to mind, so do foreign exchange dealings. They may also result between the parties if one of them defaults in his relationship with any third party pursuant to a cross-default clause. The netting itself could even be agreed between a group of active swap parties. This is multilateral close-out netting, and may operate quite apart from a pooling in a clearing and settlement or CCP system. The intention is that aggregation, contractual close-out, or bilateral netting results in one amount either owed or owing. It best operates if it can be seen or characterised as a continuing process that has automaticity. Such termination through acceleration would still be at the option of the non-defaulting party, which may alternatively wish to take the risk of continuation, not uncommon in the case of minor defaults outside a bankruptcy situation. The end result in a closeout is payment of one sum either way, that is either to the defaulting or to the non-defaulting party which, however, is only a competing claim for this amount. Yet as it is only a net amount, in a bankruptcy of the counterparty it is likely to work out much better than a situation in which the non-bankrupt party is payor (in full) under every swap where the bankrupt party is in the money, but receives the pro rata distribution dividend only in each swap where the non-bankrupt is winning. There has always been some opinion that in bilateral netting the non-defaulting party would not need to pay the bankrupt party anything upon a close out if the latter were overall in the money. This is because of the notion that nobody should profit from their own default. This is the so-called ‘one-way payment’ or walk-away facility, well accepted in English law in the case of a contingent instead of a vested profit. It may also be contained in a standard clause in a swap. On the other hand, when termination follows for reasons other than default, any benefit may be claimable under the contract by the non-petitioning party in whole or in part, but not by the petitioning party. Thus, under the contract there may be a termination option for parties in the case of new tax or regulatory burdens or in the case of intervening illegality or impossibility, leading to a so-called ‘limited two-way payment’, which can also be incorporated into standard documentation.

Volume 5: Payments, Modern Payment Methods and Systems 361 The full two-way payment happens when payments are made to whoever is in the money (either in each swap or in bilateral netting overall). It is the more normal situation and also the ISDA approach. Walk-away clauses were increasingly criticised and are now commonly deleted from standard documentation. One reason for this is that they may further endanger bilateral netting schemes in bankruptcy. Another similar type of netting of values may be found in repo master agreements (see section 4.2.4 below). See for foreign exchange ECHO, note 562 above. As mentioned above, ipso facto termination combined with a contractual acceleration and aggregation clause in close-out netting as foreseen in the modern swap and repo documentation may not be acceptable under the set-off provisions of all bankruptcy laws. The immediate problem is again that there may not be sufficient capacity left in the bankrupt to support the continuing netting. In the EU, Article 9 of the Settlement Finality Directive 1998), which has an important netting definition putting emphasis on the conversion into one net claim or obligation in Article 2 (k), guards against this risk for payments and investment securities transfer systems. Although modern French and US law, with their reorganisation-oriented insolvency laws, do not or no longer accept any automatic acceleration nor the automatic termination of contracts pending the decision on the continuation of the business: see Article 37 of the French Bankruptcy Act 1985 and section 365 of the US Bankruptcy Code 1978,573 they increasingly started to favour netting in principle, but are likely to (re)allow a temporary stay, which is now also part of the banking resolution system in the EU and led to amendments in 2014 in this respect of the Settlement Finality Directive and also of the Collateral, and Bank Winding-up Directives which had equally favoured netting as we shall see.

3.2.5. The ISDA Swap and Derivatives Master Agreement and the Repo Master. The Notions of Conditionality and ‘Flawed Assets’ as an Alternative to the Set-off. The EU Collateral Directive As already mentioned, to ease the problems with close-out netting, particularly in bankruptcy, the aggregation principle has been pursued through the use of master agreements under which, particularly in swaps, all swap dealings between the same parties, present and future, are deemed integrated into one contract. Once signed between two parties, all their swap dealings are thus meant to be covered by it, and any new swaps are integrated into this system through standard confirmations.574 This integration is certainly the prime objective of the International Swap Dealers Association (ISDA), which produced in this connection in 1987 an industry standard, the ISDA Swap Master

573 As we have seen, it has motivated bankruptcy law amendments in both countries to exempt swap netting, in France under Law No 93-1444 of 31 December 1993 for swaps now covered by Art L 431-7 of its Monetary and Financial Code of 2000, in the US under ss 559 and 560 Bankruptcy Act respectively for repos and for swaps (see also s 3.1 above). In Germany, there is now s 94 of the Insolvency Act 1999. This is unlike the situation in the Netherlands, which (still) has liquidation-oriented insolvency laws. In other countries, the fact that acceleration is possible in bankruptcy may not mean that the other contractual set-off enhancements are also automatically acceptable under applicable bankruptcy law. Thus, in Australia, s 16 of the Payment System and Netting Act 1998 provides a broader exception. 574 There are other important industry standard master agreements like the 2000 TBMA/ISMA (now ICMA and SIFMA) Global Master Repurchase Agreement, see s 4.2.4 below, the Overseas Securities Lenders Agreement, the International Currency Options Market Terms (ICOM), and the International Foreign Exchange Master Agreement (IEFMA).

362 Volume 5: Payments, Modern Payment Methods and Systems Agreement, in the latest version extended to all derivatives (see also section 2.6.7 above),575 accompanied by the ISDA Credit Derivatives Definitions. There were always two masters, the Rate Swap Master for interest rate swaps and the Rate and Currency Swap Master for both interest rate and currency swaps. The former is the more common outside the US and is normally covered by English law (whereas the latter is commonly covered by New York (NY) law) and is usually the one referred to. It was amended in 1989 and 1992 to also cover other derivative products, and became a multi-product master agreement, recast as the Swaps and Derivatives Master Agreement in 2002 to better deal with distressed counterparties and markets following the problems in the Asian markets in the late 1990s. In particular the close-out provisions were reconsidered (see also the discussion at the end of section 3.6.3 above). Force majeure and acts of state affecting payment or compliance with other material provisions were notably not to upset the close-out and its effectiveness, and present a new termination event or event of default.576 There is a basic three-part architecture maintained for the beginning: Form-ScheduleConfirmation. As to Form, since 1992 there is standardised template that covers the terms and conditions applicable to all transactions. The Schedule allows parties to structure their individual transaction and is usually a short statement which also allows for amendment of the basic terms and conditions. The Confirmation allows for all oral transactions to be recorded in writing and prevails in case of conflict over the Form and Schedule. The Confirmation became gradually an electronic facility for most participants and is usually no longer than one page. In 2009, ISDA developed a new Master Confirmation Agreement, also called the Big Bang Protocol, which introduced two further changes. First, it established so-called Determination Committees taking binding decisions on whether a credit event occurred, replacing the prior need for bilateral negotiation. Second it made auction the default option for the price determination of distressed bonds necessary to liquidate CDS contracts. ISDA further arranged greater standardisation for CDS in terms of expiry dates and premiums, the latter being able to force protection sellers or buyers to make up-front payments to compensate for the difference between these premiums and the market price. As already mentioned, the Schedule allows parties a number of different options in the various swap aspects and provides flexibility. Cross-border swaps are also covered. For US counterparties, a special schedule is adopted. The Swaps and Derivatives Master is now often also subject to NY law, although English law may alternatively be made applicable. It does not prevent parties from choosing any other law, but it is not common. However, the impact in bankruptcy remains unavoidably subject to the applicable (domestic) bankruptcy laws. Both Swap Masters are similar in approach and in much of their detail. The more common Swaps and Derivatives Master is of immense importance and lends itself to extension to other products because of its generic nature. It is based on the notions of a) acceleration, b) valuation, and c) aggregation, and in particular attempts to expand the concept of integration to all swaps between the same parties (section 1(c)), although it still makes exceptions: in the case of certain termination events, like a change in tax law, only certain swaps may be affected. Parties may also reserve the right to lift certain swaps out of the totality and either terminate them or transfer them separately, while only specific swaps may be guaranteed by outsiders, such as parent companies, and not the totality. 575 In 1984, ISDA started to concern itself first with the drafting of a Code of Standard Wording, Assumptions, and Provisions for Swaps which parties could incorporate in their contract. It also dealt with valuations especially in the case of early termination and started to define events of default. There was not yet a master agreement structure covering entire transactions, but this was soon borrowed from the British Bankers’ Association, which already had one and required only a one-page confirmation of the deal elements of the transaction. 576 See also PC Harding, Mastering the ISDA Master Agreements 3rd edn (London, 2010).

Volume 5: Payments, Modern Payment Methods and Systems 363 Section 2(c) contains the netting clause proper and refers to one transaction in the same currency. It may be extended to other transactions payable on the same date in the same currency. It is in the nature of a novation netting for interest rate swaps leading to a contract for differences, but it may be broader and also include exchanges of principal, although again in the Schedule specific swaps may be excepted from it. For close-outs, acceleration is provided in Section 6, which includes a reference to a single payment obligation (in Section 6(c)) and also contains a payments clause (in Section 6(e)) leading to the close-out netting with the necessary valuation formulae (see for the calculations also Section 9(h)(ii)). The aim is clear and the approach assumes that a contract with a chosen domestic law can govern an international financial transaction in all its aspects and even aggregate all such transactions between two parties for bankruptcy purposes. In practice, this may prove not to be fully effective, especially as regards aggregation and netting. As mentioned before, the status thereof in bankruptcy may remain unclear or contested as the aim is to claim an enhanced (set-off) right at the expense of other creditors. Nevertheless, established market practices based on the universal acceptance of the principle of set-off itself may increasingly underpin the contractual netting concept internationally, also in its enhancement of the set-off principle, at least outside bankruptcy. It has already been said that in bankruptcy, it often appears that there must still be some innate connexity on which to build, which may be found, however, in the legal interdependence created under the master agreement, at least in as far as all aspects of one swap transaction are concerned—see also the discussion in the previous section. The increasingly customary nature of the ISDA rules, especially of the Swaps and Derivatives Master, may further enhance the status of contractual netting in bankruptcy everywhere as a matter of transnationalisation of the law.577 It is then a question of recognition and proper enforcement, also domestically. The netting facility under repo agreements (GMRA) is similar and discussed in greater detail in section 4.2.4 below. It may in this connection be of some interest to compare swap and repo netting in one particular aspect: the notion of a ‘flawed asset’. This concept has been used to underline the status and characterisation of the ISDA Swap Master as an alternative to set-off, therefore as a facility that is not constrained in bankruptcy by any limitations that may be inherent in an (automatic) bankruptcy set-off (but then also does away with its potential support). Indeed, Section 2(a)(iii) attempts to make it clear that the Swap Master is based on conditionality and not on traditional notions of set-off. Whether it succeeds or can ever succeed in this objective is another matter where mutual payments are concerned. The ‘flawed asset’ theory assumes in this connection that a flawed asset is created, which disappears upon an event of default and is then automatically replaced by the early termination amount. This conditionality works best, however, in respect of a single swap. Following pressures to at least accept a temporary stay in bank resolution situations, ISDA produced in 2014 a Resolution Stay Protocol, replaced in 2015 by the Universal Resolution Stay Protocol. Parties adhering to it accept that they will exercise 577 For banks and other financial institutions that are subject to regulation, one of the regulatory requirements is usually that they maintain certain minimum capital adequacy standards, under which all their outstanding liabilities are weighted and protected by the capital of the institution according to certain formulae, more extensively discussed in Vol 6, ss 2.5ff. In this respect it is of great importance for these institutions that their liabilities may be netted out as it will reduce their capital needs and thereby their cost. Naturally, if in a swap only the outgoing cash flow is counted as a liability without any set-off of a related incoming flow, the need for capital will rise dramatically. Also, if in a swap hedge both positions are counted separately, it will create extra capital cost in terms of credit risk but also market risk. On the other hand, if the whole swap book may be netted, at least for market risk purposes, this will be greatly beneficial. If all swaps may be set off between two parties in a full bilateral netting, the credit risk is still more reduced, which will save further capital.

364 Volume 5: Payments, Modern Payment Methods and Systems their ‘Default Rights’ only to the extent permitted by the applicable special resolution regimes, which they would be unlikely to be able to avoid anyway. The EU Collateral Directive envisages also a special close-out netting facility that must be considered bankruptcy resistant in EU countries (see Volume 4, section 3.2.4). Netting is defined in Article 2 (1)(n) and emphasises acceleration or termination and replacement by a single payment obligation either way. The idea is that financial transactions that are conditional or temporary, such as repos and securities lending, or that move in and out of the money like swaps, futures and options, and maintain collateral requirements to back up the resulting retransfer or payment obligations, are subject to a (statutory) bilateral close-out and netting of all payment and delivery rights and duties in each EU country. Collateral itself is here a broad and undefined concept that may entail investment securities, title transfers, or margin accounts.578 For the Directive, the key is the untrammelled facility to realise any security interest or to appropriate the relevant assets (in the case of a title transfer) or margin, all to the extent these assets are in the possession or control of the non-defaulting party, and net out all delivery and payment obligations in a final close-out upon an event of default. Local bankruptcy laws that impede these facilities or require statutory delays were accordingly made ineffective for these types of financial transactions. However, in a later 2014 amendment, also to the Settlement Finality and Bank Winding-up Directives, in Member State banking resolutions, (temporary) stay provisions may now be (re)introduced and upheld.

3.2.6. International Aspects: The Law Applicable to Set-offs and Contractual Netting under Traditional Private International Law. Jurisdiction Issues In section 3.3 below, we shall deal with a number of international payment arrangements, such as collections and letters of credit, which reduce payment risk internationally. The point here is that special facilities were created to deal with international complications rather than resorting to or relying on more traditional rules of private international law or on balancing concepts in respect of regulatory (foreign exchange and other) restrictions on the movement of payments (money). One may see them as important early examples of financial structuring in which legal risk was reduced. Private international law rules may revive, however, in connection with international bank or money transfers and payments, which was already mentioned briefly in section 3.1 above. As far as set-offs are concerned, especially if seen as a form of payment, there are no specific new facilities created at the transnational level except in terms of international master agreements International regulators favour netting, but have been careful in accepting the netting concept for capital adequacy purposes without further discussion. Originally, they accepted novation netting in respect of a single swap only on the basis of the 1988 Basel Accord but have gradually allowed bilateral close-out netting even of the novation type (see Vol 6, s 2.5.5), provided there results a single obligation between the parties and the financial institution concerned obtains legal opinions confirming that the netting agreement is enforceable under the law (a) of the jurisdiction of the counterparty, (b) its acting branch if situated elsewhere and (c) of the relevant netting agreement. This could mean three legal opinions at some considerable cost. In April 1996 the BIS allowed reinterpretation of the Basel Accord to facilitate multilateral netting, but only for foreign exchange contracts, as is now operated interbank in London for members of ECHO: see n 562 above. Bankruptcy courts are also on the move and may in this respect increasingly accept the practices of the international marketplace, see s 3.2.3 above. This may be supported by local legislators in bankruptcy law amendments, as we have seen especially in the US. 578 The ECJ in Private Equity Insurance Group SIA v Swedbank AS, [2016] c-156/15, narrowed the scope of the Directive somewhat to situations where the collateral is actually provided (and control has passed) before the commencement of the insolvency proceedings.

Volume 5: Payments, Modern Payment Methods and Systems 365 under the ISDA Master Agreements, notably for swaps where netting out across borders and between different currencies is an important issue as we have seen. Indeed, these netting agreements also present important examples of financial structuring meaning to curtail risk, although their legal status transnationally and the issue of the applicable law may remain in doubt. The transnationalisation of the applicable legal regime is here a particularly important issue. Again, with respect to the international flows, transnationalisation on the basis of international practice or custom will have to help out, if only as a matter of efficiency: see section 3.2.9 below. It may be recalled in this connection that when in Europe in the Middle Ages set-off was under similar threat of domestic inroads and curtailment, the automaticity notion was used to overcome some of these problems.579 As we have seen in the previous sections, differences in the approaches to set-off, especially in respect of the limitations, may be found in the nature of the set-off itself. It gave rise to netting agreements, either to widen the set-off, or to avoid it and its limitations altogether. This also raises the issue of the status of these netting agreements internationally. Traditionally, in respect of the set-off if operating internationally (thus when a claim in one country, or arising under the law of such a country, is to be set off against a claim arising in another), conventional private international law or conflicts rules are here invoked. It will become apparent that it is by no means always clear which law should then prevail, while a contractual choice of law to overcome these problems is not automatically effective in bankruptcy nor in any other aspect of set-off and netting not truly at the free disposition of the parties. This may be assumed to be in all aspects where third parties are affected, thus especially where a preferential effect is claimed. In any event, even the chosen law may itself prove defective or inadequate. A contractual set-off choice of law clause presents other problems: can it affect other claims between the parties, therefore those outside the contract, which includes the choice of law provision? In international arbitrations this is now often assumed and in line with the idea that the law of the main claim used in the set-off in this regard also covers the cross-claims between the same parties. If not, the default rule of the applicable private international law may still apply. Another closely connected issue is jurisdiction over the cross-claim or the absence of it.580 The 2010 UNCITRAL Arbitration Rules in Article 21(3) expressly allow counterclaims and set-off to be considered by arbitrators. If the set-off is considered procedural like (mostly) in England (outside bankruptcy) and perhaps in international arbitrations, the jurisdictional issue is also important from that perspective as the lex fori then commonly decides these issues (short of a choice of court provision). In arbitrations where there is no natural lex fori, arbitrators would indeed have to rely on their powers in matters of procedure. 579 See Pichonnaz (n 532) 979ff. 580 It need not be with the court of the main claim, at least under what is now the 2012 EU Regulation (Brussels I), see the ECJ in Case C-23/78 Nicholas Meeth v Glacetal [1978] ECR 2133, 2142 rendered under the earlier Brussels Convention of 1968. At least there is not supposed to be a tacit exclusion of a set-off in those circumstances. Rather, there may be tacit inclusion. In arbitration, it is often considered a matter of interpretation of the arbitration clause, but it is also a matter of efficiency, or of the more basic question why the one party should pay if the other will not or prevaricates. Lord Hoffmann called the attitude quite unreasonable where a party opts for arbitration and uses it to exclude from set-off other claims not subject to the same dispute resolution facility, see Aectra Refining and Manufacturing Inc v Exmar NV [1994] 1 WLR 1634. Connexity might still help, but it seems not to be absolutely necessary, see Case C-111/01 Gantner Electronic GmbH v Basch Exploitatie Maatschappij BV [2003] ECR I-4207. In C-341/93 Danvaern Production A/S v Schuhfabriken Otterbeck GmbH&Co [1995] ECR I-2053, 2075, the ECJ dealt more generally with set-off in ordinary court proceedings under the earlier Convention (Arts 6(3) and 22). Counterclaims were here distinguished as they seek a separate judgment and denote a particular cause of action, while in a set-off the cross-claim is in essence not contested except perhaps as to its maturity and liquidity. It followed that Art 6(3) regarding counterclaims was considered not applicable. The effect of an exclusion of set-off may then also be in doubt: can the exclusion affect claims under other contracts. Again, it may be a matter of interpretation.

366 Volume 5: Payments, Modern Payment Methods and Systems It may be important in this connection to make some distinctions. The set-off may be (a) a remedy to be invoked by the parties outside bankruptcy when they may be able to invoke it either generally upon giving notice (as in Germany and the Netherlands) or only as a defence in litigation (as in England, unless there is connexity or an agreement to that effect). In these countries, the set-off is in essence subject to party autonomy, including the right of the parties to expand the notion in the context of bilateral or even multilateral netting agreements when, as we have seen, the issue arises to what extent parties by common agreement can intrude on the rights of others. There are limits here, although it was shown that modern risk management needs and regulatory support may overcome them as is clear from amendments to modern bankruptcy laws. These issues will also arise in an international arbitration outside bankruptcy, which, although not strictly speaking judicial, will deal with procedural and defence issues and any agreement of the parties in this connection. As we have seen, the alternative is to view the set-off (b) as an ipso facto or automatic facility as in the older French tradition and elsewhere in bankruptcy only where it is imperative, as the set-off might otherwise not be effective because the bankrupt party is no longer in a position to dispose of his assets so that the set-off would be at the mercy of the bankruptcy trustee, and would then as a minimum lose its preferential character. Another (but related) issue here is whether (c) by agreement the ipso facto set-off can still be expanded (or outside bankruptcy) avoided by alternative netting agreements. Are these contractual expansions sustained in bankruptcy? Limitation in this respect, already highlighted before, may arise and differ in: (a) the eligibility of the payment obligations that may be reduced by set-off; (b) the questions of the maturity of both claims; (c) their being liquidated to money; (d) their being in the same currency; and (e) the question of the retroactivity in legal systems that require notification by the party invoking the set-off. Another difference may arise (f) in the set-off possibility of time-barred counterclaims. Most importantly, (g) the applicable bankruptcy law may not be receptive to any expansion of the set-off concept by contractual netting arrangements, when it may matter most, unless special amendment provides for it. Altogether, these differences raise important issues concerning the applicable law. Conflicts rules in matters of set-off have not been the subject of much study. More importantly, there is no consensus and different suggestions have been made. Barring a valid and effective choice of law by the parties, the lex fori approach is a common one and leaves the decision to the law of the country in which the adjudicating court sits. That would be logical at least where the set-off is (largely) considered procedural as in England (unless there is connexity) or arises in bankruptcy even if the debtor and the claimants are outside the bankruptcy jurisdiction. It clearly introduces an objective element, but the set-off may not then appear to be capable of being governed by a contractual choice of law either. Outside bankruptcy, this approach is also understandable in countries where the set-off remains ipso facto as was the French approach and of countries following it. This approach may also be justified by the indirect preferential nature of the set-off. The lex fori approach depending on the law of the country where a court sits has understandably found support in England581 and is (more surprisingly) sometimes also advocated in the Netherlands even outside bankruptcy.582

581 It is to be noted that English law is undecided: see Dicey and Morris on The Conflict of Laws, 15th edn (London, 2012) r 19, 7-039. 582 The lex fori approach finds support in the lower courts in the Netherlands: see Crt Alkmaar, 7 November 1985, NIPR, no 213 (1986) and was perhaps logical when all set-off was ipso facto as was the case in the Netherlands before 1992 (in the French tradition).

Volume 5: Payments, Modern Payment Methods and Systems 367 A cumulative application of the set-off requirements under the laws of both claims to be set off is another option if they are covered by different laws. Again, at least outside bankruptcy, these laws may conceivably be chosen by the parties, which introduces a subjective element and makes the applicable law a lex contractus issue notwithstanding the preferences that result and may affect other creditors adversely. This nevertheless appeared to have been the French approach regardless of its ipso facto attitude,583 but it is sometimes also favoured in the Netherlands,584 and would more particularly recommend itself for netting agreements. It was an approach sometimes believed to be supported by Article 10(1)(d) of the 1980 EU Rome Convention on the Law Applicable to Contractual Obligations, now replaced by Article 12(1) (d) of the EU Regulation of 2008 (Rome I) (see Volume 3, sections 2.3.9 and 2.3.10). It provides that the law applicable to a contract also applies to the various ways of extinguishing obligations. Yet, even though the set-off is often considered a means of payment, therefore a particular means of extinguishing a monetary obligation, it need not necessarily be characterised as a way of extinguishing obligations and could equally be viewed as a surrender of claims or sometimes even as a mere accounting device.585 In a contract for differences, depending on novation netting like the modern swap, it may even be questionable whether the set-off is a method of payment of underlying claims at all. Rather, there is a new financial instrument and merely a contract for differences, as we have seen in section 3.2.3 above, see also the next section. In any event, the special feature of the set-off in terms of the creation of a preference may need to be considered separately, especially its effect on third parties. It has already been said that where set-off is becoming a major risk management tool, its effect may well have to be distinguished from payment. As we have seen, regulatory favour is an important issue here, which may also support party autonomy more broadly, resulting in a much wider set-off facility at the expense of common creditors. Finally, it is not uncommon to see an approach under which a debtor invoking a set-off (therefore a counterclaim) in his defence can only do so under the law of the first claim, therefore the claim against which the set-off is made. This is the German586 and Swiss587 approach, in which the applicable law depends on the party first invoking the set-off (as it is always the law of the other party’s claim). It is now also the approach of the EU Regulation (2012, Rome I, Article 17)).

583 See for the French cumulative approach, H Batiffol and P Lagarde, Droit international privé, 7th edn (Paris, 1983) ii, no 614. There are several variations on this theme in France and it is sometimes believed that the details of the set-off in terms of calculation and the effects depend on the law applicable to each claim: see P Mayer, Droit international privé (Paris, 1983) no 732. See also MA Storme, ‘Set-off in the French Reform of the Law of Obligations: A Tale of Missed Opportunities’ (2016) KU Leuven. 584 See Crt Arnhem, 19 December 1991, NIPR nr 107 (1992). 585 As regards the applicability of Art 10(1)(d) of the Rome Convention, opinion was divided. In Germany, it was applied only if both claims were governed by the same law: see J Kropholler, Internationales Privatrecht (Tübingen, 1994) 426. In the Netherlands, its general applicability to set-off outside bankruptcy was advocated by RIVF Bertrams, ‘Set-off in Private International Law’ in K Boele-Woelki (ed), Comparability and Evaluation, Essays in Honour of Dimitra Kokkini-Iatridou (Dordrecht, 1994) 153. Because of the uncertainties in this regard, a new Art 17 was included in the text of the EU Regulation of 2008 (Rome I) replacing the earlier Rome Convention and opting for the law of the claim against which the set-off was invoked. 586 See BGH, 11 July 1985 [1985] NJW 2897, and earlier 38 BGHZ 254 (1962); see further D Martiny, Münchener Kommentar zum Bürgerlichen Gesetzbuch (1990) EGBGB, s 32, Rn 37. In a bankruptcy, however, the lex fori concursus is preferred: see BGH, 11 July 1985, cited above; see also H Hanish, ‘Report for Germany’ in I Fletcher (ed), Cross-Border Insolvency: National and Comparative Studies (Hamburg, 1992) 111. 587 See Art 148(2) of its Private International Law Act 1987 referring to the law applicable to the claim against which the set-off is invoked as a defence. See also L Pittet, La competence du juge et de l’arbitre en matière de compensation: étude de droit interne et international (Zurich, 2001).

368 Volume 5: Payments, Modern Payment Methods and Systems Since the law so applicable may still be a law chosen by the parties to their contract, there may still be a subjective element, at least in the areas of set-off that are at the free disposition of the parties. Again, it would seem to be problematic to contractualise the issue where third parties who may be adversely affected are concerned. In any event—and it follows—an exception is commonly made for the case of bankruptcy when the applicable bankruptcy law is thought to determine the set-off right. This is then a reversion to the lex fori (concursus) approach but only in the context of insolvency and for its regime only, in which connection it needs to be remembered that bankruptcy is a limited measure geared to a particular set of circumstances, in practice territorially confined (unless there is a recognition treaty law or something similar like a Regulation in the EU), even though the consequences may be large. Again, regulators may support the set-off internationally as a major risk management tool, which is the reason why modern bankruptcy legislation has often been amended to allow for much greater party autonomy here as we have seen, now again being curtailed in bank resolution regimes. One could deduce from this that there are mandatory transnational minimum standards outside, or even inside, bankruptcy. Internationally, there are also jurisdictional issues: are offsetting claims counterclaims, or do they stand alone (a well-known concern under the EU Regulation, Brussels I) and under what law should this be decided?588 International jurisdictional issues arise also when it comes to determining a set-off of or against a claim which arises in another jurisdiction or may have to be handled (at least to the extent contested) in a specialised forum, notably an (international) arbitration. Although there may now be some greater clarity in these matters for the courts in EU Member States, this is not so transnationally and not in international arbitrations either. It should be noted in so far as international arbitrations in these matters are concerned that neither the EU Brussels I nor the Rome I Regulations are applicable.

3.2.7. International Aspects: The Law Applicable to Netting under Transnational Law In swaps in particular, the essence is often a contractual netting arrangement that acquires a distinct character and is likely to be subject to its own (contractual) rules. It was argued that novation netting producing the modern swap as a contract for differences has in fact resulted in a separate financial product altogether.589 It is not then properly a set-off issue. As for these contracts for differences, there is something to be said for the applicability of the law of the place of payment (under the swap) if parties have not chosen another law in their contract. However, it would make the applicable law dependent on whether a party was in the money, which could change from one payment date to another. It may be compatible, however, with the lex fori approach assuming that any litigation will normally take place at the place of the debtor (for the time being) under the swap. Applicability

588 See ECJ cited in n 581 above. 589 In s 3.2.4 above it was noted that especially modern swaps make use of the netting concept and this at three levels: (a) the level of the exchange of cash flows where there is in essence a contract for differences with settlement on agreed dates during the swap period; (b) the level of all related transactions in one swap including, as the case may be, any exchanges of underlying assets out of which the cash flows arise; (c) at the level of the close-out netting, when all swaps between two parties are netted out through bilateral netting (there could at this stage even be multilateral netting). It is quite conceivable that the law applicable to netting is different in each instance.

Volume 5: Payments, Modern Payment Methods and Systems 369 of the law of the claim against which a counterclaim is being set off as a defence (as is now also the approach for netting under Article 17 of the EU Regulation (Rome I)) is here in any event beside the point, as the netting is the essence of the contract, must in bankruptcy take place ipso facto, and is not meant to be used as a defence or to create a preference. In fact, in individual cases, there is here no settlement or payment of underlying claims at all and no set-off proper either. This makes it more likely that even in a bankruptcy of one of the parties this type of swap will be considered a purely contractual matter. If there is no new financial instrument intended (like a contract for differences) but merely the integration of all aspects of one swap transaction and the netting out of all payments thereunder in a bilateral manner, the situation may be quite different. There are likely to be attempts at integration, conditionality, and novation netting. The netting is still a matter of contract law (but not necessarily the preferential result) in which connection it would be unlikely, however, that if the parties had not chosen the applicable law in respect of this type of netting, the law applicable to each particular aspect of the transaction could still prevail. Again, the applicable law overall could be that of the place of the net payment, but it could also be the lex fori. This is particularly understandable in a default or bankruptcy situation, where the lex fori concursus is likely to prevail in the first instance, more so when a full bilateral close-out netting follows, which is in any event usually structured as an ipso facto set-off of all claims between the two parties. The question of characterisation in terms of settlement or novation netting and the status of the latter in such a bankruptcy would then also be matters for the lex fori concursus. Whether, in a full multilateral netting in the context of clearing systems this would be different is yet another issue. The law applicable to the system would in such cases be another possibility and might be attractive as the system could not then be disturbed by different bankruptcy laws that may impinge on one of the members. But again, there is hardly any reliable guidance or sufficient legal stability or certainty. Yet at least in bilateral close-out netting, the lex fori (concursus) is not unlikely to apply (when there is a bankruptcy situation) regardless of what parties may have agreed in their contract or (swap) documentation, as preferences are intended to be created at the expense of other creditors, the acceptability or efficiency of which would appear to be determinable only under more objective standards and is not at the mere discretion of the contracting parties. In any event, the law of the main claim could not possibly function as controlling, as there are many claims, and the whole objective is to arrive at one amount, regardless of which party goes bankrupt or invokes the set-off. Transnationalisation of the applicable legal regime as a matter of market custom and practice might then be the only rational solution. It should be noted that in this respect the ISDA Swap Master Agreements may well have acquired their own transnational status, superseding in reality the domestic law declared applicable by the parties (usually English or New York law) or any domestic mandatory law resulting under conflict of laws rules, at least in bankruptcies. They are intimately connected with the operation of the international marketplace. It has already been said that the result—the preferential status of any resulting set-off—is not merely a contractual matter and may then depend more directly on transnational custom and practice or general principle. The true issue is how far that also obtains in bankruptcy situations where the lex fori concursus may be considered ultimately still to control the effect of the netting agreement. But even the applicable domestic bankruptcy laws may increasingly have to accept the ISDA netting arrangements as an expression of the international market custom and practice in the context of the hierarchy of norms of the modern lex mercatoria (see Volume 1, section 3.2.5). It is then a question of recognition and enforcement of transnational law only and would concern mandatory practice or customary law, thus being binding also on local bankruptcy courts. It is supported by important

370 Volume 5: Payments, Modern Payment Methods and Systems Australian case law,590 and a current trend in favour of globalisation: if a country wants the benefits, it must understand that the occasional disadvantages must also be accepted and that its own legal order no longer stands alone. It was also said that regulators increasingly took a similar position and favour the set-off internationally as a risk management tool rather than a form of payment. There are minimum transnational standards developing here. Domestically this is reflected in accommodating amendments in respect of netting clauses to bankruptcy acts. Even so, how these newer instruments and attitude are translated and incorporated in domestic bankruptcy laws remains a practical but not then a fundamental issue It was noted in this connection that the BIS became involved early while allowing netting in banks for capital adequacy purposes (see Volume 6, section 2.5.5). It allows bilateral swap netting if the country of the residence of the counterparty (or of its place of incorporation) and of the branch through which the bank acted, as well as the law applicable to the swap, accept the close-out netting principle. Legal opinions have to be produced to the effect, and the continuing dependence on national laws should be noted. As yet, formally, there is here not yet a transnationalised concept at work, but the direction is clear. The transfer of swaps as contracts for differences may then also increasingly follow their own distinct pattern and transnationalised market practices. Technically, it requires the consent of the other party to the swap and may well result in a novation, the concept and manner of which could then also be transnationalised. These complications are the reason why swaps are usually not transferred but rather hedged or unwound. If there is nevertheless a transfer, the law selected by the original swap parties591 is usually believed to be able to cover the novation in all its aspects (again if it is not assumed that distinct transnational practices prevail here as well). It is logical as termination of the old agreement (or an amendment short of a novation) would also be covered by such chosen law and any new agreement would be subject to the parties’ choice also, at least in the aspects at the free disposition of the parties. In EU countries, in the private international law approach, the 2008 Regulation on the Law Applicable to Contractual Obligations (replacing the 1980 Rome Convention) determines the applicable law in the contractual aspects of the swap transfer (for the netting aspect there is now Article 17, as already mentioned). It is either the law chosen by the parties or otherwise the law with the closest connection, which is that of the party that must perform the most characteristic obligation, unless otherwise stated. In a swap, it is not easy to determine, however, which party in an exchange of cash flows performs the most characteristic obligation. There is something to be said for the law of the party that must pay, but it has already been said that under a swap this party is likely to change at different payment dates. It is interesting though that the regulation admits that if the law is standardised in official markets, it is the law of that marketplace that is likely to apply: see Article 4(1)(h). That would suggest room for transnational customary law. Whatever the applicable law, according to Article 12 of the Regulation, the contract covers the interpretation, the performance, the consequences of breach, including the assessment of damages, the various ways of extinguishing obligations and the consequences of nullity. Although, as already mentioned, probably no longer relevant for the set-off, it may remain so for swap transfers. It appears that the Regulation does not cover questions concerning proper capacity (although it may cover the consequences of the lack thereof) and any proprietary matters such as the tracing of proceeds, exchange of underlying assets, etc if that became necessary as part of a swap transfer, even if itself only considered a novation.

590 See n 565 above. 591 See in the Netherlands, HR, 19 May 1989 [1990] NJ 745.

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3.2.8. Domestic and International Regulatory Aspects of Netting As we have seen, domestically, the proper operation of the payment system is a major regulatory concern, and usually greatly preoccupies central banks and banking regulators. Clearing and settlement of payment instructions are then also likely to solicit regulatory interest. That may also generate interest in settlement and novation netting facilities. From a broader regulatory perspective, the limitation of risk through set-off and netting is indeed an important issue as we have seen also. It is no longer merely a method of payment under the relevant applicable law but becomes an important risk management tool. Netting gave rise at an early stage to particular regulatory interest in connection with the amendment of the Basel I Accord concerning capital adequacy requirements: see further Volume 6, section 2.5.5. As mentioned above, netting in clearing and settlement systems is fully recognised in both the EU Collateral and Settlement Finality Directives, the latter also guarding against undesirable interruptions because of an intervening bankruptcy of any of the participants in the clearing and settlement process. Naturally, there may also be money laundering concerns and the use of the banking system and bank transfers to that end (see section 3.4 below). The true issue here is whether transnational minimum standards are developing and how they are going to be enforced and support the set-off and netting facilities, especially in their risk management function. Again, this is no longer a pure issue of party autonomy, which in any event could never fully regulate the relationship with third parties which are affected by the set-off. It becomes a matter of financial stability. In the EU, the Collateral Directive was here a particular and important policy example supporting a transnationalising underlying risk management trend.

3.2.9. Newer International Attitudes and Approaches to Set-off and Netting Especially in Insolvency It may finally be of use to summarise here newer attitudes that internationally have been formulated in respect of the netting concept and its status transnationally. Netting as a financial risk management tool may have first been identified as such by the BIS in 1990, in its Lamfalussy Report, which noted that, although netting could reduce the size of credit risk and liquidity exposure and thus contribute to the containment of systemic risk, it would depend on the legal soundness of the netting arrangements. As mentioned in the previous section, this concern was reflected in the 1996 amendment to the Basel I Accord concerned with capital adequacy, see Volume 6, section 2.5.5 which particularly covered the netting of all swap and repo positions592 between the same banks.593 The condition was that the country of residence of the counterparty (or its place of incorporation) and of the branch through which the bank acted, as well as the law applicable to the swap or repo, must accept the netting concept. As a consequence, it was still left to each country effectively to incorporate or clarify the notion of netting in its own legal system,

592 This became a major challenge as it could not always be obtained by contractually extending the netting concept of the law of the residence of the counterparty: see eg M Affentranger and U Schenker, ‘Swiss Law Puts Master Agreement in Question’ [1995] International Financial Law Review 35. Statutory amendments became therefore necessary in various countries. 593 In April 1996, the BIS released a further paper on ‘Interpretation of the Capital Accord for Multilateral Netting of Forward Value Exchange Transactions’, which facilitated this type of netting also for foreign exchange transactions.

372 Volume 5: Payments, Modern Payment Methods and Systems particularly also in bankruptcy. In the EU, this capital adequacy aspect required amendment of the relevant Directives, subsequently incorporated into the national laws of each Member State and the approach remained therefore entirely in the domestic law tradition.594 One question might then be how international concern and interest in the concept has contributed to its transnationalisation.595 In international reports, a considerable measure of party autonomy is now often suggested but ultimately finds its limits in national bankruptcy laws, which limits need then be explored and concern priority and public policy, in particular the effect on third parties, especially common creditors. In the EU the principle of party autonomy was firmly accepted in 2002 in the Collateral Directive (Article 7 which refers to ‘in accordance with its terms’) and no less so in its Settlement Finality Directive as we have seen, but it may also be found in Principle 6(1) of the 2013 UNIDROIT Principles on the Operation of Close-Out Netting Provisions. Here the specific idea was that implementing states should not impair the operation of close out netting by imposing national restrictions before or after bankruptcy. Reference may also be made to the 2004 UNCITRAL Legislative Guide on Insolvency Law, which covers both monetary and non-monetary obligations and in that context also contains valuation clauses (in paragraph 12 (aa) it refers to different types of netting), using set-off language emphasising and putting emphasis on the termination of all outstanding transactions, and the ISDA Model Netting Act, which both provide further guidance for national legislators. The Financial Stability Board,596 IMF597 and World Bank598 have also been active in this area. It still leaves the question of the applicable law which is then often also considered a matter of parties’ choice even though their freedom to do so must be considered limited in priority and public policy or regulatory matters. In particular the lex concursus cannot be avoided in this manner, although transnationalisation may give party autonomy a stronger status also domestically. It becomes a question of recognition and subsequently enforcement of the transnational practice embodied especially in customary law and general principle of the modern lex mercatoria. But even if transnational law is here in principle ever more intruding, might it still be different in reorganisation and liquidation proceedings, particularly in matters of a stay of all enforcement measures pending banking resolution? The EU 2014 Banking Recovery and Resolution Directive (BRRD) and Regulation /2014/806/2014, the latter covering particularly banking resolution in the eurozone (the Single Resolution Mechanism), now empower resolution authorities to impose a (limited) stay of close out netting, which has also led to an amendment of the EU Collateral Directive (as well as its Settlement Finality and Bank Winding-up Directives) and constitute one example of a regulatory limit on the operation of party autonomy in these matters, at least in the EU.599 In the US, the Bankruptcy Code in the amendments of 2005 favoured close out netting but made it is still subject to stay provisions. 594 In the meantime, ISDA reported that more than 70 countries have now adjusted their local bankruptcy laws, see . 595 See also Muscat (n 525), 61ff. 596 Particularly in its support for a temporary stay of close out netting in its 2011 Key Attributes, Section 4, 10. 597 See n 570 above. 598 See n 569 above. 599 The older Banks Winding Up Directive of 2001, amended by the BRRD (Art 117) in 2014, also to cover collective investment undertakings and investment firms, might also be mentioned. The Directive accepted the home state bankruptcy principle which according to Art 10 (2)(c) also covers the set-off but by way of exception allows in Art 23 creditors to demand a set-off under the laws applicable to the bankrupt institution’s claim if it allows it, see also M Virgos and F Garcimartins, ‘Close-out Netting, Insolvency and Resolution of Financial Institutions in the EU. A Conflict of Laws Analysis’, in B Santen and D van Offeren (eds), Perspectives on International Insolvency Laws: A Tribute to Bob Wessels (Alphen aan den Rijn, 2014).

Volume 5: Payments, Modern Payment Methods and Systems 373 Modern scholarship favours the lex mercatoria but still has difficulty in accepting its autonomous status and often still makes it dependent on prior local incorporation in terms of acceptance, enforcement and the fitting in process in local bankruptcies so that its status is no more than guidance (or soft law) and there is hardly a notion of its sources and their hierarchy and of the role of mandatory international minimum standards. Transnational law does not then have an autonomous status and does not speak for itself. All the same, in terms of more general principle, netting is increasingly seen as a stand-alone facility, separate from the set-off, which seems to suggest that indeed party autonomy can be used to create preferences at will, not even hindered by the rule against preferential transfers but technically it still depends on it being considered a legal act even in bankruptcy, nevertheless capable of enhancement, which, however, commonly still needs statutory backing to benefit from ipso facto and retroactive status even if careful drafting can be helpful in terms of integration, conditionality, acceleration, and retroactivity. Differences between common and civil law may here be less important; it has been noted that competitive issues between legal systems, notably in France and England, may play a more significant policy role. Common creditor protection is waning as a principle, efficiency considerations take over but, in banking resolution, now also more particular countervailing policy concerns connected with the continuing stability of the financial system.600

3.2.10. Concluding Remarks As for the notion of payment through set-off, the facility of netting as an elaboration of the set-off (originally as a way of payment) has great relevance particularly in the netting out and closing of swap and repo relationships in the event of default. It is also important when settling transactions with CCPs in regular derivatives markets, as we have seen in section 2.6.5 above. Domestic law remains erratic. That is due to historical accident and modern policy imperatives. Although the concept of set-off is known everywhere and generally supported even in bankruptcy, in the details it proves difficult to distil general principle and in terms of the modern lex mercatoria, it is necessary to think along new lines in which connection the EU Collateral Directive particularly showed some of the way. The UNIDROIT Principles of International Commercial Contracts in its chapter 8 cover set-off in some of its aspects, as do the European Contract Principles (PECL) in its chapter 13, and the DCFR in its chapter III: 6.1. They do not of course deal with jurisdictional and choice of law questions and are so far no more than models. Some general principle might be detected here, but more important is to recognise the role of industry practices and custom, particularly in respect of the status and effect of the swap and repo master agreements transnationally (that is, the ISDA and ICMA/SIFMA Master Agreements) and their promotion (or not) by public policy. They are key documents. Indeed, it is risk management in the international marketplace that is truly the issue. This requires transparency and finality cross-border and therefore a more truly transnational legal framework to diminish legal risk and transaction costs in the international marketplace. It was already said that the facility becomes connected with financial stability but whilst doing do it may lose its autonomous character and becomes incorporated in policy that may support or modify it. To resume in this context the discussion on the modern lex mercatoria as perceived in this book, it is fundamental principle, custom and practices, treaty or similar law where available if widely ratified, general principle, and party autonomy that determine the legal environment in the international flows including the possibility to set off and netting claims in that environment. 600 Muscat (n 525), 322.

374 Volume 5: Payments, Modern Payment Methods and Systems Local law may remain the residual rule but is then elevated to the level of transnational law also and is adjusted and fulfils its role in that context. Transnational minimum standards may correct, so may domestic standards, but only in respect of demonstrable conduct and effect in state territories. That is policy. Local bankruptcy laws remain here particularly relevant in the absence of an international enforcement agency and may adapt, as is clear especially with regard to the netting principle, but case law may further elaborate as the Australian Ansett case has shown.601 It was said before that the progression of globalisation requires it for those who claim its benefits, the concept of set-off being a fundamental concept and infra structure element of any marketplace as basic legal risk management tool, and needs to throw off domestic shackles of the set-off to be transnationally effective as it did earlier after the Middle Ages, again not least to operate as an effective and sufficiently stable risk management tool in the international financial flows. It was also noted that increasingly, international arbitrators may have to deal with these matters. Where the issue is considered mainly procedural, they have great powers. When deemed substantive, it may no longer be much different, since it is now generally accepted that international arbitrators may also apply the modern lex mercatoria in that case provided it is properly pleaded but still subject to any choice of a domestic law by the parties which, however, needs to then be explained in the above manner: all mandatory rules in terms of transnational principles and customs will prevail over it and its residual function elevates it to transnational law after adjustment for any domestic law and shedding any particularities for it to make sense in the international order. Where party autonomy cannot reach, it is irrelevant also in the choice of a domestic law, therefore especially while affecting third parties, bankruptcy being a notable feature of this situation even if it remains largely territorial (short of treaty or similar law, even within the EU). Again, the applicable law bears a close relationship to the powers of international arbitrators, but any ensuing arbitral award may still be affected in recognising countries, especially on the basis of the local bankruptcy order and its preservation being considered a matter of public order, although one may still ask whether bankruptcy judges are here the proper judges under the New York Convention—it depends on local incorporation laws. In any event, we have seen progression and in a globalising world domestic public policy may be less of a bar (also in bankruptcy) than it was once believed to be.

3.3. Traditional Forms of International Payment 3.3.1. Cross-border Payments and their Risks In the previous section modern payment systems were considered, especially those of banks domestically—although they may result in international payments through internationally connected payment systems, as we have seen in section 3.1.7 above. It remains important, however, to consider also the more traditional ways in which payment was made and especially how these payments were made safer in international transactions, many of which, especially the letters of credit, remain relevant. Guarantees of payment other than through letters of credit should then also be considered. On the other hand, bills of exchange, which were also used in this connection, are not now as important as they used to be. In all cases

601 See n 565 above.

Volume 5: Payments, Modern Payment Methods and Systems 375 the status and effect of these instruments operating as international practice or custom within transnational law or the new lex mercatoria also need to be considered. The more technical aspects are to some extent a distraction in this book, which is more interested in newer concepts, but we are concerned with important facilities of long-standing usage, which is a part of the older law merchant, and still retains relevance. They also provide examples of the force of the international marketplace in the autonomous creation of risk-protection devices. Their background is that in international trade, payment and payment protections always had a special significance because there were greater payment risks, primarily the risk of the far-away debtor not being able or willing to pay. This credit (or counterparty) risk is inherent in all transactions but internationally it is greater as the creditworthiness of the counterparty and its willingness or continuing ability to pay may be much more difficult to gauge and pursue. The supplier of goods or services to an international buyer will on the whole be in a poorer position than s/he would be if dealing with a local buyer in remaining informed until the payment day. A special aspect of this counterparty risk is the foreign debtor refusing to accept the goods or documents themselves for reasons which may not be easy to ascertain, but which, whatever the excuse, may often have to do with the goods no longer being needed or the buyer having spotted a better deal somewhere else. It naturally leads also to a refusal to make the necessary payments. Another risk is in disputes, real or contrived, concerning the quality of the goods upon arrival, which could hold up the payment indefinitely. In this connection, the need for transportation unavoidably implies special risks in terms of safe arrival and (deteriorating) quality of the goods, often referred to as quality or manufacturing risk, but may also be viewed as another form of credit or counterparty risk where the foreign buyer proves unusually quarrelsome and is intent on price reductions or likes to take advantage of a more complicated situation than would follow purely locally. The fact that, short of a contractual forum selection clause, litigation would most likely have to be conducted in the foreign country is in itself, of course, of some help to the debtor, if only because of the practical difficulty that the creditor may encounter in terms of cost and communication. When payments are made in the country of the buyer, either in the own currency or in any other, there are, if there is a restricted foreign exchange regime (for example, as there still is in China), also the questions of free convertibility and transferability of the currency. They may present great risks to the seller to be discussed in section 3.3.3 below. A seller may thus also need some safeguards against depreciating values but more so in terms of proper transfers into convertible and transferable currency. To guard against depreciation, the seller may use a different unit of account in the contract (see section 3.3.2 below) or may otherwise organise some currency hedge in its own country but it is likely to be costly. To guard against risk to the convertibility and transferability of the payment proceeds, the seller may in particular demand a letter of credit with payment in its own country, as we shall see. This is also likely to be costly, and for its effectiveness the debtor who opens these letters may still require prior authorisation by its own authorities. There are other risks inherent in international trade, such as the country risk and political risk. They may be closely related to the convertibility and transferability risks. Country risk has to do with the country of the debtor no longer being able to provide the necessary foreign exchange when the price is expressed in other than the local currency, even though it was originally promised. It may also be in such disarray as no longer to be organised to supply the necessary currency in time for the debtor to make international payments, even though the debtor may be perfectly willing to do so and is in a position to provide the necessary local currency to buy the foreign exchange at prevailing rates. Political risk is narrower and arises, for example, where a country no longer allows the free convertibility and transferability of the agreed price as a matter of policy

376 Volume 5: Payments, Modern Payment Methods and Systems or interferes in the transaction in other ways through legal action. It may also affect any intermediary bank in the country concerned, when used in the payment process, for example under a collection or letter of credit, although such a bank may have a special position and more leverage than its clients or greater set-off possibilities allowing it still to arrange the necessary payments to the foreign seller (at a price). There are also related risks, for example possible delays in local settlement (and authorisation) practices, often referred to as settlement risk, but connected with country risk when any promised convertibility and transferability of the payment proceeds are not forthcoming (see for these various risks Volume 3, section 2.1.2).

3.3.2. Paper Currencies, Modern Currency Election and Gold Clauses Before going any further, it is clear that for international transactions there is the important issue of different currencies and payments in them. This became especially relevant when money lost its intrinsic value after the abandonment of the gold standard by most countries in the 1930s, when pure paper currencies were introduced. This meant that the promise a central bank now makes is no longer to provide gold for paper, but only to replace paper for paper (known as ‘fiat’ currency). Henceforth it became easy politically to adjust the value of the currency, which could practically also evaporate (through inflation). Modern paper (or in many cases ‘polymer’) money has no more than a statutory value base and thereby acquired the form of a national currency without any objective value. It could be devalued against other currencies at will or otherwise be allowed to float against other currencies, which is now the more normal situation, at least for currencies that operate freely internationally, but it makes payment in foreign currency more speculative as far as value is concerned. In the modern system of paper money, money thus lost its intrinsic value, and as a consequence also its transnational status. It is only accepted in payment because of a mandatory statutory requirement that at least in the country of the currency it should be so. There is no good reason why it should be accepted as such anywhere else, except where parties have expressly agreed to it. Indeed, exchange rates may change dramatically from day to day. Especially where there are large differences between incoming and outgoing payments in the country of the particular currency as a consequence of trade imbalances leading to serious payment in- and outflows (not compensated for by capital out- or inflows), the value of the currency may fluctuate considerably in the international markets. If these imbalances become structural, as they are in many developing countries, and as they were even in many developed countries after World War II, a restrictive foreign exchange regime—therefore a regime that does not allow for the free convertibility and transferability of its own currency by its own citizens (as payors)—often is the sequel of such artificial or paper currencies. It thus poses the additional problems of free convertibility and transferability, particularly important in international sales in respect of the sales proceeds, but similar problems attach to payments for services, for example, or in respect of accrued interest on borrowings. Paper money thus becomes soft currency. The currency of the payor may even become internationally valueless as it may no longer be convertible and transferable. If in such situations foreign (stronger) currency was agreed as the unit of payment (commonly the US dollar), it might not automatically be available to a payor who, under its own laws, may not then be able or allowed to obtain such foreign exchange freely in the foreign exchange market or from its own central bank in exchange for its own currency.

Volume 5: Payments, Modern Payment Methods and Systems 377 Such a restrictive foreign exchange regime preventing a free outflow of currency or of foreign currency reserves may at the same time reduce imports (which in such situations may also become subject to prior official approvals, tariffs, or a quota system). In most of the developed world, these foreign exchange limitations and import restrictions are now gone. That is so for foreign exchange at least between all EU Members (since 1988), and also now between the EU, the US and Japan, although there may still be some trade barriers, even between these major economic powers (but substantially no longer within the EU). However, they have been or are gradually dismantled in the GATT/GATS/WTO (see also Volume 6, section 2.2). Regional trade blocs like the Transatlantic Trade and Investment Partnership (TTIP) between the US and Europe may follow. Naturally, in a system of artificial currencies, there is a much greater importance attached to the currency chosen by the parties for payment and there also results a more fundamental distinction between the currency of account and the currency of payment if they are not the same. Clearly in international sales to preserve value in this system, (a) currency election clauses may become desirable under which the parties choose a strong currency for payment. As we have just seen, in a restrictive foreign exchange regime of the payor, such clauses may not be effective as the payor may not be able to obtain the necessary foreign currency on the due date and its laws may not enforce these clauses. In that case, (b) foreign parties may agree instead at least a specific strong currency of account (a more stable currency therefore, usually the US dollar), different from the currency of payment, which will be the weaker currency of the payor, the only one that may effectively be used for payment. Payment would then be made in whatever number of units of the weaker currency of payment it would take on the date of payment to correspond to the amount stated in the currency of account and the exchange rate would be determined by the foreign exchange market on the payment day. The result is that the payee still ends up with non-convertible and non-transferable currency in the country of the payor, but at least s/he will have more of it and will have avoided the devaluation risk so far. In international contracts, which are contracts between parties from different countries under which goods and services (normally) move, such clauses became quite common. In this connection, a gold clause might also be used, at least as a unit of account. Such clauses, if forbidden for local transactions, were often upheld for international contracts, even if governed by that same local law. At least that was the situation in France after it left the gold standard in the 1930s.602 Currency election or gold clauses thus became frequent in international contracts before and after World War II, and proved more palatable if such an election was only made in respect of the unit of account. In domestic contracts it remained exceptional. Some believed that such (domestic) foreign currency contracts had to be recharacterized, and in fact, became in the case of a sale an exchange of two types of goods, therefore a barter rather than a sale against payment, even though the difference was not very great in all legal systems. The risk of ending up with substantial balances in local currencies in the country of the payor, which could not be exported or converted without approval of the country of the payor, remained, however, undesirable for parties which had no substantial payment requirements in that country. Hence prior agreement for such conversion and transfer was normally sought from the relevant authorities in the payor country. Even if letters of credit (see sections 3.3.8ff below) under which foreign payments would

602 This was the gist of the French gold clause cases: see also GR Delaume, Transnational Contracts. Applicable Law and Settlement of Disputes (New York, 1989) 119. In France it led to the development of the theory of the ‘international contract’, which in that country also became important in the attitude towards arbitration clauses.

378 Volume 5: Payments, Modern Payment Methods and Systems be made (in the country of the seller/payee) were issued, the buyer/payor would normally require its government or central bank approval before they were arranged.

3.3.3. Freely Convertible and Transferable Currency It follows that in international transactions, a principal concern of the payee in a system of artificial currencies is that the currency of ultimate payment, whatever it is and however it is calculated (where there is a difference between the currency of account and the currency of payment), is fully convertible and freely transferable. ‘Convertibility’ means in this connection that the authorities in the country of payment will allow the conversion of the proceeds into a different currency if required. But the payee needs also to be certain that the proceeds (even if freely convertible) may be transferred to wherever s/he directs them (normally his own country). That is ‘transferability’. Convertibility and transferability usually go together, but need not. Thus, if the currency of payment is not that of the debtor, the creditor will not only be concerned that the necessary currency is available to the payor on the date of payment, but also that there is free transferability to the place of the creditor or to any other s/he may indicate, assuming that the agreed currency is in principle available and as hard currency is also convertible. Otherwise, the money, even if convertible in principle, might still have to be held in blocked accounts, or could itself come from blocked accounts, and as such remain embargoed, subject therefore to investment restrictions and the restrictions in the use of these moneys in further payments (by the creditor). So, even the transferability of harder convertible currency may still be curtailed by some countries, mostly in respect of residents but sometimes even in respect of foreign holders of such currency. Where there are restrictions in respect of both convertibility and transferability, different procedures and approvals may apply to lift them. The reader may notice that the author grew up in an era when these issues were still very dominant. However, it has already been said that in practice the question of convertibility and transferability has lost a great deal of importance with the freeing up of currencies and their movement in the last several decades. Euros, pounds sterling, US, Canadian, Australian and New Zealand dollars, as well as the yen, are now all freely convertible and transferable (although one can never be absolutely sure that this will continue, especially important for long-term agreements). Many other currencies have followed suit but that is not to say that this is now the general condition, yet crypto currencies may in the future provide another escape route. They are not real money either but are at least free from political manipulation assuming that states will allow its citizens and companies to operate in it. This can by no means be assumed, but such payments might be conducted through off-shore related companies. Whether this may or may not be desirable is a matter of opinion, but it is clear that it is another indication that states are not all powerful in a globalising environment and cannot remain indifferent to it except if one wants to become a Northern Korea. As already mentioned at the end of the previous section, the dangers to convertibility, and especially transferability, were traditionally alleviated through the use of confirmed letters of credit payable in freely convertible and transferable currency (often US dollars) in the country of the seller (see, for the details, sections 3.3.8ff below). Confirming banks in that country would often assume the currency (convertibility and transferability) risks, which they might be able to handle better than their clients (sellers), if only through informal clearing and set-off facilities, frequently in the context of special arrangements with their own central banks as currency regulators or otherwise only with their approval from case to case. Central banks would then remain in overall or specific control.

Volume 5: Payments, Modern Payment Methods and Systems 379 By choosing a country of payment that does not restrict access to convertible currency and does not limit its transfer, parties may aim at a similar form of protection. However, if the country of the payor subsequently imposed mandatory restrictions disallowing the payor from making the relevant payments elsewhere, there would obviously still be a problem, especially if the payor did not have the relevant currency available in the agreed country of payment and was dependent on its own central bank to allow the transfer of adequate funds. Even if the payor had these funds available in the foreign place of payment, the limitations of its home country in this regard could still affect it or be used by the payor as an excuse against payment in the agreed currency. Whether this would allow a plea of force majeure would generally depend on the foreseeability of the political intervention and the risk distribution language in the agreement. In that case, the courts in the agreed country of payment (assuming they had jurisdiction, to be determined, for example, pursuant to an attachment of the relevant funds by the payee) would also have to consider the extraterritorial effect of these restrictions. Article 9 of the 2008 EU Regulation on the Law Applicable to Contractual Obligations (Rome I) gives the courts in the EU discretion depending on the closeness of the connection of the payment with the country of the payor and the effects of the application or disapplication of the relevant mandatory rules. There is here a balancing of interests and a determination of which policy must prevail (see also Volume 1, section 2.2.6). In this connection, the International Monetary Fund (IMF) rules were also important, and still are in countries that have not made their currencies fully convertible and transferable. Under the Bretton Woods Agreements of 1944, which set up the IMF, there is a distinction between current payments and capital transfers. The IMF rules are concerned with payments in this connection (Article XXX-d of the IMF Articles of Agreement). For current payments in respect of the delivery of goods and the rendering of services cross-border, governmental payment limitations are in principle forbidden (Article VIII-2-a) except for those members that claim an exception under the transitory arrangements of Article XIV. The number of these so-called Article XIV countries has steadily declined and accordingly the number of Article VIII countries has increased. Convertibility in this context means the right of the (foreign) seller when paid in the currency of the buyer to use the proceeds freely in settlement of current payment obligations in that currency, or to demand conversion into its own currency (through intervention of their own central bank with the central bank of the currency concerned). The free convertibility for payment purposes in this manner does not mean that there may not be supervision, if only to guard against disguised capital transfers in countries still limiting them or against the possession and circulation of foreign currency. There is a way of challenging these limitations on their legality before the relevant national courts pursuant to Article VIII-2-b, since the IMF rules in this area are directly effective (or self-executing) in Member States. Before the full liberalisation of the foreign exchange regime in the EU, the EU had a fartherreaching foreign exchange regime operating between its Members as a consequence of its freedom of movement of goods, services, payments and capital. It was effectively superseded (especially as to capital movements and payments) by a 1988 Directive, which since 1990 has eliminated virtually all foreign exchange restrictions (in respect of both capital transfers and payments), also in respect of non-member countries: see more particularly Volume 6, section 2.4. Full liberalisation occurred after a period in which, on the basis of the directly effective Article 106(1) of the original founding Treaty (of Rome of 1958), only current payments were considered liberalised and merely as a sequel to the ongoing liberalisation in the movement of persons, goods, services and capital. Even then, it was only achieved in the currency of the Member State in which the creditor or beneficiary resided. Agreed payments in the currency of the debtor were therefore not necessarily free. Capital transfers were not liberalised at all as the relevant Article 67 of the

380 Volume 5: Payments, Modern Payment Methods and Systems Treaty (concerning the freedom of capital movements) was not considered directly effective in this respect without further implementing legislation. The 1988 Directive was by its very nature directly applicable to all Member States, and covered all movements of money, whether for capital transfers or current transactions, all at the prevailing exchange rate for the latter. It ruled out two-tier foreign exchange markets in the process. Between those EU countries that accepted the euro, this type of foreign exchange risk has completely disappeared.

3.3.4. The Effects of a Currency Collapse. Redenomination of Payment Obligations The legal effects of a currency collapse need also be considered. This became of interest when in the mind of some the euro was on the brink in 2011 (now known as the ‘European Sovereign Debt Crisis’). The situation was much exaggerated by journalistic pundits; in the event nothing happened, either then or in 2012 or much thereafter. It was hoped by some outsiders, especially in the UK, that the default of Greece would lead to the end of the euro (as if the dollar would be finished in the case of a default by California). Conversely, it is arguable that countries with weaker economies leaving the euro, rather than claiming long-term support from the ECB, may actually strengthen the euro. The idea that one country leaving is a disaster and breaks up the euro, was always spurious: these issues are not directly related. Barring a collapse of the world economic order, the euro is only likely to disintegrate if a large Member State such as Germany, France, Italy or Spain decided that it was no longer worth continuing with the euro project. This can be judged mainly in the longer term. Even Germany could leave of its own accord upon an attempt by the ECB or others to debase the euro, but we are also still far removed from that situation, never mind the precipitous fall of the euro in 2015 following quantitative easing by the ECB. Moreover, the entire Brexit ordeal has served as a warning to any EU Member States (in particular to those that have adopted the euro as their official currency) that were previously having thoughts about leaving the EU that the process will be a long and turbulent one. The Euro may still have structural defects, but its collapse is nowhere in sight. Overall, the euro has remained steady in the international markets during the whole period of its ‘travails’. By the end of 2015, in dollar terms, it was hardly lower than when it was first introduced. Even in the popular perception in Greece, the euro was here to stay. People liked it representing greater value if not the discipline that went with it. Or to put it differently: people liked the low interest rates and stability, but governments not always the upfront restructuring, which being a member of a hard currency zone, is required to derive the maximum benefit. Pricing oneself out of the market, and therefore high unemployment, is the alternative, as the facility to devalue the currency lapses. That was what many euro countries on the periphery had allowed to happen, and the adjustments that became necessary proved painful, but were likely to be temporary, as the Irish and Portuguese examples showed by 2015. More fundamental restructuring was necessary everywhere in the Eurozone, but risked being undercut by the ECB and its devaluation policies. More serious was probably that many governments had allowed themselves to be overextended on low interest rates and had lost important levers of power to redress the situation on their own, more particularly visible in the hardest hit countries. Market forces and international organisations moved in, the latter to provide the money which the international capital markets were no longer willing to supply at affordable interest rates. But the true underlying problem had long been a lack of discipline in an entitlement society, where government, banks and consumers alike had allowed themselves to become strangled in debt, all on the idea that the bonanza would

Volume 5: Payments, Modern Payment Methods and Systems 381 never end or take care of itself—see further the discussion in Volume 6, sections 1.3.4 and 1.3. If we fast-forward to 2021, the euro has even strengthened in value throughout the Covid-19 global pandemic vis-à-vis other major currencies such as the USD, CAD and the Japanese yen. The euro had its own problems however: the key stability pact based on restraint and moderation in governmental policies was at first not even taken seriously by France and Germany. Also, it had always been irrational that all member countries could borrow up to 60 per cent of GDP, even those who had no real growth, and that the ECB took all euro government debt as equally sound on the repo. Furthermore, banks were not subject to capital requirements while holding any of these governments’ debt, even if this changed a little (but not enough) under Basel II. Again, all euro government debt was treated equally, with the result that much of it was not properly rated. This could lead to sudden crises and huge hikes in interest rates for some, which showed after 2010. It should have happened much earlier, would have given better warning, and suggests serious market failure. In other words, the euro in the way it was originally conceived and started to operate hid many structural problems in member countries. This was being rapidly corrected after 2010. It is conceivable that individual countries may leave the euro (while others join). Although leaving was legally not foreseen, it would probably be condoned in respect of the severest cases, therefore for countries that could or would not restructure sufficiently and need devaluation instead to regain international competitiveness. A temporary exit could then also be considered. Leaving would lead to many immediate problems for the leaving country unless its domestic savings were enough to support its lifestyle. If not sufficient, an exiting country would have to borrow in the international markets, most likely in hard currencies at punitive interest rates. A further collapse of the country’s finances and lifestyle would then be the likely result. Although it must be questioned in retrospect whether it was wise for some of the EU countries to come into the euro so early, for those who depend on international financing leaving proves hardly a real option. In any event, the idea that devaluation is an elixir that would automatically produce growth while returning to national manipulative currencies is a chimera, although still adhered to by many even in the US. Worse: the necessary structural reforms are likely postponed or altogether ignored, always the drawback of devaluation. It is an easy ad hoc way out that solves nothing for the future and postpones the need for remedial action, which is likely to remain half-hearted. For some countries, a median solution might be shifting to competing currencies, that is to dual legal tender. Savings in euros could remain safe. Indebtedness contracted in euros would remain. The currency of existing contracts would be maintained. New debt could be in the local currency and local salaries and benefits would henceforth be paid in such currency also, although new savings could still be freely converted into the euro. This would allow for a way to decrease salary costs and pension benefits through devaluation. In terms of their EU-denominated debt, but also in international terms, the people would be poorer but at least they would be more competitive for a while. If there were not to be a dual legal tender solution in the above sense, any exit would raise the broader question of payment of existing debt (loans or bonds) denominated in euros and of other payment obligations under contracts or financial instruments when maturing in the exiting state. What debt and which contracts or financial instruments would be redenominated in the new currency? Would this be for the future only or also for past outstanding obligations? Domestic savings in euros (deposits, cash holdings and stocks and shares in local companies) may then also be converted into the new currency. That would be the more drastic scenario. Legislation in the exiting country would in the first instance have to define who would be affected, especially relevant for foreign investors, banks or companies holding local deposits or

382 Volume 5: Payments, Modern Payment Methods and Systems debt instruments including those of the local government or other claims under contracts with locals or with the local government. Foreign investment treaties entered into by the exiting country or bilateral investment treaties (BIT) might here also be relevant. What about existing foreign suppliers? Would they also be caught and still have to continue to perform, for example deliver foreign goods or services under an existing sales agreement, but now be paid in devalued local currency? Could the applicable contract law make a difference if it was not the law of the exiting country? It could hardly be so in respect of mandatory laws and public policy in the exiting country under its own rules. Would existing credit lines of foreign banks for local companies equally be redenominated or would they terminate in such cases? Depending on the after-effect in economic terms, the result of redenomination could still be frustration of the contract or a change of circumstances, even under the law of the exiting country, if that law were to be applicable. The redenomination and continuity issues are thus closely related. The situation may also resolve in an event of default under applicable documentation if containing the possibility to modify or terminate the agreement under a contractual hardship clause. A material adverse effect may be enough. But probably as important is to determine what are international contracts. They are not per definition subject to the law of the exiting country and its mandatory provisions in this regard. Eurobonds may be in this category also. It would be a question of the extraterritorial effect of mandatory redenomination provisions of the exiting country, especially if they were all comprehensive. Who is to determine this and on what grounds? Jurisdiction issues may play an important role. If the courts in the exiting country are competent, they may find quite differently from courts elsewhere or international arbitrators, whatever the law chosen by the parties (if any). These issues are in truth regulatory or objective (like the internationality of the contract or bond) and not issues of party autonomy; they are not at the free disposition of the parties choosing, for example, the law of a third country. It may be a matter of conflict between domestic public policies and the public interest or policy in the transnational legal order itself. Arbitrators, assuming they have jurisdiction and that these matters are arbitrable, might take views very different from those of the courts of the exiting country, which are likely to support domestic policies first. So may courts elsewhere. It may thus be doubted whether the choice generally of a foreign law would make an appreciable difference, at least as long as performance and payments were foreseen in the exiting country. But especially if payment were agreed to be made outside the exiting country, while courts elsewhere or international arbitrators had jurisdiction, a more balanced approach may follow, regardless of legislation in the exiting country whose international scope and extraterritoriality would then have to be determined. For foreign courts or international arbitrators that may be so even if payment were to be made in the exiting country, as the place of payment may for them not be the sole relevant factor. Another factor may still be the chosen or otherwise applicable private law, but, as already mentioned, it may not determine the issue either. Again, this is the area of public policy. The situation may be different again if parties had explicitly chosen the euro as the currency of payment (regardless of the applicable law) in a contract or legal instrument with sufficient international aspects. In such cases, the currency might only be deemed to be changed by courts elsewhere or in international arbitrations if the law concerning the euro would itself require it (lex monetae),603 but the operation of the lex monetae is obscure in a currency zone as such a

603 See Eurozone Bulletin Linklaters, 15 December 2011.

Volume 5: Payments, Modern Payment Methods and Systems 383 zone has no natural law of the currency except a transnational one. At least prima facie, the euro denomination would stand as long as the euro itself survived in some countries. These countries might even amplify the lex monetae and decree its continuing force. In other words, the exiting country would have power as issuer over their new currency, but not over the old one of which they are not the issuer, or at least not the sole issuer and in which they do no longer participate. Also, from that point of view, redenomination is not in their full power. If nothing about the currency is said in the contract, the underlying intent may still be relevant and any payment obligation thereunder, for example, in respect of goods or services and damages to be rendered or suffered by a foreign investor or supplier, could still be deemed to be in euros.604 Again courts in the exiting country may react differently and see here mandatory law trumping the explicit or implied choice of the currency by the parties.605 The concept of the lex monetae may in such cases suffer from its connection with party autonomy, which may be ignored, at least in the mind of the domestic courts in the exiting country. As already mentioned, in matters of public policy, the normal conflict of laws rules do not apply, even in foreign courts or in arbitrations;606 see also Article 9 EU Rome I Regulation. On the other hand, it should also be considered in this connection that any arbitral award, in order to be recognised in the exiting country, would have to pass the public policy bar in that country under the New York Convention, and this may not be likely. In respect of ordinary judgments, in the EU, the relevant Regulation (Brussels I) would allow a similar bar, but only if the decision was manifestly against the public order of the exiting state. Precedents are rare so far, but a currency break up might be in that category. As a special category, sovereign debt obligations of the exiting country would likely be redenominated, also for the past, but whether that would affect foreign holders in respect of old debt is again another matter. Here also, the place of payment and the jurisdiction in dispute resolution could play a role. It has already been said that foreign investor protection under BITs may also become an issue, depending on their texts and definitions of investment, especially indirect investment. Germany has a BIT with Greece, which suggests that German investors in Greek sovereign debt may be protected even if they agreed to a discount (BIT protection itself being of public order and not subject to party autonomy, although, of course, no one needs to pursue its remedies, even if formally they continue to exist). Finally, there are likely to be convertibility constraints and transferability limitations imposed on the new currency at the same time to prevent capital flight. The latter could also affect the euros still within the country. However, any effect on the free movement of capital and payments would have to be considered at least within the EU. Equally any accompanying tariffs and other import 604 A stranger situation may arise in respect of payment obligations that arose before the exiting country entered the euro, therefore under older contracts or financial instruments. In such cases, there would have been no intent to be paid in euros, but probably only in the former currency of the exiting country, and the payment obligation might then more readily be redenominated in the new currency (which may assume the name of the old). 605 So may courts elsewhere and international arbitrators in the case of ‘exchange contracts’ that might violate the new order (especially newly imposed exchange controls in accordance with IMF and EU rules, in the latter case justified unilaterally only temporarily on the basis of public order as long as the exiting country remains a Member of the EU). 606 Art 3 of EU Council Regulation (EC) No 1103/97, OJ L162 (1997) established the principle of continuation of all contracts denominated in the currencies preceding the euro and implied the full redenomination in the new currency, but it can hardly be explained as reversible when a country would leave the euro. More than 1,100 securities firms signed the ISDA EMU Protocol in 1998 acknowledging the continuation of the contract under redenomination also, but they may not similarly accept a reversal. For contracting parties elsewhere, notably under New York law, the issue was whether the law of a non-Member State would automatically accept the redenomination. To this effect, the New York General Obligations Law concerning frustration was especially amended (para 5-1602 (1)(a) and (2)), but does not appear to contemplate a reversible situation either.

384 Volume 5: Payments, Modern Payment Methods and Systems controls would have to be weighed against the free movement of goods and services within the EU. Leaving the EU altogether might in such cases be the better answer, subject to a specialised deal to be negotiated. The Lisbon Treaties now make this possible (Article 50 TEU), but it is not an easy process, as the terms of withdrawal would still have to be agreed and be approved by the EU Parliament, although not by other Member States. As Brexit showed, it may prove a lengthy process.

3.3.5. Payment in Open Account. Re-establishing Simultaneity Through the Use of Intermediaries In international sales transactions, as in domestic ones, parties may agree a payment in open account. In that case, the seller ships the goods and sends the invoice together with the other documents to the buyer, who is invited to pay the agreed amount on the appointed date into a bank account indicated by the seller. This provides the seller with no payment protection at all and is therefore limited to transactions involving small amounts or to situations where the seller/creditor has no doubts about the creditworthiness and/or the willingness of its debtor/buyer to pay. It normally assumes that the parties are well known to each other (often because they deal with each other all the time) and this mode of payment is then very efficient. It is also the cheapest and often the quickest and, assuming international bank transfers can be organised, the simplest way to proceed, and therefore an attractive one. It results in a simple bank transfer, facilitated by the progressive liberalisation of current payments cross-border, and in the ease and speed with which these payments can now be made through modern international payments systems like SWIFT and CHAPS, which avoid funds being tied up in the banking system (without earning interest for the parties) for very long. They also reduce settlement complications at the same time. The details of such bank payments were discussed in the previous sections. Nevertheless, there is no protection against credit risk. If the need for such protection arises, some may be provided in the contract itself, for example through a reservation of title, but that does not force the buyer to accept the goods and may not prove to be effective when the goods are shipped to another country (see for the private international law aspects Volume 4, section 1.8), or when the goods have been commingled with or converted into others. Moreover, upon shipment, their precise location may be unknown. In any event, any reclaiming of the goods may present considerable problems, as will their subsequent resale in a foreign environment for which the seller may not be sufficiently prepared and/or equipped. Even if the seller succeeds in retrieving the assets, s/he may have to appoint an agent or incur other costs in storage, while the risk of loss of, or damage to, the goods in practice reverts to him (if not also in law). Similar contractual protection may derive from the seller being allowed to retain the bill of lading until payment, but it also does not help where the buyer does not want the goods any longer so that there is only an unsecured damage claim; neither does it alleviate the risk of loss or damage and disposal elsewhere. Where title or documents are retained, there is also no protection against country or political risk after the goods have left the country of the seller. A particular feature of international sales is that the buyer is unlikely to agree to any forms of payment (except down payments in the case of the supply for large capital goods) that aim at payment (or at least acceptance of a bill of exchange) before the goods are out of the control of the seller. This also applies to any bill of lading or warehouse receipt issued to the seller in respect of them, as these documents are often considered to embody the goods (see for more on these documents of title, Volume 4, section 2.1). That is understandable, but naturally the seller is equally

Volume 5: Payments, Modern Payment Methods and Systems 385 unlikely to surrender the goods or the documents to the buyer without payment or unconditional and watertight assurances to the effect. Because of the lack of simultaneity, there is here an inherent deadlock situation, made worse in international sales because of the need for transportation and the impossibility of simultaneity in surrender of the goods and their payment. Unavoidably, there is a different time and place for the seller physically to surrender the asset and for the buyer to take it and pay for it. It also means extra risks in transportation and deterioration in the quality of the goods. This complicates payment further in the sense that the seller will be all the more reluctant to send the goods before payment and the buyer to pay before receipt and inspection.

3.3.6. Various Ways to Reduce Payment Risk in International Transactions It follows from the foregoing that there may be an obvious need in all sales for the parties to re-establish some simultaneity in the handing over of the goods (or to documents representing them) and of the money (or to achieve any other form of unconditional payment at the same time), or at least to approximate such a situation in order to reduce the counterparty risks for both. While, as just mentioned, in international sales this will typically be lacking, a form of simultaneity may be reinstated in this connection through the use of intermediaries or agents through whose hands the goods and the payments are likely to pass. These intermediaries are the carriers and warehouse operators in respect of the goods, and they are the banks in so far as payments are concerned. The intermediation of banks in particular has allowed the creation of some schemes to approximate some simultaneity. Of these, the collection arrangements and letters of credit are the most common. In both, the bill of lading is likely to play a significant role and will be handed over through the banking system in return for payment. In a collection, a bank established in the country of the buyer will collect the money from the latter as agent for the seller (or its bank) after having been put (usually) in possession of the bill of lading by the seller (or its bank). Under a letter of credit, the issuing bank (or its agent in the country of the seller) will pay the seller in its own country, usually in its own currency, after the seller has produced the bill of lading, which the latter will have received when shipping the goods and putting them in the hands of the carrier as independent third party in this respect. If transportation is by road or air, similar schemes can be devised. It is, however, easiest and most common to discuss the structures on the basis of the carriage of the goods by sea,607 and that will be the approach of this book also. Naturally, payment protection is also important where no goods are involved or no transportation needs to take place under an international contract, for example because the goods are already on location or the contract concerns only services. For those situations, payment protections are much less well developed, although letters of credit are perfectly feasible in those cases also. Obviously, the documents to be presented cannot then be bills of lading, but they can be certificates of independent parties that the goods or services in question have been delivered (whatever their quality). In international trade, originally the bill of exchange played a role in the reduction of the payment risk for the seller. Later on, collection arrangements and letters of credit were developed, as we have seen. The bill of exchange has only modest effectiveness in this connection, as it 607 As of 2019, the total value of goods transported by sea around the globe was 14 trillion USD annually, with over 11 billion tonnes of goods being shipped around the globe each year.

386 Volume 5: Payments, Modern Payment Methods and Systems depends on acceptance by the debtor, which can often not be compelled, and does not even then protect against the debtor’s insolvency (or counterparty risk). This will be discussed in the next few sections. Moreover, payment is normally in the country of the debtor, so that the creditor also retains the transfer risk. As the goods are normally delivered before the payment date, they are gone. On the other hand, nothing in this arrangement compels the debtor to accept the goods if s/he does not want them any longer. Whatever the motive and justifications, this will lead by itself to non-payment.

3.3.7. Ways to Reduce Payment Risk Internationally: The Accepted Bill of Exchange As just mentioned, bills of exchange present a traditional method of reducing payment risk. Their creation and legal status as negotiable instruments were more extensively discussed in Volume 4, section 2.2. Here the only issue is how they may reduce payment risk. They may do so when they are accepted by the buyer. Only time bills can be so accepted, and may at the same time allow the creditor (drawer of the bill) to sell these accepted bills to (or rather discount them with) a so-called discount bank (which specialises in this form of financing) so as to obtain ready money regardless of the maturity date of the bill. In that case, a discount will be applied to the nominal amount of the bill to allow for its later maturity and also for the collection risk of the bank. The signature of the buyer on a time bill of exchange expressing acceptance provides some extra safeguard for payment as dishonouring an accepted draft is generally considered a most serious matter and likely to affect the credit standing and therefore borrowing power of a debtor/accepting drawee. However, a buyer need not normally accept a bill of exchange. Even if under the contract s/he must do so or where in countries like the Netherlands and France there may be a statutory obligation for the buyer to accept a bill of exchange (see Volume 4, section 2.2.2), this obligation is no proper substitute for the acceptance itself, which would still have to be enforced through the courts. In any event, acceptance does not protect against the credit risk including the bankruptcy of the buyer/debtor/drawee. If discounted to a bank or sold to a third party without recourse to the seller/drawer of the bill of exchange (if possible, under applicable law), the accepted bill of exchange may prove a way of obtaining early payment in a credit sale transaction which has a delayed payment (therefore when credit is given). As just mentioned, there will be a discount for interest until maturity and another one for credit or collection risk. Discounting or negotiating the accepted bill without recourse transfers the credit risk from the seller to the next holder of the bill, here the discounting bank. It may be difficult to find a bank that will discount the bill of exchange. It is likely that only the house bank of the buyer in his home country will do so, as it has enough knowledge of the debtor who is likely to be dependent on his bank for other services. It will leave the seller with cash in the house bank’s country (normally therefore the country of the buyer) so that the seller retains the foreign exchange and country risks. A bill guaranteed (avalised) by a bank without recourse to the seller and payable in the latter’s home country would help, but few banks, except again the house bank of the buyer, may be willing to do so. Any other bank may be unlikely to co-operate as it puts the risk of proper and timely payment in the required (convertible and transferable) currency fully on this bank, minimised only to the extent the debtor has put it in the required funds or has provided other forms of security or comfort. As this will normally be the exact problem in the relationship between the seller and buyer/debtor, it will not be any less so between a buyer/debtor and the avalising bank. In any event, for all these reasons such an aval would be costly.

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3.3.8. Ways to Reduce Payment Risk Internationally: Collection Under a collection, the seller (principal) normally requests his own bank (the remitting bank) to turn over the documents relating to the goods (normally a bill of lading issued by the carrier) to a bank in the country of the buyer (the collecting bank). In this transaction it is the seller/creditor who organises the payment facility. The collecting bank will be acting as the agent of the remitting bank, and will attempt to collect from the buyer through the buyer’s bank (the presenting bank) the money agreed in the contract of sale. It will do so against the handing over of the bill of lading to the presenting bank. Normally, the collecting bank will receive either money or a bill of exchange accepted by the presenting bank. The function of the collecting and presenting bank may be combined. Obviously, this type of collection will have been discussed between buyer and seller beforehand and be agreed between them. The International Chamber of Commerce (ICC) ‘Uniform Rules for Collections’ (URC) 1995, which are usually made applicable in these situations, as we shall see, prescribe that all documents sent for collection must be accompanied by a collection instruction from the seller to the remitting bank giving complete and precise details. The remitting bank has to act upon this instruction. It will also indicate what it is subsequently to do with the money or bill of exchange it so receives. This bank will provide its services in this respect for a fee, which also incorporates the fees of the other banks involved in the scheme. They have no interest of their own or exposure in the transaction as there are no guarantees. Besides the fees, they may also earn a foreign exchange spread upon conversion of the money into another currency or an interest rate spread on any discounting of the bill of exchange or on any deposit of the proceeds made with them in the meantime. The URC assume that the seller puts the instructing bank in possession of the documents, normally a bill of lading, in order to organise the collection.608 It will include instructions to deliver these documents to the buyer (the presenting bank), in which connection three methods of collection may be indicated. They are usually reflected in the contract of sale itself: (a) Cash against documents or CAD: in that case, the documents relating to the goods are delivered to the presenting bank against cash or a bank transfer, that is upon presentation by the seller’s bank (the remitting bank or the collecting bank on its behalf) of the bill of lading as soon as possible after the loading of the goods sold. It means immediate transfer of the documents against immediate payment. (b) Documents against acceptance (of a bill of exchange) or D/A: in that case, the documents related to the goods, as well as a bill of exchange drawn on the buyer’s bank (normally the presenting bank), are delivered to that bank as soon as possible after loading. The bill of exchange will be presented for acceptance to the presenting bank and will demand payment at an agreed maturity date (acceptance is strictly speaking not payment itself). It means payment (for the seller) later. There is credit given so that the seller retains a credit risk, now of the presenting bank, during the maturity period. The accepted bill of exchange may be discounted (without recourse as a ‘forfait’)609 in which case the credit risk is transferred to the discounting bank. This will often be the presenting bank itself.

608 See for the collecting bank, Art 3(a)(iii), and for the presenting bank, Art 3(a)(iv) URC. 609 See, for more on ‘forfaiting’ CM Schmitthoff et al, Schmitthoff ’s Export Trade: The Law and Practice of International Trade, 10th edn (London, 2000) 233. The forfaiter usually agrees to this only if the payment is secured by a third party, often the buyer.

388 Volume 5: Payments, Modern Payment Methods and Systems (c) Documents against payment (often of a sight bill of exchange) or D/P: in that case the documents related to the goods are delivered (to the presenting bank) only after the payment in cash of a sight bill of exchange (to the seller) on an agreed later date. D/P is thus documents (for the buyer) against cash (for the seller) later. It results in a deferred payment. Of these three collection schemes, the CAD term is obviously the best for the seller, as it effects, through the banks, a simultaneous exchange of payment against documents (allowing the buyer to transfer these or collect the goods), normally immediately upon loading. It will accordingly eliminate the risk of the buyer refusing the goods upon arrival and thus also payment. But as payment takes place in the country of the buyer there are still the convertibility and transfer risks and the related country and political risk. The remitting, collecting and presenting banks guarantee nothing in this connection. The D/A always involves credit and is only of immediate help to the seller if the latter can discount the accepted bill of exchange without recourse (as a forfait). If s/he has this opportunity, the D/A provides for the seller protection very similar to CAD, but the discounting will impose extra costs. If the discounting facility is not available, D/A will normally be acceptable to the seller only if the buyer’s bank is of good standing as the seller still has the credit risk, assuming further that there is no undue convertibility, transferability, country or political risk. D/A gives the buyer the chance of immediate disposal of the goods and some credit and is therefore generally more favourable to him/her, although s/he may still have to guarantee the forfaiting. D/P is the riskiest alternative for the seller as, depending on its more precise terms, it may allow for the simultaneous exchange of documents and payment only towards the end of the transaction when the goods have already arrived. The danger is that the buyer may refuse acceptance of the goods, show no interest in the bill of lading at all, and will not pay. There are also still the convertibility, transferability, country and political risks. Some refinement is therefore not uncommon through additional instructions which may require, for example, acceptance of a bill of exchange forthwith, even though presentation for payment will take place only later at the agreed time and place. It then resembles the D/A without putting the goods (or documents) at the immediate disposition of the debtor. It makes the arrangement more favourable to the seller. The drawback of all these collections remains the dependence of the seller on the creditworthiness of the debtor/buyer or its bank, and especially under D/P and D/A on payment after the goods are already in transit and cannot easily be retrieved without making additional cost. Then there is the payment in the country of the debtor with the attendant convertibility, transferability, country and political risk exposure. Even the CAD, which like all other arrangements is usually executed in the country of the buyer, thus retains an element of uncertainty. Only the facility to discount accepted bills of exchange in the seller’s country without recourse (a forfait) may constitute full protection in this regard (or an aval by a bank in the seller’s own country) but may not be easily obtainable and in any event is likely to carry a high price.

3.3.9. Ways to Reduce Payment Risk Internationally: Letters of Credit. The Different Banks Involved A better and now more common way to avoid payment risk has evolved in the letter of credit. This is an undertaking by a bank (the issuing bank) committing it to pay the seller (beneficiary) a sum of money (for example, the sale price) or to accept a bill of exchange (drawn on itself and usually with the seller/drawer as payee) upon the delivery of certain specified documents, usually including the bill of lading, assuming they are regular on their face. Although the issuing

Volume 5: Payments, Modern Payment Methods and Systems 389 bank will subsequently hand over these documents to the buyer (applicant), who has normally arranged and requested the letter of credit (as a condition of the sales agreement) and by whom it will ultimately be reimbursed, the payment to the seller (beneficiary) is not dependent on it. Nor is it affected by any problem that may arise in the relationship between the buyer/applicant and the issuing bank, or even in the original relationship between the buyer/debtor and the seller/creditor. That is for them to sort out later. The payment obligation of the bank is thus an independent obligation. While a collection is organised by the creditor/seller at its expense and is effected at the place of the debtor/buyer, the letter of credit is requested by the debtor/buyer from a bank as is normally provided for in the contract of sale. The costs are in principle also for the buyer (although they may be partially discounted in the sales price) while payment will normally be arranged in the country of the seller. That is, besides the independence, the great attraction of the letter of credit for the latter. The reason an issuing bank is willing to give an undertaking of this nature (for a fee) is normally that it knows the buyer/debtor who instructs it well. Naturally, it takes a risk as to its own reimbursement by the buyer, but it is likely to have a lot of business with its client under which it regularly receives money on the latter’s behalf. Alternatively, it may have been put into funds by the buyer or been given other types of security or comfort. As the bank is likely to become holder of the bill of lading upon payment of the seller, this may also give it a retention facility as added security for reimbursement by the buyer. For the issuing bank, the situation may not be fundamentally different from an aval given for payment to the seller directly in his own country. As mentioned before, an aval is a bank guarantee supporting an accepted bill of exchange drawn by the seller on the buyer, but there is an important difference in that the aval is mostly considered a secondary obligation only. This means that the creditor (holder) can invoke it only if the drawee/debtor defaults on his payment. This is not so for the letter of credit, under which the bank has a primary obligation and is required to pay (or accept a bill of exchange) as soon as the relevant documents are presented to it and found to be in order. That means that the issuing bank must pay if the documents are on their face in compliance with the terms and conditions of the letter of credit. Although this primary payment obligation of the bank does not, strictly speaking, substitute for the payment obligation of the buyer/debtor, it will normally be the bank that pays. However, the buyer is not released, and may still be required by the seller to pay if the bank somehow does not or cannot do so (for example, because the documents are not in order or because the bank is bankrupt). The buyer therefore remains a primary responsible debtor, at least in such cases. That is only exceptionally relevant, however, and not the normal method of payment once a letter of credit is issued as the letter of credit is likely to give the seller a more creditworthy debtor than the buyer and more efficient access to the money. Through it, the credit and other payment risks are all shifted to the bank, which is the principal benefit of the letter of credit and its rationale. As just mentioned, there is here not only an independent, but also a primary obligation of the bank issuing the letter of credit, which is only subject to the documents being found in order. The issuing bank still acts as agent for the buyer (and therefore not in all aspects independent from him), however, in effecting through its payment a release for the buyer under the sales contract. It has on the other hand an independent duty vis-à-vis the buyer to provide him with the documents. The ICC restated the most common rules concerning the letter of credit in its Uniform Customs and Practice for Documentary Credits or UCP, for the first time in 1933, with the latest text issued in 2007 (UCP 600). The UCP contain only a partial codification, like all ICC Rules. They are without official status, but they have great authority. Upon request, the ICC Commission on Banking Technique and Practice also gives interpretations. Like the ICC UCR, they have

390 Volume 5: Payments, Modern Payment Methods and Systems developed their own terminology. The revised Article 5 UCC in the US tracks this UCP system: see its Comment 1. The UCP apply only to documentary letters of credit, therefore only to letters of credit that are payable upon the presentation of specified documents. This normally concerns the bill of lading, but there could be others. The key provisions of the UCP define the various banks involved and their duties, such as those of: (a) (b) (c) (d) (e)

the issuing bank; the instructing bank and correspondent issuer; the advising bank; the nominated bank; and the confirming bank.

They also define the various kinds of credits, such as: (a) (b) (c) (d)

the sight credit; the deferred payment credit; the acceptance credit; and the negotiation credit.

Indeed, in documentary letters of credit of this sort, there are in international situations normally a number of banks involved. The chain normally starts in the country of the buyer/debtor who organises the facility and ends in the country of the seller/creditor, who will want to receive the money in his own country mainly to avoid counterparty, transfer and country risk. The issuing bank is in this connection the bank that is asked by the buyer/debtor to issue the letter of credit. That is normally its own bank in its own country (assuming it is acceptable to the seller), but it can be another bank, for example when the buyer’s own bank does not provide this kind of service. The buyer’s own bank can then limit its role to that of an instructing bank. In relation to the instructing bank, the issuing bank is then the correspondent issuer. The issuing bank will sign the letter of credit and send it to the seller/beneficiary but it may use an advising bank in the country of the seller to advise the issuing of the letter of credit. It gives the seller the comfort of the originality of the signatures (as there are many falsified letters of credit in circulation). Under Article 9 UCP, the advising bank has to ascertain with reasonable care the apparent authenticity of the letter of credit. In the US, under section 5-107 UCC, it also assumes an obligation for the accuracy of its own statements in this connection, but (at least in the US) there is no duty of timely transmission.610 The issuing bank may further appoint a nominated bank in the country of the seller. This bank will examine the documents presented by the seller and, if they are in compliance with the terms of the credit, it will take them up against payment or against acceptance of a bill of exchange drawn by the seller: see Article 12 UCP. This nominated bank is usually the advising bank but need not be the same: for example, the advising bank may be the house bank of the seller/creditor, but the nominated bank may be the branch of the issuing bank in the country of the seller. For these purposes, branches are usually considered independent entities. The examination of the documents is a sensitive task. The documents may be falsified but the more common problem is that they are not strictly speaking in compliance with the terms and conditions of the letter of credit: Articles 14ff UCP. Especially if quality certificates are required, they may also not be in the precise form. Shipping documents may not be made out to the proper 610 Sound of Market Street, Inc v Continental Bank International 819 F 2d 384 (1987).

Volume 5: Payments, Modern Payment Methods and Systems 391 entities (but rather to agents). Invoices especially, establishing the sales price, are often not in the required form or may slightly deviate in amount. Many discrepancies are small and do not matter, but they may nevertheless require consultation with the issuing bank and subsequently with the buyer to prevent any danger to the reimbursement of the issuing bank by the buyer and of the nominated bank by the issuing bank. The compliance of the documentation is determined by international standard banking practices as reflected in the UCP, not necessarily an easy criterion, but the ICC Banking Commission may help in the interpretation. Section 5-109(2) (old) UCC used to require that the documents were examined with care leading to immediate reimbursement by the applicant, but the UCC did not define the necessary standard. The new section 5-108(e) UCC refers to standard practices of financial institutions that regularly issue letters of credit. The UCP refer to international practices in this respect, the UCC probably still to national standards. In any event, standards per branch are ignored611 because it was considered quite impossible to know the customs of thousands of trades for whose dealings letters of credit may be issued. Article 14(b) UCP sets a time limit of five banking days for the examination, but the bank cannot exceed a reasonable time, even within that time limit. The reasonable time and the time limit concern the examination activities of all the banks involved together, and they are not a time frame for each bank involved, as there may be the issuing and nominated bank. In international transactions, the duty to examine the documents is normally delegated to a nominated bank appointed by the issuing bank. It does not, however, discharge the issuing bank from its own duty in this regard vis-à-vis the buyer of/applicant for the credit. As already mentioned, normally, the nominated bank is also authorised to take up the documents from the seller against payment under a sight credit. It may also be authorised to do so against acceptance of a bill of exchange on behalf of the issuing bank. This is called an acceptance credit. In such a case, the nominated bank may also be called the paying bank, respectively the accepting bank. If the nominated bank is required to negotiate the bill of exchange at the same time, it may also be called the negotiating bank. If the documents are not found to be in compliance with the letter of credit, the nominated bank may refuse payment: Article 16(a) UCP. It will then give notice stating all discrepancies to the seller/beneficiary within seven days of receipt of the documents (Article 14(c) UCP) and should return the documents to the beneficiary (or the bank acting for it in the collection). If the documents appear on their face to be in compliance with the terms of the letter of credit, the nominated bank will pay or accept a bill of exchange, as the case may be. It will turn over the documents to the issuing bank, which is bound to reimburse the nominated bank, provided it also finds the documents on their face in compliance with the credit. In this process, neither the advising bank nor the nominated bank accepts liability. They are only operating as agents for the issuing bank subject to its instructions—see also Article 12(c) UCP612—although the agency notion should be seen here primarily as operating within the context of the letter of credit. As already mentioned, the advising bank may at a later stage also become the nominated bank as it is rare for more than one bank to be involved in the country of the seller. The situation is very different when the issuing bank appoints a confirming bank in the country of the seller/beneficiary. It is a normal request of the latter when the issuing bank is elsewhere. The confirming bank takes on an independent undertaking under the letter of credit

611 See the English case of JH Rayner & Co v Hambros Bank Ltd [1943] 1 KB 37. 612 See in the US, Bamberger Polymers International Bank Corp v Citibank NA 477 NYS 2d 931 (1983).

392 Volume 5: Payments, Modern Payment Methods and Systems (see Article 8 UCP) and such a bank is often inserted in the protection afforded by the letter of credit to make sure that the seller may depend on payment in his own country. At the same time, it gives the seller/beneficiary extra security because the issuing bank is not discharged. If there is a confirming bank in the country of the seller, it is normal for it to be the advising bank in the first instance and/or later also the nominated bank. If there is a payment obligation and a bill of exchange to negotiate, the nominated bank must also negotiate the bill of exchange on behalf of the issuing bank without recourse to the drawer or holder in order to provide for the necessary payment. The confirming bank is sometimes considered the agent of the issuing bank,613 which is not necessarily inconsistent with the language of the UCP. It may be doubted, however, and in any event this agency would be of a very different nature from that of the advising bank and the nominated bank. The issuing bank is notably not liable for any negligence or misconduct of the confirming bank. There may yet be another bank, namely a bank engaged in a silent confirmation, but such a bank operates at the request of the seller, who pays for the benefit, and this arrangement is quite separate from the letter of credit itself and not covered by the UCP. On the seller’s side there may be another set of banks involved. The seller can use a bank, usually his own house bank, to hand the documents over to the nominated bank, at the counter of which the letter of credit will be available for payment or acceptance (or negotiation). It is not a relationship covered by the UCP either, but rather by the URC (see section 3.3.8 above). Under the URC, this bank will be the remitting bank (to which the documents are remitted by the seller for collection). It may still use a collecting bank, which may in turn use a presenting bank. When the nominated bank takes up the documents against payment or acceptance (or negotiation of a bill of exchange), the issuing bank must reimburse it: Article 13 UCP. The issuing bank may, in this connection, use a reimbursing bank, useful in particular when the currency of the credit is neither that of the issuing bank nor of the nominated bank. The issuing bank carries here also the transfer risk. Special complications may arise in the case of the bankruptcy of the issuing bank. The paying bank may not then reclaim the money from the beneficiary.614

3.3.10. The Types of Letters of Credit A letter of credit must clearly indicate whether it is available by sight payment, by deferred payment, by acceptance, or by negotiation: see Article 6(b) UCP. The most convenient letter of credit for the seller is the one available at sight upon presentation of the documents by a bank in his own country, because the proceeds thereof are then at the immediate disposal of the seller. There are other ways, however. In a deferred payment credit, the issuing bank undertakes to pay after a period of time. Nonetheless, it assures the seller that payment will be made on the due date. In the acceptance credit, the seller must draw a time bill of exchange on a specific bank (which can be the issuing bank, the confirming bank or another bank). After the documents have been found to be in compliance with the letter of credit, the drawee bank will accept the bill of exchange, by which it confirms to the seller/payee a commitment to pay on the maturity. 613 See in England Bank of Baroda v Vysya Bank Ltd [1994] 2 Lloyd’s Rep 87. 614 This will be different in the case of negotiation. Admittedly, there is no recourse to the seller, but it is accepted that a negotiating bank will only pay provisionally subject to its reimbursement by the issuing bank. Thus, the negotiating bank takes up the documents or a bill drawn on the issuing bank by the seller to his/her own or someone else’s order, and pays the seller for the documents or the bill of exchange, conditional upon reimbursement by the issuing bank.

Volume 5: Payments, Modern Payment Methods and Systems 393 In respect of the bank, the acceptance credit allows the buyer a grace period, giving him the documents and therefore the disposition rights over the goods, while s/he will be charged with the draft amount only upon maturity. It does not prevent the seller or a third-party payee from discounting the draft (usually with the accepting bank), if they want ready cash, which protects them fully, assuming they may discount without recourse. The acceptance of a draft by the nominated bank acting on behalf of the issuing bank can be affected by a mistake, however. This may present a valid excuse for the issuing bank not to pay the beneficiary, but it will not affect any third-party holder in due course of the bill. In a negotiation credit, the bill drawn on a bank indicated in the letter of credit is available for negotiation with a bank either designated in the letter of credit, when there is a limited negotiable credit, or to be chosen by the beneficiary, when there is a freely negotiable credit. If a negotiating bank is appointed, it has to give value for the bill of exchange (and/or the documents, see Article 8(e)(ii)), but only conditionally, that is depending on whether the issuing or confirming bank will subsequently reimburse the negotiating bank interposed by them. The bill of exchange (and/or documents) is (are) thus conditionally sold to the negotiating bank for immediate cash. This negotiation results in a provisional payment only, which may be recovered from the beneficiary if the issuing or confirming bank does not reimburse the negotiating bank.615 The drawing of a bill of exchange under both an acceptance credit and a negotiation credit will be in the interest of the seller as it gives him the chance to obtain ready cash by discounting the instrument. Under an acceptance credit, s/he will receive payment in this manner unconditionally (assuming s/he may do so without recourse), but under a negotiation credit, only conditionally, therefore depending upon reimbursement of the issuing bank.

3.3.11. The Documents Required under a Documentary Letter of Credit In the previous sections, reference was made to documents. In documentary letters of credit, presentation of certain documents is a condition for payment. They are mostly assumed to be shipping documents like the bill of lading or a sea waybill, but they may also be insurance documents or invoices. In fact, all may be required in the case of a sale of goods. Only an invoice may suffice in the case of services. Less common, although not infrequent, are quality, quantity, weight or origin certificates or customs papers. There may also be a combination. The UCP discourages conditions if not reduced to the presentation of a specific quality or health certificate certifying the on-spec quality of the products upon arrival. In particular, quality requirements destroy much of the purpose of the letter of credit, which seeks to achieve payment regardless of any dispute on quality or even an official certificate that all is well. It does not exclude the possibility, however, that the seller has to provide a special bank guarantee to cover any shortcoming in quality. One sees here a system of guarantee and counter-guarantee developing, in each case for different risks. 615 This system is not immediately clear from the UCP, but see Decision (1975–79) of the ICC Banking Commission, ICC Publication No 37 1, R 6, 18 (meeting 11 October 1976), see also Art 9(a)(iv) and (b)(iv) UCP 1993. It suggests that the negotiating bank does not negotiate without recourse, unless it is at the same time the issuing bank or the confirming bank, when recourse is excluded. Thus, it is obviously better for the seller always to negotiate with the issuing bank or the confirming bank. If there is ‘a freely negotiable credit’, this is what s/he will do. In continental European countries, the drawer/beneficiary cannot exclude recourse against himself. This is different in England and the US.

394 Volume 5: Payments, Modern Payment Methods and Systems The UCP in Articles 23–38 distinguish four types of documents: (a) the transport documents, which may be: –– the marine/ocean bills of lading (Article 20); –– a non-negotiable sea waybill (Article 21); –– charterparty bills of lading covering a time or voyage charter of a ship, which normally implies an agreement for the carriage of the goods (Article 22); –– multimodal transport documents, which are used for different modes of transport (eg, ship, aircraft or truck) and derive their name from the UNCTAD or UN Convention on International Multimodal Transport of Goods and the UNCTAD/ICC Rules for Multimodal Transport of 1991 in countries that adopted the Convention, cf also the ICC Uniform Rules for a Combined Transport Document 1991 (Article 19); –– air transport documents (Article 23); –– road, rail and inland waterway transport documents (Article 24); and –– courier service documents and post receipts (Article 25); (b) the insurance documents as proof of the appropriate insurance safeguarding the quality while in transit and the safe arrival of the goods unless otherwise stipulated in the letter of credit (Article 28); (c) the invoices, which on their face must be issued by the beneficiary in the name of the applicant but need not be signed, and the amount may not exceed the amount permitted by the letter of credit (Article 18); and finally (d) a category of other documents, like warehouse receipts, certificates of origin, weight, quality or health or custom papers, the latter either being furnished by the seller, like packing lists, or issued by an independent third party, like certificates of origin, when the name of the certifier needs to be checked if indicated in the credit.

3.3.12. The Right of Reimbursement of the Issuing Bank under a Letter of Credit The issuing bank is bound to reimburse the nominated bank which has paid or accepted or negotiated a draft. The issuing bank thereafter looks for reimbursement to the applicant/buyer/debtor. When the applicant fails to reimburse and there was no prepayment or special security in place for the issuing bank, the question arises what the issuing bank may do. When the issuing bank is also the house bank of the applicant, it may be able to set off its claim for reimbursement against the current account balance of its client, which is likely to be used by the applicant for normal collection purposes. Failing timely reimbursement, the issuing bank may also have a retention right in the documents that have come into its possession. A retention right may still imply an execution possibility, at least in modern systems of retention like the Dutch one. It then requires an execution sale of these documents. If they include a negotiable document, for example a bill of lading made out to bearer (that is, that there is no named consignee) or endorsed in blank, such a document also gives the bank a facility to reach the goods, which could then also be sold. If made out to the buyer or his order, this would require an endorsement by the buyer to the issuing bank. As the buyer is unlikely to do so if s/he does not want to pay, there will still be retention of the documents until reimbursement but there will be no access to the goods.

Volume 5: Payments, Modern Payment Methods and Systems 395 This is so even in the case of a sea waybill (see for these various documents Volume 4, section 2.3.1). But by statute there may be special relief. Thus, even if the document is made out to the buyer or is non-negotiable, the issuing bank might still be marked as the consignee. US law assumes in such cases a perfected security interest on the basis of possession: see sections 9-312 and 9-601(a)(2) UCC,616 but this would still require an execution sale. In the US and England, the issuing bank may also benefit from a trust receipt. However, this protection must be specifically agreed between the issuing bank and the buyer, and is more particularly used when the applicant/buyer needs the documents to on-sell the goods, which will enable and require him to reimburse the issuing bank out of the proceeds s/he receives upon the resale. These trust receipts have also become common in the Netherlands and Germany. Under them, the buyer keeps the documents, goods and proceeds in trust for the issuing bank. In civil law countries, it may remain doubtful, however, whether the goods and proceeds, if not clearly kept separate, represent assets that are sufficiently segregated from the applicant’s estate and are reclaimable by the issuing bank, particularly in the applicant’s bankruptcy.

3.3.13. The Letter of Credit as Independent and Primary Obligation: The Legal Nature of Letters of Credit and the Issue of Strict Compliance. The ‘Pay First, Argue Later’ Notion The letter of credit is in fact neither a letter nor a credit,617 but rather an independent payment obligation of the issuer, as we have seen in section 3.3.9 above. This payment obligation is meant to be independent of the underlying contracts. It is therefore not tied to any defence emanating from either (a) the relationship between the seller and the buyer giving rise to the payment, when, for example, the goods do not meet the quality requirements of the underlying sale; or (b) the relationship between the buyer and the issuing bank out of which the letter of credit in favour of the seller arose, when, for example, the buyer goes bankrupt and is unlikely to be able to reimburse the issuing bank. This double independence of the undertaking of the issuing bank is one of the keys to the whole scheme (besides the payment in the country of the seller) (see Articles 4 and 5 UCP and section 5-103 (d) UCC), as contrasted with the so-called accessory guarantee, of which the surety is the main example and which stands or falls with the validity of the underlying contract it guarantees (but, on the other hand, remains attached to the obligation to pay even if transferred to others). 616 The prevailing view is that an issuing bank which pays the seller against the documents is, in so far as the documents are concerned, only an agent for the buyer, see eg C Gavalda and J Stoufflet, Droit Bancaire (Paris, 1974) 734; J Hartmann, Der Akkreditiv-Eroeffnungsauftrag (Munich, 1974) 93. The UCP are silent, as they do not deal with proprietary issues. It means that the issuing bank has no ownership rights in the documents even if they are made out to bearer or endorsed in blank or to the issuing bank (although bona fide purchasers of the bill of lading from the issuing bank may then be protected). If the bill of lading is in the name of the buyer, the issuing bank is unlikely to have any proprietary right in it at all. The consequence is that the buyer is the owner of the goods at the time the issuing bank or its agent bank takes up the documents against payment. That does not, however, rule out a retention right of the issuing bank in these documents, which under some laws may be construed as a security interest at the same time. 617 The term derives from the former practice of banks issuing their travelling clients with letters (of credit) requesting correspondent banks in the country to which these clients were travelling to provide them with cash upon request.

396 Volume 5: Payments, Modern Payment Methods and Systems As we have already seen, it follows that the letter of credit is that it contains a so-called primary undertaking of the bank, which follows from Article 15 UCP. If the documents are in compliance with the credit, the nominated bank must pay regardless of whether the seller has first demanded payment from the buyer, who has refused to do so. In fact, in international transactions, the seller will normally only request payment from the bank, as it will give him the proceeds in his own country and save him considerable collection and administration costs. Again, this is unlike the surety. Under a surety, enforcement must first be sought against the main debtor, and the guarantor is only held liable for any shortfall. Under this type of secondary undertaking, whatever is required in terms of enforcement may be unclear as it may vary from a single letter requesting payment to a default judgment. In such cases, it is a matter for the guarantee or for the law to define the trigger mechanism. This is not an issue in letters of credit. The practices developed for the letter of credit in the succeeding versions of the UCP over many years aim foremost at preventing any uncertainty in these aspects of independence and primary liability and any confusion about what is required. In Europe, domestic practices have attempted to restructure the surety in the form of an independent and primary obligation in a similar manner through standard documentation developed by banks. Only the efforts within the ICC have managed to give these attempts the required unity of purpose and standing so that a truly new type of protection could be developed. We shall revert to this for independent guarantees in section 3.3.17 below. As in the case of letters of credit, the independence and primary nature of guarantees find their true support in the international law merchant, for which room is often now made in national laws, usually through case law but sometimes also through codification, as in the UCC (Article 5) in the US. In that country, the notion of independence of guarantees did not evolve from the indemnity contract, with which banks were not allowed to concern themselves, but was more directly derived from the established letter of credit practice, which developed separately in its own right. In an economic sense, the letter of credit may be seen as a tripartite structure under which a bank acting on the instructions of the buyer undertakes to pay the seller. There are therefore at least two contracts: the sale between the seller and the buyer and the instruction to issue a letter of credit from the buyer to the issuing bank. The payment commitment contained in the letter of credit itself creates yet another legal relationship, now between the issuing bank and the seller. In a legal sense, however, the letter of credit itself is not a tripartite arrangement, even if it results from a tripartite structure. It is an undertaking of a bank to the seller only, even if instructed by the buyer, and is entirely independent of the two underlying contracts giving rise to it. In countries like Germany and the Netherlands, which under local law find it difficult to accept the unilateral binding nature of such a payment commitment, a kind of acceptance by the seller is mostly thought necessary, so that a contract comes into being between the bank and the beneficiary supporting the bank’s obligation. Internationally, such an attitude is not useful, and may give rise to the applicability of very different contract models in terms of offer and acceptance and consideration requirements. It is not favourable to international letters of credit and their independence. If the contract construction is used, however, it is best to view the bank as agent for the beneficiary in the acceptance of the commitment, which is therefore instantaneous and does not depend on a further act of the seller beneficiary. In any event, there is no possibility for the bank to withdraw or vary the letter of credit before acceptance by notice to the seller/beneficiary. In the view of most, the seller is strictly speaking not a true third-party beneficiary under the agreement between the buyer and the bank (as a concept not even accepted in this connection in English law), although it has some attractions. Under it the beneficiary would be considered to

Volume 5: Payments, Modern Payment Methods and Systems 397 have a vested third-party beneficiary interest once the letter of credit is received by it and kept. In common law terms, the consideration or justification is then found in the entire arrangement. Once the undertaking is in place, which means signing and handing over the letter of credit to the beneficiary or its agent, it is binding and cannot be withdrawn, unless perhaps there was a mistake in the sense that the contract between seller and buyer never required a letter of credit. It would in any event be an abuse of right by the seller otherwise to invoke it. If on the other hand the sale proves invalid or is voided, this does not affect the agreement between the buyer/applicant and the issuing bank or the letter of credit itself. There is finality and form prevails over substance and there is strict compliance,618 again quite different from how the underlying contractual arrangements may be interpreted. In fact, the letter of credit can best be seen as an irrevocably binding unilateral commitment of the issuing bank towards the beneficiary (unless expressly made revocable). The true justification lies in commercial necessity rather than in any particular domestic legal constructions. The contract may be seen as the fuse that sets it off but its structural feature is not contractual and derive from custom in the international marketplace. It is demonstrated by its independence from three relationship out of which it arises (much line in the case of negotiable instruments), the primary payment obligation, and the strict compliance obligation and its attitude to fraud (see next section). As has been noted before, where payment is promised by the bank pursuant to the letter of credit, it does not replace the payment obligation under the sale. There is therefore no payment substitution agreement. In fact, the issuing of a letter of credit itself is no payment at all. Only an alternative payment duty is provided, under which the payment itself is subject to proper tender and acceptance, especially if the payment is ultimately made through a bank transfer. The letter of credit does not properly suspend the payment obligation of the buyer either, although there may be some doubt on this point. In any event, the buyer remains additionally liable, and the seller still has an action for payment against the buyer if the issuing (or confirming) bank does not pay. This may happen because either the documents are not in order or the bank is bankrupt. The normal way of payment is, however, through the letter of credit. As mentioned earlier, that is so because there may be fewer collection costs and the payment will be safeguarded in this manner in the country of the seller. It follows that payment pursuant to a letter of credit aims at immediate payment (or the acceptance of a bill of exchange by a paying bank) regardless of any defences or disputes between seller and buyer (or buyer and the issuing bank). That is the consequence of the independence notion, which makes payment under a letter of credit only dependent on the presentation of the proper documents. For the buyer and the seller, it results in a situation of ‘pay first, argue later’. That is the essence of all good payment protections and an old maxim (solve et repetere). It relies on the fact that, even when, for example, the seller has defaulted on or has committed a breach of the contract of sale (for example, by delivering off-spec material), the issuing bank (or its agent, the nominating bank) must pay and will normally already have done so before the goods have reached the buyer and breach is discovered, for example in the case of the supply of faulty material. Thus upon default, which the buyer is likely to discover only when s/he takes delivery of the goods from the carrier, s/he will have to start an action against the seller for recovery in whole

618 This concerns especially the type of documents that must be presented, see in England, Equitable Trust Co of New York v Dawson Partners, 27 Lloyd’s L Rep 49 (1927), see also Sec 5-108 UCC in the US, but can be extended to all wording of the letter of credit. It is not specifically covered as such in the UCP but very much a structural element of letters of credit.

398 Volume 5: Payments, Modern Payment Methods and Systems or in part of the money paid by the issuing bank (and likely to have been debited to the buyer’s account with it). This action will be based on a breach of the sales contract. Since payment has been made, the result is that the litigation burden substantially shifts to the buyer. Under a letter of credit, the calling for a quality certificate as part of the documents to be delivered to the bank before payment is made may reduce the room for later argument in this connection considerably, but it also substantially defeats the attraction of the letter of credit for the seller. In independent bank guarantees on the other hand, ‘pay first, argue later’ is not always the objective. They may replace the original obligation upon default altogether, while payment under it could then be final by way of liquidated damages. That is often the case in performance bonds. Where the guarantee replaces an attachment to preserve the goods pending litigation, there is also no question of paying first and arguing later. The slogan ‘pay first, argue later’, although popular in this context, is no legal maxim and no particular legal consequences flow from it. It is a state of affairs that results from all payments being agreed to be made against documents without inspection of the goods. The expression now refers more particularly to the double abstraction or full independence of the undertaking of the bank towards the beneficiary. As such it signifies a most important aspect of letters of credit and often also of independent guarantees (see for these more particularly section 3.3.16 below), and the modern lex mercatoria concerning them.

3.3.14. Non-performance under Letters of Credit: The Exception of ‘Fraud’ As we have seen, under a documentary letter of credit, the issuing bank has an unconditional obligation to pay the seller upon presentation of the required documents (assuming they are in order). No defences may be presented on the basis of the underlying sales contract giving rise to the payment, or on the basis of defects in the relationship between the buyer and the issuing bank giving rise to the letter of credit. There may still be some question, however, on the validity of, and payment duty under, the letter of credit when it was issued by mistake, in which case the seller may not be able to rely on it, as we have seen in the previous section. The issuing bank (or its agent, the nominating bank) is also not required to pay under the letter of credit when there has been ‘fraud’ by the seller. The ‘fraud’ exception is important and much talked about in the literature although in practice ultimately seldom relevant. It remains mostly undefined, but is limited to situations when, for example, there is prima facie irregularity on the part of the seller, or when the documents presented by him or on his behalf look obviously forged. Non-payment then serves the paying bank as protection against any charges of conspiracy to defraud the buyer/debtor. The UCP as partial restatement of the rules do not cover the fraud exception. The UCC in the US mentions the concept in section 5-109(a), again without any definition. It depends on the circumstances, and the courts are likely to assume some discretion here, but it is clear that a prima facie case must be presented. In other words, the situation must be pretty bad and the need for redress obvious. It should be noted in this connection that a holder in due course of a bill of exchange drawn under a letter of credit is always protected whatever the ‘fraud’. The issuing bank is entitled to refuse payment only when the ‘fraud’ is proven. Normally there will therefore be a need for a court order. The refusal to pay can never result from a buyer’s complaint concerning the performance of the underlying (sales or other) contract. The buyer can protect himself against defective products by requiring presentation of further documents in the letter of credit, for example one that verifies quantity and quality by an independent expert, as we

Volume 5: Payments, Modern Payment Methods and Systems 399 have seen, even though it is none too common. It is costly and, in any event, detracts substantially from the efficiency of the letter of credit as it may give rise to problems (and delays) at the start. It will reduce the chance of argument later but also of payment first. It is also possible (and more likely) that the buyer as part of the original deal will require a (primary or secondary) bank guarantee from the seller to cover the eventuality of poor quality after payment pursuant to a letter of credit. The result is two guarantees, one in favour of each party, but for different risks. The letter of credit guarantees payment by the buyer and the bank guarantee guarantees conform delivery by the seller, which will be an issue to be settled later. In that sense this type of guarantee does not detract from the letter of credit. In politically sensitive situations, for example when governments embargo trade, as happened in more recent times between the US and Iran and Iraq, the issuing bank (in the US) still had to pay the seller (here in Iran or Iraq) regardless of non-delivery (because of the embargo) but was, nevertheless, put under great pressure not to do so by the US government, and was thus tempted to refuse to reimburse any confirming bank in Iran and Iraq for any payments it made to the seller in these countries. Avoiding any impression of conniving with the enemy may then be invoked as an excuse by the issuing bank, but this should not be accepted as an excuse. In other words, political risk is no excuse for non-payment. It is certainly no part of the ‘fraud’ exception either. The seller may sometimes have to refrain from invoking the letter of credit, but equally only in exceptional circumstances, often also referred to as situations of ‘fraud’ (although this could also happen if the credit was issued by mistake, as we have seen). These situations are not normally defined either, but frequently are connected with known deficiencies in the assets as produced by the seller. In fact, it might in such situations be easier for the interested ultimate debtor (buyer) to restrain the seller/beneficiary from requesting payment from the issuing bank than to restrain the bank from making it. Thus a seller may notably be considered to be abusing its rights under a letter of credit or guarantee when it has knowingly provided rubbish or already been paid through a properly notified set-off, or having agreed to a substantial reduction in price it still seeks full payment on the basis of the letter of credit. It may well be that civil law notions of good faith (gutte Sitten or Treu und Glauben) may be more lenient in this area towards the buyer/debtor than common law traditionally is. The civil law, although fully recognising the importance of the independence principle and generally limiting the fraud exception, nevertheless here risks being weaker than the common law. Part of the problem is that in countries in the French tradition the relationship between the seller and the bank is characterised as a commission contract or some kind of agency under which the bank renders a service for the seller and must therefore care for the latter’s best interest. This is indeed the danger of the agency construction already referred to in the previous section. The other problem is the nature of the recourse in the case of alleged fraud, which, in the absence of a clear mechanism, is in civil law frequently tied to good faith or at least absence of bad faith in demanding payment, or to abuse of right or the exceptio doli. As these concepts are vague, they leave ample room for courts less versed in commerce to find exceptions to the independence principle on the basis of fairness or by looking at substance rather than form, the latter (and its finality) being the essence of the letter of credit. Common law takes a formal approach and robust attitude here as a matter of principle, which may suggest at the same time that it is best to make the law of a common law country applicable to the letter of credit. Another issue may be whether international arbitrators may see here a common transnational standard, while strictly upholding the principle of independence except in prima facie cases that would suggest otherwise. Yet another is whether arbitrators could order injunctive relief and have the necessary power to do so. Article 17 of the UNCITRAL Model Law as amended in 2006

400 Volume 5: Payments, Modern Payment Methods and Systems would suggest so, therefore if the Tribunal is sitting in countries that have adopted the Model Law as amended. This would also mean that they could deny this relief, which decision would then be final. International custom should adjust the attitudes in this aspect and lead to a more uniform approach, which could incorporate the stricter common law attitude, which itself may well result from the nature of the commercial or professional relationship. It is better to refer here to the developing standards of international trade or transnational law (lex mercatoria).

3.3.15. Transferable Letters of Credit and Back-to-Back Letters of Credit Where a seller obtains goods from a supplier, the seller may agree with its buyer that the letter of credit shall be transferable to pay the supplier. However, a letter of credit can be transferred only if it is expressly designated as ‘transferable’ by the issuing bank. In that case, the seller (the so-called first beneficiary) may request the bank authorised to pay (the transferring bank) also to accept or to negotiate the credit to make the ‘transferable credit’ available to the supplier (the second beneficiary). It leads to direct payment of the supplier under the letter of credit. It is accepted that the ‘transferable credit’ can only be transferred on the same terms, but the name of the seller can be substituted for that of the buyer in order to protect his/her interests, while the amount of the letter of credit, the unit prices stated therein, the expiry date, the last day for presentation of the documents and the period for shipment may be reduced or curtailed. In the required documentation, the seller has the right to substitute his own invoice(s) to the buyer for that of his supplier. The letter of credit will remain good for payment of the rest (the seller’s profit) to the seller. The UCP, Article 38, allow only one such transfer. Naturally, the proceeds of a letter of credit may themselves be assigned by the seller, but that does not amount to a transfer of the letter of credit itself. The seller may in this connection also apply for a back-to-back letter of credit in favour of the supplier under which a new letter of credit is issued on the basis of an already existing, non-transferable letter of credit. Amount, duration and required documents or other imposed conditions will be exactly the same, although the second letter of credit will be legally entirely independent from the first and not conditional upon its effectiveness. It allows a seller to use the credit organised by the buyer (the first letter of credit) to support a letter of credit which the latter needs to arrange for the benefit of its own supplier (the second letter of credit). The documents will be directed by the supplier to activate the first letter of credit under which payment will be directed towards the issuing or confirming bank under the second letter of credit. This will trigger its payment to the supplier.

3.3.16. Ways to Reduce Payment Risk Internationally: Autonomous Guarantees. Standby Letters of Credit The bank guarantee appears frequently in international trade. Although the letter of credit implies a primary bank guarantee, as we have seen, it has developed in its own way and it is better to distinguish it from other such guarantees. It is true that the seller may want a guarantee from a bank for the eventuality that a buyer does not want to pay, and the (documentary) letter of credit is a variation on that theme. But there may be other reasons or needs, not directly related to payment or the counterparty risk in this connection. As already noted in the previous section, a buyer who has to provide the seller with a letter of credit may still demand from the seller a bank

Volume 5: Payments, Modern Payment Methods and Systems 401 guarantee to secure the conformity or quality of the delivered goods. A bank, in providing such a guarantee, undertakes to compensate financially the creditor/beneficiary for any default in the performance of the obligations of the debtor/applicant. A guarantee of this sort will generally be ‘autonomous’. It means that the guarantee (like the letter of credit) is independent of the principal contract between the creditor and the debtor and from the relationship between the debtor and the guarantor. Although it guarantees the seller’s performance under the principal contract, it is thus separated from the contract itself, and it will narrowly define the obligations to be guaranteed. Any valid excuse that the seller may have had for non-performance will then not be accepted as a defence against payment under the guarantee. Again, that would have to be argued out later. There are other more common forms of autonomous guarantees. The performance guarantee or performance bond already mentioned is a most important example. It serves as a security for the correct performance of the underlying contract by the debtor, for example in the construction industry. Also, the guarantee may balance the letter of credit: the first may protect the party who orders a project against poor workmanship. The second will protect the seller or construction company against non-payment. The performance guarantee will cover only a small percentage of the value of the sale or the project, while the letter of credit or a sequence of letters of credit may cover the entire price of the project. It may also be that the performance guarantee constitutes the liquidated amount of damages that can be claimed for non-performance by the construction company in this connection, especially if it has not even started the project and will not continue with it. It does not void letters of credit already opened to pay for the construction, but they may contain language that covers the cancellation possibility. The tender guarantee or bid bond is another example of an autonomous guarantee. It protects the instigator of a public tender and covers the risk that the bidder who was awarded the contract may ultimately not sign it or not provide the required performance bond. The maintenance guarantee or maintenance bond is usually also drafted as an autonomous guarantee and serves to secure the supplier’s undertaking for maintenance of the equipment. The idea is thus that the autonomous guarantee is independent. It will normally also be a primary obligation, and therefore not dependent on an earlier call by the creditor on the debtor and a default of payment in that relationship. As in the case of a letter of credit, it means that the guaranteeing bank will normally pay the price or amount guaranteed directly to the creditor and must seek to recover the amount so paid from the debtor. At the other end of the scale of the autonomous guarantee as independent and primary obligation is the (bank) surety as an accessory and secondary obligation. It allows defences in the underlying relationships to be a bar to effective payment, and also requires the debtor to be in default of payment to the creditor. It is still used, especially where a parent company guarantees the performance of a subsidiary. An advantage for the creditor may be that a surety transfers with the debt and therefore remains in place for any assignee. In between these two types of guarantees, there are all kinds of other bank guarantees, as for example the aval on a bill of exchange, mostly considered an independent but secondary guarantee. All types may have further conditions attached to them. In view of these differences, it is always necessary to ascertain exactly the quality of a guarantee in terms of (a) its independence, (b) its primary or secondary status, and (c) its conditions, such as the presentation of documents (which may simply be a written request for payment under the guarantee) or evidence of performance of the parties to the underlying agreement (which may be a quality or completion certificate). The first demand guarantee denotes in this connection an independent and primary guarantee payable upon first demand of the creditor, with this first demand in writing being the only condition or document required for the payment obligation of the guarantor to mature.

402 Volume 5: Payments, Modern Payment Methods and Systems Confusion on these key points in the drafting remains all too common and may prove fatal for the effectiveness of bank guarantees. In letters of credit, it is less likely as there is now sufficient standardisation supported by the UCP, but it is not impossible when confused language is being used. Where a judgment in the underlying obligation against the buyer is a prerequisite, it is to be noted that a bank guarantee thereby automatically becomes accessory and secondary, and thus a surety, no matter what other wording may have been used in the document. A similar situation results if a letter of credit is made dependent on a default judgment against the buyer. The UCP will then no longer (fully) apply. The standby letter of credit was developed in the US when banks could not guarantee obligations of others and act as sureties. Traditionally, this activity was left to insurance and bonding companies, but banks could always issue an independent guarantee in the manner of a letter of credit. They were thus allowed to accept an undertaking in this respect. Outside the payment circuit, these independent guarantees were then called standby letters of credit. The term is confusing but was imposed by expediency. The difference with a letter of credit is in the default condition. It is irrelevant in the letter of credit, but triggers the standby letter of credit. This does not, however, undermine its independence from the underlying contract the performance of which is guaranteed, and is therefore not subject to its defences. There is a further difference in the presentation of documents, which, in the case of a standby letter of credit, may be no more than a unilateral written declaration of default by the seller/beneficiary. Since 1983 standby letters of credit as payment guarantees have (in principle) been covered by the UCP. They tend to be cheaper as they require much less involvement of the bank. Technically, they could be made fully documentary, but may then still be considered different from the normal documentary letters of credit because of the default condition. For CDS as an important modern variation on the guarantee theme, see section 2.5.3 above.

3.3.17. Transnationalisation: The Law and/or Rules Applicable to Bills of Exchange, Collections, Letters of Credit and Bank Guarantees. The ICC Rules and their Status. The Modern Lex Mercatoria The international payment facilities and protections discussed in this part of the book concern the operation of the older law merchant and were first developed thereunder. As of the nineteenth century, they were increasingly meant to operate under a national law rather than under transnational custom as it developed. Even so, internationalising tendencies could not altogether be denied even here. The International Chamber of Commerce (ICC) and UNCITRAL built on this. The private international law aspects, uniform treaty law (Geneva Conventions) and the lex mercatoria in respect of bills of exchange have already been discussed in Volume 4, sections 2.2.10, 2.2.11 and 2.2.12. The ICC has issued the Uniform Rules of Collections (URC) since 1956, with new versions in 1967, 1978 and 1995 (ICC Publication 522). They require, according to Article I(a), incorporation in the collection agreement. As mentioned before, since 1933, the ICC has issued the Uniform Customs and Practice for Documentary Credits (UCP) for documentary letters of credit. They were last revised in 2007 (ICC Publication 600). The key principle of independence is expressed in Article 4 UCP and the primary nature of the payment undertaking in Article 15 UCP. The principle of strict compliance is not so expressed but is maintained in case law. As we have also seen, the UCP particularly concern themselves further more in particular with the roles of the various banks used in the scheme, the various types of letters of credit, role of the documents and use of bills of exchange in the context of letters of credit.

Volume 5: Payments, Modern Payment Methods and Systems 403 They particularly fail to cover the principle of fraud, which is mentioned (without clear definition) in the US in section 5-109 UCC, at least in respect of the payment obligation of the issuing and confirming banks. In other areas not covered, or in deviations from the rules, much depends on the wording of the letter of credit itself. It is important that this wording generally conforms to the UCP terminology so as to avoid unnecessary confusion. In Volume 1, section 3.2.6, the role of the URC and especially the UCP within the lex mercatoria was discussed as directory custom and practice except for the structural parts where customary law may be considered mandatory. Even though both sets of rules now assume for their application the incorporation of the rules in the respective contracts creating the collection or letter of credit facility and the facility itself, it is not the sole manner in which these rules may become relevant, and they may also or even more likely apply as custom or industry practices.619 It is in fact best and more rational to assume the applicability of an autonomous legal system in and around the URC and especially the UCP within the lex mercatoria. At the same time, this clarifies the question of which law applies when the URC or UCP do not elaborate. In the manner of Article 7(2) of the CISG, it would be normal to look first at the general principles on which the URC and UCP are based and only subsequently at domestic laws resulting under the applicable rules of private international law. It is the thesis of this book (see Volume 1, section 1.4.13) that besides custom and contract, the other rules of the lex mercatoria as elaborated in the hierarchy of norms, especially mandatory fundamental principle and directory general principles, also precede the application of domestic laws, rendering private international law appointing a domestic law as applicable only residually relevant as the lowest-ranking rule within the lex mercatoria hierarchy. Where private international law rules are still relevant, within the EU they may for strictly contractual issues derive from the 2008 EU Regulation on the Law Applicable to Contractual Obligations (replacing the earlier 1980 Rome Convention on the same subject). In agency aspects, in the countries that have ratified it, these rules could derive from the Hague Convention on the Law Applicable to Agency of 1978 although not so far effective for lack of sufficient ratifications. As the more specific rule, it would prevail over the EU Regulation in countries like France and the Netherlands that are subject to both. For the rest the applicable domestic law may be more difficult to ascertain, especially in the more typical or structural aspects of letter of credit.620 For guarantees, the ICC has compiled two sets of uniform rules. The first, the Uniform Rules for Contract Guarantees of 1978 (URCG), is meant to cover the tender bond, performance and repayment guarantees. It has not been successful because it requires a prior judgment or arbitral award and is therefore little more than the traditional surety and is not therefore considered an independent primary obligation of the bank. This goes against industry practice. The second set, the Uniform Rules for Demand Guarantees of 1992 (URDG), covers the first demand and other types of documentary guarantees as independent, primary obligations (see Articles 2(b) and 20). It is meant to replace the first set, which has, however, not been withdrawn, and covers in any

619 See JF Dolan, The Law of Letters of Credit, Commercial and Standby Credits (Boston, MA, 1999) 4.06 [2] [l] and for further references, Gao Xiang and RP Buckley, ‘The Unique Jurisprudence of Letter of Credit; Its Origin and Sources’ (2003) 4 San Diego Int’l LJ 91, 108. The latter authors still do not see the UCP as law, however, as it issues from a non-governmental institution (ICC), p 112. 620 Whether it is the law of the debtor or of the issuing bank or any other bank is a debated question, see in England the Supreme Court in Taurus Petroleum Limited v State Oil Marketing Company of the Ministry of Oil, Republic of Iraq [2017] UKSC 64. It may be noted that it is not normally considered to be the law of the underlying contract, but the uncertainty itself would appear to favour the transnational approach in which domestic law is only the residual rule.

404 Volume 5: Payments, Modern Payment Methods and Systems event a narrower field. Because of this discordant approach the URCG probably has no place within the lex mercatoria. The URDG that are reflective of market practice have such a place, much in the same way as the URC and UCP. The standby letter of credit, being a special form of bank guarantee, is covered not by the URDG but by the UCP (since 1983, see its Preamble), even though large parts of the UCP may not be directly relevant to it, since it is often not documentary. It could even be argued that standby letters of credit are covered by both when the URDG are incorporated and the UCP function as custom. This may be undesirable, and coverage of standby letters of credit by the UCP is an historical accident. They fit better under the URDG. The main reason for the confusion is that, in the US view, the similarity between the (US) standby letter of credit and the (European) first demand guarantee was not at first fully understood in terms of the similar approach to the independent and primary status of the payment obligation, and also the possibility for these guarantees to operate in the payment circuit beside the letter of credit. It must be admitted that there was also some confusion in Europe especially in the first aspect, probably because the independent payment guarantee developed there out of the surety. Comparative research, especially of case law, showed the similarities between the standby letter of credit and independent bank guarantee, which is increasingly accepted. As already noted, it suggests that standby letters of credit are better covered by the URDG only, except that the status and sophistication of these rules are not yet comparable to those of the UCP.

3.3.18. Transnationalisation: The UNCITRAL Convention on International Guarantees and the World Bank Standard Conditions UNCITRAL drafted a Convention on International Guarantees and Standby Letters of Credit in 1995. It covers the guarantee and the standby letter of credit in similar terms, and has achieved an important convergence of view between the US and European traditions. The Convention was intended to receive treaty status and would as such be of a different order from the ICC Rules. It largely converts the ICC Rules into (uniform) law. It makes adaptation to new practices much more difficult, however, as it would require a formal amendment to the Convention. Parties from Contracting States opting for the ICC Rules, the UCP or URDG instead would have to exclude the applicability of the UNCITRAL Convention in doing so. Even if not contractually incorporated in the standby letter of credit or the bank guarantee, at least the UCP might still prevail over the Convention as customary law. It would be a difficult question to resolve should the Convention be widely adopted (which is not so far the case), but it follows automatically from the hierarchy of norms in the lex mercatoria (in which the UCP is the higher norm) here advocated. The World Bank (IBRD) also operates some standard conditions in this area under its General Conditions—applicable to loan and guarantee agreements of the World Bank (1980) and under its Guidelines for Procurement Under World Bank Loans and IDA Credits (1977). Their status as custom within the lex mercatoria may be in greater doubt but they are still likely to have persuasive influence outside the area of their immediate application.

3.3.19. Distributed Ledger Technology and Letters of Credit There have been a few initiatives to digitise letters of credit (LC) and share the data on a private distributed ledger in order to create efficiencies between all the parties involved in an international transaction using trade finance. For example, the Voltron system digitises letters of credit

Volume 5: Payments, Modern Payment Methods and Systems 405 and shares the data on a distributed ledger in order to allow its users to make faster financing decisions and reduce the amount of reconciliations between companies and banks. This is integrated with the existing Bolero system. The benefits of using distributed ledger technology (DLT) for trade finance include: 1. Transparency: a distributed record of all the documents will reduce instances of fraud and errors. This should reduce the costs of transactions between the participants involved, as the reconciliation process will be simplified (and potentially automated). This distributed ledger could also facilitate the tracking of the physical assets that are being transported. 2. Immutability: the unchangeable nature of a distributed ledger offers the potential to provide a secure transfer of value. 3. Automation: smart contracts can be used to automate the entire trade financing process. There are essentially seven steps to a letter of credit transaction that uses DLT: 1.

The buyer (importer) requests for the issuing bank to issue a LC, which is then stored on the distributed ledger. 2. The issuing bank receives notification to review the LC and can approve or reject it depending on the data received. Once it is approved by the issuing bank, access is provided to the seller/exporter’s bank (that is, confirming bank) for approval. 3. The seller’s bank approves or rejects the LC. If approved, the seller is able to view the LC requirements. 4. The seller completes the shipment by adding the invoice and any other relevant documents. Once validated, these documents are added to the distributed ledger. 5. These documents are viewed by the seller’s bank, which approves or rejects the application. 6. The issuing bank reviews the documents against the LC requirements, marking any discrepancies for review by the buyer. When approved, the LC goes straight to completed status or is sent to the buyer for settlement. 7. If required due to a discrepancy, the buyer can review the export documents and approve or reject them. Overall, financial technology should help to improve efficiency and reduce costs for the parties involved in trade finance transactions. It is yet to be determined whether DLT will actually strengthen the rights of the parties involved, or merely introduce an extra level of legal uncertainty when there are problems with the technology.

3.4. Money Laundering 3.4.1. Techniques and Remedies Money laundering is the processing of criminal proceeds to disguise their illegal origin (Financial Action Task Force—FATF). The aim is to disguise or hide the true nature, source, movement or ownership of money or property, or pretend that the money comes from a legal source. In other words, money laundering is a crime of deception. It is important to note that the purpose of money laundering is not to make a profit, but rather to conceal the origins of the dirty money, although sometimes a profit will be made in the process. Ultimately, as far as payments are concerned, the question of laundering illicitly obtained proceeds (often cash) through the international banking system has created some considerable interest in view of the large amounts of

406 Volume 5: Payments, Modern Payment Methods and Systems money involved in drug trafficking and other offences, notably terrorist activity and similar types of serious crime. The amounts involved are difficult to estimate, but the United Nations Office on Drugs and Crime reported in 2009 that criminal proceeds amounted to 3.6 per cent of global GDP, with 2.7 per cent (or USD 1.6 trillion) being laundered.621 As mentioned above, the objective of money laundering is to make illicitly acquired proceeds appear legal by making them indistinguishable from others in the banking system. It is a question of fungibility and tracing difficulty as a consequence. Originally, the concern was foremost with cash derived from drug trafficking, but after 9/11 the concern was extended to funds being raised for acts of terrorism. Clearly, it would be of the greatest interest for money launderers to allow any cash obtained through these and other illegal activities (such as international prostitution, child pornography and illegal immigration rings) ultimately to surface in an account in a first-class bank, so as to create the impression of respectability and achieve free circulation and participation of these proceeds in the international money, capital and investment flows through the banking system. One key to combating this practice is therefore for banks always to be able to establish where cash came from and to refuse it if its origin or the persons or entities attempting to make the deposits are suspect, or if intermediaries (especially little-known banks or investment management companies in poorly regulated countries) are knowingly used to push this money into the international banking system. One important approach is therefore that banks are always aware and able to reveal the principals, while records should be kept to identify all deposit entries (the ‘know your customer’ principle). There are usually several phases in the process of money laundering:622 the placement stage, the layering stage, and the integration stage. The goal of placement is to deposit the criminal proceeds into the financial system in order to distance new forms of assets from their criminal origins. For example, a criminal may convert the physical bank notes that they obtained from a sale of drugs into a different denomination (for example, a stack of $5 notes may be converted into $100 notes in order to facilitate transportation). Another example is where a criminal deposits cash that they obtained from a criminal act (for example, bank robbery, drug sale, human trafficking, etc) into their local bank account. The dirty money may then be transferred to a larger multinational bank in an offshore financial centre upon conversion of the money into foreign currency (which is part of the layering stage). The money launderer may also attempt to buy assets (bearer shares, long-term bearer bonds or real estate) and pay from his local account either into the anonymity of a broker’s account or through privileged lawyers’ or other professionals’ accounts. To encourage these deals, the money launderer may be willing to pay a high price and take a loss upon a subsequent resale. The goal of layering is to conceal the criminal origin of illegal proceeds by moving funds through multiple bank accounts, crypto-wallets, financial institutions, companies and countries. For example, once the criminal has deposited the proceeds of financial crime in their bank account (the placement stage), they will transfer the money to multiple accounts at different banks around the world in order to make it harder for the authorities to trace the origins of the dirty money. The bank accounts may be in the name of shell companies in order to further mask the origins of the money. Part of this process is always to confuse the trail by engaging in numerous interim transfers and transactions and commingling dirty with clean money.

621 FATF website: www.fatf-gafi.org/faq/moneylaundering/. 622 See also P Alldridge, Money Laundering Law (Oxford, 2003).

Volume 5: Payments, Modern Payment Methods and Systems 407 Finally, the goal of integration is to create a legal origin for the illegal proceeds so that they can be used by the criminal for their own personal benefit. For example, the criminal will make a withdrawal of money from their account (which has already been layered through multiple accounts) and buy themselves high value assets or luxury goods. Litigation or arbitration may unknowingly support money laundering, for example when it concerns assets acquired by dirty money. This poses the question whether courts or arbitrators need to be alert and support mandatory international public order requirements as expressed in treaties and principles referred to below and whether they should do so autonomously, regardless of the pleadings of the parties or the otherwise applicable laws. It is submitted that, at least in international arbitrations, arbitrators have these powers and probably duties: see Volume 1, section 1.2.5. The fight against money laundering has been greatly complicated by the large sums of US dollars cash floating around in developing countries as common currency in a cash society. Thus, a criminal cash hoard in US dollars might be shipped to Russia, converted there into local currency through organisations of cash operators and converters and be invested in the Russian manufacturing or mining industry with readily exportable products. These products may be sold several times further to confuse the trail. Ultimately, they may be bought by a London shell company of the original money launderers and then sold in the international markets for hard currency paid by the buyers into the bank accounts of the sellers in London banks. The question for the London banks is then whether or when they must intervene, and how they can do so not knowing the background story. Even if they did, would they be obliged to refuse the payment or report it pursuant to newer reporting duties, now that the payment is totally clean, coming from a bona fide buyer in the market who pays through the banking system from his own funds, which are entirely legal? It is a fact that the illegal money entered the system once the Russian interest was bought and it should have been checked at that time. If that was not done, for whatever reason, it may not be reasonable to require action from the banks down the chain on the basis of mere suspicions. The approach in most countries is now that banks must report all suspect transfers. It discharges them from further action, and it is then up to the regulators to pursue the investigation and take the appropriate measures, but it leaves the burden of determining what is suspect largely with the individual banks. Many countries maintain a simple rule to the effect that cash deposits above a certain amount must be reported per se; for example, banks in the US are required under the Bank Secrecy Act to report to the Internal Revenue Service any cash deposits made by a customer over an amount of USD $10,000. In other countries, bank transfers by foreigners above a certain amount must be accompanied by information about the original instructing party and the recipient as well as their bank. It is clear that the problem is not or no longer one of cash alone, and money laundering need no longer concern only cash and its entry into the banking system. It may even concern ordinary bank payments in respect of illegal activities, which permits criminals to use of clean money already in the system to promote or pay for crimes. Here again, it would in the first instance be for banks to make sure that the accounts held with them are not used for this type of activity. Knowing the principals and keeping records has also become a key control function of banks in this activity. Related to this category are amounts already held by criminal groupings and terrorist organisations in reputable banks, and the simple holding of these funds by these organisations in the banking system may be objectionable as such. Not all of the money may be tainted, however, and some may be legally obtained. Even criminals can enter in normal banking transactions covering, for example, their normal cost of living out of legitimate earnings. This may become a due process issue. Here the idea is to prevent these organisations from using the banking system at all and to have their balances confiscated. This goes beyond money laundering

408 Volume 5: Payments, Modern Payment Methods and Systems proper, and must be seen in the context of international crime prevention as such and the war against organised crime and international terrorism. The definition of the ‘predicate’ crimes is a key legal aspect of the fight against money laundering. Narcotics syndicates, drug trafficking, illegal immigration rings, human trafficking and child abuse organisations, the parking of money by former dictators and terrorism are a major concern for governments all around the world. The prime relevance is that the moneys used in and proceeds received from such crimes may become traceable through the banking system, in which connection banks have acquired special investigation and information duties while bank secrecy duties are lifted. This is necessary in respect of major crimes, but an important development in this connection has been the increasing governmental concern with other legal activity, especially tax evasion. This may involve parking altogether legal income streams abroad (on which subsequently no tax is being paid) or depositing proceeds in foreign bank accounts, the origin and purpose of which from the potentially black economy can only be evaluated with the benefit of hindsight. This may nevertheless entail an important further infringement of traditional bank secrecy provisions and has undermined the credibility of the policies and activities combatting money laundering, which thus turns probably too easily into a tax collection facility.

3.4.2. Why Action? Remedies and the Objectives of Combating Money Laundering Money laundering is a major new crime. It requires international action as without it some countries may wish to benefit from the investment streams it engenders (whatever their origin), which other countries are trying to prevent at a high cost to them. How it works in all its diverse methods, what the total amounts involved are, and to what extent money laundering distorts payments and investment streams is less clear, as is its effect on the operation of the capital markets. Its impact may be less than sometimes claimed, especially by the organisations involved in combating money laundering, and there may be a fashionable element in it,623 but there can be little doubt that it is or may become a major issue if left unchecked. Thus, preventing money laundering is an important objective, if only in the context of combating organised crime, which is now largely drug, immigration, and terrorist related. Confronting organised crime of any nature, including terrorism, at the international level has probably become the true aim, while the distortion in money and investment streams and its effect on the capital markets are secondary. The market and regulatory concern with clean money and a clean banking system are real, especially for the major international capital centres, which do not wish to become tainted. But it may be said that combating money laundering is now only one way (albeit an important one) of countering the larger threat of organised crime of all sorts at the international level. The actual measures to prevent money laundering or to combat it effectively in international finance centre on: (a) the role of banks as informants; (b) the co-operation of other intermediaries such as brokers and similar agents or lawyers; and (c) confiscation or forfeiture. This being said, the co-operation and information duty of banks and other intermediaries is a substantial deviation from the traditional notion of confidentiality and secrecy in client dealings and not only puts 623 See for a critical review P van Duyne, ‘Money Laundering: Pavlov’s Dog and Beyond’ (1998) 37 Howard Journal of Criminal Justice 359.

Volume 5: Payments, Modern Payment Methods and Systems 409 a considerable administrative burden on these intermediaries, but also requires a great deal of sound judgement on their part. It makes banks in fact criminal enforcement agencies within a slender due process framework. It is also clear that this breach of privacy may be used for other ends by investigators to whom they report, especially tax inspectors. The confiscation notion on the other hand focuses on disgorging the benefits of illicit activity so that no one can benefit from major crimes as defined for these purposes and is as such new in many countries, although there was always some (often limited) room for it in homicide cases. Rather, in most countries, punishment was traditionally seen as a separate issue, leading to prison sentences or to fines, while confiscation was not an automatic sequel. It could leave criminals with substantial gains, an issue now increasingly addressed. Confiscation might raise further legal issues, especially the question of who would be entitled to the money. At least the traditional distinction between criminal and civil law is here blurred. The manner in which the confiscation is done may also need some review under due process principles, but the concept is sound and is now often also found in insider dealing cases. In the case of (suspected) terrorist accounts or of the accounts of erstwhile dictators, the remedies may also involve freezes of these accounts, and in the case of dictators, the eventual turning over of the moneys to the states from which these dictators have been driven. But as in the case of terrorists, the status of these accounts can often only be determined with the benefit of hindsight, and not when the deposits are being made. As for terrorism itself, the situation may have been profoundly changed after the attacks in the US in 2001, leading to a political environment in which the borderline between military and police action became blurred, while at the international level, this type of activity may acquire the status of acts of war, leading to intervention and international sanctions, rather than to extradition, trial and punishment of individuals within the more traditional framework of the criminal systems of nation states. International organised crime gangs with related or other objectives may increasingly meet similar responses. The prime issue is here no longer one of money laundering proper, although international terrorism often has close connections with arms dealings, drug trafficking, prostitution, or child abuse rings, and illegal immigration that commonly engage in it. Piracy may be another case in point. But even in respect of money laundering itself, the internationalisation of the effort to combat it has led to the notion of the nation state as the prime mover in criminal law being abandoned in favour of a different kind of intervention that uses untraditional methods. Again, one salient feature in this connection is that banks have been recruited in these efforts as main enforcement agencies without many legal safeguards for their clients.

3.4.3. International Action. The G-10, the Council of Europe and the United Nations It was already posited that globalisation has made money laundering and the use of money for criminal activity a particularly difficult problem that can no longer be dealt with at the national level alone. Above, it was pointed out that criminal law of the national variety is reaching its limits in its effectiveness. In any event, organised crime and especially terrorism has now acquired forms that can hardly be combated by the traditional criminal law methods. International co-operation at the criminal, political and now also military level appears increasingly necessary to have adequate effect, in which connection the measures against money laundering constitute only one of the tactics used. Since 1980, when the Council of Europe first issued certain recommendations in the field of money laundering, the subject of money laundering has increasingly received the attention

410 Volume 5: Payments, Modern Payment Methods and Systems of international bodies. The banking supervisory authorities of the G-10 (within the Bank for International Settlements) adopted a declaration of principles in 1988, while the G-7 of the most developed countries at its Paris Summit in 1989 instituted a task force on the subject - the FATF. It now covers 29 so-called FATF countries. FATF issued many recommendations. They have no binding force as such but have had a great deal of influence. The key is customer identification, mandatory suspicious activity reporting, and due diligence of banks. A major objective is further to include also non-banking entities in the drive against money laundering, such as lawyers, accountants, and other professional advisers. One of its (informal) sanctions is to blacklist countries, thus excluding them from the international banking circuit. Tax havens in particular, such as the Bahamas, Liechtenstein, the Cayman Islands, and Panama have been so targeted and did adjust their ways, albeit more for tax avoidance purposes, once this became also an aspect of money laundering. Many Eastern European countries also remained a major problem. In fact, the involvement (whether active or passive) of the City of London has also often been mentioned. On the other hand, in many countries including the US the ‘know your customer’ and reporting rules have been questioned in the context of a concern for privacy. This has come under scrutiny in particular with tax management. In this connection it should be considered that in terms of tax avoidance, the operation of offshore tax havens is not in itself offensive, and the question is whether banks in those havens must guess the motives behind the deposits with them, especially for money transfers coming through payment instructions from reputable international banks. In this connection it should be recalled that in 1996 the FATF asked for the offences to be extended to all serious crimes and in 1999 it asked for the inclusion also of tax evasion. Valid as these concerns are, it was already said that combining these concerns with combatting serious crime may taint the effort and raises even more the spectre of due process. There are here also serious definitional problems. The United Nations adopted a (Vienna) Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances in 1988.624 It defined a number of drug trafficking-related crimes, lifted bank secrecy in respect of them, and required domestic laws to incorporate the concept of confiscation. By 1994 it had been adopted by 148 countries and the (then) European Community.625 It was followed more generally in relation to all criminal activity (as determined by individual states) by a Council of Europe Convention on laundering, tracing, seizure and confiscation of proceeds of crime in 1990, which acquired the required number of ratifications (three) in 1993 (namely the UK, the Netherlands and Switzerland). It is now ratified by most FATF countries. It should be recalled in this connection that the Council of Europe’s involvement has two particular features that make it important in this field. First, it has criminal jurisdiction (even though it cannot bind its members), which the EU generally lacks (except if sufficiently intimately connected with the free flow of persons, goods, services and money). Secondly, it has among its 624 Before this, the fight was mainly against opium: see the International Opium Convention of the Hague of 1912. In 1939, there followed the Convention for the Suppression of the Illicit Traffic in Dangerous Drugs. It first introduced the concept of confiscation. In 1964, the UN followed with the Convention on Narcotic Drugs. The 1939 Convention was expanded to synthetic drugs by the 1971 UN Convention on Psychotropic Substances. These earlier Conventions covered production and dissemination. The 1988 UN Convention covered the money laundering aspect also. 625 In 1993, the UN set up a model law facility on Money Laundering, Confiscation and International Co-operation in relation to Drugs. A Global Program against Money Laundering was set up in 1997 under the Office for Drug Control and Crime Prevention as a means to further technical co-operation and preventive action. The financing of terrorism was condemned immediately after the terrorist attacks on the US in September 2001 as we have seen and put that at the centre of money tracking activity.

Volume 5: Payments, Modern Payment Methods and Systems 411 members the Eastern European countries and former members of the Soviet Union and Asia. The importance of this Convention is further that it goes beyond drug trafficking.626 But it requires co-operation between the signatories in the investigation and confiscation of proceeds, for which there is a need for an active implementation programme. The Council of Europe regularly issues papers on best practices in this connection concerning the combating of fraud, drugs and organised crime.

3.4.4. The EU On 10 June 1991, the EU issued a first Directive on the prevention of the use of the financial system for the purpose of money laundering in connection with all criminal activity whether or not in a Member State or elsewhere aiming through a separate declaration also at a system of (domestic) criminal sanctions in each EU country.627 Although it was already said that the EU has no general criminal jurisdiction, it is agreed that it may assume628 powers in this field if the free flows of persons, goods, services, capital and payments are directly affected. The stated motive for EU action in this field was indeed the protection of the integrity of the financial system at large in the Community. The Directive itself elaborated rules on combating the money laundering offence by imposing on financial institutions special duties of identification (of their customers, Article 3) and of investigation (such as tracing, disclosure and reporting of suspicious money movements (which remain undefined, Article 6)). These financial institutions must avoid any notice to customers (Article 8) and maintain internal procedures in this respect (Article 11). To this end, bank secrecy obligations (statutory or contractual) are lifted and special protection is given to reporting financial institutions and persons therein against liability for wrongful disclosure (Article 9). It is clear that within this framework, financial institutions within the EU are forced to undertake their own identification and investigation role in aid of criminal prosecutions, an onerous and sensitive task. Other professionals (such as lawyers and auditors) may also be included through the implementing legislation, as the UK has done. A Contact Committee was set up at EU level to co-ordinate the approach of the authorities in this matter (Article 13). Laundering of drug money was the main target of the first Directive, but as Member States could add the holding of proceeds of other offences, notably those connected with terrorist activities, the coverage of the implementing legislation could be wider in each EU country. Most, like the UK, included from the beginning proceeds of any serious crime such as fraud, theft, or extortion. It was not the intention to cover the proceeds of all crimes generally, including those connected with taxation and black-market operations, although France went that way. Indeed, this EU system of forced bank co-operation in criminal prosecutions could and did serve as a model eventually to attack the so-called black money and tax evasion circuit more generally. As already observed, that may well undermine, however, the credibility of the entire policy, which would thus become a prime tax collection tool. It is therefore necessary to define the policy

626 A Council of Europe Criminal Law Convention on Corruption has additional money laundering provisions in this area. 627 Following an earlier resolution of the European Parliament of 1986: on the history see KD Magliveras, ‘Money Laundering and the European Communities’ in J Norton (ed), Banks: Fraud and Crime (London, 1994) 171. 628 Under the so-called Third Pillar there are further powers based on additional Conventions between Member States that deal with fraud and corruption. There was created an Action Plan in this connection, which was first to suggest that the major enemy is now organised crime.

412 Volume 5: Payments, Modern Payment Methods and Systems objectives clearly, all the more so because of the criminal nature of the charges. Is it illegal cash entering the banking system? Is it money already in the system but transferred in respect of illegal transactions? Is it the criminal record of the recipients itself? And in terms of criminal activity, is tax evasion or the suspicion of it through black market transactions or the diversion of income streams to other countries included? Other obvious questions are to what extent banks can reasonably and efficiently be used or relied upon as enforcement agencies and how far bank secrecy is to be lifted. It should be noted that so far, the objectives in this connection may remain quite unclear or some kind of mixture. The developments since 1991 centred first on implementation, in which connection there were two EU Commission Reports which notably called for central reporting units and the inclusion of lawyers. The European Parliament responded to the first report with a 21-point resolution calling notably for the extension to the proceeds of all organised crime. One of the main problems was that in each Member State the reporting of banks to the authorities acquired a domestic form which inhibited the exchange of information as the status of these so-called Financial Intelligence Units could be quite different and be, for example, part of the police or the judiciary, independent or an administrative body.629 Another problem was the exchange of information with non-state bodies. In 1996 a common definition was agreed and a certification procedure which gave access to a central internet and e-mail system of information exchange. A Second Money Laundering Directive was agreed in November 2001, when, under pressure of the terrorist attacks in the US, the stumbling block of including lawyers in the investigation and reporting process was removed. It amended the first Directive and extended the coverage to all drug trafficking offences of the Vienna Convention, organised crime, serious frauds, corruption, and any offence which could generate substantial proceeds, and which was punishable by severe imprisonment under the criminal law of the relevant Member State. A Third Money Laundering Directive was agreed on 20 September 2005.630 It consolidated the earlier two and also included the 40 FATF Recommendations of 2003. It gave rise to extensive discussions on the details, but the basic approach, which can be summarised as combating organised crime and terrorism at the international level through a system of preventive action, was not changed. A Fourth Money Laundering Directive dates from 20 May 2015 and is more particularly (but not only) directed at terrorist financing. The purpose of the Directive was to remove any ambiguities in previous legislation and improve consistency of AML/CTF rules across EU Members States. The main changes relate to the areas of risk-based approach, ongoing monitoring, beneficial ownership, customer due diligence (CDD), politically exposed persons (PEPs), and third-party equivalence. A Fifth Money Laundering Directive was agreed on 19 April 2018, and came into force on 10 January 2020. This Directive introduced some important changes to aid the authorities and regulators in the various EU Member States in the fight against money laundering and terrorist financing. Another important change includes requiring virtual currency providers and custodian wallet providers to conduct AML/CTF background checks (that is, Know Your Customer, or KYC) on their customers, as there is evidence that criminals are using virtual currencies and

629 See for the operation of these Units also G Stessens, Money Laundering: A New International Law Enforcement Model (Cambridge, 2000) 143ff and V Mitsilegas, ‘New Forms of Transnational Policing: The Emergence of Financial Intelligence Units in the European Union and the Challenge for Human Rights’ (1998) 3 Journal of Money Laundering Control 147. 630 Directive 2005/60/EC of 26 October 2005 of the European Parliament and of the Council [2005] OJ L309/12.

Volume 5: Payments, Modern Payment Methods and Systems 413 virtual currency exchanges to conduct criminal activities and to launder the proceeds of crime. These providers are required to monitor transactions and report suspicious activities to the respective Member State regulator. There is research from 2017 suggesting that approximately one-quarter of all Bitcoin users and 44 per cent of Bitcoin transactions are associated with illegal activity (although it is hard to know exactly what the real figures are).631 For example, criminals are able to accept payment in virtual currencies (for example, Bitcoin (BTC) or Ethereum (ETH)) for illicit goods (for example, weapons, drugs or child pornography) that they sell online on dark net sites such as the Silk Road. The criminals can then use virtual currency exchanges such as Coinbase to convert their virtual currencies back into fiat currency (for example, USD or EUR). Although the market for virtual currencies was very small in its early days, it has grown large enough in the past decade for regulators to be concerned. For instance, the market capitalisation of Bitcoin in January 2021 reached a high of USD $700 billion, with the price of a single Bitcoin reaching USD $40,000 for the first time on 7 January 2021. Moreover, the market capitalisation of all virtual currencies combined was over USD $1.1 trillion in January 2021. It is evident that these markets should no longer be ignored. Therefore, the regulation of virtual currency exchanges and wallet providers is a step in the right direction in order to make it harder for criminals to launder money in this fashion. However, to be fully effective, the new Directive arguably does not go far enough. The Directive only applies to virtual currency exchanges that convert virtual currency into fiat currency (and vice-versa) for their customers. The AML/CTF requirements do not apply to entities that issue virtual currency or entities that exchange one type of virtual currency for another type of virtual currency (for example, BTC for ETH) (known as virtual currency administrators). Therefore, criminals can easily use these entities to convert their ill-gotten gains into different types of virtual currency. For example, a criminal can convert their BTC into ETH, and then back to BTC using the services of a virtual currency administrator. This means that the criminal in this example is using the entity to launder the proceeds of their crime. The criminal is then able to convert their laundered proceeds into fiat currency over the counter on one of the many available websites (that is, by making the exchange face to face). The entity is aiding in the layering stage of the money laundering process without having to know who the customer is or without having an obligation to report any suspicious activities to the relevant regulator. Therefore, the Directive falls short on combating money laundering and terrorist financing in comparison, for example, to regulations in the US, where FinCEN imposes AML/CTF requirements money services businesses that exchange virtual currency for fiat currency and that exchange one type of virtual currency for another type virtual currency. This is also the requirement in Australia under the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 under an amendment made on 3 April 2018. Although the EU Commission has proposed the creation of a new Regulation of Markets in Crypto-Assets (MiCA) in order to provide a single licensing regime for crypto-assets across all Member States by 2024, this proposed regulation (in its current form) does not directly address the challenge of money laundering and terrorist financing. Therefore, if the EU wants to demonstrate that they are serious about combating financial crime being conducted with virtual currencies, they will need to include additional requirements to specifically dealing with virtual currencies and other crypto-assets in the Sixth iteration of the Money Laundering Directive, or include additional provisions in MiCA.

631 Sean Foley, Jonathan R Karlsen and Talis J Putnins, Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies?, Oxford Business Law Blog (19 February 2018).

414 Volume 5: Payments, Modern Payment Methods and Systems Aside from shortcomings with respect to virtual currencies and other crypto-assets, the Danske Bank money laundering scandal demonstrated that the current regulatory framework in the EU may not be robust enough to tackle money laundering and terrorist financing, arguably because supervision is too fractured. This scandal, which was uncovered in 2017, involved €200 billion of suspicious transactions that flowed from Estonian, Russian, Latvian and other sources through the Estonia-based bank branch of Denmark-based Danske Bank from 2007 to 2015. The amounts being laundered were quite large, bearing in mind that Estonia had a GDP of just over €23 billion in 2017. Thus, this scheme was the largest money laundering operation ever uncovered in the EU, and possibly the largest in world history. The Estonian bank branch was being supervised by the Financial Supervisory Authority of Denmark (as the bank had its headquarters there) and the Financial Supervisory Authority of Estonia (as the branch was located there). In the aftermath of the scandal, both supervisory authorities blamed the deficiencies on each other. However, it was quite clear that both had turned a blind eye to the entire situation. There was punishment allocated to ten former employees of the Estonian bank branch who were arrested by Estonian authorities in December 2018. The Estonian authorities required the branch to shut down its operations in 2019. With respect to legal reforms, the Danish Parliament increased the penalties for money laundering eight-fold. Moreover, the European Banking Authority (EBA) launched an investigation into the entire affair. However, it closed the investigation early and did not publish its findings, much to the dismay of many. In order to avoid such a situation in the future, it may be necessary to increase the role of an EU regulator (such as the EBA) in the supervision of large European banks, in particular those which have branches in multiple EU Member States. Such an EU supervisor could impose more stringent requirements; for example, the rules could require the employees of large banks to file suspicious transaction reports directly with this ‘supra-regulator’, as well as with the relevant EU Member State supervisory authority. This could permit the supra-regulator to detect and put a halt to large-scale money laundering operations sooner rather than later.

Part IV Security Entitlements and their Transfers Through Securities Accounts. Securities Pledges and Repos 4.1. Investment Securities Entitlements and their Transfers. Securities Shorting, Borrowing and Repledging. Clearing and Settlement of Investment Securities 4.1.1. Modern Investment Securities. Dematerialisation and Immobilisation. Book-entry Systems and the Legal Nature of Securities Entitlements The modern law of investment securities, particularly in the form of book-entry entitlements, was extensively discussed in Volume 4, Part III, and will only be summarised below. Of more special interest is here how these entitlements may be used in financings and how that may affect their status, clearing and settlement. The normal types of investment securities are shares and bonds. They are typical capital market products, used therefore by issuers to attract funding directly from the public. Shares are a type of participation certificate in companies that give the owner dividend, voting and information rights and, in the case of a liquidation, a pro rata share of any liquidation proceeds. They are issued by companies including banks. Bonds are promissory notes of an issuer, often a company or bank, but governments or government agencies are also important borrowers in this manner. Both types of investment securities may be tradable. In the first case, this means that after they have been issued, they may be bought or sold in official (stock exchanges) or in OTC markets. To that effect, traditionally these investment securities came in the form of negotiable capital market instruments, which the bond as promissory note always was, but shares could be similarly treated, both mostly as bearer instruments. Especially in the US, where they are a product of State law that prevails in this area, they could also be to order, which for shares is more unusual elsewhere. Being negotiable means that they are transferred, in the case of bearer instruments, simply by handing them over to the buyer or, in the case of order instruments, by endorsement and handing over. This physical delivery requirement became a big paper mill, untenable by the 1970s, when a crisis occurred in the settlement departments of major stock exchanges, especially in the US (known as the ‘paper crunch’). There is another way of going about this, and that is used in England, where investment securities were not issued in bearer or order form, but were paperless or dematerialised from the

416 Volume 5: Security Entitlements and their Transfers Through Securities Accounts outset. These securities existed in and could only be transferred through the issuer’s share or bond register, maintained by the issuer (for shares therefore by the relevant company). Although there could still be certificates, these were only evidence of ownership and played no role in the transfer itself, which was only complete upon a change in the register when a new certificate would be issued to the new owner. Yet because of the continuing need for some certificate, there arose paper handling problems in this system as well. Particularly in the US under State law, various forms of shareholdings and transfers could exist side by side, and still do.632 But in 1994, Article 8 UCC introduced a uniform system, not in respect of these underlying investment securities themselves, but in the manner of their subsequent holding and transfer. It reflects and elaborates on market practices that had developed in the meantime to overcome the paper crisis through the use of a custodial holding system. In this system, investment securities were not necessarily dematerialised as such, but as a first step they were immobilised in that the issuer would issue them to one or a small number of custodians called depositories (or depositaries) who would thereby become the sole owners of the securities and keep them for end-investors (which implied great cost savings to the issuer). The main depository in the US is now the Depository Trust Company (DTC). The depositories would not retransfer these investment securities to end-investors but hold them for them in perpetuity (in the traditional manner as bearer paper or by way of registered securities). Although we speak here of a custodial system, it should be realised that depositories hold the underlying securities as legal owners. They only issue entitlements to security brokers, who in turn issue entitlements to their clients as end-investors: see for greater detail Volume 4, part III. As a result, end-investors no longer owned the investment securities, but only entitlements in them against their brokers in which connection they could be several tiers removed from the depositories/owners. This is the modern system of securities holdings for investors subject to a simple facility of debiting or crediting their securities accounts by their direct intermediaries. To some extent they become comparable to bank accounts, but it should be stressed that the claims in a securities account are not merely contractual; as we shall see, it is a major legal issue. In this manner, there could be many intermediary holders in what is a tiered system of security holdings through (sub-)custodians. There may thus be a whole line of intermediaries or sub-custodians who hold entitlement rights only against the next intermediary or sub-custodian until the depository is reached, who is the share or bond holder proper as far as the issuer is concerned (cf section 8-102(a)(7) UCC). This tiering of rights is also called compartmentalisation. At the level of these entitlements, all rights are thus dematerialised in security accounts for clients and transfers go through amendment (crediting or debiting) of book-entry security accounts, again much as bank accounts are credited or debited to make payments through the banking system. This has become the modern way of holding and transferring investment securities. In this system, entitlement holders only have rights against the immediate intermediary in the tier above them, and can no longer go through the system to reach the depositories or issuers to reach the underlying investments. Such a so-called pass-through right would revive the old paper trail, and is normally excluded. The direct connect between issuer and investor

632 Publicly traded securities are issued in the primary market and traded in the secondary markets. How these markets operate is covered in Vol 6, ss 1.5.2ff. Whether or not the securities are issued in entitlement or other form is not crucial for the way they are issued or traded, and primary or secondary market activity in them will therefore not be discussed in the present context.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 417 is broken, and it is important to realise that book-entry systems of securities entitlements have in principle nothing much to do any longer with the issuer and the way or form in which the securities are issued, but everything to do with the way in which the investment securities are subsequently held (first by the depository and thereafter through brokers or other custodians as intermediaries) and transferred in the different tiers. In international transactions they are even likely each to have their own legal regime unless we can accept transnationalisation of the law pursuant to international practices. It follows that in a book-entry system, the entitlement holder is a person identified only in the records of its immediate securities intermediary (rather than the issuing company), like a depository, or more likely its broker (who in turn will have an account and entitlement with the depository or other intermediaries). This has brought great simplicity to investment security dealings and solved the paper mill problem. Another advantage is that the underlying nature of the securities, be they tradable, fungible or not, becomes irrelevant. All become transferable at the level of the security entitlement. The disadvantage is loss of confidentiality which bearer holdings traditionally offered investors. There may also be greater complications in the number of shares credited to accounts and extra reconciliation costs. Naturally, the end-investor still believes itself the owner of these shares or bonds, but it should be realised that in a book-entry system this is no longer strictly speaking the case. Under applicable law, the interest of entitlement holders is nevertheless still proprietary, or at least must be handled as such in the sense that, upon a bankruptcy of their intermediary, the back-up entitlement of the bankrupt intermediary corresponding to that of the investor is not considered part of the intermediary’s bankruptcy estate. End-investors are often held to be together jointly entitled to all beneficial interests that their intermediary (or broker) holds through its own entitlement with the depository or other intermediary immediately above it in the particular shares or bonds—see section 8-503 UCC—even though without a pass-through right they cannot reach these interests directly (they can only ask for these interests to be moved in the intermediary’s bankruptcy). In this system, the intermediary is not entitled to pledge or encumber such corresponding back-up entitlements either: section 8-504(b) UCC. In order for this regime to be effective, the applicable law must express this, which in many modern legal systems is achieved through statute and may be achieved at the transnational level through practice and general principle. Indeed, most modern countries now operate similar systems, but there remain characterisation problems. The characterisation of the investor’s interest as common or joint property (as is usual in civil law) is here less satisfactory. It was already said that notably there is no passthrough right for any nor for them jointly, only segregation in the case of a bankruptcy of the intermediary (broker). Even then, the back-up does not accrue to the end-investors, but they may appoint other brokers to whom their back-up must be transferred by the bankruptcy trustee. That is all. What then is the true nature of the end-investors’ interest? In the US, Article 8 UCC is here best seen as creating a sui generis proprietary right or a bundle of rights against an intermediary, under which the investor loses direct access to the underlying securities (or entitlements higher up in the chain except if otherwise agreed), but, whatever the layers of holdings (and regardless of any direct access to the issuer and depository because of pass-through rights, which are now normally excluded), the end-investor retains the ultimate right to the coupon and principal repayment in the case of bonds, and to income or dividends in the case of shares, and then also to the voting rights, any winding-up proceeds, and to corporate information. In that sense, the intermediary is only trustee in respect of these rights for the end-investor (or the next tier of intermediaries through which the end-investor is ultimately reached). Common law can express this better.

418 Volume 5: Security Entitlements and their Transfers Through Securities Accounts In this system, the intermediaries must back up the entitlements they issue to their customer with entitlements of their own against the next higher tier in the chain: see section 8-504(a) UCC. This asset-maintenance obligation is crucial to the system, and the back-up must be achieved ‘promptly’, allowing, however, some time to elapse in order to allow the intermediaries to make the necessary adjustments (that is, reconciliations) to rebalance the system. This has to do with the fact that they often deal with their customers from their own account and do not previously cover any sales to clients with an adjustment of their own entitlement. That is done later, but it could destabilise the entire system, and investors are at risk of an intermediary not taking the asset-maintenance obligation seriously. If there is no sufficient back-up, in a bankruptcy of the intermediary the investors’ entitlement would be diluted in respect of all holdings of the same type of investments. For them that is the risk of having chosen a dishonest broker. The law allows some rational leeway in the adjustment process, but that works against investors in an intervening bankruptcy of their intermediary. It should be understood that this tiered system of entitlements is in truth only an administrative arrangement. Although of the greatest importance in facilitating the modern holding and transfer of securities in an efficient and safe manner, it undermines the proprietary status of the holding as we shall see. They become mere claims. It is nevertheless true that, even if in principle the entitlement can only be claimed against the immediate intermediary and certainly not directly against the depository or the issuer, the end-investors still have direct rights against the depository should all intermediaries somehow disappear. It also follows that if all end-investors somehow disappeared, the intermediaries would have no proper right against the issuer or depository, who would owe them nothing. It could also be said that, as a consequence, the entitlements of the intermediaries are not truly of the same order as those of the end-investors, who are the true beneficiaries. This also explains why (in a proper book-entry system) if an intermediary goes bankrupt, its back-up entitlement in respect of its clients against the previous layer can be immediately redirected by its clients to such replacement intermediaries as they choose, and that the bankruptcy trustee must give immediate co-operation to achieve this. In other words, the entitlement against the previous layer does not belong to the bankrupt estate of the intermediary (except for that part of which the bankrupt broker was itself the demonstrable end-investor). It has already been said that the interest of the investors is not therefore merely contractual, even if it may be difficult to define in a proprietary sense. The interest can be described as a statutory form of beneficial interest which provides an end-investor with proprietary rights. In a tiered system, it should be understood that, in principle, each tier has its own legal regime. This has already been mentioned and has consequences, particularly in international transactions. In such cases it would be quite normal, for example, for a French end-investor who buys Dutch government bonds to have an entitlement against its French broker (say BNP), who has a back-up entitlement against a Dutch broker (say ABNAmro), who has in turn an entitlement against a Dutch depository (normally Negicef). It may also be that both BNP and ABN have a securities and bank account at Euroclear in Brussels where the positions are settled, while Euroclear in turn has an entitlement against the Dutch depository of government bonds. If the French investor wanted German government bonds, a German broker (say Deutsche Bank) could become involved. Settlement could still be at Euroclear in Brussels, which would maintain a corresponding entitlement in respect of these German government bonds against Clearstream in Frankfurt, which is the normal depository in Germany. Thus, different claimants arise in different tiers in respect of the same underlying investment securities. They each operate under their own rules, which may be different from country to country. This may produce some disparities in the chain and affect the way the voting or dividend collection is passed in each tier, ultimately to the end-investor. Party autonomy and therefore

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 419 a contractual choice of law to bring some unity might not be effective in these proprietary aspects, and only a transnationalised system could then prevent this from happening. That has already been mentioned also and is an important issue. A (uniform) transnationalised approach would also be useful to determine absolutely the status of book-entry entitlements in a bankruptcy, wherever opened, so that, upon a bankruptcy of an intermediary, entitlement holders could always move their accounts to another intermediary at once, resulting in an automatic corresponding reduction of the entitlement of the bankrupt intermediary against higher intermediaries, wherever operating, in favour of the new intermediary. This is now the objective of the 2009 UNIDROIT Geneva Convention, which, however, lacks sufficient ratifications—see also Volume 4, section 3.2.4. It may also help to determine the position of collateral holders as we shall see. Again, a contractual choice of law per layer in favour of a foreign collateral law and its rules of perfection or control may not prove sufficiently effective, at least not when it comes to collection of dividends and the exercising of voting rights or to an unravelling in a bankruptcy of a broker elsewhere.

4.1.2. Securities Transfers: Tiered or Chained Transfer Systems. The Legal Characterisation of the Securities Transfer and its Finality The security entitlement, if properly understood, is a derivative of which immobilisation is the essence. The concept allows for many variations: it is possible to immobilise all kind of assets, even international cashflows that become tradable on the basis of entitlements, in this manner. In book-entry systems of this nature, any subsequent transfer is a simple matter and is for investment securities basically a book-entry change in the nature of a crediting or debiting of a securities account of the investor at the level of his broker. It has already been said that it is like crediting or debiting bank accounts. In terms of back-up, if a broker has no ready seller among its clients, it may deal out of its own inventory, or if it has none in the given securities, it will have to acquire some from other brokers/custodians or from the market through a more traditional system of clearing and settlement. However it is done, it is not uncommon for the broker to immediately credit the client (unconditionally at market prices) and take some time (and risk) to adjust the system as part of its asset-maintenance obligation. Again, the situation looks like that for payments in the banking system and is much inspired by it, but it is not the same. A distinction must be made in the sense that modern securities holdings represent tiered systems and modern bank account holdings chained systems of transfer: see section 3.1.4 above. In a tiered system, there are no credit transfers through the system proper; there are only (asset-maintenance) adjustments made after security accounts are credited or debited in terms of back-up in the higher tier. One could also say that this is the effect of compartmentalisation. It is facilitated by the fact that sellers and buyers of securities in official markets are not directly connected and sell to or buy from intermediaries, who subsequently adjust their own back-up holdings. Investors thus normally buy and sell into a market system in which intermediaries make constant adjustments, but in which the end-seller and buyer are in essence anonymous (except in respect of their own broker) and not connected. In chained systems, such as the payment system, that is quite different as there is a direct connection between transferor/payor and transferee/payee. At least in a push system, the chain starts with debiting the payor, then going through the system by way of a debit in the first layer and credit in the next one, until the bank of the payee is reached and the payee is ultimately credited by this bank: see again more particularly section 3.1.4 above. As we have seen there, until the final crediting, there is no payment proper.

420 Volume 5: Security Entitlements and their Transfers Through Securities Accounts That can exceptionally, but does not normally, occur in a system of securities entitlements and transfers. There is only a true chain when both end-parties are identifiable and directly connected in a sale or similar transaction. This may still happen in the case of securities lending, as we shall see. Thus, securities entitlement transfers are not normally dependent on the performance of intermediaries in a chain. A security entitlement is created as soon as a broker creates one, even if the broker fails to meet its asset-maintenance obligation and no underlying adjustments are (as yet) made.633 It follows the practice of large brokers often to deal from their own inventory (at least for the smaller transactions) in which they might go short (subject to their assetmaintenance obligation).634 That is also called self-dealing. They may also net out their client’s buy and sell orders in the same securities on a continuous basis, another form of internalisation. To repeat, the essence is that the debiting and crediting of the entitlements is between investors and their custodians/brokers only, who keep their clients’ securities accounts subject to an asset-maintenance obligation, an obligation which does not result for intermediary banks in the bank payment system. It follows that, unlike in the payment system, there are normally no push or pull systems of transfers and no credit or debit transfers, while the questions of assignment or novation do not arise either. In respect of their investors’ interests, intermediaries are activated by clients’ instructions only. As a consequence, both the client’s securities and money accounts with the intermediary (broker) will be affected, the money accounts very likely in the manner of a bank account if the broker is also a bank. By way of further elaboration, it may be useful for a moment to return to the payment situation and compare the role of a broker holding a securities account for its client with that of a bank holding a cash (bank) account for its client. In fact, if the broker is at the same time a bank, which is often the case at least in Europe, both accounts are likely to be connected, in the sense that if the client sells shares its securities account will be debited but its bank account will be credited with the sales proceeds and vice versa. There is no need to find a new end-investor first and await its payment through the system. To repeat: looking through the transaction, the seller will be directly debited (unconditionally) in its securities account while its bank (as broker) may not take any further action for the moment (and rebalance the system only later). The payment will then come from the broker/bank and result in an unconditional credit in the bank account of the seller. Should, however, the end-investor use a broker that is not its bank at the same time, its security account would be unconditionally debited immediately (by the broker), but the end-investor may have to wait for its payment in its bank coming from its broker through the banking system in a chained transaction. If the end-investor were the buyer of securities, its broker would credit the security account immediately, but may have to wait for payment by the client through the banking system (to avoid any risk, the broker may want pre-payment). The client may also keep a bank account with the broker directly, but that would be in the nature of a segregated client account (that is, a cash account) and could not be an ordinary checking account unless the broker is also a bank.

633 For a clear description see JH Sommer, ‘A Law of Financial Accounts: Modern Payment and Securities Transfer Law’ (1998) 53 The Business Lawyer 1181, 1203. The reason for the difference appears a practical one. Banks do not like to tier deposits, which would lead them to hold balances with their corresponding banks larger than needed to run a payment system. That is costly for them, and they prefer to run debit balances instead. In the case of security dealings, it appears on the other hand cost-effective for them to use higher-tier intermediaries to satisfy their assetmaintenance obligation. 634 Smaller brokers may act differently and still go through the chain until they find someone who deals from their own inventory or goes short.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 421 The security entitlement situation and the clarification of the relationship with the broker resulting in entitlements against the broker (through the securities account) leads to a situation in which the end-investors need to be less concerned about commingling and segregation, which in a system of physical securities holdings (especially if issued to bearer) traditionally undermined their position, subject to some rights of tracing (in civil law only if the investor had the numbers of the securities) or constructive trust (but only in common law countries). Thus, there is clarification and reassurance here, but also loss of anonymity. Confidentiality may now only be assured by moving to brokers in other countries. To repeat, as to cash accounts, if the broker is not a bank or other licensed deposit-taking institution, the broker is not the owner of its client’s money. Here the maintenance of true client accounts and segregation remain an important precaution. As already mentioned, in securities transfers, there is likely to be a system of self-dealing and set-off of orders (internalisation) by brokers, which raise issues as to price and best execution. These may in turn raise important regulatory concerns to be discussed in Volume 6, section 1.5.9 but do not distract from the basic set-up in which brokers no longer act as undisclosed or indirect agents in the proprietary aspect of securities dealing unless they go into the markets first. It would require them to follow their deals on an individualised basis, which is inefficient, at least for smaller transactions. They continue, however, to have fiduciary duties, such as obtaining best prices, considering suitability, protecting confidentiality and the like. Brokers may still deal on stock exchanges, however, where they will meet other brokers, especially for larger orders or to rebalance their own back-up positions as part of their assetmaintenance obligation. If they deal for clients in the open markets, they still operate as indirect or undisclosed agents. In the absence of self-dealing, the entitlement system may thus be coupled with indirect agency rules in respect of unfinished trades, under which an automatic right to an entitlement might result for buyers in respect of whose acquisitions the broker’s own entitlement has already been adjusted, but not yet theirs. This would entail, however, some pass-through right, infringe the compartmentalisation notion, and may as such no longer be viable, although, if the broker thus has excess back-up, it should be available for end-investors at least in the broker’s bankruptcy, therefore even if not already credited to the end-investors. It is also important to understand that in security transfers, whether tiered or not, there is not or should not be securities creation. In principle, no new shares are created, as all entitlements must be backed up by entitlements in the next higher tier of intermediaries. Although there is a facility for the broker going temporarily short, it is subject to strict asset-maintenance duties and a need to make prompt adjustments through the system to rebalance it, as we have seen. There should not in the end be open positions. To repeat, banks can create (or destroy) money by taking it in or out of the system, although they do not commonly do so in the payment circuit. Custodians should not create security entitlements, although technically they can, and are indeed likely to do so momentarily. Indeed, they may also do so in short positions (as we shall see in section 4.1.3 below) but, beyond mere adjustment delays, this could soon become fraudulent. There would be a lack of back-up, which would dilute the holdings of other investors in the same investment securities with the same broker and could be very serious for all of them in a bankruptcy or the broker or similar intermediary. Hence the supreme importance of the assetmaintenance obligation. One of the big disadvantages of having a tiered system of security entitlements is that it could result in an overissue (and potential shortfall) of securities, as the broker is in charge of crediting and debiting an end-investor’s securities account. A major problem is that of overissuing

422 Volume 5: Security Entitlements and their Transfers Through Securities Accounts shares,635 where the broker credits more securities to the investor omnibus account than it actually holds with an upper-tier intermediary or depository. This is problematic in situations where the broker becomes insolvent, as more investors have claims to a share than the quantity that actually exists. This could lead to a shortfall situation if the broker becomes insolvent, which typically arises where a broker is operating a Ponzi scheme, or where the broker misappropriates an investor’s securities. Although most countries provide end-investors with some form of state-backed insurance protection in situations where the broker becomes insolvent and it is subsequently discovered that there is a shortfall of shares in the client omnibus account, the losses are generally capped at a certain amount (for example, investors in the US are protected under the Securities Investor Protection Corporation (SIPC) for an amount of $500,000 for securities and $250,000 for cash held by a broker), meaning that investors may experience losses on anything above the insured amounts. Therefore, investors are ultimately exposed to custody risk for any losses above the insured amounts.636 As in payment systems, not only the security entitlement itself, but also the transfer and its mechanism, is best considered to be sui generis. The legal aspects remain therefore to be determined in a manner that reflects the nature of the interest. It appears to do away with traditional delivery notions and requirements in terms of cause, disposition rights and formalities. It is a simple (unconditional) crediting and debiting system of book entries. Since there is no transfer proper, one may also ask whether there is still room for a protection of bona fide transferees against any shortcoming in disposition rights. More generally this goes to the finality of any book-entry credits. First, buyers should not need to concern themselves that the securities with which they are credited may derive from someone who is not a true seller, for example the latter having received the securities merely as a repo buyer or securities borrower or under a pledge; see also the discussion in the next section. Compartmentalisation means that there is no transfer proper. Another aspect is that a buyer should not worry about the broker unilaterally withdrawing the credit at will. It is final, never mind a proper back-up—mere mistakes in the booking are not sufficient to make adjustments. Neither is a lack of back-up. As for this protection of the bona fide purchaser, it is likely that the bona fide purchaser protection works here directly against the intermediary in terms of sharing in any asset back-up or pool, especially if new credits were not properly supported. It means that the bona fide purchaser, even if the last purchaser who was demonstrably not covered by the broker’s back-up duty, still shares pro rata in the pool. This becomes the risk of the holders of the same securities with the same broker. In terms of the legal characterisation of the transfer and its finality, similar issues arise as in the case of payments through the banking system, even if these are chained, not tiered: see section 3.1.3 above. These issues centre on (a) the effect of fraudulent or defective instructions, (b) the meaning of acceptance of instructing the broker and the execution of the order,

635 There is evidence of this happening in the US. ‘The “overissue” problem is significant – it means more owners have valid claims to an asset than the quantity that exists, and by definition this suppresses the price of securities by inflating their supply artificially. The best example of this issue is In re Dole Food Company, a 2017 class action lawsuit before the Delaware Chancery Court in which investors alleged that the shares were undervalued at the time of a management buyout. A total of 49.2 million “facially valid” claims to Dole Food shares, all backed up by brokerage statements as proof of ownership, were filed for the 36.7 million shares outstanding’. Andrea Tinianow, ‘A Split Emerges in Blockchain Law: Wyoming’s Approach Versus the Supplemental Act’, Forbes (7 March 2019). 636 Custody risk is the ‘risk of loss on assets held in custody in the event of a custodian’s (or subcustodian’s) insolvency, negligence, fraud, poor administration or inadequate recordkeeping’. BIS Glossary.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 423 (c) the question of capacity and intent in the selling and buying of the securities between seller or buyer and their broker or between brokers among themselves (there normally being no chain), and (d) in the transfer, its formal requirements (for example, in terms of existence, identification and delivery). As in payments, finality would be underpinned by (i) de-emphasising the role of capacity and intent; (ii) the abstract nature of the crediting or debiting; (iii) notions of independence of the instructions; (iv) the bona fides of investors once they have been credited, so that they need not be concerned about the origin of the securities or their being tainted, unless the investor was involved in the fraudulent scheme—it is truly a question of title and disposition rights in the securities, which may be assumed; or (v) as a question of reliance. It is, however, possible that the issue of finality is handled somewhat differently for securities entitlement transfers than in payments. Thus, for securities, the necessary finality may acquire a somewhat different slant, as there is no ‘transfer’ in the traditional sense. For payments, the emphasis in the reasoning may be on (i), (iv) and (v). For investment securities, it may be more on (ii), (iii) and (iv) in line therefore with the notion of abstractions of the transfer and independence of the instructions derived from the practice of the old negotiable instruments, which investment securities traditionally were. In the US, Article 8 UCC appears to favour option (iv)—finality is enforced and adverse claims cannot be made against bona fide transferees for value: see sections 8-502, 8-503(e) and 8-510 UCC.637 Similar needs arise also in respect of the irreversibility of instructions once the process is set in motion, although if the transaction is not chained, there is less danger of legal disruption. However, especially in the case of fraud, it may still (exceptionally) be possible to prevent or reverse any securities credit to an investor. Also, if the debit or credit is due to an error at the level of the immediate intermediary, the latter may autonomously be able to correct its mistake by amending the booking, but not for other reasons. In other words, the intermediary must also respect the finality of the booking. It is not certain whether in the daily practice that is always sufficiently understood by them. As we have seen, this might be somewhat different for bank accounts where the bank is more properly a counterparty and no proprietary rights in assets are directly involved. In securities trading, special finality issues arise in a bankruptcy context. They do not then concern the finality of any transfer proper, but rather the power of an insolvent intermediary still to execute instructions, its (continued) functioning in the relevant clearing and settlement facilities, the effect on its participation in the netting, and any retroactivity of the bankruptcy in this regard until the beginning of the day of the bankruptcy (which is a common bankruptcy rule and undermines all transactions in which the bankrupt was involved on the day of its bankruptcy). These finality issues arise typically in the context of the settlement of agreed transactions and have in Europe been the subject of the EU Settlement Finality Directive: see more particularly section 4.1.5 below. There is more generally a conceptual challenge in book-entry systems. We try as far as possible to reach a similar result, as if there were still traditional shares or bonds rather than indirect holdings. The situations cannot always be equated, however. This has led to confusion, as may also be demonstrated in the next section. While applying the new rules, reaching similar results may, however, still be an important guide.

637 See also C Pitt, ‘Improving the Legal Basis for Settlement Finality’ (2003) 18 Journal of International Banking and Financial Law 341. The emphasis is here on statutory law and the EU Settlement Finality Directive.

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4.1.3. Securities Shorting, Securities Lending, Pledging and Repledging of Securities. The Notion of Rehypothecation An investor may want to sell securities short if it expects investment securities to go down in value. It means the investor sells securities it does not have but expects to buy them back later at lower prices to cover the sale so as to create a profit. However, there would have to be delivery on the agreed delivery date which would be the usual settlement date in the particular market. It is normally the next day, often three days in the US. If the seller did not have the securities, it would need to borrow them for a fee and its broker would normally arrange this. Thus, securities borrowing/lending is the ancillary to this activity, although the short sale may also be ‘naked’, meaning that by agreement no delivery will be required. The buyer would not have any knowledge of the short sale, for him it is one like any other. Only in the case of a ‘naked’ short is the buyer on notice. The sale is not complete in the proprietary aspect and the buyer accepts settlement risk although she may demand collateral or margin. In the case of securities lending proper, it is the lender who will do so to ensure that s/he gets the securities back on the appointed date. More likely is that in a book-entry entitlement system, the broker will debit the security account of the seller and may not immediately look for an endbuyer, especially when the short is intra-day or part of trading activity, which itself suggests lesser need for back-up. The result is that temporarily there may be more investments (securities) on the books than there are in reality. Regulators may outlaw such shorting in certain situations, although if done intra-day or within the settlement period it may be difficult to spot or be relevant as no delivery is yet required. It may be part of ordinary trade or market-making operations and then becomes a definitional issue. In the EU short selling is now subject to a Regulation: see Volume 6, section 3.7.9. In order to be fully effective, the delivery of borrowed securities normally includes the facility to sell on the borrowed shares or bonds. This is in common law also referred to as the right to use or reuse. In practice it means that the securities’ lender does not retain a proprietary interest in them and there can be no tracing in equity. Unless some conditional or temporary ownership structure can still be construed or an effective system of tracing, the lender may thus only have a contractual or personal claim against the borrower for the return of a similar number of securities of the same sort. Hence the need for collateral or margin, short of the possibility of bilateral set-off and netting if there are sufficient mutual claims. We assume here that it concerns fungible securities, which will normally be the case and the right to use is in fact very much connected with or follows from the nature of investment securities as fungible assets: only the same number need to be returned and there may be commingling. This situation is generally understood to exist and is recognised in legislation. Notably in the EU, reference may be made to Article 2(1)(a) of the Collateral Directive,638 see for this Directive section 1.1.9 above, MiFID (Article 13(7)),639 see for this Directive Volume 6, section 3.5.3, and the AIFMD (Article 4(1)), see for this Directive Volume 6, section 3.7.7, which all accept it explicitly. In practice, the situation is of particular

638 It is relevant in this connection also the EU Collateral Directive, see s 4.1.5 below, aims at a most simple form of creation of collateral and finance sales (like repos) in underlying investment securities, through mere contractual description of the assets and the rights created in them and dispenses with all formalities of creation and enforcement or transfer of the ensuing proprietary right. It contemplates also a shift between security and cash accounts in the nature of a floating charge with strong possessory features. 639 See also Art 19 Commission Implementing Directive 2006/73/EC subject only to keep records of clients’ details.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 425 relevance in professional dealings often in the public sector like in dealings with central banks or the BIS, IMF and in bodies that have a post-trading or clearing infrastructure like CCPs, but also central depositories in the EU then largely covered by the EU Collateral Directive. Another aspect is that if there is such a right for the borrower to use and deliver the underlying investment securities outright, bona fides does not come into the protection of the next buyer who would acquire good title immediately. Even if there was a conditional or temporary ownership right created or construed in the borrower, upon delivery, the buyer of the securities would not normally know about it and would be protected against these equitable interests as a bona fide purchaser (as she would have been if the securities were still issued as negotiable paper). There is here a clear break, the consequence of how security entitlements are issued and structured through security accounts that end investors hold with their brokers. The buyer then also ignores tracing rights. In any event, it is unlikely that except in ‘naked’ short positions, the buyer even knows about the sale to him being a short sale and about any of the underlying share-borrowing facilities. It follows that normally the sale is not tainted by the obligation that sooner or later the seller must return shares of the same sort to the security lender.640 It could not be otherwise; it would upset all transactional finality in the market. The upshot is that the securities lender has a weak position if the securities borrower does not return the underlying securities at the agreed moment. Hence again the need for collateral or margin, which then becomes the proper response amongst professionals. It has already been said that in the securities market the end-buyer and end-seller are not normally connected, and the ‘borrowing’ is in the case of short sales normally done from the broker, who may ‘lend’ the securities out of its own inventory subject to its rights to retrieve a similar number back from its client (the short seller) in due course (contractually). Again, the buyer (and its broker) would know nothing about it. Only if the broker is not in the position to function as ‘lender’, it would go into the market to find someone else. Exceptionally, the result may in that case be a chained transaction, as there would be a direct connection between the ‘lender’ and ‘borrower’, even if there was in fact a sale and that technique was used. It may be asked in this connection whether the operation of security entitlements instead of physical (fungible) securities may still make some difference. That would in the first instance appear to depend how far any such ‘proprietary’ interests could still be part of the entitlement register maintained by the intermediary. Normally, pledges or similar security interests can be marked, but not other types of equitable proprietary interests like conditional or temporary sales, including repos. In any event, if, as in short sales, a delivery becomes necessary, the buyer would not be satisfied with a limited right in the securities for which s/he will have paid in full. On the other hand, in a securities entitlement system based on an easy and uncomplicated form of crediting and debiting securities, no delivery in the traditional sense is required, and there could simply be an unbacked up credit of securities.641 The possibility of shortening securities and their back-up would thus appear enhanced and facilitated. The broker could simply credit the

640 A modern closely related alternative for an investor wanting to go short is a futures contract under which a sale at a future date is agreed for present-day prices. This is in truth a present sale with a delayed delivery: see s 2.6.1 above. Another way of shorting securities is selling (naked) call options in them. Here there is no need for a securities lending transaction either. 641 Full compartmentalisation is here assumed and no pass-through right to the depository, which is now highly unusual and ordinary end-investors are usually barred from having direct accounts with the depository. It follows that there can be no form of blocking of the investment securities at that level unless it were part of the asset maintenance obligation of the broker with whom the end-investor has its securities account. This is not implied and again offends against the fundamental notion of compartmentalisation.

426 Volume 5: Security Entitlements and their Transfers Through Securities Accounts securities account of the short seller and not back it up through asset maintenance. In any event, in book-entry systems, issues of real or physical existence and identification of the securities may become irrelevant or acquire a different meaning. However, the result would be a form of share or bond creation. In other words, when a broker provides shares which its client does not have, the back-up pool of the same shares for its clients gets diminished unless it is topped up in some way. It would in the first instance be the responsibility of the broker who allows the short sale. In view of the asset maintenance obligation, some form of securities borrowing thus remains necessary. The alternative is an ordinary back-up purchase by the broker, for which it may not have the money unless it is allowed to use the cash account of the short seller, who will have received payment from his buyer. The system of security entitlements and asset maintenance by the intermediaries would not appear to allow for much else. Without it, the interest of investors in the same securities would simply be diluted, as in a bankruptcy of their intermediary the corresponding entitlements in the higher tier would not be there. It means in practice that the business of going short only translates in a duty for the short seller to unwind the whole sequence at a later moment in time whilst paying the stock lender a fee even if the lending is booked as an outright transfer. Again, margin or collateral would protect the lender against the danger that the securities are not returned. In the meantime, the securities ‘lender’ may remain entitled to the income through substitute payments from the securities’ ‘borrower’ (on top of the fee paid). The ‘lender’ may also retain the voting rights. Yet on the books, the ‘borrower’ appears as the owner, who subsequently (or more likely simultaneously) delivers the investment securities so ‘borrowed’ to its buyer. If the broker retains the voting rights, there will be a problem, as the new owner, unaware of this, will also have these rights, as there is no such thing as a negative voting right that the short seller could provide to the security ‘lender’. It follows that the more shorting there is, the more excess or ‘phantom’ voting rights there may be.642 Assume that only 100 proxies come from the depository, all entitlements (say 120) have no more than 100 votes. In practice, the problem is solved in that few end-investors vote and the intermediaries, having allowed the short sales, will hope that there are no excess voters at the level of their clients and may also forego their own votes. But it is a form of appropriation of end-investors’ voting rights, which may be illegitimate in the sense that it could amount to a form of vote manipulation, especially relevant in a takeover situation. More properly, security ‘lenders’ should no longer reserve their voting rights and vote while understanding that they no longer have any entitlements. In a more rational system, there should be a market in voting rights which the stock ‘borrower’ (or his broker on his behalf) should buy (from the ‘lender’), say 20 in the above example, and take out of the market, meaning that neither the lender nor borrower would exercise them. It is one reason why shorting securities may be subject to regulatory concerns and restrictions. Another is of course the risk in shorting itself, especially for smaller investors. Regulators may in particular forbid brokers to lend (or temporarily transfer) shares (or entitlements) of other clients to earn a fee for themselves on this type of ‘lending’. Under applicable law, they may not normally do so without the consent of the relevant client and without the latter sharing in the benefit. Yet it may happen regardless more than one would think. Shorting may even be considered a form of market abuse when the market value of whole institutions is pushed down concertedly. This was felt to have been a problem with banks during the 2008 crisis in the government bond

642 See for the complications of voting in a custodial system, M Kahan and E Rock, ‘The Hanging Chads of Corporate Voting’ (2008) 96 The Georgetown Law Journal 1227.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 427 market where it came to be seen as a potential form of market manipulation—see again Volume 6, section 3.7.9. In the currency markets, this may also happen to currencies. A temporary halt to such activity at the instigation of the regulator is then the normal remedy. Strangely, though, such action is not normally considered when booms in securities are created in a similar manner.643 Pledging of securities to obtain funding is another normal securities transaction, but may also create special problems, especially in a book-entry or security entitlement system: see section 9-314 UCC in the US. When investment securities were still physical, it would normally mean a possessory interest and control would be taken by the financier/lender. In a book-entry system, this control is commonly differently expressed. In this case, unlike in repos, the interest may be marked on the books of the intermediary or the intermediary may agree to accept instructions of the interest holder only: see section 8-106(d) UCC. This is different from other interests such as security lending, which appears not to be so markable as we have already seen. In any event any buyer would not want to buy subject to such interests. The repo is here yet another legal structure; it is a conditional sale although as such closely related to the modern form of securities lending, as we shall see in section 4.2.2 below, and such sales cannot be marked either. The result is that in the absence of such markings, all such transfers appear as outright sales in the book-entry system, suggesting full entitlements in the new owners. In other words, the new set-up of intermediary holdings cannot otherwise cope with these structures and complications.644 The consequence is full ownership in any subsequent buyer. But even in the case of pledging when marked, there may still be a right of use (including repledging), implied if the broker has provided the funding. It has already been explained that the intermediaries (brokers) themselves have no right to grant security interests to third parties in their clients’ entitlements, nor should they use them for securities lending or appropriate the vote without consent; cf also Article 22 UCITS IV in the case of fund management. Similarly, they should not engage in finance sales (or securities lending) or repos involving the entitlements of their clients, except on the latter’s instructions. Intermediaries may do so of course to the extent they are themselves end-investors (section 8-504(b) UCC). 643 The tables were turned during the GameStop trading frenzy in late January 2021, where online investors were in the media spotlight and on the radar of the Securities and Exchange Commission (SEC) in the US because a group of retail investors bought up shares in GameStop in order to cause losses to hedge funds that had shorted the company’s shares. The event unfolded as follows: a large group of retail investors (who were aware that several hedge funds were shorting GameStop’s shares) communicated with each other on the Reddit forum ‘WallStreetBets’ and agreed to buy as many shares in GameStop as possible in order to drive up the share price, all whilst discussing their tactics and reasoning on the online forum. This event has led to calls for the SEC to investigate whether there was potential market manipulation, as the online investors had caused the price of GameStop shares to shoot up from around $39.12 per share on January 20 to $347.51 on 27 January, thereby causing the hedge funds that had shorted the shares severe losses. For example, the hedge fund Melvin Capital Management, which took a large short position in GameStop, lost 53 per cent of the assets it had under management, which went down from $12.5 billion at the beginning of 2021 to around $6 billion by the end of January 2021. However, it remained unclear whether the actions of the online investors amounted to market manipulation. Market manipulation cases usually fall into two categories: where sophisticated techniques are used to create a false sense of volume and interest in a particular security, or where false information is spread to drive the price of the security up or down. Therefore, there needs to be some form of ‘deception’ in order for the action to be considered market manipulation. It is unlikely that this herd behaviour was the result of anyone being deceived or trying to deceive others. 644 The reversionary interest of the original pledgor could itself be considered a type of security entitlement, reflected in a credit in its security account, but its meaning would be obscure, while the interest would only run against the intermediary and would not give special rights in his/her bankruptcy. There would, however, be normal set-off rights if the original pledgor had a debt to the intermediary, assuming there is a sufficient netting regime in place that can deal with this kind of situation where one asset is non-monetary, although not uncommon without it in securities transactions in the US: see Van Bommel v Irving Trust Co (In re Hoyt) 47 F2d 654 (SDNY 1931).

428 Volume 5: Security Entitlements and their Transfers Through Securities Accounts Regulatory interest expressing a similar concern in the US is expressed in SEC Rule 15c2-1 and in the Customer Protection Rule 15c3-3. These Rules also insist on consent. For swap clearing, a similar protection may be found in Section 724(a) of the Dodd Frank Wall Street Reform and Consumer Protection Act. Interesting is here also the situation where investors have bought securities on margin, that is, against borrowed money (not to be confused with margin payments in repos or derivatives: see sections 2.6.4 above and 4.2.4 below). The lender (often the broker) will normally ask for the resulting entitlements as security for the loan so made to the investor. Again, it is usually the broker who provides this facility and the broker will in that case keep ‘control’ of the securities so acquired (therefore over the margin buyer’s book-entry entitlement with himself). Particularly in such cases, the broker is likely to want the right to repledge these securities to serve its own funding requirements: see in the US sections 9-207(c)(3) and 9-314(c) UCC. This is in fact standard practice, and the broker is now normally given this right as part of the deal. Reference is in this connection also made to ‘rehypothecation’.645 It is usually believed that this right may be assumed to exist even without the margin buyer’s specific consent (which can, however, explicitly be withheld). It is achieved by the broker in ‘control’ transferring the relevant entitlements of its client to its own financier (with the duty for the latter to retransfer a similar number when the loan is paid off by the broker) in what may often be a repo transaction: see section 4.2 below. Technically, that would be the end of the ‘control’ and of any securities interest of the broker but for section 9-314(c) UCC, which in the US in such cases specifically maintains the perfection for the broker by statutory disposition. In the meantime, rehypothecation has become a major issue in the derivatives market where collateral is given for the performance of OTC derivatives like interest rate swaps. In fact, it is an issue in all situations where investment securities or other fungible financial instruments are given as collateral. In all such cases, a right of use may be implied and the secured party normally has the rights to sell these securities (or repledge them) and retain the proceeds or reinvest them, which is also reflected in the ISDA documentation.646 It follows that the position of the original investor is seriously weakened upon rehypothecation, and s/he may no longer have a proper entry in the security account, but at best some other indication of his/her right. Even if it is still proprietary in principle, again, bona fide purchasers of these entitlements are likely to be protected. Thus, also in this case, the investor’s property right disappears in a kind of fog and may no longer be traceable. It is an important issue that has also reached the courts.647 In fact, there 645 See also M Deryugina, ‘Standardisation of securities regulation: Rehypothecation of securities commingling in the US and UK’ (2009) 29 Review of Banking and Financial Law 252, 257 and 261. 646 The older common law rule in the US was that the repledge could be no longer than the original pledge and could not be for a debt larger than the original one. The original pledgor thus had the facility, if need be, to retrieve his/her assets by simply tendering payment to the repledgee. That was still embodied in s 9-207(2) UCC (old), but these limitations were abandoned in the 1999 Revision of Art 9. Parties may still agree otherwise, but it may be asked what the third-party effect would be if any imposed limitations were violated by the repledgor. 647 The idea is that there must be some res in order for a proprietary right to be reclaimed, although in equity this concept is loosened, as the very notion of tracing already suggests, as are also the concepts of constructive and resulting trusts. Indeed, trusts are sometimes deemed to exist in abstract amounts, a dollar figure not tied to any asset as such not otherwise properly segregated: see in the US Begier v Internal Revenue Service 496 US 53 (1990). Similarly, deposits not segregated are sometimes held in the US still to have some separate asset status and a special position in the general pot out of which they can be reclaimed without being considered a preferential payment in a subsequent bankruptcy; see Spina v Toyota Motor Credit Corp 703 NE 2d 484 (1998). This goes very far, but does not as yet represent a fundamental extension of the notion of tracing, which normally still runs out in a commingled environment, especially in respect of money or fungible investment securities. In England, these problems surfaced in the Lehman cases after its bankruptcy in 2008. The courts faced the problem of the effect of the right of use of the assets by secured creditors or in repos and its impact on the

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 429 may also be serious re-characterisation issues in the broker/client as well as broker/financier relationship, as both the original pledge and the subsequent repo or rehypothecation could in any event be re-characterised as outright sales, when issues of traceability and bona fide protection become irrelevant. This again leaves open the important question of what kind of proprietary rights are here created or subsist, if any. As already mentioned, rehypothecation has become an important issue, especially in the swaps market. In the EU, it is covered by the Collateral Directive: see section 1.1.9 above and especially section 4.1.5 below. It is the proposition of this book that secured interests only exist where there are clear loans identified by an explicit interest rate structure. If there is none, there is a finance sale, which is unlikely to transfer title absolutely and there must as a consequence still be some residual proprietary right in the transferor—the reversion of a conditional or temporary ownership right. But it was also said that fungibility may imperil these rights, and in security entitlement systems also the fact that these interests cannot be properly marked. This goes back to the sui generis nature of these types of rights (conditional or temporary ownership rights) operating outside the established traditional proprietary system with their own types of protections and modes of transfer, here further complicated by the fact that these rights are created in security entitlements with their own sui generis character and limitations. In the US, Comment 3 to section 9-314 UCC raises this issue without solving it. Also, in the US, it is thus problematic whether and how the margin buyer of investment securities may have retained some reversionary interest if there is a conditional or temporary transfer or some other tracing right in his original securities taken by his financing broker as collateral. These rights may be further confounded by the nature of subsequent repos, even more so if the broker repledges pools of assets of various margin buyers or when there are various repledges. Again, as a result of any pre-default appropriation of the pledged securities by the broker/financier for the latter to attract its own funding (which is likely to be authorised by the margin buyer), the margin buyer or anyone who allows repledging of the securities or their other use could be left entirely without proprietary rights, and therefore, also without any protection of overvalue therein whatever. Especially in times of financial crisis and bankruptcy of banks, that may become quite problematic. The more logical solution would then appear to be that, in an insolvency of the broker in a true loan situation, resulting therefore in a secured transaction between the margin buyer and its broker, the latter’s bankruptcy trustee has only a preferred right in the underlying security entitlements to the extent of the original margin loan (between margin buyer and broker) and has no right to any overvalue in the relationship between broker and his financier, assuming there was no outright bona fide sale (to the broker’s financier). If, however, there was a finance sale (repo) also in the original relationship between margin buyer and broker, the over-value could be deemed to have been surrendered by the margin buyer, and then accrues to the financier of the bankrupt broker, but only if the margin buyer cannot tender the repo price at the appointed date. In either case, the financier of the broker is no better placed than the broker and has no greater equity in the underlying securities than the broker has unless s/he is a bona fide outright purchaser (and believed that the offered securities were the broker’s own). If, on the other hand, as a result of the repledging, the original margin buyer is considered not to have more proprietary claims of owners or repo sellers to a return of the property. Importantly, in secured transactions, the right of use was not considered an impediment to the return of the assets or duty to replace them, nor commingling per se either. Apparently, a form of tracing and of constructive trust remains implied (Re Lehman Brothers International (Europe) [2012] EWHC 2997 (Ch) (also called ‘Extended Liens’ case)), but for repos, it was different, and the repo buyer appeared to have all the rights, Re Lehman Brothers International (Europe) [2009] EWHC 2545 (Ch) (also called the ‘MCF’case).

430 Volume 5: Security Entitlements and their Transfers Through Securities Accounts than a personal right to redelivery or redemption of investment securities while it may still need to repay the margin loan, at best the margin buyer and broker may result as mutual creditors, and the former must hope that there is at least a possibility of a set-off, better still if a proper netting agreement between them is in place. It would allow the securities entitlements to be netted off against the loan. Still, the over-value could not be retrieved in a bankruptcy of the broker except on a pari passu basis with other unsecured creditors. These are therefore the risks of the margin buyer in margin financing.648 On the other hand, the broker’s financier may have to assume that the collateral may have to be returned to the broker’s clients. That could affect its bona fides and it would then appear to be its risk if the broker’s financier was or should have been aware of the underlying margin transaction between broker and end-investor (provided the repledged securities can be traced back to this loan transaction). The result would be that the financier’s loan to the broker, if not liquidated at the same time, might continue unsecured after the margin buyer pays off its funding to the broker. This may also come about when the margin buyer resells its entitlements. It will depend on the original margin agreement whether the margin buyer can do so. If allowed to, its entitlements must be deemed released when it does, thus at the same time divesting the financier of the broker of the repledge. Clearly if the retrieval rights in these situations become merely contractual, there might still be set-off and bilateral netting rights, but this is only effective when there are mutual retrieval rights which are unlikely to exist when there is short selling, repledging or margin buying by an individual end-investor.

4.1.4. Modern Clearing and Settlement. Central Counterparties and their Significance In investment securities dealing, settlement is in essence nothing more than the completion of a trade as a consequence of which the seller receives its proceeds and the buyer its securities. It is therefore the method and the occurrence of payment either in cash or in kind. It has already been said that in modern securities accounts, securities entitlements and cash accounts are usually held together with a broker/intermediary. This results in crediting and debiting of securities and of proceeds or in reinvestment of cash balances through connected movements in the securities account (even if payment and the delivery of securities should still be distinguished as a technique, as we have seen). Thus, the buying of securities will result in the crediting of the securities account with the number of securities so acquired, accompanied at the same time by a debit of the cash account for the purchase price plus commissions. It was already said that cash accounts with brokers are not the same as those with banks; they are client accounts that must be segregated in principle (while commingling with the broker’s own cash must be avoided). Clearing has many meanings, but is in financial markets best defined as a technique of simplifying this process among intermediaries during a certain time frame, usually one day. It often includes a netting facility, which means that, instead of settling each trade with each other,

648 See KC Kettering, ‘Repledge and Pre-default Sale of Securities Collateral under Revised Article 9’ (1999) 74 Chicago Kent Law Review 1109. This is an important contribution in respect of the situation in the US under the UCC, which, however, ignores the characterisation of security lending, repos and rehypothecations as finance sales or conditional/temporary ownership transfers and its ramifications, notably also their cut-off if the asset becomes untraceable and the protection of bona fide purchasers who may ignore these equitable proprietary rights.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 431 intermediaries will net them out bilaterally or, in a more sophisticated set-up, multilaterally. This may apply to both payments (as we have already seen in payment systems) and (fungible) securities.649 In modern securities trading, this will be connected with the rebalancing of the system when, after individual end-investors have been credited or debited by their brokers, brokers adjust the positions among themselves to rebalance their books and comply with their asset-maintenance obligations (per type of security). Thus, if a broker sells from its own account to a client, the broker is technically short of back-up assets unless it had its own inventory in the securities concerned (which it is then reducing) or had selling clients in the same securities for the same amounts at the same time. If the broker is short, it must adjust its own entitlements against the next tier by buying from other entitlement holders. It has already been noted that it is more likely that large intermediaries trade constantly for their own account, in which connection they take a risk in any uncovered position until it is balanced. They may take some loss here, but could also turn a profit. They may also net out their buy and sell orders, another form of internalisation, as we have seen. On the whole (even if they are market makers) they will as prudent traders avoid much exposure and lay off their risk on the market (in auction systems or through market makers) as soon as possible. In this connection, in the holding and transfer of securities through book-entry systems and modern custodial arrangements, the settlement and clearing facilities between intermediaries have been fundamentally refined: see Volume 4, section 3.1.6. First, to the extent transactions are not internalised but take place in the open markets, at least between various brokers, settlement if involving other intermediaries is now normally combined with an information matching system, in which as a first step buyers and sellers will confirm their trades with an independent third party or settlement agent, through whom trades may subsequently also be settled. In principle this agent will do so only if the information received from both counterparties was identical, and, even then, would only complete the transaction on an exchange of documents and money. This is the so-called DVP system of settlement, or the documents versus payments facility, in which simultaneity between both sides of the transaction is maintained and no title transfer occurs before the information of seller and buyer in respect of the transaction is properly matched.650 It suggests a delayed transfer or special type of title transfer in these transactions, which ties it to the receipt of funds from the buyer and securities from the seller. In the meantime, there are no more than obligatory rights of both parties against each other in respect of their transaction. The object here is the limitation of settlement risk. Of course, if late settlement or no settlement results under these rules, the party in default will still be liable for damages.651 649 See also HF Minnerop, ‘Clearing Arrangements’ (2003) 58 The Business Lawyer 917. 650 DVP is not one single type of system, but comes in many variations. In 1992, the BIS Committee on Payment and Settlement Systems noted three versions. There may be (a) real-time gross settlement that means settlement trade by trade; (b) gross settlement of the trades but net settlement of the payments at the end of a cycle; and (c) net settlement of trades and payments at the end of the cycle. Even then, securities are only handed over against payment, and a default by one participant will undo all transactions with that participant during the cycle, which may lead to a recast or an unwind situation as in the case of payment systems: see s 3.1.6 above. Also, insolvency rules may interfere with the operation of the system, although in the EU the Settlement Finality Directive was passed to deal with a number of the adverse consequences in this connection: see s 4.1.5 below. 651 DVP is not without its problems, especially because credit lines have to be provided to allow the settlement while there may also be time differences between the receiving and delivering DVP. It is now supplemented by Straight-through Processing or STP, which deals with the multi-tiered structures in clearing and settlement where there are different phases and levels, each of which need separate input. To automate the whole cycle from trading to settlement, including DVP and clearing, is the objective, and if this could also be achieved cross-border it would mean great savings: see the First and Second Giovanini Reports on Cross Border Clearing and Settlement Arrangements in the European Union (2001 and 2003).

432 Volume 5: Security Entitlements and their Transfers Through Securities Accounts In modern settlement systems, there may be a progression, and this constitutes the second phase of this clearing process. A settlement agent may have bilateral agreements with all (pre-selected) participants in the system under which the agent holds sufficient money and securities entitlements from each participant in such a way that inter-day debits and credits (of fungible securities and moneys) are netted out on a constant basis (which raises the legal nature and status of these settlement netting agreements, which in international systems could also be transnationalised, cf section 4.1.7 below). It refines the DVP system at the same time. In book-entry or securities entitlement systems, the physical nature of securities transfers and payments has completely disappeared, as we have seen. The settlement agent is, in such systems, likely to be the sub-custodian of all participants who hold securities, as well as cash accounts with this intermediary, who may organise a multilateral settlement system between them all. A modern system of clearing may be combined with the settlement function, which will facilitate the settlement. That is the reason why modern clearing and settlement are now mostly referred to together. It can also be seen as the third phase in the process. Often the depository will maintain and operate a multilateral system between all pre-selected member brokers with whom it deals, in many cases exclusively. It will net out all asset-maintenance changes between its members and ultimately adjust their security entitlements with itself. Like all settlement systems, it works most efficiently in a multi-participant set-up, and therefore in a multilateral manner where, as in Euroclear or Clearstream, all brokers in the Eurobond market (but not necessarily their clients) are part of the system. Say broker A owes at the end of the day 50 shares in company Y to broker B, B owes 50 Y shares to C, and C owes 50 to D, while C also owes 50 to A. In such a situation, it is obviously advantageous that instead of four transfers, C simply delivers 50 shares in Y to D. It would lead to adjustments of only their accounts with the depository, resulting in one (net) transfer of securities. Assume that all prices of the transactions were the same, there would also be one physical (net) payment. Cash proceeds are likely to be settled in a similar way within the clearing system for payments. That would be the second phase of this clearing process. There would of course still be adjustments of each and any securities and bank account of all four participants with their settlement agent. As intermediaries, they would in turn break out these balances and settle with their clients individually, if they had not already done so, but these would all be mere book entries. Thus, the number of adjustments (debiting and crediting of both individual securities and cash accounts) is not reduced, simply the movement of assets, either securities or cash. This simplification through clearing significantly reduces the costs of settlement and also the settlement risk. That makes it also of great interest to regulators and is favoured by them. The modern book-entry system for investment securities and electronic bank transfers for proceeds further simplifies this operation as the net amounts of securities and cash resulting from the clearing need no longer be transferred physically. Electronic transfers thus become possible for both securities and cash. Normally, in these book-entry systems, clearing and settlement organisations such as Euroclear and Clearstream in the Eurobond market also operate as depositories, as does the DTC in the US, therefore as the legal owners of all securities so settled, but this is not necessary for the operation of modern clearing. Thus, Clearstream might be the depository of securities settled through Euroclear and vice versa. Furthermore, these clearing systems tend to operate as banks to their members to facilitate the net payments or the cash side of modern clearing and settlement. The objectives are always to promote liquidity, to increase speed in the settlement, and to reduce settlement risks and costs. Another evolution in this system is the appearance of a central counterparty (or CCP). It allows all securities transactions to be conducted with one central entity, who acts as buyer or seller in all cases on the basis of back-to-back agreements with preselected (or clearing) members of the system. Thus, if someone long on securities in this system (acquired from the CCP) wants to sell, there will be a sales agreement with the same CCP, who will net both the original purchase

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 433 contract and the new sales contracts out and pay the seller the difference. At the same time, there will be a new agreement in place with a buyer, who will have paid the CCP for the position. If there is no simultaneous outside buyer for the moment, there may be market makers in this system who will act as buyers from the CCP against a spread which they will quote and at which the CCP will acquire the position of the seller (plus a small fee). This CCP system is practised in official derivative exchanges (see section 2.6.5 above), but not (yet) at Euroclear or Clearstream, or in modern payment systems, as we have seen in section 3.1.6 above. Its function in the derivative markets is further complicated, but also reinforced by the fact that these derivatives operate in a time frame that may require regular payments. In the investment securities markets, the operation is simplified and is naturally attractive for end-investors as it combines liquidity with a safe execution facility. Of course, the CCP could go bankrupt, but is normally guaranteed by the participants in the system by way of the interposition of so-called financially strong clearing members (activated by brokers who are approved by them) and who are the only intermediaries with whom the CCP will deal. Margin may further protect the operation. From a practical perspective, the CCP acts as an administrator, and it does not take any risk itself, except those that are fully hedged. It was said before that this CCP facility shows the close modern connection between clearing, settlement and the securities markets. These markets, especially when operating a matching system of orders, could dissolve altogether in modern clearing and settlements organisations combined with a CCP. It may be the way of the future, even for securities trading as it already is in regular derivative trading, and could even mean the end of official stock exchanges as we know them today.652

4.1.5. International Aspects. EU Settlement Finality and Collateral Directives. The Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary. The Geneva Convention on Intermediated Securities. Transnationalisation and the Modern Lex Mercatoria We have seen above653 that in connection with the transfer of investment securities, also in entitlement form, there arise (a) proprietary issues, which have to do with the nature of the holding 652 Not every intermediary can be a ‘member’ of a clearing system, especially not the smaller brokers. They are likely to outsource most of the settlement and custody function to members of clearing systems, usually the larger brokers or investment banks. In the US, these smaller brokers are then called ‘introducing brokers’ while the others are called ‘clearing brokers’. Although the latter perform an agency function for the former, regulatory law has made important modifications in the older common law of agency in this connection to the effect that the clearing broker has a direct relationship with the end-investor coming to him/her through introducing brokers, of which the investors must be informed, except if there is a so-called ‘omnibus account’ between introducing and clearing broker under which the latter maintains its own record of customer trades and provides statements. They are usually larger brokers who have nevertheless decided to farm out part of their settlement and custody functions. In the arrangements where there is full disclosure of customers, in the US the clearing brokers used to exercise full regulatory supervision of the introducing brokers, including their sales activity, and were responsible for it. The justification is that the clearing brokers take over credit risk in respect of unsettled deals and margin trading. After the end of fixed commissions this burden could no longer be carried by the clearing brokers, while it remained vital, however, that they continued to offer their services to the smaller brokers’ community. It is a substantial cost-saving exercise that also contributes to the standing and reliability of the introducing brokers. Clearing brokers are now responsible only for the outsourced functions and the introducing brokers for the rest, supervised by the SEC. 653 See Vol 4, s 3.1.3.

434 Volume 5: Security Entitlements and their Transfers Through Securities Accounts of the investors in terms of proprietary, co-ownership or beneficial (or similar) rights against intermediaries. There also arise (b) so-called finality issues in connection with any transfers made or in connection with the continued validity of settlement instructions concerning the transfer in the case of an intervening bankruptcy of one of the parties. Finally, there is (c) the question whether any transfer by a bankrupt intermediary under these circumstances, even if validated in principle, may still be considered prejudicial or preferential in respect of the general creditors of the intermediary. The question arises how these issues must be handled in international transactions, particularly of the securities entitlement type. These issues were first discussed in Volume 4, section 3.1.654 Because of the advent of book-entry systems, which may still be perceived as purely domestic facilities, it is clear that on the face of it there could be a strong regression into domestic concepts even in respect of underlying securities that were transnationalised such as Eurobonds. Transnationalisation remains important nonetheless and necessary in the proprietary and finality aspects; that is to say in (a) (b) (c) (d) (e) (f)

the asset-maintenance obligation affecting tiers in other countries; the protection against insolvent brokers who have back-up entitlements in other countries; a shortfall in such entitlements if there is insufficient back-up; any remaining pass-through rights in other countries; the prohibition on the pledging by intermediaries of back-up entitlements if elsewhere; the way end-investors may themselves encumber their entitlements or transfer them conditionally depending on where they are held; (g) the issue of rehypothecation in particular when these assets are taken under a repo or used as margin in transactions in other countries; (h) the protection of bona fide buyers of these entitlements everywhere; and (i) the effect of intervening bankruptcies on instructions, clearing and settlement in respect of such entitlements. Especially the concept of finality and its theoretical underpinnings remind us of the transnational lex mercatoria. Internationally, these were early concerns in respect of negotiable instruments and later letters of credit and in more modern forms of bank payment. Indeed, these concerns arise in all internationally traded commodities and payment facilities. Nevertheless, these issues are often still perceived as matters of national law. In respect of the proprietary issues, one could, however, cogently argue that, as in the case of traditional negotiable bearer certificates, registered shares or book-entry entitlements may, at least in the case of international trading, by themselves start conforming to an international or law merchant type of property, including transferability and its finality, which goes beyond the local (statutory) form and structure. We have seen this happen earlier with the Eurobond as a (materialised) bearer security of a transnationalised type. It was reinforced for book-entry systems when they became common in that market. It may now also happen when domestic shares are traded internationally in the form of book-entry entitlements. This would be a most important development, which will impose itself further with the increase in international trading. The creation of book-entry

654 At the end of s 4.1.1 above, an example was given of an international holding and its manifestation in connected systems of a securities entitlement.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 435 entitlements as proprietary structures implies in any event a separation (in law and in fact) from the underlying securities and the nature in which they are held and transferred (through the intermediation of depositories). That favours the transnationalisation of the transfer of security entitlements based on them, but also the versatility in the type of other interests that may subsequently be created in these entitlements, such as security interests, repos or conditional or temporary interests backing up financing. The key is that through book entries a different interest layer is created, which may be transnationalised independently, and which is in any event separated from the underlying securities and not necessarily covered by their applicable (local) laws. Thus, through a book-entry system, these domestic securities may become indirectly transnationalised. This signifies the operation of the transnational lex mercatoria in this area. In any event, they may become subject to the law of another country, for example that of the place of a depository or intermediary/custodian (assuming that its laws are sufficiently sophisticated to handle the new interests). If that is now a possibility, there is in principle nothing against a transnational law prevailing in the international markets in this area. This development was more fully discussed in Volume 4, section 3.2.2. It means that domestic laws become irrelevant and conflict of laws rules redundant in this area. They always posed difficult questions in the proprietary area: see Volume 4, section 1.8. Market practices and general principle take over, and that is the natural trend in view of the ever-increasing size of these international markets. It would also allow for transnationalised notions of security interests or repos and conditional or other finance sales to attach to or operate in them. In fact, at least in respect of the status of securities entitlements and the type of proprietary interests that may be created through them or in them (such as repos, conditional transfers, pledges, and the like), domestic laws found so applicable may not contain much guidance when these entitlements are traded internationally, that is away from the place of the underlying investment securities. In such cases, transnational market practice starts to prevail as of necessity. It could do so even domestically and could be expressed simply in the general conditions of the system supplemented by general principle. This concerns also the protection of bona fide buyers and the issue of segregation of the client’s interest from that of its broker or other intermediaries, which in turn relates to the entitlement representing some proprietary interest with reference to, if not directly in, the underlying securities or to some co-ownership rights in pools, or (in the worst case) merely to some contractual claim against the intermediary. Transnationalisation is an important development that creates uniformity on the basis of market practices and reasonable expectations. Market practice also presents the ultimate opportunity to provide finality. Issuers, if not already actively promoting this transnationalisation, will have to accept the results, which are likely to be dictated by the interests of the international investors and not by the issuers or their legal systems. Through this tiering or layering, in reality (if not also legally), the nature and status of domestic securities may thus be transformed and the trading therein at the same time. On the part of the issues, that can increasingly be seen as the risk an issuer takes while encouraging international trading in its investment securities, whether through special share registers abroad or through depository arrangement coupled with book-entry systems. So far, this may be clearest for Eurobonds, but the same applies to all investment securities or security entitlements that are internationally traded with (or even without) the encouragement of the issuer. In the EU, the EU Settlement Finality Directive presents a form of mini transnationalisation, here through legislation limited to the EU area, although still couched in terms of harmonisation

436 Volume 5: Security Entitlements and their Transfers Through Securities Accounts of domestic laws.655 It seeks to deal especially with the bankruptcy problems under (b) and (c) above and provides for a harmonised regime meant to protect the position of the European Central Bank (ECB) in its liquidity-providing function to the banking system, which is based on repo financing. Most EU countries have implemented the measure to apply more generally: see also Volume 4, section 3.1.5. The Directive intentionally side-stepped proprietary issues under (a), which therefore remain unharmonised in the EU. However, in 2004, a limited effort was made in the EU Collateral Directive to deal with (some) rights (in terms of securities or repos) that can be established over securities entitlements, without, however, defining these entitlements and their nature either; see for greater detail Volume 4, section 3.2.4.656 It is a significant development, which, even though limited to financial collateral, aims to introduce at EU level (through harmonisation of the local rules in Member States) a modern collateral law, a project which has so far eluded most EU countries for personal property more generally at the national level. The most important features of the Collateral Directive are in the simplified uniform rules for the creation, perfection and enforcement of collateral, here limited

655 In the EU, the Settlement Finality Directive of 1998 (Art 3(1) and (2)) was meant to reduce the liquidity risk particularly in transactions with the European Central Bank (but was given a wider scope in most EU countries in the implementing legislation). Ultimately the concern is to reduce systemic risk linked to payment and securities settlement systems and is therefore not only (or even primarily) concerned with payment systems, but at least as much with security entitlement systems and any transfers in those systems (although added only in the later drafts). It only affects certain payment and securities settlement systems governed by the law of a Member State and notified to the Commission by the states whose laws apply to them. Participants are also a defined class and only include supervised financial institutions, public entities, CCPs, clearing houses and settlement agents. The Preamble (paras 4, 9 and 11) sets the stage and requires that neither the status of the instructions of a participant nor the law against fraudulent or preferential transfers should disrupt the payment or security settlement systems in respect of pending transactions when one of the parties is declared bankrupt. In particular, the enforceability of transfer orders, collateral, and netting initiated or obtained before the bankruptcy of a participant would not be affected by this bankruptcy, in which connection a uniform rule was adopted as to the moment bankruptcy for these purposes would become effective (in fact the common rule of 00 hours on the date on which the bankruptcy was opened was eliminated for these purposes). To this effect Art 3 makes transfer orders and netting legally enforceable and, even in the event of insolvency proceedings against a participant, orders them to be binding on third parties, which should be understood to be the bankrupt participant and all its creditors (who could not therefore challenge the transfer orders or any netting concerning them on the basis of the intervening bankruptcy or any avoidance provisions under the applicable bankruptcy law) unless issued after the other parties involved did or should have known of the insolvency. Art 9(1) ring-fences all collateral given to central banks or other participants and protects it against the effects of insolvency proceedings. This could be seen as an expression of the normal self-help rule. Art 7 deals with the zero-hour rule, while Art 5 confirms the irrevocability of transfer orders after the moment defined by the system’s rules (rather than, eg, by the moment of entry). Art 8 means to insulate any relevant system against complications concerning foreign (bankrupt) participants, and locates each system with reference to the applicable law (rather than the place of residence or registration of any foreign bankrupt participant). Any chosen law must be the law of an EU Member State for the system to qualify for the Directive. This is meant to neutralise the effect of any bankruptcy law (also if non-EU) on any system subject to any of its laws (assuming that one law applies to the whole system, which may still be a complicating issue). Generally, the rule of Art 8 will work if one assumes that the system concerned is (wholly) operating in the EU. 656 The Directive was issued pursuant to an ISDA report of March 2000 on Collateral Arrangements in the European Financial Markets, the Need for Law Reform. Harmonisation of the law in this area at EU level was believed important to facilitate the possibility of funding participants to use the collateral which they received to secure this funding for their own financing needs. This meant the facility to on-sell, lend or repo investment securities received as collateral subject to an obligation to return similar securities. It is often perceived as a novel departure, but in fact a similar system had always existed in respect of fungible securities that had not been set aside for specific clients. A similar facility was created in respect of bank balances, which could thus also be used as collateral.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 437 to cash and investment securities given to support financial obligations and expressed through bank accounts for moneys and in book-entry entitlements for securities. All formalities are dispensed with in terms of registration or publication of collateral, or in terms of an execution sale/appropriation. The type of collateral is also not defined657 and could be a security interest of conditional or temporary ownership. It is left to the description by the parties. Floating charges are also possible that cover future assets and transfer them in bulk, again subject to an adequate description. Control must be surrendered, but that is possible in many forms, which remained largely undefined also.658 Only a document is required to record the collateral transaction and describe it. For the interest to attach in investment securities, the simple marking of the (possessory) pledge or title transfer in the books of the intermediary indicating the pledgor’s or seller’s interest is sufficient. In the case of a default, an execution sale may be informal, subject to a commercial reasonableness test, important especially when selling to related entities. Provided that a proper valuation formula exists, there may also be appropriation. Importantly and correctly, there is here a sharp distinction between pledge and title transfer (or finance sale) leading to the enforcement through a sale in the former place and appropriation of full title in the latter case. Re-characterisation, both at the time of perfection and enforcement, is avoided. It is to be noted that non-possessory security is not being considered and constructive de-possession in terms of losing ‘control’ is necessary. Bankruptcy stay provisions are suspended in respect of enforcement, which is cast in terms of a pure self-help remedy. In the case of a title transfer, there is a recognition of close-out netting arrangements (Article 7), particularly relevant for repos. For cash balances the situation may be more complicated. There is the usual confusion in many countries, whether it concerns here merely an obligatory claim or at the same time also ownership in respect of third parties. As the account can be pledged (or given as collateral), it is clear that there are proprietary rights operating in it. Again, this is of special importance in respect of other creditors in other relationships who might claim superior rights in the account upon collateralisation. In practice, collateralisation means the transfer of the money to the account of the funding party or the establishment of his exclusive right in the account. This may not amount, however, to commingling and the account may remain segregated in which case its use as further collateral results in a double layer of collateral interests. If the balances are taken in the name of the funding parties, there is likely to be a form of commingling, which raises tracing issues. The money may also simply have disappeared. Dutch law, as in the case of investment securities, automatically assumes the loss of all proprietary rights upon any collateralisation that gives the funding parties user rights in the collateral and provides in exchange a preference for the affected funding

657 The ISDA Report Collateral Arrangements in the European Financial Markets. The Need for Law Reform (2000), which was at the origin of the Directive, contains a definition: ‘A collateral arrangement, broadly defined, is an arrangement under which one party (the collateral giver) delivers some form of property typically securities and or cash to another party (the collateral taker) and agrees that the collateral taker may use that property, in the event of a default of the collateral giver, to satisfy outstanding obligations of the collateral giver to the collateral taker’. ‘Cash’ should be understood here as cash accounts, see also Collateral Directive Art 2(1)(d) and Preamble 18, and ‘use’ includes the possibility to sell or appropriate the collateral depending on its agreed nature and also the possibility of rehypothecation. 658 This issue arose in the Lehman bankruptcy cases, where insufficient control was considered to defeat the idea of a floating charge which lost its protection, see Re Lehman Brothers International (Europe) [2012] EWHC 2997 (Ch) (also called ‘Extended Liens’ case). But control is not the essence of a floating charge proper, rather the opposite, and the issue was in truth one of tracing, cf also L van Setten, The Law of Financial Advice, Investment Management, and Trading (Oxford, 2019) 140. See for the meaning and impact of the Lehman cases, also Vol 2, s 2.4.3.

438 Volume 5: Security Entitlements and their Transfers Through Securities Accounts party in the bankruptcy proceeds of the party requiring the funding, if becoming insolvent. The Directive itself is mainly concerned with the narrower issues of collateral. The legal status of the underlying investment securities and especially of securities entitlements or the bank balances is not considered, and as a consequence neither are the important segregation and pooling issues. Nor is the question of the residual proprietary right of the original owner in the assets offered as collateral. Here, in the minds of many, conflict of laws notions may remain important, also in the question of the protection of bona fide security investors and in the issue of finality to the extent not covered by the Settlements Finality Directive. Like the latter Directive, the Collateral Directive opts here for the so-called PRIMA rule (or ‘place of the most relevant intermediary approach’), and therefore for the law of the most immediately concerned intermediary with whom the account is held: see Volume 4, section 3.2.2. There are some clarifications, however, and in Article 9 a number of issues are clearly identified as being covered by the law of the book-entry register, notably whether the entitlement holder’s right is overridden or subordinated to security interests or conditional sales, the legal nature of any such rights, their creation and effect, the position of bona fide purchasers in this connection, and the execution of such interests. If the 2002 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary, which introduces the PRIMA notion internationally, is adopted by EU countries, it would prevail over the provisions of the Collateral Directive in this regard and notably introduce a degree of party autonomy allowing for a contractual choice of law. The problems with the PRIMA approach were highlighted in Volume 4, section 3.2.2 and the absence of any sensitivity to market practices and international custom in respect of the operation of modern book-entry systems remains an important oversight in the EU Collateral Directive. It ignores the connection with the modern lex mercatoria and its different legal sources and their hierarchy. A related problem in the Directive is that, even for the uniform perfection regime, reference is still made to conflicts rules, while local registration requirements also remain applicable, as long as they do not undermine the validity of the relevant security interest or title transfer. Ranking is also specifically left to the law so found to be applicable. It would of course still be subject to the normally applicable execution or bankruptcy rules. In the meantime, UNIDROIT started work on a Convention on securities held with an intermediary, aiming therefore at some uniform law in this area, a first draft being published in 2005. It resulted in the 2009 Geneva Convention: see Volume 4, section 3.2.4. It presents a treaty effort which so far suffers from a lack of ratifications.659 The text is complex and would, in the approach of this book, still have to be considered within the context of the modern lex mercatoria, meaning that any mandatory transnational custom and practice, particularly relevant if in the proprietary area, would still prevail over it.

4.1.6. Regulatory Aspects There are a number of obvious regulatory concerns in the operation of book-entry systems. In terms of pure legal risk, at domestic levels, they may be considered to be taken care of in modern statutory law in most countries with substantial capital market activity. International complications are often considered resolved in principle through the Hague Convention, although not

659 As of January 2021, it has only been signed by Bangladesh.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 439 widely ratified. The international practice is happier with its present state. As mentioned before, the role of international custom and practices, and therefore of the modern lex mercatoria, remains largely ignored here. Regulatory concerns proper may concern self-dealing and other forms of internalisation and the best price protections that are afforded. Margin trading and the maintenance of open positions through short selling may be others. Erroneous trades may present further worries, also for regulators. Another regulatory issue of concern may be short selling more generally, the stresses it imposes on entitlement systems, and the risks especially for smaller investors. Naked short selling emerged as a particular concern in Germany in 2010 following the Greek crisis, but it was not immediately clear how it was defined and different from any other shorting: see also section 4.1.3 above. In principle, any impossibility to deliver the securities would limit the activity, if not making it illegal at the same time. Intra-day trading or trading occurring within the particular settlement period may, however, not require any delivery at all as the position will be closed out before. Short selling (unless clear market abuse) is usually the messenger of bad tidings. There is an inclination to shoot this messenger, but the result may be a false market (see for the EU action in this regard, Volume 6, section 3.7.9 below).

4.1.7. Concluding Remarks. Transnationalisation Book-entry systems are an enormous and ingenious step forward in the matter of the holding and transfer of investment securities. They underline the importance of dematerialisation of assets more generally and the ever-greater impossibility to handle them physically (unless they must physically be used). They increasingly become mere claims although still of a proprietary nature. This presents a number of important proprietary issues, which arise particularly in a bankruptcy of an intermediary and in the manner of transfer and finality, and attract the interest of the modern lex mercatoria. The proprietary interests created, their mode of transfer and its finality all suggest a new (sui generis) proprietary interest opening up the system of proprietary rights, also in countries where it was once considered closed. Again, the nearest equivalent is an equitable interest in common law terms. It has already been pointed out many times that, especially in civil law countries, the operation of such interests is of considerable systemic importance (and concern) and of great practical and academic interest. This presents a great challenge, but also a great opportunity for the transnationalisation of the law in the international marketplace. In the UK in the Lehman cases there was a beginning of recognition in the ‘purposive interpretation’ approach.660 Modern clearing and settlement facilities also acquire special significance here, in which connection the netting principle is particularly important. It promotes liquidity and reduces settlement risk considerably. In international transactions these facilities will benefit from legal transnationalisation and the support of transnational practices and customs, as here developed

660 In Re Lehman Brothers International (Europe) In Administration) aka Pierson v Lehman Brothers Finance SA, EWHC 2914 (Ch), 232 (2010), the court was concerned with the nature of the interest of entitlement holders, see also L van Setten, The Law of Financial Advice, Investment Management, and Trading (Oxford, 2019) 111, segregated in a form of trust, but not passing through to the back up in insolvency situations, which back up is nevertheless segregated, again conforming to transnational market practice, also in the matter of a shortfall in backup and equal treatment of all entitlement holders in the same class of assets in such cases assuming that they acquired the interest as bona fide purchasers. See for other Lehman cases s 2.4.3 below.

440 Volume 5: Security Entitlements and their Transfers Through Securities Accounts by the financial services industry itself. This was discussed earlier in Volume 4, section 3.2.3 and more generally within the context of the hierarchy of norms of the modern lex mercatoria in Volume 1, section 1.4.13.

4.1.8. Impact of Fintech. Permissionless Frameworks and Permissioned Blockchain Off-ledger Securities Trading As we have seen, investment securities are today mainly held as intermediated securities or securities entitlements. It means that the issue process is based on a dematerialised and/or immobilised system of intermediated securities.661 These securities are ‘dematerialised’, meaning that no paper certificates are issued at all (registered securities), and/or they are ‘immobilised’, meaning that all securities (dematerialised or not) are issued to or, in the case of bearer securities, are deposited with a central custodian or depository. Either way, any transfers to end investors or their brokers will take place by book entry only, and all will become dematerialised in a tiered system of securities holdings. Thus, large financial institutions will maintain a securities account with the depositories, and their clients will maintain securities accounts with them. These clients may be a smaller banks or brokers, and may sell the securities on to their own clients, perhaps retail investors. Again, the intermediary will credit the investor’s account maintained with the client with the appropriate amount of securities purchased (and debit the related cash account, or in the case of a sale debit the account whilst crediting the related cash account). The legal nature of the investor’s entitlement depends on the legal system and may be a form of co-ownership in a pool of fungible securities, or a beneficial interest under a trust structure, or some security entitlement as a sui generis right. The essence is that under applicable law, the securities credited to a client’s account are segregated from the intermediary, which means that they are not available to the intermediary’s general creditors in the intermediary’s insolvency. All participants and investors within this multi-tier system hold in this manner some proprietarily protected pro rata interest in the securities embodied in the investment securities held by the depository, but the investor will only have contact with the immediate intermediary. That is compartmentalisation. In this system, the client’s title is vulnerable to the extent that it depends on the immediate intermediary’s back-up by the same securities entitlement immediately higher up in the chain (which, if not properly accounted for, could result in a shortfall situation upon the intermediary’s insolvency). The basic rights of investors cascade down this system: dividends, voting rights, corporate information, and liquidation proceeds, but there are commonly no passthrough rights, only claims against the immediate intermediary. Problems may here arise with securities borrowing, repos, re-hypothecation, as we have seen, when there may be in particular issues with the exercise of voting rights, and there could conceivably be more voting rights than there are investment securities (that is, the problem of ‘overissue’). We can now look at a simplified and stylised transaction effectuated within this holding system. The seller and buyer instruct their respective brokers as to their willingness to trade. The orders are routed to a trading venue where they can ‘cross’ in the order book or on an alternative trading system and make a trade. The details of the trade may be sent to a clearing house that reconciles orders, possibly netting them with other pending instructions in order to lower

661 The following text is substantially taken from the King’s College Executive LLM organised by JH Dalhuisen, C Kletzer and M Schillig.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 441 outstanding positions of its members. The clearing house may even become the central counterparty (CCP) to both seller and buyer (novation netting). More likely is that the brokers self-deal and credit their client accounts at market prices, subject to their asset maintenance obligation which they must implement promptly in the manner they deem best. The potential contribution of direct holdings through crypto-securities is as follows. Blockchains could record native tokens in the form of cryptographic signatures, or claims that refer to off-ledger assets. Only where securities are issued in the form of native tokens (crypto-securities) may settlement then be effectuated entirely within the blockchain. A permissionless peer-to-peer framework could thus be envisaged, and a direct holding system of crypto-securities would operate as follows. Network participants maintain a distributed asset ledger that is linked to a distributed cash ledger. Securities are issued directly onto the asset ledger. Participant 1—a financial services provider—underwrites an issue. Throughout the network, the transaction will be recorded as a credit to Participant 1’s securities account; there is no need for a depository. Simultaneously, the issuer’s cash account (in crypto or fiat money) that it maintains with Participant 1 in form of an electronic wallet will be credited with the proceeds of the issue. It is possible to envisage the issue as a form of ‘global note’ representing, say, 100,000,000 tokens with a cryptographic signature derived from the initial global note and each token being separately transferable. Tokens may be distributed (for cash) to other network participants who operate full nodes, and to their customers, who may access the network through their securities wallets provided by a participant. Thus, an investor may have obtained tokens in a new issue either through Participant 2 (its wallet provider) or directly from Participant 1. In any case, with the tokens stored in the investor’s wallet and recorded on the blockchain (maintained by all participants), the investor will own the crypto-securities directly. There will be a direct relationship between the investor and the issuer. Through any full node that holds the blockchain in its entirety, the issuer can know who holds its securities at any particular time. The possibility of receiving more votes than outstanding shares may also be greatly reduced. The payment of dividends or coupons could be managed and automated through smart contracts embedded in the token resulting in credits to the holder’s cash account, either periodically or upon occurrence of a specified event (a dividend being declared). For a secondary market transaction, a seller and a buyer would be matched on a trading venue, a service that could be provided by one of the network participants. On the basis of previous blockchain entries it can be automatically verified that both parties have the means (securities and cash on the respective ledgers) to complete the transaction. The seller and the buyer would jointly sign the transaction by applying their private keys to unlock their securities (tokens) and cash, and then by transferring ownership to the recipient via their public key. The signed transaction will be broadcast to the distributed ledger to be validated and recorded in the next update, along with a simultaneous update to the cash ledger. The transfer of securities takes place directly between the seller and the buyer. There are no intermediaries in the traditional sense of the word. Settlement finality occurs as soon as the buyer’s wallet shows the receipt of the tokens as confirmed. It remains to be seen whether there remain finality issues. This system would remove a number of functions that are essential for the current intermediated holding system. Securities depositories, custodians, central counterparties (assuming that there is instantaneous settlement, as there would no longer be any counterparty risk) and settlement agents would no longer be required. The role of financial services providers would be limited to maintaining the blockchain and providing their customers with an interface for accessing the network. This is attractive in principle, and the issues with voting and disposition rights upon securities lending, repos, pledging and re-hypothecation may also be reduced or disappear.

442 Volume 5: Security Entitlements and their Transfers Through Securities Accounts Such a system could dispense with any specific legal underpinning and accept that legally the cash flow and control rights inherent in a security attach to the token in a way similar to bearer securities. Given that securities markets are international, this understanding would have to be international and be accepted as customary in that market. More problematic is probably that such a securities’ holding system would have to be integrated with a crypto-currency system to effectuate the cash transfers efficiently. Alternatively, the users would have to make payments using the traditional payments system. In this situation, the resulting interaction of traditional payment systems with the blockchain securities holding system would cause frictions that may outweigh the possible advantages (that is, the securities leg would be settled instantaneously, but the payments leg might be settled on a delayed basis, which would introduce settlement and counterparty risk).662 Indeed, it is unlikely that the large number of traditional securities currently held through intermediaries can be converted (that is, encrypted) into crypto-securities in the near future to such an extent as would be necessary for having deep and liquid securities markets that could operate through a fully integrated and independent crypto system (although this is what some securities markets, such as the ASX in Australia, are planning to do in the future). Moreover, as confidence in the cash flow and control rights inherent in securities is essential for allowing both corporate financing in the primary market, and maturity transformation, storage of value and hedging in secondary markets, for issuing and settling securities transactions between issuers and investors through a distributed ledger for mainstream markets may still appear to be unrealistic. Therefore, some involvement of regulated—identifiable and accountable—entities, notably of issuers and brokers, would still seem to be required regardless of the technology adopted. This being the situation, several large exchanges (for example, the ASX and the DTCC) are currently exploring more limited advances using distributed ledger technology-based solutions mainly to improve existing post-trade processes for clearing and settling trades made on exchanges. These systems propose to implement a permissioned distributed ledger for the trading of securities. To this end, these exchanges are developing Proof of Concepts (small scale experimental uses of technology) to track ownership of digital representations of securities in order to potentially combine the trade and post-trade processes for asset transfers into one step. Overall, most industry participants are now looking at ways to integrate the technology into existing systems and institutions. Models may alter or eliminate some roles of current intermediaries, but may not necessarily eliminate the need for coordination or centralisation of certain functions of trusted intermediaries. The idea is that the use of the distributed ledger to manage security issuance and track current ownership may greatly simplify asset servicing in a manner that would be very difficult to achieve with legacy centralised technology (in particular in the US, where there is no definitive record of who owns which security). A significant challenge will be the integration point of assets inserted into a distributed ledger, with assets that exist in legacy form away from the ledger. However, we could also envisage a model based on ‘off-ledger’ securities traded and transferred through a distributed ledger system. In this model, an issuer issues securities in either registered or bearer form, all to be transferred to a depository. These off-ledger securities then have to be represented by tokens on the blockchain. Thus, the depository will create tokens that

662 However, this problem can be resolved by using a real-time gross settlement system to effect instantaneous payments, or the brokers can take margin from their clients in order to mitigate any counterparty risk.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 443 will be traded ‘on-ledger’ (that is, on the blockchain) that uniquely refer to the securities that are held ‘off-ledger’ (that is, by the depository in the client’s securities account). Whereas the tokens created by the depository are ‘native’ to the blockchain maintained by the participants (member banks, brokers and trading venue), the actual securities (that is, non-native assets) are held off-ledger. Upon issue, the Member Banks may acquire a number of tokens that they can then distribute to their clients by crediting the respective number of securities to the account of Non-Member Bank (in exchange for cash), who may then credit its client’s securities account. The buyer’s holding remains indirect and intermediated, as the buyer has a securities account with the Non-Member Bank, who has a securities account with Member Bank, who has a securities account with the depository. As for secondary market transactions, a seller and a buyer would instruct their brokers to initiate a transfer, who would route the offers to a trading venue where they could be matched. Through accessing the blockchain, it could be automatically verified that a seller (through his broker) owns the securities and that the buyer has sufficient funds to pay for the securities. Broker 1 and Broker 2 would then sign the transaction message to the network. Upon verification (through the consensus mechanism), the respective number of tokens would be transferred from Broker 1’s wallet to Broker 2’s wallet. Automatically the broker’s (off-ledger) securities accounts with the depository would be amended accordingly, as would the seller’s securities account with Broker 1 (by debiting it) and the buyer’s securities account with Broker 2 (by crediting it). There would be a direct token transfer between Broker 1 and Broker 2 between their respective wallets. In this system there would be no need for a CCP (unless the system provided an option for delayed settlement, or there was no delivery versus payment) and for settlement agents; the number of intermediaries could thus be significantly reduced, and the tasks that they traditionally perform (that is, execution of trades and reconciliation of accounts) could be automated through embedded smart contracts. There seems to be significant potential for time and cost savings. The widespread adoption of this and other more limited models currently face significant challenges in terms of scalability of operations and the interoperability with legacy systems and potentially other blockchain arrangements. A new legal framework would then need to establish the link between tokens and off-ledger assets. The ownership rights and obligations associated with tokens and assets must be defined. Settlement finality also needs to be reconsidered in a legal sense in order to accommodate the probabilistic finality whereby the longer a transaction is considered settled by the system participants, the less likely this transaction will be reversed. Currently, distributed ledger technology remains immature, largely unproven, has inherent scale limitations and lacks underlying infrastructure to cleanly integrate it into the existing financial market environment. The necessary improvements will take time. In the meantime, other alternatives may emerge more based perhaps on current systems that may be able to address their shortcomings with less disruption. In conclusion, it might be said that the current system of dematerialised and immobilised indirect holding systems has been developed incrementally over the last 40 years. Generally, these systems are robust and largely efficient. However, there are also some shortcomings. Intermediated holding systems are complex and therefore prone to error (for example, such as the overissue problem) and make it easier for brokers to conceal elaborate frauds for longer periods of time (for example, as was done by Bernie Madoff, who operated a $65 billion Ponzi scheme for almost 20 years). The rights of end-investors vis-à-vis the issuer are reduced compared to holders of bearer securities (that is, it may not be possible for an end-investor to bring a claim directly against the issuer of the security). Confidentiality of the holdings is challenged. The indirect holding system is not in line with general corporate law and corporate governance arrangements. Securities trading and settlement is costly due to the number of fee-charging intermediaries

444 Volume 5: Security Entitlements and their Transfers Through Securities Accounts involved, and can take up to a number of days, which limits the actions that investors can take in the interim. Moreover, counterparty risk is significant, and is heavily reliant on CCPs to neutralise this risk. Whereas the introduction of a fully operational direct holding system based on cryptosecurities (that is, a system that deals exclusively with native assets) may not be viable for the foreseeable future, a more limited ‘hybrid’ system based on native ‘on-ledger’ tokens and nonnative ‘off-ledger’ securities (as the ASX is planning roll-out in 2021) could reduce the number of intermediaries involved, speed up the settlement cycle, reduce counterparty risk and increase overall efficiency. However, a large-scale adoption of such a system seems to be at least a few years away for the majority of exchanges. Scalability of the technology is here also an issue, as are the interface with legacy systems and the necessary legal framework. The operational risk implications are similar to those in respect of payment systems. It may turn out that alternatives based on the existing intermediated system may be more effective and efficient for addressing current shortcomings. In the context of securities trading and holding, distributed ledger technology may turn out to be more immediately relevant for certain niche sectors.

4.2. Investment Securities Repos 4.2.1. The Repurchase Agreement as a Prime Alternative to Secured Lending. Its Legal Characterisation, the Effect of Fungibility, and of the Right to On-sell the Securities The repurchase agreement is a prototype alternative to the secured loan, and in its purest form results in a conditional sale of assets, subject to a repurchase right and duty of the seller. As was noted in sections 1.1.5–1.1.6 and 2.1.1 above, a sale subject to a repurchase facility of the asset,663 and a loan secured on the same assets lead on their face to similar funding alternatives, but they are neither legally nor practically the same. It was found above that the sale subject to a repurchase facility is likely to have a different risk and reward structure, is subject to different (or no) formalities, and also has a different proprietary structure and enforcement regime. In particular, in the case of default, therefore upon a failure to tender the repurchase price on time, it leads to appropriation of the asset by the financier and not to an execution sale with a return of overvalue to the defaulting transferor. There is, however, a risk of re-characterisation, rendering a repurchase agreement a secured transaction, especially in the US. It was posited in that context that the repurchase agreement would only have to be considered a secured transaction subject to its formalities (and possible nullity in the absence of their being observed) in its creation and enforcement regime if there is a clear loan agreement of which an agreed interest rate structure is the indication. This has to be taken formally, and the mere existence of a repurchase price premium, which is in the nature of a markup as a reward for this service, is no proper indication of an interest rate (unless there is a sham).

663 S 101(47) of the US Bankruptcy Code now defines the (financial) repurchase agreement and still limits it to certain securities (although much extended in the 2005 amendments) and to a repurchase period of one year. It may also be seen as a current sale coupled with a forward contract. The US courts remain divided over whether repos of other securities are sales or secured loans, see Granite Partners, LP v Bear, Stearns & Co 17 F Supp.2d 275, 300–04 (SDNY 1998) and RTC v Aetna Cas & Sur Co of Illinois 25 F 3d 570, 578–80 (7th Cir, 1994).

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 445 In fact, this fee, which in investment securities repos is called the repo rate, will normally be lower than the prevailing interest rate for secured loans. That is (besides the informality and the 100 per cent funding) the main attraction of the repurchase agreement for the party requiring financing and shows the alternative. The quid pro quo is in the different rights and obligations of the parties in respect of the assets during the repurchase period and particularly in the different remedies in the case of a default. Thus, the repurchase agreement generally allows for more flexibility in the funding arrangements: there will be no publicity or other formal requirements in the creation nor an execution sale or other forms of disposition upon the failure of the seller to repurchase the assets. Under a true repurchase agreement, the buyer/financier will automatically become full owner upon default if the seller had a right and duty to repurchase. Compared to secured transactions, there may also be different arrangements in terms of possession and user rights and liability for the asset, and more particularly there is the different attitude to any overvalue when no repurchase takes place. It means that in the seller’s bankruptcy, the conditional buyer/financier in possession will in principle be able to retain the assets or, if possession was left with the seller, s/he may be able to repossess them (assuming there was no contract transferring user rights which may still have some value to the estate). If, on the other hand, the buyer will not redeliver the assets on the appointed date, the seller may be able to reclaim the assets as the full owner upon his tender of the repurchase price, even in a bankruptcy of the repo buyer. If the seller was still in possession, the latter keeps the goods; if the buyer was in possession, the seller will be able to reclaim them. However, as we have seen in section 2.1.1 above, the seller may also be considered to only have a call option (instead of a right and duty) to repurchase the asset on an agreed date at an agreed price. In that case, it is unlikely that there is a conditional sale proper and the financier may result immediately as the full owner subject to a mere contractual or personal retrieval right of the seller. Depending on the terms of the repurchase agreement, there could also be an option for the financier to retain the asset. In that case, there would be a put option, again probably only as a personal right. Normally there is, however, a right and a duty for the seller to repurchase and for the buyer to receive the repurchase price while surrendering the assets. Indeed, that is the nature of a true repurchase agreement. Only that would lead to the conditional sale and transfer with a dual ownership structure, in which the interest of the buyer/financier could be characterised as proprietary, subject to a rescinding condition (of the tender of the repurchase price) and of the seller as an ownership under a suspending or acquisitive condition, giving rise in common law terms to a future interest: see also sections 2.1.5–2.1.6 above. Alternatively, the right of the buyer could be characterised as a temporary ownership, leading to return of the full title to the seller at the end of the period, as upon the end of a usufruct in civil law, or as a reversionary interest in common law. It is thus a question of characterisation of the interest, but it is submitted that the conditional ownership characterisation is in principle the better one: see section 2.1.2 above. Both conditional and temporary ownership are easily possible in common law, as we have seen. Common law is used to cover future interests and split-ownership types of this nature. They are equitable and therefore cut off at the level of the bona fide purchaser for value so that the commercial flows remain protected against these interests. In civil law, this remains all much more problematic, as noted before. Moreover, the dilemma is often not clearly identified or understood. In new Dutch law, the conditional sale and transfer is known (Article 3.84(4) CC), but the problem is that, in the case of a conditional sale, the structure may be deprived of any proprietary effect if it is seen as an alternative security interest, which is avoided under Article 3.84(3) CC: see for this problem more particularly section 2.1.5 above. If seen as a temporary transfer, it is converted into a usufruct under Article 3.85 CC. Either alternative is clearly undesirable.

446 Volume 5: Security Entitlements and their Transfers Through Securities Accounts The US unitary functional approach of Article 9 UCC could have an equally adverse effect on repurchase agreements, converting them into secured transactions subject to their formalities, but they are now generally considered to be outside the reach of Article 9 UCC,664 at least in the case of the investment securities repo.665 In fact, the terminology often used by repo users does not help. They may refer to debtors and creditors, and the repo fee is sometimes referred to as ‘interest’ rather than the ‘repo rate’. The investment securities are themselves often referred to as ‘collateral’. That should not mislead the lawyer, but this terminology is undesirable and confuses. To repeat: unless there is an agreed loan set-up, the repo rate is not an interest rate, but rather a reward fixed under the competitive conditions of the repo market itself. The funding through a repo is therefore not a secured transaction but a finance sale. The seller retains as a consequence a proprietary (reversion) right in the sold assets, which should give him a proprietary position in a bankruptcy of the buyer. That is the basic structure also of securities repos. For investment securities repos, the further problem is the fungibility of the underlying assets, while a right to resell the securities is usually deemed implied in a securities repo in any event. This was already mentioned in section 4.1.2 above. It follows that upon a resale to a bona fide purchaser, any proprietary right of the seller in the assets could be deemed exhausted, even where a form of tracing is practised. Here we see one example of why the protection of bona fide purchasers may remain an important issue, also in a book-entry system. The repo being in fungible assets, this may in itself deprive it of a proper res upon commingling with other entitlements of the same sort by the buyer, although a form of tracing may still be possible and may make a difference here, at least in common law countries. In civil law countries it may be a question of retaining a proprietary right in replacement (future) assets, which may still raise questions concerning adequate disposition rights of the buyer/re-seller in them at the time the repo is concluded. It is often assumed that only an obligatory or contractual right survives. Sometimes the repo seller is given a preference in the bankruptcy proceeds, but that is then deemed exceptional.666 There may also be a right to repledge the repo-ed securities (rehypothecation). This may make tracing a virtual impossibility and unavoidably dilutes the proprietary reversion right of the repo seller even further. Again, this is an issue already discussed in section 4.1.2 above. In principle we should always try to equate the situation of paper securities, but that may not always be possible in a system of mere entitlements. 664 However, where the repo price is clearly expressed in terms of the original purchase price plus an agreed interest rate, the repurchase may be re-characterised as a secured loan, also in the US. It is submitted that that is correct and certainly in line with the approach of this book. Otherwise, it is generally agreed that the characterisation of repos as a secured transaction would be disastrous. It would lead to dispositions upon default and perhaps even to filing needs at the time of creation in view of the fungible nature of investment securities and therefore the tenuous nature of the possession by the financier. There would also be the danger of a stay and adjustment of the security: see MA Spielman, ‘Whole Loan Repurchase Agreement’ (1994) 4 Commercial Law Journal 476 and JL Schroeder, ‘Repo Madness: The Characterisation of Repurchase Agreements under the Bankruptcy Code and the UCC’ (1996) 46 Syracuse Law Review 999. 665 The term ‘repo’ is usually considered to refer to repurchase agreements in respect of investment securities of the fungible type. 666 The introduction of the EU Collateral Directive in the Netherlands has, upon an amendment of 2011, gone this way: see Art 7.53(3) CC and also s 4.1.5 above. In the absence of tracing facilities and in view of the protection of bona fide purchasers, that was apparently deemed the only way under the Dutch legal system to deal with the loss of a proprietary right. Note that the assumption here is that the on-sale of the underlying investments automatically means the loss of all proprietary rights therein (probably unless the asset is fully segregated or set aside in separate security or bank accounts). It has already been said that the Directive is incorporated in local laws in EU Member States (especially on the European Continent) very differently and this is an example of its collision with, or assumption into, local system thinking.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 447 Where entitlements are held with third-party custodians, that may make tracing, on the other hand, easier and in any event, commingling should not truly present a problem in a book-entry system. Nevertheless, especially because of the fungibility and the facility of on-sell or debiting or repledging, the securities repo is often considered in danger of losing its finance sale structure altogether, especially in a securities entitlement system, and may ultimately result in no more than an obligatory claim of the seller on the buyer to receive a similar number of entitlements on the repurchase date, therefore a call option balanced by a put option for the buyer, both at the repurchase price (striking price). The proprietary rights of the repo seller are thus debased. The securities repo therefore risks no longer being a true repurchase agreement or finance sale. These problems need not be insurmountable where, particularly in more enlightened legal environments, continuing proprietary rights may be claimed in replacement assets, provided, however, that tracing remains a practical feasibility. The entitlement structure itself with its sui generis type of property right may be able also to reinforce the proprietary characterisation of the repo, in the same manner as it did away with the commingling and segregation complications. The proprietary aspects and effects of finance sales, of which repos are an important class, were extensively discussed in section 2.1 above and are important for a proper understanding of this asset backed funding facility. All the same, in modern securities repos, it is often assumed that there are only contractual claims of the repurchase seller under executory (not fully performed) contracts.667 The consequence is that in a bankruptcy the bankruptcy trustee is given the choice to disown the contract (subject to a claim for damages, which would only be a competing claim). It means that the bankruptcy trustee of either party could insist on a return or retention of the asset depending on whether it had either risen or dropped in value. Again, that would normally result under normal bankruptcy rules, which allow for the repudiation of burdensome contracts if still executory, that is, not fully performed by either party (possibly subject to a damages payment, which would only be a competing claim). This means that in securities repos the bankruptcy trustee of either the seller or buyer may be allowed to choose (or cherry-pick) to continue or terminate the contract depending on the behaviour of the underlying asset. Thus, if there are no proprietary reclaiming rights, in a bankruptcy of the repo buyer, the assets could be retained by the trustee if they had increased in value. The seller would only have a competing claim for damages (that is, the excess of the value over

667 Strictly speaking, a true repurchase agreement is not purely executory, however. Technically, contracts that are followed by a transfer of proprietary rights never are. Moreover, one party has already performed in full. Nevertheless, because of the fungible nature of the securities (notwithstanding tracing rights) and more so because of the likelihood that the securities have been on-sold or repledged, the executory contract characterisation has become common in situations like these, therefore for securities repos (not necessarily for ordinary repurchase contracts in respect of other assets). In a true conditional (or temporary) sale, upon a proper analysis, both parties would have a proprietary interest, and the trustee of the bankrupt repo buyer/financier (in possession) would have had to return the asset when it became subject to the seller’s reclaiming or revindication right at which time the buyer’s title lapsed upon the timely tender of the repurchase price by his/her seller and the seller’s right became full again. This tender would happen when the price of the asset had risen. If, on the other hand, the price of the asset had fallen so that the seller might not be interested in it any longer, the bankruptcy trustee of the buyer could still force him/her to tender the repurchase price and take the securities, possibly in an action for specific performance under the contract. In the case of a bankrupt repo seller/capital raiser, the buyer in possession would rely on his/her proprietary right to retain the asset for the duration of the repurchase agreement and might also have a retention right for the repurchase price. Upon a failure of the bankruptcy trustee of the seller to tender the repurchase price, the buyer would become full owner, possibly with a competing claim against the seller for any loss in value, at least if specifically so agreed. If not in possession, the seller’s failure to tender the repurchase price would give him/her reclaiming rights against the trustee.

448 Volume 5: Security Entitlements and their Transfers Through Securities Accounts the repurchase price which s/he would have to pay). If they had fallen in value, the trustee could still insist on the performance of the repurchase agreement, receiving the repurchase price while returning the asset. The trustee for a bankrupt repo seller would have similar options when the price of the assets had moved. This would only be different for market price-related contracts in countries like Germany, which are always rescinded in a bankruptcy as from the moment of the bankruptcy decree. There is then no election. Only the characterisation of a repurchase right and duty as a conditional or temporary ownership interest rules out any cherry-picking option of the trustee in the bankruptcy, in practice particularly relevant in reclaiming assets that have increased in value from a bankrupt repo buyer. Indeed, there would not appear to be such a thing as a proprietary put option that would allow the solvent repo buyer to force the insolvent repo seller to take depreciated assets back in return for the full repurchase price. In a system of true conditional proprietary rights, there are no special options of bankruptcy trustees, and there are also no rights to early termination of the arrangement (in the nature of an executory contract). Of course, neither party would need to exercise its proprietary rights in a bankruptcy of the other. Either could claim damages instead as a competing creditor, but invoking proprietary protection would often be beneficial. Again, it would not help where the price has fallen, and a bankrupt seller’s trustee does not retake the asset nor pay the agreed repurchase price. In that case, the buyer has at best a competing claim for damages while retaining the depreciated asset.668 For the reasons mentioned, for securities repos contractual characterisation became dominant. The undesirable effects of cherry-picking, which result from the contract characterisation, are at least for securities repos now commonly balanced by netting agreements in which the (re)delivery obligations in respect of securities (entitlements) are also reduced to contractual claims for damages. This assumes that these netting agreements may be validly made and are effective in bankruptcy, now especially so provided by US and German bankruptcy law amendments (section 559 of the US Bankruptcy Code and section 104 of the German Insolvency Act 2001). In other countries, such as the UK and the Netherlands, statutory intervention was not deemed necessary. This type of (close-out) netting is effective only between the same parties with mutually balancing positions, therefore with positions not all one way or even if one way when prices have not moved in similar directions. In this connection, for securities repos, frame or master agreements have commonly been devised, specifically aiming at bilateral contractual netting. The best known is the PSA/ISMA, now ICMA/SIFMA, Global Master Repurchase Agreement of 1992, amended in 1995, operating in the New York and London repo markets for investment securities and reissued in 2000: see section 4.2.5 below. It is in practice particularly relevant for repos concerning Eurobonds but through its various Annexes may now also be extended to repos in UK gilts and US Treasuries, which are the UK and US government bonds.

668 In talking about the reversionary interest of the repo seller, it should be borne in mind that, in a securities repo, the asset, being merely a book-entry entitlement is, as far as the entitlement register of the seller is concerned, sold and there is nothing left for him/her on the register. In other words, his/her reversionary interest is nowhere marked, also not on the entitlement of the repo buyer. This should not, however, in itself destroy any reversion. In respect of chattels and intangibles, we do not on the whole practice a system under which proprietary interests must be either marked or recorded either. That is also clear from Art 2A UCC in the US in respect of equipment lease interests. They nevertheless exist.

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4.2.2. The Development of the Repo in Fungible Investment Securities. Securities Lending and the Buy/Sell Back Transaction It may be useful to elaborate some more on the investment security repo in its various forms, although repos are also common in some agricultural products and commodities. In Europe, securities repos have acquired a special importance because the ECB commonly provides liquidity to banks through repo transactions.669 The development of the modern repo in investment securities derived from the lend/borrow activity in these assets. Bond lending, or more generally securities lending, has long existed to meet the needs of a market operator with short positions who is asked to deliver (see also section 4.1.2 above). The latter can do so either by buying the relevant securities in the market, if available, or otherwise by borrowing them, allowing him more time to close out his overall position. This borrowing was always of a special type because it gave the borrower the right to sell the stock. There was therefore some passing of title implied. In fact, from a legal point of view, it could be characterised as a purchase with a sell-back right and duty at the end of the borrowing period. In a proper characterisation, the sale could then be considered conditional or temporary. Legally, it was in any event not pure lending, even when physical bearer securities were involved, because the lender did not retain a full proprietary interest, although s/he retained some interest in the asset as long as it was not on-sold and, conceivably, in any replacement securities or a proprietary expectancy in any such securities once repurchased by the borrower as a form of tracing. The periods involved varied between a few days and a few weeks. The price for this service was not a sales price followed by a repurchase price, but a fee, normally depending on market rates and the financial standing of the borrower and his anticipated ability to return the borrowed securities. Security was normally asked for, and could consist of a portfolio of (other) securities which the borrower put at the disposal of the securities lender. If the latter did not return sufficient assets of the same type at the end of the lending period, their full market value would become payable at that moment, and upon non-payment would be set off against the realised value of the security. There could also be a margin requirement: see further section 4.2.3 below. Normally, the borrower was not entitled to the income on the stock, and had to make substitute payments to the lender for the relevant amounts (the same goes for the lender in respect of any income s/he may receive on stocks given to him as security). This type of securities lending still exists. It is not a funding transaction and, economically speaking, therefore a type of transaction quite different from a repo, even though legally it bears a close relationship.670 This is shown in that the seller in the repo pays a repo rate in a funding transaction, while a securities lender receives a fee in the securities lending transaction. Since there is no funding, no substantial fund transfers are involved either (except in case of default), while the borrowing of securities may also be a cross-borrowing. It could be said that the lender in securities borrowing and the buyer in repos (the financier) are in comparable positions, as both receive a fee for their services. The funding element makes the difference.

669 Art 18.1 of the ESCB and ECB Statute mentions the (reverse) repo as one of the monetary policy instruments of the ECB: see also E Uwaifo, ‘The Legal Requirements for Securities Lending and Repos and the Legal Effect of EMU’ [1997] European Financial Services Law 224. 670 See C Brown, ‘How to Spot the Difference between Repos and Stock Loans’ [1996] International Financial Law Review 51.

450 Volume 5: Security Entitlements and their Transfers Through Securities Accounts Naturally the repo buyer needs to be rewarded for the service and funding s/he provides; s/he only buys (conditionally) in that context. In securities lending, on the other hand, it is the borrower/conditional buyer who receives a service and must therefore pay. Again, in book-entry systems, this may all be arranged between a customer and its broker only, in terms therefore of mere debits and credits. On their face, therefore, they may look the same, and nothing is marked in the security account but a full transfer. Although the outward form of modern repos, at least of investment securities, is increasingly considered an executory sales agreement in which both legs of the transaction are integrated through repo master agreements, as we have seen, it can also still be a buy/sell back transaction, in which there is no such integration.671 Thus, in securities lending the objective is to cover short positions and in true investment securities repos it is funding, and to this effect there is an ordinary sale of the securities against what will usually be a normal spot price, subject to a repurchase right and duty at a later time against what could be considered a forward price. The repurchase date is normally fixed, but could be open (‘open repos’), which means that each party can end them at any time, or it may be subject to an option for the one or other party or both to continue (‘rolling repos’). The repurchase price, although a forward price, may be quite artificial, set by competitive conditions, and will include a fee for the service (the repo rate), which will also allow for the credit risk of the seller and the quality and liquidity of the securities. In a repo, the result is an immediate payment of a sale price proper and a repurchase price agreed at the same time but payable on the repurchase date. Periods are normally short, from a few days to a few months. As in securities lending, the income still belongs to the seller and substitute payments must be made by the buyer, but it is more common that the repo period is chosen so that no investment income will be received during it. Substitute payments are therefore normally only of interest in the open or rolling repo. Repos in marketed securities are usually organised to finance their acquisition themselves. Especially in bonds, they are normally much easier and quicker to arrange than a loan secured on the same assets, as the normal channels of trading and settlement of investment securities are used. The documentation (sales note) can also be kept simple, although the repurchase duty, period and price still need to be expressed on it. The arrangement can often be made instantaneously for large amounts of money, and repo-ing has become a normal extension of the ordinary trading activity of the trading desks in large banks to fund their positions. There is speed and flexibility with low transaction and documentation cost. On the other hand, the form is sometimes dictated by other considerations: many professional fund managers may be allowed to sell securities, but not to lend them to others under the terms of the fund management contract. Therefore, they may make extra money through repos instead by reinvesting the moneys they so obtain. Tax considerations may also play a role. It follows that, as between the lend/borrow arrangement and the repo proper, there has been a change in perspective from pure securities lending, with the objective of receiving some extra income on one’s securities holdings, to a structure through which these holdings are themselves funded in a manner that is cheaper and quicker than

671 This was the original form, still used on occasion. Under it there are two separate transactions in the same investment securities, one of sale and the other of purchase. There is therefore neither a conditional sale and transfer, nor a margin obligation, nor a close-out and netting mechanism. The income on the sold securities belongs to the buyer, and no substitute payments take place, but the income so received is recompensed in the repurchase price. In this structure, it is all the clearer that there is no substitute secured loan, not even a conditional sale. There is clearly funding, however, and security is likely to be offered separately as in the case of securities lending, usually by offering other assets as collateral (mostly investment securities of a different type).

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 451 would be possible otherwise, for example through a traditional loan secured on the same assets. The repo is now commonly used for the funding of most trading positions in government bonds in the US and Japan and in Eurobonds, with banks being the majority of the users or fund providers. The repo is also increasingly used for share funding. Where a bank provides the money and is therefore commonly the purchaser or repo buyer, the result is called a reverse repo if the bank initiates the transaction. This has become important business for many banks. In this evolution, banks have moved from the position of securities borrowers to that of money providers, and the securities lender has become a client who receives funding. However, the initiative will normally still be with the trading or security house, which may take this practice a step further by repo-ing its own securities if it has any excess holdings. In this way it may be able to obtain funding at a discount to the LIBOR rate of a loan in the same amount while funding others with this money. This is called repo-matched book trading. The use of the securities markets for repos may subject these markets to price reporting requirements and the need specially to identify off-market transactions upon the repurchase at the repurchase rate, which may lead to off-market prices on the repurchase date, which prices could, as already noted, be quite artificial. In the Eurobond market, the repo traditionally concerned a negotiable instrument, and may well have required further formalities or acts of delivery/transfer of possession. It was always clear, however, that within Euroclear and Clearstream the formalities for the creation of secured interests supporting loans were not used for repos. As already mentioned above, in the modern system of securities entitlements in book-entry systems, the repo buyer is commonly identified as the owner of the securities.

4.2.3. Margining In practice, the funding party in the repo, therefore the repo buyer, may require protection against the price of the underlying assets going down, which would expose him in a bankruptcy of the seller, even if s/he relies here on possession and ownership rights as basic protection. Accordingly, s/he may request a special margin or haircut, that is to say that s/he may deduct a small percentage, often 2 per cent, of the sale price, and so of the cost at which s/he acquires the investment securities (‘cash margin’). It may also be achieved by the seller providing extra securities (‘margin securities’). A variable margin is now more common, adjusted daily on the basis of a mark to market of the underlying assets. It may require extra cash or added (margin) securities of the same sort. Additional margin may be negotiated for any currency mismatch between the denomination of the funds received and the market price of the assets. It requires extra documentation, which is time-consuming and costly and destroys one of the more attractive features of the repo of investment securities, especially the commoditised types thereof, such as government securities and Eurobonds. A system of daily adjustment of margins requires an administrative infrastructure which is also costly. It may be farmed out to an agent who will also hold the investment securities in question. This is sometimes referred to as a tri-party repo. Other forms of protection may be provided under a system in which the repurchase price is regularly adjusted. It means on each occasion the termination of the original transaction and the replacement by a new one (repriced transaction). The investment securities, the termination date and the repo rate, as well as the margin, remain the same. The price of the new transaction will be set off against that of the old, and the party in a negative position will pay the difference to the other party. This repricing mechanism is particularly suitable in a buy/sell-back, which traditionally has no margin requirement but may be protected in this manner. There may also be

452 Volume 5: Security Entitlements and their Transfers Through Securities Accounts a replacement under which the old transaction is replaced by one with another number or other type of investment securities. The key is that the replacement securities have as market value the amount of the original repurchase price. We must distinguish and see what the margin is for, and what other protections are offered. Margin may be for the funding institution, which is the repo buyer. It will hold the investment securities entitlements in its own name to be returned on the repurchase date, assuming the repurchase price is tendered by the repo seller. If not, for example because the repo seller is bankrupt, the repo buyer has the risk of being left with securities that might have decreased in value. Margin covers that risk. The repo seller who received the funding, on the other hand, faces the risk that on the due date, when s/he tenders the repurchase price, the repo buyer may not perform, for example because of its bankruptcy. That is problematic if the securities have increased in price. Here it would be helpful if there were a proprietary right for the repo seller. But it has been explained that for many reasons this proprietary right may be weak. Here we have the set-off to protect instead and additional margin may be less common.

4.2.4. The Netting Approach in Repos. Close-out Whether repurchase agreements should be considered conditional sales or merely executory contracts is particularly relevant in a bankruptcy of either party, when in the first case the proprietary rights of either in the asset would determine the position while in the latter there would be a cherry-picking option for the trustee (see section 4.2.1 above) in which the market price movement in the assets would largely determine whether the trustee would want to honour the contract or repudiate it (except that in countries like Germany contracts in market-related assets are always rescinded in bankruptcy: see section 104 of the Insolvency Act 1999). Cherry-picking between the two sides of what is in essence one transaction, of which only the first leg, the sale, is executed, creates this possibility. We have seen that given the fact that at least investment securities repos are often characterised as contractual in view of the fungibility of the underlying assets and especially because of the likelihood that the buyer has on-sold or repledged the assets to which s/he is commonly believed to be entitled pending the repurchase, the more common approach is now to characterise securities repos merely as executory contracts subject to termination by a bankruptcy trustee of either seller or buyer. As in swaps, where there is considered to be only one contract through the integration of all aspects of the deal (see Volume 6, sections 2.6.6–2.6.7 below), there has been a similar attempt, however, at limiting the implied cherry-picking option in repos by emphasising the close relationship between both legs of the transaction and its integrated nature. The aim is a system of immediate set-offs upon default. This facility is then contractually enhanced, with the aim of allowing either the original transaction to be completed as planned once the sale has happened, or rather immediately to terminate both sides of the transaction while netting them out through acceleration and the substitution of monetary values for redelivery obligations. The monetary values are thus netted out in what ultimately amounts to a close-out netting. For the seller, the future benefit of cheaper finance is, however, lost in a bankruptcy of the buyer/financier, and s/he has to accept any shortfall in the close-out caused by any lowering in the value of the underlying assets (while any increase may still be for the bankrupt buyer). An extension of this netting idea is to allow all repo transactions between the same parties to be netted out in this (immediate) manner through the principle of aggregation, which will also cover these shortfalls, but its success will still depend on whether there are sufficient mutual transactions between both parties. Increased asset values will then also be netted out. This full

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 453 bilateral netting could even be triggered by a default of either party in another relationship under a cross-default clause. Close-out is the aim here, rather than replacement, which may be more relevant in swaps than in repos because of their short-term nature.

4.2.5. The ICMA/SIFMA Global Master Repurchase Agreement (GMRA) A master agreement with a bilateral accelerated rescission clause, through which all repos between the same parties may be considered integrated, may help to clarify the situation, especially in respect of close-out netting, and is now in place in the London and New York markets under the ICMA/SIFMA (formerly the PSA/ISMA)672 GMRA of 2000, the 2011 text being the enhanced latest version, for repos in investment securities, especially for Eurobonds in the London market, but it may be used for other products as well such as UK gilts or for buy/sell-back transactions. It was greatly inspired by the earlier US Master Repurchase Agreement (MRA). The Master Agreement is a framework agreement with two principal Annexes (which may be adjusted according to the products) and is subject to English law (which is not necessarily defining in bankruptcy, which will primarily be subject to its own bankruptcy laws). It is applicable to all subsequent repos concluded between the parties to the Master. Its main objective is the facilitation of margin payments and of close-out netting in the case of default. The two Annexes are the most important. The first contains a list of subjects in respect of which parties must make a choice or must make disclosures. Under it, they may also opt for other terms (‘Supplemental Terms and Conditions’) and will choose the ‘base currency’ of the agreement, which is particularly relevant for the margin and netting facilities. The base currency may be different from the ‘contractual currency’ of each deal under Article 7 GMRA. Annex I covers addresses of the parties and possible choices of residence. Under it the parties will also specify their ‘designated offices’, which can only be offices of the parties in jurisdictions that accept the close-out netting of the GMRA. Annex II covers the confirmation (‘Form of Confirmation’) and the transactional details (like the nature and number of the securities, the purchase and repurchase price and the margin particulars). The GMRA in Article 1(c) allows for repos other than gross paying bonds (notably Eurobonds) and also covers net paying securities (securities on which income is paid after withholding tax). All securities must be negotiable instruments, however, or at least subject to the book-entry system of Euroclear or Clearstream or another clearing system or be transferable in any other way mutually acceptable to the parties (Article 6(a)). There may also be country Annexes, like the Belgian, Dutch and Italian (domestic) Annexes for transactions between citizens of the same country in investment securities of that country. All these various optional Annexes are integrated into Annex I.673 The Master Agreement addresses a situation in which it is impractical to introduce the necessary clauses on the sale tickets while they are as yet unlikely to be deemed implied or customary. It means that regular repo partners in London and New York now normally execute master agreements among themselves. 672 SIFMA is the US Securities Industry and Financial Markets association, the successor of the TBMA or Bond Market Association in New York, the itself the successor of the Public Securities Association (PSA). ISMA was the Eurobond market’s International Securities Market Association, since 2005 absorbed in ICMA (the International Capital Market Association). A particular new feature of the 2000 GMRA was the inclusion of conditions precedent allowing parties to withhold further payments or deliveries as soon as a potential event of default occurs. 673 See also G Morton, ‘International Coverage of the PSA/ISMA Global Master Repurchase Agreement’ [1997] Butterworth’s Journal of International Banking and Financial Law 128. Some countries like France have their own master agreements for domestic products: see n 133 above.

454 Volume 5: Security Entitlements and their Transfers Through Securities Accounts The Global Master contains a margin facility and a close-out system operating on the basis of notional values on the repurchase date resulting in net payments close-out after acceleration in the case of a default (as defined in Article 10(a)), in which delivery obligations are also reduced to money (Articles 6(i) and 10(c)) and all are converted into the base currency. There is no cross-default clause, but there is aggregation upon default of either partner, resulting in a two-way payment, that is to say that, even if the defaulting party stands to gain a net benefit, it will be turned over. As in swaps, repo netting is not necessarily effective upon bankruptcy under all bankruptcy laws. It depends therefore on the applicable bankruptcy legislation, in which respect the US Bankruptcy Code 1978 as amended in this regard (section 559) and the German Insolvency Act 1999 (section 104) are important. In the EU the bank resolution regime of 2014 introduced the possibility of a temporary stay in respect of close out netting in all Member States, relevant more in particular for banks in the euro zone (the Single Resolution Mechanism), see Volume 6, section 4.1.3.

4.2.6. International Aspects International aspects of repos arise in particular with the netting facility and any contractual choice of law in the netting agreement. It may well cause problems in other countries, for example if English law, made applicable by the parties to the close-out netting under the GMRA, is in result different from that under the applicable bankruptcy law. There may, for example, be conflict in the conversion of all obligations into the base currency on the day following the bankruptcy under the GMRA, which conversion may well have to be on the date of the bankruptcy in some countries. Any subsequently accruing interest may also not be offsetable. The base currency itself, which is unlikely to be the currency of the bankruptcy, may also be questioned. Attachments in respects of moneys subject to the GMRA may also interfere with the set-off and it must be questioned whether this aspect could also be covered by English law if the bankruptcy is opened elsewhere, especially sensitive if the attached claim is sought to be set off against a later arising counterclaim. The other danger is one of re-characterisation of the repo as a secured loan transaction or even as a temporary transfer or usufruct. These dangers exist particularly in the US and under new Dutch law, although modern case law seems to be aware of the risks and may be inclined to support the modern repo practice as a funding arrangement in its own right as we have seen. Within the EU, under Article 9(2) of the Settlement Finality Directive,674 the law of the clearing centre in which investment securities are registered in a book-entry system covers the security interests that can be created in them. Strictly speaking, this does not cover other types of transfers, including repos, which are not secured transactions, but rather conditional sales. It would be logical, however, to deem the same law applicable also to repos of such book-entry securities. In any bankruptcy conducted under the bankruptcy law of an EU country, this choice of law rule would have to be respected, but it may not determine the repo’s priority in relation to other proprietary interests accepted by the lex concursus in respect of the same assets, while it says nothing about the set-off and close-out netting aspects of modern repo transactions. The attitude in this book is a different one. It was submitted that the proprietary interests created in internationalised instruments such as Eurobonds are likely to have an autonomous transnationalised regime. This could then also extend to the trading of domestic instruments

674 Directive 98/26 EC of 11 June 1998 [1998] OJ L166/45.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 455 internationally, and would affect repo trading as well. International clearing, settlement and custody organisations such as Euroclear and Clearstream also have their own transnational regimes, reinforcing this transnationalised proprietary approach. It is true that they are backed by domestic legislation, but this does not appear controlling and domestic case law can, in this view, hardly distract from the prevailing legal regime, which has its base in transnational commercial law and practice.675 In this view, the TMBA/ISMA Master is a further expression of these practices.

4.2.7. Domestic and International Regulatory Aspects The repo market (like the swap market, as we have seen) is a vivid and important example of an industry-driven and market-supported form of risk management, aided by a risk reduction facility centred on the netting principle and the TMBA/ISMA Master Agreement. While for repos legal risk may on the one hand be increased because of an inadequate proprietary legal framework under traditional laws, with the attendant characterisation problems and resulting uncertainties and lack of protection, as explained above, the situation is substantially retrieved through the use of the set-off principle in netting agreements, assuming that facility is sufficiently supported in law. This may be at the expense of unsecured creditors, but it reduces counterparty risk, liquidity risk, and most importantly systemic risk. It is no wonder therefore that it is popular with regulators and that, where necessary, extended set-off rights of this nature have been supported by statutory amendment, as in sections 555 and 559 of the US Bankruptcy Code, and are also fundamentally favoured and protected in the EU Settlement Finality and Collateral Directives.676 Another more general problem that surfaced during the financial crisis proved to be the possibility of rolling over repos. More collateral was commonly demanded (or higher haircuts so that 100 per cent financing became illusory). This was considered a proximate cause of the Bear Stearns failure in 2008. Earlier it had been believed that overnight financing in this manner had been risk free, but this obviously depends on the types of assets that are repo-ed. In the crisis of Greek government debt in 2010, the acceptance of Greek government bonds under a repo by the ECB became problematic, and can become even more so between ordinary banks. It then becomes a systemic risk issue, which is likely ultimately to be accommodated by central banks or rather taxpayers (as again proved to be the case in May 2010), lest banks holding inferior investments are overwhelmed from a liquidity point of view. It may well be asked what the proper regulatory response should be. It could be in higher capital to be held against this type

675 It is true that adverse Belgian case law (see n 136 above) prohibiting the fiducia as an alternative to secured transactions was remedied for Euroclear by correcting legislation, but the applicability of domestic law should be questioned and it was not applied pending the correction. 676 There is, however, a problem connected with the price at which assets are temporarily removed from balance sheets through repos and they may be used to hide losses during vital reporting dates, usually at the end of each trimester. A case of regulatory arbitrage was reported in 2010 in connection with the earlier bankruptcy of Lehman’s (the Repo 105 issue). By conducting the deals in London, where under prevailing legal standards they were considered to be true sales (which would not have been the case in the US), they were then so considered in the US upon consolidation of the US and UK accounts. In the US this removed the assets from the balance sheet, even though under prevailing accounting rules in London the characterisation of a ‘sale’ would not have made a difference. Rather than being a traditional regulatory issue, this would appear to be a question of harmonisation of accounting standards worldwide.

456 Volume 5: Security Entitlements and their Transfers Through Securities Accounts of exposure, influenced by the rating of the underlying securities, which may easily be adjusted downwards. Another approach may be in the standards for liquidity management. The market is likely to protect itself through over-collateralisations. It may be the more effective practical response but risks creating important liquidity or refinancing problems overall. It may affect broker/dealers in particular, who use this kind of funding for their trading and may use intermediaries to find the right counterparties. It has already been mentioned as the tri-party repo market. A CCP may also help where deals of this nature are then guaranteed by a much larger segment of the financial community (the clearing members). Its success depends on this community’s vitality as a whole, which is also affected by its involvement in the regular derivatives markets, as we have seen. Clients may also not like the stricter margin calls. On the other hand, they may be faced with greater capital charges if they continue to trade merely OTC. Another matter is whether there is truly a regulatory problem. The EU seeks greater transparency and trade reporting to a trade repository (TR) in the 2015 Securities Financing Transaction Regulation (SFTR).677 SFTs are transactions in which investment securities are used to borrow money. Practically, it concerns temporary transfers in repos, securities lending, and sell-buyback transactions. CCPs would effect an even more robust reporting and also a clearing and settlement facility.678 Under the Dodd-Frank Act in the US no need for regulation of the repo market was felt. In the meantime, in the Eurobond market the ICMA warned in early 2016679 against the cumulative effects of various regulatory and monetary policy measures on the repo market. The combined effect of Basel III with its capital requirements, leverage ratio (and extra ratio for US banks), Liquidity Coverage Ratio and Net Stable Funding Ratio (see section 2.4.12 below), and ECB monetary policy (with its negative interest rate) are considered the main problem. Especially the leverage ratio was identified as having a profound impact making this market unprofitable. The result is retrenchment in most banks. By 2016, many provided this service to their clients only as loss leaders. The feeling was that the vital operation of this market besides the interbank market was not properly understood and that it suffered from unintended consequences of regulation and central bank policy.

4.2.8. Concluding Remarks. Transnationalisation The particular aspect of repurchase agreements in the modern sense is that, at least for repos in fungible investment securities, they are as a practical matter now mostly considered to be contractual, as we have seen, and are in fact characterised as executory contracts for this purpose subject to repudiation by the bankruptcy trustee of either party, the effects of which are, however, sought to be corrected by a bilateral close-out netting agreement. This will mostly bring relief against any cherry-picking which follows from the contract characterisation provided there are a sufficient number of mutual positions between the parties and the close-out netting is

677 (EU) 2015/2365 of the European Parliament and of the of the Council OJL 337 Dec 23 2015. 678 See Paolo Saguato, ‘The Liquidity Dilemma and the Repo Market’ LSE Law, Society and Economy Working Papers 21/2015. The author notes the ‘deep opacity of the repo market, its proneness to runs, its structural weaknesses, the interconnectedness of its participants, the absence of stability buffers, and the lack of any comprehensive regulatory or supervisory framework’ in the American market and sees it as the true cause of the 2008 financial crisis. Lack of regulation is seen here as bad per se; CCPs are recommended as the answer, but as the European experience shows (see the next footnote), the problem may be to keep this market active in bad times, much like the interbank market, and regulation will hardly achieve this. 679 ICMA Quarterly Report Issue 40 (First Quarter 2016), 26ff.

Volume 5: Security Entitlements and their Transfers Through Securities Accounts 457 supported by the applicable bankruptcy regime. This does not go without saying, and it has, for example, required amendment to the federal Bankruptcy Code in the US (section 559). This approach detracts from the characterisation of pure repurchase agreements as conditional sales and transfers. For securities repos (only), it is nevertheless a practical solution that will often prove sufficiently effective, so that reliance on the proprietary nature of the structure will not be needed, and the effects of fungibility and any on-selling or repledging rights for the repo buyer (or of the shifting of the reversion into replacement goods and the notion of tracing) may remain largely untested in this area. In international transactions, the TMBA/ISMA—now ICMA/SIFMA—Global Repurchase Master Agreement and the netting facility vitally depend on international industry practices for their support. This is the area of legal transnationalisation, and of the modern lex mercatoria exerting its influences on local bankruptcy laws. See section 3.2.7 above for the international aspects of set-off and netting.680 In this connection, the EU Collateral Directive681 and the UNIDROIT Geneva Convention may also be recalled. Although covering very different strands of the applicable law—the one collateral agreement backing up financial instruments and the other the operation of securities entitlements, the one having been adopted in all countries of the EU and the other lacking sufficient ratification so far—they may both be seen as making a substantial contribution to the modern lex mercatoria in this area. Although they remain in essence territorial in nature, they may operate transnationally in terms of general principle within the hierarchy of the modern lex mercatoria where transnational custom and market practices are higher.

680 See L van Setten, The Law of Financial Advice, Investment Management, and Trading, 133 (OUP 2019) for the meaning and impact of the Lehman cases, cf also Vol 2, s 2.4.3. 681 Re Lehman Brothers International (Europe) [2012] EWHC 2997 (Ch) (also called ‘Extended Liens’ case), shows, however, limitations in the purposive approach when the purpose of the collateral Directive was narrowly defined and floating charges excluded. See L van Setten, The Law of Financial Advice, Investment Management, and Trading (Oxford, 2019) 142.

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INDEX Introductory Note References such as ‘178–79’ indicate (not necessarily continuous) discussion of a topic across a range of pages. Wherever possible in the case of topics with many references, these have either been divided into sub-topics or only the most significant discussions of the topic are listed. Because the entire work is about ‘transnational law’ and ‘commercial law’, the use of these terms (and certain others which occur constantly throughout the book) as entry points has been m inimised. Information will be found under the corresponding detailed topics. abandonment 63, 137, 376 absolute title 108, 141–42, 144 Absonderungsrecht 94, 97–98, 100, 102, 147 abstract system 61, 93, 152, 200, 322 abstraction 56, 96, 104, 193, 398, 423 abuse of rights 78 academic models 53 acceleration 289–92, 350–53, 358, 360, 362–64, 373, 452, 454 acceptance 19, 213–14, 315–16, 320–23, 325–26, 386–88, 390–93, 396–97 acceptance credit 390–93 accepted bills of exchange 386–89 accessories 28–30, 37, 94, 99, 132, 139, 395, 401–2 accessory nature 29, 71, 83, 117 account debtors 176, 179, 196, 204 account holders 328, 341 accountants 262, 303, 410 accounting hedges 252 accounting rules 215 accounts 125–27, 318–21, 324–25, 327–29, 334–42, 377–78, 417–20, 437–38 deposit 127, 341 margin 69, 280, 299, 364 multiple 406–7 securities 416, 419–21, 426, 430, 440–41, 443 trading 298–99 accruing cash flows 14, 267 acquired rights 77, 222 acquisition costs 218, 226 acquisitive prescription 107, 150 administrative law 309 administrators 110, 180, 433 advice 15, 301–2 advising banks 390–92 after-acquired property 94, 121–22, 128, 143

agencies 160 enforcement 409, 412 government 300, 415 rating 237, 239, 243, 250, 252, 262–64 agency 48, 113, 279–80, 301, 313, 325, 391–92, 403 construction 277, 325, 399 indirect 48, 280, 421 law 301 relationships 279–80 agents 47–48, 279–80, 325, 384–85, 391–92, 396–98, 421, 431–32 aggregation 360–63, 452, 454 agreed interest rate 98, 113, 135 structure 36, 38, 113, 115, 132, 135, 171, 215–16 agreed prices 15, 265–66, 272, 294, 375, 445 agreed repurchase prices 133–34, 448 agreed striking prices 265, 269, 273 agreements back-to-back 355, 432 collection 126, 184, 186, 197–98, 200, 208–9, 211, 213 credit 71, 102, 167 factoring 199, 206, 209 loan 105, 132–33, 175, 177, 215, 235, 263, 268 netting 50–53, 55, 293, 295, 353–54, 356–57, 364–67, 454–55 rental 102, 129, 218, 220 repurchase 37–38, 74–76, 80, 82, 85, 113, 444–48, 456–57 sales 81, 93–94, 146, 148, 206, 209, 382, 389 security 121–22, 125–28, 141, 167–68, 176–77, 182, 199, 238 supply 217–19, 221, 223, 226–27, 229–33 tripartite 235, 276, 316–17 underlying 113, 185, 193, 209, 235, 401 agriculture 272

460 Index aircraft 27, 32, 161, 168–69, 215, 220, 222, 228 engines 168, 215, 233 equipment 169–70 ambivalence 4, 59, 211 American courts, see United States, courts amortisation 31, 99, 218, 221, 226–27 anonymity 338, 342–43, 406, 421 anti-money laundering duties 334 Anwartschaft 95, 98, 100, 102, 104, 134, 152, 156 apparent ownership 51, 183 applicability 21–22, 202–3, 205–7, 226, 229, 231–32, 368, 403–4 applicable domestic laws 13, 19, 23, 44, 154, 165, 210–11, 228 appropriation 24, 37–38, 87, 111–14, 146–47, 153–54, 216, 437 facilities 101, 104, 146, 162, 196 approximation 64, 78, 173–74, 216, 322 arbitrage 270–71 instant 304 arbitration 167, 211, 349, 365, 368, 383, 407 commercial 167 international 295, 365–66, 368, 382, 407 arbitrators 166, 263, 274, 365, 382, 399, 407 international 349, 374, 382, 399 Asia 309, 362, 411 assessments 259, 301, 310, 370 asset and liability management (ALM) 301 asset-backed funding/financing 1, 4, 22, 28, 36, 44, 131–32, 137 local differences and similarities 23–28 asset-backed securities 3, 238 asset classes 11, 67, 69, 78, 104, 174, 190, 213 asset ledgers 298, 441 asset-maintenance obligation 418–21, 426, 431, 434, 441 asset managers 47 asset pools 197, 240, 253 asset securitisation, see securitisation asset side 2–3, 270 asset substitution 4, 66, 70, 181, 213 assets, see also Introductory Note back-up 253, 422, 431 banking 253 client 48, 66, 91 debtor’s 18, 47, 50, 113, 205, 316 flawed 361, 363 foreign 77, 164 fungible 36, 40, 149, 157, 311, 354, 424, 446 illiquid 261 loan 234, 236, 242, 245, 247, 255 long-term 313 off-ledger 337, 441, 443 replacement 4, 12, 65, 67–68, 177, 179, 184, 189 risk 237, 240, 245–46, 254, 261, 268 secured 24, 29, 31, 37, 121, 168, 175, 185 sold 54, 94, 132, 176, 446

transferred 85, 239, 254 trust 90–91 underlying 46–47, 154–56, 158–59, 264–66, 268–70, 272–73, 277–78, 451–52 values 246, 265, 452 assignability 80, 88, 190–92, 199, 203–4, 208, 210, 213 assigned claims 29, 192, 203, 208 assignees 28–29, 185–87, 189–93, 197–98, 203–8, 210–13, 235–37, 325 collecting 60, 126, 212 foreign 199, 214 security 68, 78 assignments 59–61, 125–26, 142, 178–80, 184–214, 234–38, 257–58, 325–27 agreements 180, 186, 188, 203, 210, 235 automatic 161, 188 bulk 61, 178–79, 184–89, 191–92, 197–202, 204–6, 208–14, 235–36 special problems 184, 187 conditional 29, 99, 202 constitutive requirements for 209 equitable 29, 60, 179, 353 international 20, 61, 164, 191, 205 multiple 60, 205 prohibitions 193, 196, 204, 235 of receivables 58, 67, 119, 125–26, 157, 179, 189, 192 registered 70 restrictions 176, 185–87, 190, 209, 213–14, 235–37 security 67–68, 89, 126, 174, 195, 201–2, 211, 238 single 125–26 assignors 29, 185–87, 191–93, 196–201, 203–5, 211–13, 235–36, 238–39 collecting 78, 236 attachment 119–21, 126, 129, 143–44, 153, 316, 347, 379 Aussonderung 46, 94, 98–99, 101, 147, 180 Australia 253, 287, 413, 442 authorisation 22, 144, 299, 304, 309–10, 313–14, 324, 375–76 and supervision 309 authorities 80, 94, 341–42, 375, 377–78, 406, 411–12, 414 automatic assignment 161, 188 automatic retransfer 200–1 automatic return 81, 94, 114, 227 automatic set-off 344, 346–47 automatic transfer 181, 210, 226, 233 automaticity 85, 344–46, 348, 350, 352, 354, 358, 360 autonomous guarantees 400–1 autonomy 22–23, 27, 49–50, 54–57, 59–60, 171–73, 187–89, 212–13 group 46 party, see party autonomy aval 386, 388–89, 401

Index 461 back-to-back agreements 355, 432 back-to-back letters of credit 400 back-up 19, 252–53, 417–19, 421–22, 424–25, 440 assets 253, 422, 431 entitlements 417–18, 434 bailees 39, 141–42, 151 bailment 31, 107–8, 122, 124, 134, 141–43, 150–51, 216–17 balance sheet risk 250 balance sheets 234, 237, 240, 242, 253, 255, 257, 268–70 balances 69, 87, 174–75, 242, 292, 333–34, 341, 437–38 bank 87, 164, 174, 318, 321, 328, 334, 438 cash 69, 430, 437 credit card 234, 240, 242 net 290, 292, 356 bank accounts 315, 328, 333–34, 336, 406–7, 416, 418, 420 bank balances 87, 164, 174, 318, 321, 328, 334, 438 bank guarantees 21, 29, 389, 393, 398–402, 404 bank loans 11, 113, 121, 126, 240 Bank of England 288, 329, 339, 350 Bank of International Settlement, see BIS bank payments 17, 316, 331, 384, 407, 434 Bank Recovery and Resolution Directive, see BRRD bank regulators 243, 293 bank transfers 316–23, 325–26, 334, 371, 384, 387, 397 electronic 432 international 364, 384 legal nature and characterisation 325–28 modern 325–28, 332 bankers 348 banking 10–11, 13–17, 249–50, 304–7, 309, 323–25, 328–29, 405–8 commercial, see commercial banking investment 16, 309 modern 237 narrow 160 products 2, 11, 13–17, 27, 170 sharia 160 supervision 307 supervisors 239 systems 306–7, 323–25, 328–29, 332–33, 338, 384–85, 406–8, 419–20 banking assets 253 banking business 2 banking crisis 247 banking regulators 170, 371 bankrupt brokers 418, 429 bankrupt counterparties 46, 52, 97, 330 bankrupt debtors 44, 94, 344 bankrupt estates 4, 9, 44–45, 47, 70, 94, 97, 344 bankrupt intermediaries 417, 419, 434 bankruptcy 43–50, 62–64, 97–104, 159–64, 289–93, 344–49, 351–69, 451–55

courts 40, 59–60, 62, 163–64, 289, 296, 364, 369 foreign 24, 162–63 France 10, 25, 80–81, 83, 86–87, 89, 99, 218 Germany 34–37, 43, 94, 99, 101–2, 345, 347–48, 352 impact of regimes 61–65 intervening 40, 97, 178–79, 181, 200, 209, 353–54, 434 law(s) 46–50, 59–64, 159–60, 166, 289–93, 345–48, 358–69, 453–54 local 9, 19, 41, 154, 173, 189–90, 296, 373 Netherlands 25, 34, 38, 78, 87, 147, 202, 366 proceedings 81, 163–64, 222, 359 protection 5, 41, 47, 50, 52, 221, 252 resistance 3, 17 set-off 346, 351, 354, 363 situations 36, 38, 47–48, 57, 59, 354, 356, 369 trustees 70, 134, 145, 155, 161, 180, 417–18, 447–48 banks 11–17, 234–44, 247–50, 315–19, 323–33, 385–94, 396–403, 406–10 advising 390–92 central 287–88, 317–19, 329–31, 333, 336–37, 339–42, 376, 378–79 commercial 2, 14–17, 246, 248, 306, 337, 339, 341–42 correspondent 334 foreign 329, 382 house 24, 386, 390, 392, 394 instructing 327, 387, 390 intermediary 324, 326, 328, 334, 376, 420 investment, see investment banks issuing 385, 388–400, 405 major 285 nominated 390–94, 396 nominating 397–98 ordinary 305, 455 originating 238–42, 259 paying 329, 391–92, 397–98 presenting 387–88, 392 remitting 387, 392 smaller 250, 440 United States 456 Basel Committee 352 Basel I 371 Basel II 249–50, 381 Basel III 456 bearer securities 415–16, 434, 440, 442–43 Belgium 21, 25, 66, 69, 79, 185, 220, 346 bespoke products 284 best execution 308, 421 best practices 245, 411 best price 45 Big Bang 245, 362 bilateral netting 273, 289, 291–92, 294, 329–30, 358, 360–61, 369 bilateral set-off 4, 424

462 Index bills of exchange 28, 56, 316, 323, 374, 384–93, 397–98, 401–2 accepted 386–89 sight 388 time 386, 392 bills of lading 20, 28, 56, 61, 295, 384–85, 387–90, 393–94 bills of sale 31, 35, 106, 110–11, 113–14, 116 binding force 410 BIS (Bank for International Settlements) 293, 364, 370 Bitcoin 335–40, 413 blockchain 263–65, 297–99, 335–37, 339, 441–43 permissioned 334, 339, 440 private 298–99 public 298 technology 264, 334–35, 338–39 blocking clauses 264 blocks 276, 335–36 bona fide assignees 193–94, 197, 207, 213, 322, 327 bona fide creditors 6, 8, 50–52, 60, 81, 143–44, 147, 182–83 bona fide outsiders 6, 51, 234 bona fide payees 322, 326 bona fide purchasers 26–29, 50–52, 56–57, 60–61, 111, 126–27, 140–43, 221 protection 28–29, 32, 35, 51–52, 55–56, 60–61, 140, 142 bona fide successors 161, 188 bona fide transferees 185, 422–23 bond holders 159, 238–39, 247, 253–54, 271, 416 bond issuers 270–71 bond issues 158, 237, 247, 254, 271, 289–90 bond portfolios 238, 267 bondholders, senior 239 bonds 3–4, 14, 237–41, 253–55, 269–72, 281, 415–18, 450–51 corporate 238, 269 covered 234, 253 government 253, 418, 426, 451 bonuses 252 book-entry entitlements 415, 419, 424, 434, 437 book-entry systems 56, 417–19, 426–27, 431–32, 434–35, 438–39, 446–47, 450–51 emergence 56, 174 regulatory concerns 438–39 boom and bust 160 bordereau 89 borrowed securities 424, 449 borrowers 17, 175–77, 194–96, 263, 271, 311, 424–26, 449 securities 311, 422, 425, 451 branches 293, 359, 364, 370–71, 390–91, 414 Brazil 35, 66 breach of contract 155, 193, 301, 347 Bretton Woods Agreements 268, 379 Brexit 288, 384

broker/dealers 456 brokerage 15, 300, 307, 311–12 activity 306, 312 prime 300, 307, 311–12 brokers 275, 278–80, 308–12, 347, 416–17, 419–35, 440, 442–43 bankrupt 418, 429 floor 275, 278–80 house 279–81 prime 159, 310–12 buffers 337 Bulgaria 330 bulk 12, 88, 176–78, 191–92, 199–200, 202, 212–13, 235–36 bulk assignments 88–89, 185–89, 191, 197–99, 201–2, 204–5, 208–14, 235–36 international 199, 202, 207, 212, 214 special problems 184–87 bulk transfers 173, 175, 178–80, 184, 187, 189–90, 210–11, 213 buyer/debtors 386, 389–90, 398–99 buyer/financiers 85, 98–100, 102, 123, 132, 445, 452 buyers 80–83, 139–46, 148–51, 277–80, 384–91, 393–400, 419–27, 445–50; see also purchasers conditional 113, 142, 144, 166, 170 margin 428–30 original 139, 278 in possession 144, 148 repo 136, 155, 157, 422, 445, 447–48, 450–52, 457 CAD (cash against documents) 56, 85, 381, 387–88 calculations 273, 363 call deposits 11 call options 265, 269–70, 294, 298–99, 445, 447 calls, margin 245, 275, 282, 285–86, 298, 456 Canada 220, 343, 347, 378 capacity 315, 318, 320–22, 326–27, 345–46, 356, 359, 423 capital 14–15, 174–75, 186, 242–43, 249–50, 261, 309–10, 379 minimum 309 venture 306, 312 capital adequacy 2, 234, 238, 241–43, 250, 259, 261, 371–72 purposes 237, 248, 261, 364, 370 relief 235–36, 239–40, 261 requirements/standards 157, 170, 234, 242–43, 261, 294, 371, 381 capital charges 456 capital goods 168, 226, 233, 384 capital markets 10–11, 14–16, 237, 246–47, 249–50, 252–53, 262, 408 activities 438 capital movements 379–80 capital requirements, see capital adequacy, requirements/standards

Index 463 case law 35, 38–39, 54–55, 68–71, 76, 95–97, 141–44, 146–47; see also Table of Cases cash accounts 44, 175, 263, 420–21, 426, 430, 432, 440–41 cash against documents, see CAD cash balances 69, 430, 437 cash deposits 407 cash flows 11–12, 235–36, 238–42, 248, 253, 269–71, 273–74, 357 accruing 14, 267 fictitious 267–68, 274, 289–90 fixed rate 267, 269 floating-rate 267, 269, 273 underlying 239–41, 248, 289 cash ledger 298, 441 cash payments 317–20, 322, 327 cash settlements 43, 244–45, 273, 298–99 cash transfers 319, 342, 442 CBDCs (central bank digital currencies) 316–17, 337, 339–43 CCPs (central counterparties) 244–45, 260–61, 265–66, 273–75, 277–88, 293–95, 331, 432–33 concept and potential 285–88 CDD (customer due diligence) 412 CDOs (collateralised debt obligations) 14, 160, 238, 240, 248, 253, 259 CDS (credit default swaps) 14, 238–39, 241–47, 256–61, 287, 293, 362, 402 characterisation and insurance analogy 256–57 contracts 244–45, 257 market 296–97 naked 256 single name 244 Cedel 346 central bank digital currencies, see CBDCs central banks 315, 319, 329–31, 333, 336–37, 371, 376, 378–79 central clearing 281–86, 293–94, 299 central counterparties (CCPs) 244–45, 260–61, 267–68, 277–87, 293–95, 331, 354–55, 432–33 centralisation 260, 300, 442 certainty 61, 80, 152, 354 certificates of deposit 56 pass-through 238 CESR (Committee of European Securities Regulators) 245 CFTC (Commodity Futures Trading Commission) 258 chained transactions 326, 332, 420, 425 chains of ownership 150 characterisation 37–40, 100, 124, 130–31, 218–20, 232, 325–26, 448 legal 10, 27, 132, 159, 197, 216–17, 290, 334 characteristic obligations 162, 204, 223, 231, 258, 370

characteristic performance 204 chargees 110, 121, 181 charges 12–13, 32–35, 113–16, 161–64, 167–68, 173–83, 187–89, 193–94 capital 456 equitable 33, 105–6, 112, 115–17, 190 fixed 110, 179–80 hidden 34, 51, 60, 194 non-possessory 57–58, 67, 80, 110, 167, 183 registrable 116 chattel mortgages 31–33, 36, 105–6, 111, 114–15, 140 chattel paper 29, 121, 127, 176 chattels 24–36, 38–39, 51–52, 105–11, 126–28, 142–44, 183–85, 217–18 interests in 107, 143 law of 26, 107, 119, 161–62, 205 non-possessory security interests in 24, 33–34, 36, 59, 80, 106, 131, 167 registered 111, 220 cheques 316, 321, 323–24, 329 cherry-picking 85, 134, 155, 448, 452 Chicago Board of Trade (CBOT) 275 Chicago Mercantile Exchange (CME) 275, 287–88 child abuse 408–9 child pornography 406, 413 China 160, 343, 375 CHIPS (Clearing House Interbank Payment System) 329–30 choice of law 56–57, 159, 203, 223–24, 231, 258, 419, 454 citizens 341, 343, 376, 378, 453 civil codes, see codification; Table of Legislation and Related Documents civil law 9–13, 28–32, 47–49, 51–52, 57, 107–8, 148–56, 172–75 approach 32, 104, 106, 111, 146, 151–52, 170–72, 326 countries 12–13, 26, 30–31, 133–35, 150–52, 188–90, 194, 232–33 lawyers 172 modern 137, 327, 348 notions of commercial law 10 claims 190–93, 199–201, 203–5, 208–14, 316–19, 344–47, 349–53, 365–69 assigned 29, 192, 203, 208 competing 47, 145, 292, 344, 360, 447–48 contractual 211, 334, 435, 447–48 intangible 1, 6, 119–20, 188, 194 mature 201, 347, 349 monetary 18, 22, 46, 185–87, 190–93, 344, 347, 353 mutual 4, 40, 44, 47, 134, 331, 424 secured 28–29, 37, 45, 62, 121, 127 underlying 203, 208, 367, 369 unsecured 28–29, 89, 292, 384 clearers 260, 283

464 Index clearing 15–16, 275–76, 278–83, 286–88, 294–95, 300–1, 329–31, 430–34 agents 331 facilities 260, 286, 431 houses/institutions 275, 279, 282, 284–85, 330, 440–41 members 260, 268, 274, 277–83, 285–86, 295, 433, 456 obligations 285 process 275, 284, 432 systems 260, 283, 293, 329, 331, 333–34, 355, 432 Clearstream 418, 432–33, 451, 453, 455 client accounts 4, 48–49, 346, 421, 430, 441 segregated 420 client assets 48, 66, 91 clients 15, 278–82, 301, 328–29, 418–21, 425–28, 430–32, 440 corporate 249 retail 261, 302, 308, 329, 342 close-out events 281, 290–91, 295, 350, 356 close-out facilities 282, 286, 295 close-out netting 277–78, 282, 289–90, 292–94, 356–58, 361, 363–64, 452–54 bilateral 360, 369 clauses 135, 292 closed system of proprietary rights 77, 92, 102, 134, 137, 170–71, 173, 232 CME (Chicago Mercantile Exchange) 275, 287–88 co-operation 167, 316, 408, 411 international 409 regulatory 16 co-ordination 442 co-ownership 49, 89, 145, 434–35, 440 cocktail swaps 267 codification 43, 55, 66, 78, 223, 389, 396 countries 233 partial 223, 233, 389 thinking 55 collateral 44, 62–63, 120–22, 127–28, 219, 424–26, 428–30, 436–38 financial 43, 69, 182, 436 rights 129, 162, 217–18, 224, 226, 230, 232–33 collateral rights under Leasing Convention 230–32 collateralisation 237–38, 257, 260, 275–77, 294–95, 437 collateralised debt obligations, see CDOs collecting assignees 60, 126, 212 collecting assignors 78, 236 collection agents 125, 236, 238–40, 346 collection agreements 126, 184, 186, 197–98, 200, 208–9, 211, 213 collection arrangements 4, 201, 385 collection risk 197, 200, 386 collections 175–77, 194–201, 203–4, 209, 212–13, 385, 387–89, 391–92 excess 99, 201 collective investment schemes 87, 300, 302–4, 309

commercial arbitration, see arbitration commercial banking 2, 10–11, 15 activities 16 products 16–17 commercial banks 2, 14–17, 246, 248, 306, 337, 339, 341–42 commercial flows 17, 22, 27, 46, 51, 172–74, 177, 182 ordinary 6, 51–52, 183 commercial paper (CP) 172, 242, 248 commercial transactions 43 commerciality 186 commingling 70, 178, 181, 421, 424, 429–30, 437, 446–47 commitments 243, 392, 396–97 Committee of European Banking Supervisors, see CEBS Committee of European Securities Regulators, see CESR commodities 4, 7, 33, 272, 304–5, 353, 449 commoditisation 185, 192, 211–12 commoditised products 5–7, 12, 27, 50–51, 55, 60, 166, 172 Commodity Futures Trading Commission (CFTC) 258 common creditors 6, 8–9, 44–45, 51–53, 55, 60, 62, 155 bona fide 52, 60 common law 28–32, 39, 44–48, 51–52, 104–8, 148–52, 216–17, 399–400 countries 4–7, 10, 12–13, 23–24, 46–48, 171–74, 200, 346–48 courts 140 modern 8, 10, 26–27, 30, 44, 52, 59, 173–74 mortgages 13, 105, 108–9, 111–12, 158 notions of commercial law 10 old 39, 105, 109, 158, 212 companies 35, 89–90, 167–68, 237–39, 312–13, 378, 405–6, 415–16 factoring 195 finance 214, 240, 243 foreign 195, 239 insurance 89–90, 195, 241, 243, 247–48, 284, 300–1 parent 268, 362, 401 public 272, 313 compartmentalisation 416, 419, 422, 440 compensation schemes 52 competencies 42, 64, 170 competing claims 47, 145, 292, 344, 360, 447–48 competing creditors 27, 51, 55, 145, 311, 344, 448 competition 25, 110, 132, 180, 215 competitiveness 381 completeness 214, 319 completion 152, 333, 430 compliance 222, 228, 362, 389–92, 396 strict 395, 397, 402 computing power 338 conditional assignment 29, 99, 202

Index 465 conditional buyers 113, 142, 144, 166, 170 conditional interests 123, 142 conditional owners 33, 74, 141, 144–45, 151–52, 217 conditional ownership 24, 79–80, 104, 133–34, 147, 172–73, 217, 219–20 interests 172 rights 41, 43, 77, 147, 150–51, 154, 163, 172 conditional sales 29–31, 33–39, 74–75, 100–2, 104–6, 111–15, 139–44, 201–2 Germany 97–100 true 49, 100–2 conditional sellers 113, 142, 144–45 conditional title 105, 142–43, 151, 162 conditional transfers 92–93, 97, 101, 103, 147–48, 152–53, 200–1, 211 conditionality 70, 72, 74, 83–85, 134, 290–91, 358, 360–61 conditions implied 148, 207 market 40, 146 rescinding 72–73, 148–49 resolving 72–73, 96, 148–50 suspending/suspensive 72–73, 148–50, 217 suspensive 72–73, 148–50 conduct of business 309 confidence 252, 285, 319, 442 confidentiality 247, 264, 306, 342, 408, 417, 421, 443 confirmations 230, 284, 355, 362, 453 confirming banks 378, 390–93, 399–400, 403, 405 confiscation 408–11 conflicts of law rules 21, 166–67, 206–7, 210, 222, 224, 228, 231–32 confusion 38, 146–47, 183, 185–86, 199, 221, 223, 402–4 connexity 4, 291–92, 317, 345–46, 348–49, 351, 353, 366 consensus 123, 264, 338, 366 consent 2, 142–43, 192–93, 266, 276, 325–27, 356, 426–28 consistency 264, 412 consolidation 237, 252, 286–87 constitutive requirements for assignments 209 constituto possessorio 98 constructive delivery 184 constructive possession 110, 181 constructive trusts 2, 4–6, 9, 23, 29, 47–48, 70, 78 consumer credit 43 consumer debt 253 consumer goods 51, 119, 127, 167 consumer leases 129, 218, 221 consumer protection 120, 215, 220, 324, 333 consumers 7–8, 11, 126, 129, 146, 215, 218, 220 contagion 306 contingencies 152 continuous novation netting 291, 331 contract interpretation 356 contract principles 207

contracts 206–9, 266–67, 269–78, 280–81, 289–91, 357–61, 367–70, 381–87 derivative 288 for differences 266, 271–74, 276, 289–90, 355, 357–58, 363, 367–70 executory 129–30, 150, 153, 155–56, 218, 222, 447–48, 452 foreign exchange 272, 364 forward 272 futures 266, 269, 273–74, 277–78, 280–81, 286 gaming 290 insurance 256 lease 220, 226, 230, 232 original 236, 280, 285 sales 276–78, 316, 389, 398, 433 smart 65, 263–65, 297–300, 338, 405, 441 standard 269, 273 supply 221, 223, 231–32 swap 294, 297, 357, 359 underlying 185, 208, 234–35, 243, 257, 395–96, 401–2 contractual arrangements 39, 124, 129, 134, 220–21, 224, 247, 316 contractual choice of law 56, 223–24, 231, 293, 365, 419, 438, 454 contractual claims 211, 334, 435, 447–48 contractual duties 155, 231, 276, 327 contractual netting 48, 289–90, 354–55, 357, 363–64, 448 clauses, see netting, clauses contractual obligations 37, 193, 203–4, 208, 257–58, 367, 370, 379 contractual rights 155, 157, 218, 228, 234, 240, 243, 294–95 contractualisation 50, 368 control 58, 61–62, 69, 110, 179–80, 364, 427–28, 437 private 45, 180 regulatory 312 risk 330–31 convergence 28–30, 40, 58, 78, 104, 283, 404 conversion 97–98, 147, 154, 201–2, 216, 218, 377–78, 454 convertibility 319–20, 332, 375–76, 378–79, 388 free 375–76, 379 corporate bonds 238, 269 corporate clients 249 corporate governance 158, 443 corporate information 417, 440 correspondent banks 334 corruption 412 costs 135–37, 215, 234, 238–39, 262–63, 271, 329–31, 388–89 acquisition 218, 226 settlement 286, 432 transaction 164, 301, 304, 314, 340, 373 Council of Europe 409–11

466 Index counterclaims 4, 196, 289, 316–17, 346, 365–69, 454 counterparties 1–2, 49–50, 266–67, 275–78, 290–91, 295, 297–99, 375 bankrupt 46, 52, 97, 330 central (CCPs) 244–45, 260–61, 267–68, 277–87, 293–95, 331, 354–55, 432–33 identifiable 337 counterparty risk 276, 282, 299, 375, 385–86, 400, 444, 455 coupons 270–71, 273–74, 290, 417, 441 court orders 109, 168, 349, 351, 353, 398 courts 36–38, 109–10, 113–14, 140, 163, 169, 222–23, 382–83 bankruptcy 40, 59–60, 62, 163–64, 289, 296, 364, 369 foreign 382–83 supreme 21, 74, 76, 106 coverage 126–27, 168, 170, 204, 206–7, 211, 213–14, 411–12 covered bonds 234, 253 CP, see commercial paper creation of security interests 56 credibility 213, 242, 245, 252, 287, 308, 408, 411 credit 191–93, 243, 245–47, 322–27, 374–78, 385–404, 419–20, 422–23 acceptance 390–93 consumer 43 letters of 29, 243, 245, 316, 322–23, 374–78, 385, 388–404 sales 105, 112–13, 116, 120, 135–36, 145, 147 standby letter of 243, 402, 404 credit agreements 71, 102, 167 credit card balances 234, 240, 242 credit cards 11, 113 credit conversion factors (CCFs) 257 credit cultures 16–23, 35 credit default swaps, see CDS credit derivatives 14–15, 242–43, 247, 254, 257, 261–62, 294, 296 credit enhancement 237–40, 247 credit event restructurings 257 credit institutions 261 credit lines 196, 198, 242, 249, 252, 329, 382 credit ratings, see ratings credit risk 191–92, 195–98, 200–1, 243–47, 264–65, 329–30, 337–38, 386–88 credit spread options (CSOs) 242, 244, 246 credit transfers 321, 324–25, 332–33, 335, 419 creditors 11–13, 31–33, 44–47, 49–53, 142–45, 179–83, 315–18, 320–25 bona fide 6, 8, 50–52, 60, 81, 143–44, 147, 182–83 common 5–6, 8–9, 44–47, 51–53, 55, 60, 62, 155 competing 27, 51, 55, 145, 311, 344, 448 general 434, 440 secured 28, 44, 49–51, 62–64, 99, 122, 127, 179–82 unsecured 35, 44, 51, 110, 121, 127, 179, 182

criminal sanctions 411 Croatia 330 cross-border payments, risks 374–76 cross-border transactions 53 cross-default 289, 360, 453 crypto-assets 6, 413–14 crypto-currencies 6, 264, 299, 334–38 fiat 337 crypto-securities 264–65, 441, 444 crypto-tokens 338 cryptographic signatures 337, 441 CSOs, see credit spread options currencies 270, 289–90, 315–20, 332–34, 352–54, 375–79, 381–83, 385–87 common 407 effects of collapse 380–84 freely convertible and transferable 378–80 hard 378, 381, 407 paper 319, 339, 376–78 virtual 335, 412–14 currency election 376–77 currency risk 270, 380 currency swaps 87, 265, 267, 270, 289, 357, 362 custodial holdings 10, 65 custodial systems 3, 6, 43, 131, 416 custodians 3, 27, 275, 416–17, 421, 440–41 custody 15–16, 145, 312 customary law 5–7, 9–10, 14, 97, 104, 369–70, 372, 403–4 customer due diligence (CDD) 412 damages 85, 144–46, 155, 229–31, 301, 347, 383–84, 447–48 dealers 33, 234 debit transfers 323–24, 335, 420 debiting 324–25, 416, 419–21, 423, 430, 432, 443, 447 debits 324–25, 327, 419, 423–24, 430, 432, 440, 450 direct 324 debt 28–30, 144, 157–58, 167–68, 177, 346–47, 352–53, 380–81 consumer 253 government, see government debt sovereign 383 debtors 28–35, 119–23, 176–79, 181–83, 191–94, 199–214, 234–36, 315–28 account 176, 179, 196, 204 assets 18, 47, 50, 113, 205, 316 bankrupt 44, 94, 344 defaulting 28, 113, 167 foreign 41, 197, 213–14, 375 deduction 113, 180, 224, 246–47, 316 deeds, trust 58, 119 default events of 244, 257, 282 risk 182 swaps 238, 265, 268

Index 467 defaulting debtors 28, 113, 167 defaulting parties 40, 147, 154, 330, 454 defeasible titles 30, 124, 142, 150, 152 defects 66, 181, 202, 231, 320, 322–23, 327, 398 defences 191–93, 208–9, 213–14, 349, 366–67, 369, 397–98, 401–2 delayed transfers 84, 148, 152, 272, 431 delivery 43, 73, 161, 188, 230–31, 320, 353–54, 423–25 constructive 184 obligations 165, 448, 454 physical 142, 415 of possession 73, 92, 121, 141 requirements 58, 176, 178, 181, 186, 311, 321 versus payment, see DVP dematerialisation 415–16, 439 Denmark 63, 170, 330, 414 deposit accounts 127, 341 deposit takers 17, 306 deposit-taking function 2, 65, 338 deposit-taking institutions 421 Depositary Trust and Clearing Corporation, see DTCC depositories 43, 313, 416–18, 426, 432, 435, 440–43 depositors 11, 16–17, 52, 160, 249, 253, 273, 342 Depository Trust Company (DTC) 416, 432 deposits 11, 14–15, 19, 341–43, 381, 387, 406, 409–10 call 11 cash 407 derivative contracts 288 derivative transactions 85, 252, 297 derivatives 13–17, 260–62, 267–71, 275–76, 284–86, 293–95, 297–99, 362–63 credit 14–15, 242–43, 247, 254, 257, 261–62, 294, 296 domestic and international regulatory aspects 293–94 exchanges 276, 279–80, 295, 433 and fintech 297–300 international aspects 293 markets 15, 258, 265, 269, 273–81, 284–86, 428, 433 regular 275–76, 279, 284, 289, 456 risk 288–90 trading 6, 65, 338, 433 transnationalisation 294–97 types and operation 265–68 use 268–72 valuation 272–74 description, mere 104 destabilisation 242, 247, 418 devaluation 381 diligence, due 182–83, 410 dilution 155, 252 dingliche Anwartschaft 57, 95, 98, 100, 102, 134, 152, 156

dingliche Einigung 94, 96, 200 direct debits 324 direct effect 54 Directives, see under EU disclosure 251–52, 262, 272, 279, 306–7, 309–11, 313–14, 411 proper 262, 309, 330 discount 195–96, 199, 201, 230, 252, 386, 388, 393 discounting 196, 262, 386–88, 393 discretion 214, 348–49, 358, 369, 379, 398 disposition duties 38, 113, 201 rights 176, 178, 184, 189, 315–16, 319–20, 322–23, 422–23 dispositions 33–34, 36–38, 40, 176–77, 180–81, 196–97, 201, 320–22 disputes 87, 192, 210, 229, 235, 375, 393, 397 resolution 65, 383 distributed ledgers 287, 297, 299–300, 335, 337, 342, 404–5, 441–44 distributions 9, 44, 47–48, 53, 168, 180–81, 216, 252 diversification 258, 268, 301–2, 338 diversity 33, 309 dividends 269, 273, 298, 417, 419, 440–41 division 217, 252, 256 documentary letters of credit 390, 393–94, 398, 402 documentation 21, 24, 183–86, 190–91, 212–13, 276, 282–83, 286 swaps 357–58, 361 documents 127, 140, 143, 185, 384–85, 387–98, 400–2, 431 scanned paper 263 of title 3, 56, 172, 384 transport 394 domestic laws 21–24, 35, 61–63, 169, 212–14, 373–74, 403, 435–36 applicable 13, 19, 23, 44, 154, 165, 210–11, 228 domestic markets 21, 154 domestic security interests 64, 154, 168 double gearing 305 double pledging 264 double regulation 304 drug trafficking 406, 408–12 DTC (Depository Trust Company) 416, 432 DTCC (Depositary Trust and Clearing Corporation) 286, 297, 300, 442 dual ownership 104, 137, 153–54, 217, 220, 445 dual regulation, see double regulation duality of ownership 73, 75, 95–96, 99–100, 102, 149–52, 154–57, 217–18 Dubai 159–60 due diligence 122, 182–83, 194, 263, 410 Dutch law 66, 68–70, 72–75, 77–78, 147–48, 153, 172, 203 new 35, 74, 78, 153, 172, 345, 445, 454

468 Index duties 192–93, 209–11, 230–32, 234–35, 265–66, 390–91, 444–45, 448–50 contractual 155, 231, 276, 327 disposition 38, 113, 201 fiduciary, see fiduciary duties 251, 262, 300–2, 308–9, 314, 421 repurchase 137, 142, 450 DVP (delivery versus payment) 56, 431 dynamism 173 early termination 245, 296, 448 earnings 15, 252 Eastern Europe 44, 411 EBRD (European Bank for Reconstruction and Development) 44, 53, 146, 164, 167 ECB (European Central Bank) 249, 288, 330, 380–81, 436, 449, 455 economic growth 250 effectiveness 25–26, 29–30, 190, 193, 316, 359, 400, 402 legal 170, 256 efficiency 171, 275, 329, 399 Einigung 99, 148, 186 election 129, 145, 344–45, 347, 377, 448 electronic money 337 electronic payments 329 electronic trading 275 EMIR (European Market Infrastructure Regulation) 261, 275, 284, 286, 288 employees 48, 80, 252, 414 end-buyers 278, 424–25 end-investors 277–78, 280–81, 286, 416–18, 420–22, 426–27, 430–31, 433–34 end-sellers 419, 425 end-users 203, 267, 279–80, 285, 294–95 enforcement 161–64, 173, 187–88, 204–5, 210, 222–26, 228–29, 436–37 actions 228, 316 international 162–64, 166, 187, 204, 223–25, 229 proceedings 50, 163, 189 UCC 120, 122, 170 enjoyment 5, 31, 46, 50, 57, 107, 134, 141 enrichment, unjust 47, 70, 78, 320, 328 Enron 251–52, 255, 262 entitlement holders 416–17, 419, 431, 438 entitlement systems 421, 439 entitlements 138, 153, 273, 415–21, 426–28, 430–31, 434–36, 446–48 back-up 417–18, 434 securities 415, 417, 419–22, 425, 429–30, 432, 435–36, 440 equality 8–9, 44, 52–53, 60, 349 of creditors 9, 49 equipment 33, 120, 127, 129, 168–69, 214–15, 218, 226–31 leases 38, 51, 122–23, 127–30, 137, 218, 221, 224 mobile 42, 165–66, 168–69, 171, 173, 183, 234

equitable assignments 179, 353 equitable charges 33, 105–6, 112, 115–17, 190 equitable interests 32–33, 41, 43, 51, 122–23, 142–43, 218, 425 multiple 143 equitable proprietary rights 23, 27, 30, 33, 45–46, 51–52, 55, 57 equitable set-off 23, 349 equitable subordination 49, 103, 123 equity 4, 6–7, 13–14, 105–8, 149–51, 216–17, 312–14, 348–49 and common law 10, 34 private, see private equity 302, 306, 312–14 of redemption 13, 105–6, 109, 112–15 equivalence 161 erweiterter Eigentumsvorbehalt 94, 96 ESCB (European System of Central Banks) 330 ESMA (European Securities and Markets Authority) 285, 288 ESRB (European Systemic Risk Board) 283 establishment 437 estates 47, 63, 68, 94, 97, 99, 344, 350 bankrupt 4, 9, 44–45, 47, 94, 97, 134, 344 ETFs (exchange-traded funds) 302, 304 EU (European Union) 63–64, 257–58, 261, 309–10, 313–14, 377, 379, 410–11 AIFMD (Alternative Investment Fund Management Directive) 310, 313–14 Directives 171, 173, 188–89, 361, 364, 373, 436, 438 ECB (European Central Bank) 249, 380–81, 436, 449, 455 ESCB (European System of Central Banks) 330 ESMA (European Securities and Markets Authority) 285 European Parliament 412 and money laundering 411–14 SEPA (Single European Payments Area) 330 Transparency Directive 330 UCITS (Undertakings for Collective Investments in Transferable Securities) 304, 309–11, 313–14, 427 euphoria 259 eurobonds 14, 16, 55–56, 432, 434–35, 451, 453–54, 456 markets 14, 16, 55, 432, 448, 451, 456 Euroclear 25, 346, 418, 432–33, 451, 453, 455 European Bank for Reconstruction and Development (EBRD) 44, 53, 146, 164, 167 European Central Bank, see ECB European Continent 25, 33, 79, 137, 147, 196, 310 European Court of Justice, see ECJ European Market Infrastructure Regulation, see EMIR European Monetary Union, see EMU European Parliament 412 European Securities and Markets Authority, see ESMA

Index 469 European Securities Committee, see ESC European Stability Mechanism, see ESM European Supervisory Authorities, see ESAs European System of Central Banks, see ESCB European System of Financial Supervisors, see ESFS European Systemic Risk Board, see ESRB European Union, see EU eurozone 288, 330, 337, 372, 380 events of default 244, 257, 282 excess collections 99, 201 excess value 46, 111–12 exchange of information 412 exchange rates 270, 273, 376–77, 380 fixed 268, 319 exchange-traded funds, see ETFs exchanges, see also individual exchange names derivative 276, 279–80, 295, 433 futures 16, 273–74, 280, 285, 294 option 273, 275 regular 266–68, 276, 286, 295 stock, see stock exchanges execution 24, 54–55, 62–63, 93–94, 99, 133, 297–98, 301 best 308, 421 duties 138, 153 sales 36–37, 44, 98–100, 111–14, 143–44, 146–47, 167–68, 201 executory contracts 129–30, 150, 153, 155–56, 218, 350–51, 447–48, 452 exemptions 53 expectancies 73, 96, 133, 141, 149, 152, 181 proprietary 57, 71, 95–96, 134, 152, 217, 449 expectations 102, 137, 156, 160, 252, 264, 347, 435 expertise 283, 300–1, 308 exposure 261, 269, 282, 284, 286, 289, 309, 311–13 large exposures 307 risk 236, 268, 388 expropriation 203 extended reservation of title 84, 103, 116 extraterritorial effect 163, 379, 382 extraterritoriality 359, 382 factoring 37–38, 74–76, 132–34, 162–66, 189–92, 194–202, 206, 208–14 agreements 199, 206, 209 companies 195 contractual aspects 198–99 proprietary aspects 199–202 of receivables 39, 41, 101, 115, 117, 133, 155, 194 recourse 195, 197, 209, 213, 216 fairness 78, 173, 399 farm products 126–27 FATF (Financial Action Task Force) 405, 410 fault 141 FCCs, see fonds communs de créances FDIC (Federal Deposit Insurance Corporation) 310, 352

Federal Deposit Insurance Corporation (FDIC) 310, 352 Federal Deposit Insurance Corporation Improvement Act (FDICIA) 352 Federal Reserve 259, 306, 329–30 fee structures 308–9 fees 15, 236–37, 271, 304–5, 308, 387, 426, 449–50 international payment 336–37 fiat crypto-currencies 337 fiat currencies/money 319, 336–39, 413, 441 traditional 336–39 fictitious cash flows 267–68, 274, 289–90 fiducia 34, 57, 69, 89 fiduciary duties 251, 262, 300–2, 308–9, 314, 421 reinforced 302, 309 special 302, 308 fiduciary sales 25, 57, 66, 69 fiduciary transfers 74 fiducie 87, 89–91 fiducie-sûreté 80, 87, 91 filing 35, 119–22, 125–28, 160, 162, 177, 181–83, 222 requirements 44, 119–20, 133, 142–43, 181, 183 systems 51–52, 110, 122, 127–28, 162, 168–70, 182–83, 212 finality 14–17, 55–56, 60–61, 319–23, 332–34, 422–23, 433–35, 438–39 payment 2–3, 56, 61, 314, 319–23, 326–27, 344, 346 settlement 346, 351, 358, 364, 372, 441, 443 finance companies 214, 240, 243 finance leases/leasing 1–2, 37–39, 41–43, 74–76, 100–2, 128–34, 214–30, 232–34 collateral rights under Leasing Convention 230–32 comparative legal analysis 219–21 contractual aspects under Leasing Convention 229–30 domestic and international regulatory aspects 232 enforcement aspects under Leasing Convention 228–29 international aspects 221–23 Leasing Convention 225 legal characterisation 216–19 proprietary aspects under leasing Convention 227 rationale 214–15 uniform substantive law 223–25 finance sales 1–17, 25–28, 30–44, 46–51, 58–62, 82–119, 131–35, 169–73 France 86–87 Germany 100–2 modern 38–39, 49, 117, 133, 172, 214–34 and secured transactions distinguished 36–41, 131–74 and sharia financing 157–60 United Kingdom 117–19 finance statements 120, 126–28, 177–78 Financial Action Task Force (FATF) 405, 410 financial centres 174 financial collateral 43, 69, 182, 436

470 Index Financial Conduct Authority, see FCA financial crisis 238, 246–47, 249–51, 260–61, 287, 306–7, 341–42, 455 financial derivatives, see derivatives financial engineering 14 abuse 251–53 and asset securitisation 234–40 excess 247–51 and securitisation 234–36 financial flows 1, 18–19, 52 financial futures 266, 272–73, 294 financial institutions 249, 351–52, 364, 391, 406, 411 financial instruments 126, 223–24, 265, 355, 357, 367, 369, 381 financial law 10, 19, 102, 159 financial legal order, see commercial and financial legal order financial markets 15–17, 262, 430 financial options 265–67, 275 financial products, in commercial banking and capital markets 10–16 financial risk 19 financial service providers 441 financial services 2, 15–16, 159, 189, 211, 303, 305, 309; see also Introductory Note and detailed entries industry 43, 128, 189, 211, 305, 345, 350, 359–60 financial stability 50, 53, 55, 342, 352, 357, 371, 373 Financial Stability Board, see FSB financial stress 259 financial structures 4, 10, 17, 23, 38, 43, 165, 173 financial structuring 14, 26, 50, 258, 364 financial system 6, 16, 52, 295, 298, 307, 406, 411 financial transactions 40, 44, 48, 58, 61, 85, 87, 363–64 financing 35–40, 132–33, 172–73, 195–97, 204, 209, 211, 213–16 asset-backed 22–23 ownership-based 38, 40, 56, 136, 147, 220 project 11, 17, 186, 189, 211 recourse 200 repo 17, 56, 137, 165, 436 secured 37, 127, 169, 191, 196 sharia 38, 132, 157–60 terrorist 340, 342, 412–14 finished products 33, 164, 174–75, 181, 184 fintech 6–7, 65 and derivatives 297–300 and investment securities 440–44 and payments 334–39 and securitisation 263–65 first demand guarantees 29, 245, 262, 401, 404 ‘first in time, first in right’ principle 45, 193 fixed charges 110, 179–80 fixed exchange rates 268, 319 fixed prices 266, 268 fixed rate cash flows 267, 269 flawed assets 361, 363

floating charges 4–7, 12–14, 33–35, 46–49, 58–61, 78–80, 110–11, 173–91 comparative legal analysis 177–81 domestic and international regulatory aspects 188–89 international aspects 187–88 non-possessory 110 publication or filing requirements 181–83 transnational 14 transnationalisation 189–90 types 174–77 floating interest rates 269 floating rate cash flow 267, 269, 273 floor brokers 275, 278–80 flows 7, 14, 60, 164, 189, 268, 271, 290 commercial 6, 17, 22, 27, 46, 51–52, 172–74, 177 financial 1, 18–19, 52 floating-rate cash 267, 269, 273 free 13, 126, 410–11 international 2, 10, 14, 18, 22, 59, 61, 164 ordinary commercial 6, 51–52 fonds communs de créances 88–89, 237 force majeure 231–32, 362, 379 foreclosure 11, 109, 114, 227, 242, 249 foreign bankruptcies 24, 162–63 foreign banks 329, 382 foreign companies 195, 239 foreign courts 382–83 foreign debtors 41, 197, 213–14, 375 foreign exchange 250, 259, 268, 360, 364, 375–77, 379, 386–87 contracts 272, 364 markets 376–77, 380 regimes 376–77, 379 transactions 348, 355 foreign interests 53, 57, 60, 62, 154, 161–62, 164 foreign investors 272, 303, 381, 383 foreign law 204 foreign proprietary interests 19, 162–64 foreign proprietary rights 161, 163, 222 forfait 387–88 forfeiture 38, 111, 408 formalities 69, 87–89, 133, 176–77, 201, 211–12, 215–16, 444 forum selection 375 forward contracts 272 forward rate agreements (FRAs) 271 France 10, 25, 65–66, 78–92, 146–48, 184–86, 201, 345–46 assignments of monetary claims in finance schemes 88–89 bankruptcy 25, 80–81, 83, 86–87, 89, 218, 292, 361 fiducie 89–91 finance sales, fiducairy transfers and implementation of Collateral Directive 86–87 law 25, 27, 29, 81–82, 86–88, 91–92, 199, 347–48 open or closed system of proprietary rights 92

Index 471 pension livrée 84–86, 89 reservation of title 82–84, 86 securitisation 88–89 solvabilité apparente 51, 81–83, 85, 87 trusts 89–91 vente à reméré 79–82, 86–87 FRAs (forward rate agreements) 271 fraud 65, 321–23, 328, 397–99, 403, 405, 411–12, 421–23 free convertibility 375–76, 379 free disposition 229, 315, 325, 365, 368, 370, 382 free flows 13, 126, 410–11 free movement of capital 383 of goods 379 freedom 59, 67, 77, 92, 110, 156, 372, 379–80 contractual 110 FSA (Financial Services Authority) 307 FSB (Financial Stability Board) 283, 372 full title 83, 128–29, 142, 144–45, 149, 220–21, 227, 233 functional approach 58–59, 119, 123, 126, 133, 147, 167–68, 170–71 functions 2–3, 14–15, 17, 29–30, 275, 312, 314, 441–42 fund management 15, 43, 300, 313–14, 427 fund managers 15, 308, 314 fund structures 312–13 funding 113–14, 131–34, 136–37, 154–55, 197–201, 245–50, 253–55, 449–52 asset-backed 1, 4, 22–28, 36, 44, 58, 131–32, 137 ownership-based 39, 54, 135, 137, 146, 156, 172 property-based 117, 156 security-based 114, 137 short-term 160, 242, 248, 307 techniques 17, 27, 30, 36, 39, 76, 129, 131–314 transactions 33, 57, 131–32, 213, 449 funds 114–15, 193–94, 300, 302–10, 312–14, 329–30, 334–35, 379 of hedge funds 305, 308 investment 302–4 money market 242, 343 open-ended 309, 313 pension 300–1 private equity 308, 310, 314 umbrella 302, 305 fungibility 154–56, 161, 282–83, 285, 424, 429, 444, 446–47 fungible assets 36, 40, 149, 157, 311, 354, 424, 446 fungible securities 84, 424, 432, 440, 449, 456 futures 2–3, 13, 256, 265–69, 272–78, 280–81, 284–85, 293–95 contracts 273–74, 278, 280–81 exchanges/markets 16, 273–74, 280, 285, 294 financial 266, 272–73, 294 standard 269, 272 stock index 269, 271, 273

G-10 409–10 G-20 261, 286–87, 310 gaming contracts 290 gearing 250, 259–60, 309 high 160, 247, 251, 306 general banking conditions 328 general debt registers 51, 127, 182 general power of attorney 279 general principles 32, 53, 60, 206–7, 210–11, 224–25, 228, 403 generality 67, 79, 123, 181, 192 Germany 25–27, 29–30, 34–37, 64–67, 92–104, 150–52, 181–82, 380–81 bankruptcy 63, 94, 97, 99, 181, 352 conditional sales 97–100 finance sales 100–2 law 92, 96, 100, 102, 134–35, 144, 190, 203 open or closed system of proprietary rights 102–4 Sicherungsübereignung 34–36, 57, 59–60, 66, 87, 93–94, 97–100, 102–4 Sicherungszession 66, 93, 97, 99, 103 globalisation 10, 17, 19, 23, 77–78, 296, 370, 374 globalising world 60, 374 GMRA (Global Master Repurchase Agreement) 119, 363, 448, 453–54 going concerns 175, 261 gold 319, 376–77 clauses 376–77 good faith 103–4, 121–22, 177–78, 206–7, 212, 225, 274, 399 civil law 78, 104, 173, 399 common law 24, 104, 399–400 good morals 100, 103–4 goods 111, 140–43, 178–79, 181, 375, 383–88, 393–95, 397–98 capital 168, 226, 233, 384 commingled 121, 178 consumer 51, 119, 127, 167 manufactured 106, 116, 161, 187 replacement 34–35, 46–48, 53–54, 58–59, 70–71, 176, 179, 181 governance, corporate 158, 443 government bonds 253, 418, 451 markets 426 government debt 381 governmental intervention, see intervention Greece 380, 383, 439, 455 growth 261, 381 economic 250 guarantees 29, 197–200, 238–39, 243–45, 256, 271–72, 395–96, 398–404 autonomous 400–1 bank 21, 29, 389, 393, 398–402, 404 first demand 29, 245, 262, 401, 404 independent 396, 398, 402 payment 93, 198, 374, 402

472 Index primary 243, 401 third-party 268 guarantors 3, 193, 243–44, 253, 324, 396, 401 gute Sitten 100, 102–4, 122, 399 haircuts 451, 455 harmonisation 41–44, 53, 64, 165, 172, 435–36 head lessors 227–28 health 394 hedge funds 241, 248, 250, 259, 261, 271, 302, 304–14 activity 160, 312, 314 funds of 305, 308 managers 308, 310–11 regulation 306–11, 314 hedging 8, 268–69, 290, 294, 314, 442 instruments 1–2, 268, 294 hidden charges 34, 51, 60, 194 hidden liens 51, 194 hidden proprietary interests 66, 71, 129 hierarchy of norms 18, 166, 190, 214, 262, 369, 403–4, 440 high gearing 160, 306 high leverage 249 hire-purchases 37–38, 72, 105, 111, 113, 134, 215, 219–20 holders 48, 108, 110, 150, 340–41, 343, 386, 389 in due course 322, 327 physical 141, 150 security 3, 87, 121, 179 security interest 28, 45, 182 holdership 107–8, 149–50 home countries 379, 386 home-country regulation 263 home-country supervision 313 host-country rule 304, 313 host regulators 304 house banks 24, 386, 390, 392, 394 house brokers 279–81 housing 214 human trafficking 406, 408 Hungary 197, 223 IBRD (International Bank for Reconstruction and Development) 404 ICC (International Chamber of Commerce) 387, 389, 396, 402–4 ICE (Intercontinental Exchange) 288, 297 ICMA (International Capital Market Association) 10, 17, 295, 456 identifiability 264 identifiable counterparties 337 identification 12, 176, 178–79, 181, 184, 191, 310–11, 411 requirements 120, 126–27, 176, 211 sufficient 167, 179, 181 illegality 252, 360 illiquid assets 261

illiquidity 185, 238, 247–48, 260–61 IMF (International Monetary Fund) 258, 379 immigration 408 immobilisation 415–16, 419, 440 immovable property 6, 11, 31, 58, 220 imperfect hedges 269 implied conditions 148, 207 implied terms 212 impossibility 82, 85, 87, 360, 385, 439, 446 incentives 245, 250, 257, 272, 338 income 31, 107, 245–47, 252, 270, 272, 303, 449–50 rights 5, 46, 50, 57, 134, 153 streams 24, 123, 240, 269, 271, 412 incoming payments 335 indebtedness 5, 18, 24, 51, 120, 126, 195, 235 independence 70, 186, 189, 213, 326–28, 395–99, 401–2, 423 principle 399 independent guarantees 396, 398, 402 independent third parties 385, 394, 431 index or basket CDS 244 India 160 indirect agency 48, 421 individualisation 18, 65, 88, 103, 184, 213 industry practices 166, 262, 373, 403, 457 inflation 37, 40, 146, 240, 376 information 7, 263–64, 299, 302, 308, 310, 412, 431 corporate 417, 440 exchange of 412 regular information supply 304, 309 supply, regular 304, 309 infrastructure 16, 21, 61, 259, 282, 288, 451 ingenuity 41, 262, 306 initialisation 298–99 innovation 6, 12, 202, 224, 307, 310, 338 insiders 5, 32, 46, 52, 183, 194, 197, 305 professional 5, 27, 51, 55, 177, 183 insolvency 1–2, 94, 97, 101, 255–57, 344, 346–47, 349–52 international attitudes and approaches to set-off and netting 371–73 proceedings 18, 64, 344 instability 307 instalment payments 113, 140 instalment sales 113 instalments 72, 100, 111, 134, 144, 149, 158, 215–18 instantaneous settlement 287, 300, 441 institutional investors 89, 284, 301–2, 305, 309 institutions 239–40, 249, 261, 281, 311, 339–40, 352, 426 deposit-taking 421 instructing banks 327, 387, 390 instructions 279, 321, 323–24, 326–28, 387–88, 391, 396, 423 payment 298, 316–17, 320, 323–24, 326, 335, 337, 371

Index 473 insurable interests 256–57 insurance 141, 195, 226, 256–57, 268, 286, 393–94, 402 companies 89–90, 195, 241, 243, 247–48, 284, 300–1 contracts 256 documents 393–94 industry 259 products 256 regulation 257 intangible assets, see intangibles intangible claims 1, 6, 119–20, 188, 194 intangibles 26–27, 32–34, 38–39, 59, 66–67, 105–6, 108, 154 integration 290–92, 352–53, 358–62, 369, 373, 407, 450, 452 integrity 411 market 2, 16 intent 101, 140, 315, 320–23, 326–27, 345–46, 356, 423 original 323 underlying 318, 383 intentions 93, 100, 102, 126–27, 140, 151, 297, 360 interbank market 249, 456 interbank transfers 321, 324 Intercontinental Exchange (ICE) 288, 297 interdependence 291, 329, 359–60 interest holders 33, 46, 56, 77, 107, 129, 191, 427 interest payments 11, 25, 102, 157, 235, 238, 240, 271 interest rate risk 268, 270 interest rate swaps (IRS) 260, 267, 273, 286, 288, 355, 357, 362–63 interest rates 136, 254–55, 267–70, 272, 289, 291, 380–81, 444–46 agreed 98, 113, 135 floating 269 low 380 market 273 interests 23–26, 31–35, 55–59, 105–8, 140–46, 149–53, 168–69, 417–18 conditional 123, 142 conflicts of 310 equitable 32–33, 41, 43, 51, 122–23, 142–43, 218, 425 foreign 53, 57, 60, 62, 154, 161–62, 164 insurable 256–57 international 168–70 legal 52, 78, 142, 151 local 161 non-possessory 36, 82, 105, 167 ownership 73, 123, 147, 158 possessory 182, 427 proprietary, see proprietary interests regulatory 189, 232, 371 reversionary 73, 81, 107, 150, 429, 445 secured 24, 29, 80, 99, 107, 123, 161, 170–71 security, see security interests suspensive 73, 149–50

intermediaries 308–9, 335–38, 384–85, 408–9, 416–23, 425–27, 430–35, 437–44 bankrupt 417, 419, 434 immediate 416, 418, 423, 440 replacement 418 intermediary banks 324, 326, 328, 334, 376, 420 intermediated securities 165–66, 433, 440 intermediation 277, 285, 339, 385, 435 internalisation 420–21, 431, 439 international arbitration 295, 365–66, 368, 382, 407 international arbitrators 349, 374, 382, 399 international assignments 20, 61, 164, 191, 202, 205 International Bank for Reconstruction and Development (IBRD) 404 international bulk assignments 199, 202, 207, 212, 214 international capital markets 241, 380 International Chamber of Commerce, see ICC international co-operation 409 international commerce 19, 21, 57, 173 international contracts 377, 382, 385 international convergence, see convergence international dealings 173 international finance 2, 7–8, 10, 23, 26, 40, 50, 64–65 international flows 7, 10–11, 14, 18, 22, 59, 61, 164 international harmonisation, see harmonisation international interests 42, 168–70 international marketplace 3, 5, 8, 55, 59, 61, 373, 375 international minimum standards 7, 263 international organisations 380 International Organization of Securities Commissions, see IOSCO international payment fees 336–37 international payments 14, 147, 315, 332–34, 337, 339, 374–75 traditional forms 374–405 international practices 156, 201–2, 207, 213, 225, 365, 375 international sales 43, 212, 377, 384–85 International Swap Dealers Association, see ISDA international trade 41–42, 165–66, 186, 188, 190, 197, 375, 400 international transactions 20, 23, 374, 376, 378, 391, 396, 417–18 internationalisation 17–18, 154, 161, 409 internationality 162, 202, 382 interoperability 265, 298, 443 interpretation 121, 123, 166, 169, 206–7, 212, 214, 225 contract 102, 206–7, 323, 356, 370 purposive 263, 439 uniform 169, 206, 210, 223, 225 intervening bankruptcy 40, 97, 178–79, 181, 200, 209, 353–54, 434 intervention 94, 226, 229, 244, 379, 409 regulatory 287, 314 intraday trading 304, 329–30 intrinsic value 240, 302, 304, 339, 376

474 Index inventory 12–13, 33, 120–21, 125, 174–76, 178–79, 184, 419–20 investigation 122, 182–83, 407, 411–12, 414 duty 6, 122, 133, 183, 194 investment advice 15, 301 investment advisers 15 investment banking 16, 309 investment banks 2, 14–16, 237, 249, 259, 302, 305–6, 312 investment funds 302–4 investment management 158, 300–2, 305, 457 domestic and international regulatory aspects 313–14 transnationalisation 314 investment managers 300–2, 305, 308 investment portfolios 13, 259 investment products 170, 241 investment securities 14–16, 37–41, 84–85, 135–36, 415–19, 426–30, 444–46, 448–54 entitlements and transfers 131, 415–44, 452 and fintech 440–44 fungible 84, 449, 456 international aspects 433–38 regulatory aspects 438–39 repos 38–39, 59, 84, 123, 128, 133–34, 155–56, 444–57 transnationalisation 439–40 underlying 267, 304, 416, 418, 425, 435, 438 investment services 85, 304 investments 14–15, 157–60, 244–47, 249–50, 252, 300–6, 308, 314 underlying 244, 267, 301, 416, 418, 425, 435, 438 investor protection 16, 310, 314, 383 investors 238–42, 246–49, 261–64, 300–10, 314, 416–21, 423–28, 438–42 foreign 272, 303, 381, 383 institutional 89, 284, 301–2, 305, 309 private 301, 313 professional 241, 271 retail 304–6, 308–9, 440 smaller 304, 308, 314, 426, 439 invoices 140, 196, 384, 391, 393–94, 400, 405 IOSCO (International Organization of Securities Commissions) 159, 310, 312 Iran 343, 399 Iraq 399 IRS, see interest rate swaps ISDA (International Swap Dealers Association) 4, 256–57, 274–75, 282–83, 286–87, 289–92, 295–97, 361–63 issuance 241, 263, 316, 341–42 issuers 14–15, 160, 270–71, 309, 383, 415–18, 435, 441–43 issuing activity 15, 237 issuing banks 385, 388–400, 405 Italy 197, 208, 223, 345, 380 ius commune 31, 34, 106, 143, 146, 348 ius in re aliena 90

Japan 64, 377, 451 judicial discretion 162, 214, 348 judicial liens 127, 182 jurisdiction 62–63, 163, 257, 364–66, 368, 379, 382–83, 410–11 justice 110, 140, 351 justified reliance 302, 322, 327 Justinian 72, 96, 348 keys private 298, 335–37, 441 public 298, 335, 441 know your customer duties 302, 334, 341–42, 406, 410, 412 knowledge 32, 46, 63, 66, 194, 210, 229, 308 labour 175, 304 lading, bills of 20, 28, 56, 61, 295, 384–85, 387–90, 393–94 land 31–32, 105, 107, 110, 214, 216, 219, 221 registers 13, 32 language 206, 224–25, 244, 328, 360, 392, 401 large exposures 307 last resort, lenders of 249 Latvia 170, 197, 223 law merchant 18, 28, 40, 55–56, 172, 375, 396, 402 layering of risk 240–42, 252 lease agreements 218, 226, 229, 232 lease assets 129, 215–19, 221–22, 224–30 lease contracts 220, 226, 230, 232 leases 100–1, 124, 126, 128, 168–69, 214–28, 231–32, 234 consumer 129, 218, 221 equipment 38, 51, 122–23, 127–30, 137, 218, 221, 224 finance 1–2, 37–39, 41–43, 74–76, 100–2, 128–34, 214–30, 232–34 operational 128–29, 146, 218–19, 224, 226, 230, 232, 234 leasing 76, 101–2, 123, 164–65, 197–98, 214–16, 218–27, 232–34 finance 37–39, 41–42, 74–76, 100–2, 117, 128–34, 214–30, 232–34 real-estate 215, 224–25, 227, 232 ledgers asset 298, 441 distributed 287, 297–300, 335, 337, 342, 404–5, 441–44 legacy systems 443–44 legal acts 315, 317, 320–21, 323, 344–47, 353–54, 359, 373 legal capacity, see capacity legal characterisation 3, 10, 27, 132, 159, 216–17, 419, 422 legal dynamism, see dynamism legal formalism, see formalism legal interests 52, 78, 142, 151

Index 475 legal owners 220, 416, 432 legal possession 107, 150 legal pragmatism, see pragmatism legal reasoning 322 legal relationship 176–77, 213, 236, 345–46, 349, 396 legal risk 7, 14, 17, 23, 53, 61, 364, 373 legal scholarship 223 legal status 4, 123, 295, 365, 386, 438 legal systems 4–5, 21, 23, 235–36, 238, 322, 371, 373 legal tender 342–43 legal transnationalisation 7–10, 14, 16, 18, 35, 164–65, 173, 439 Lehman cases 263, 296, 429, 439, 457 lenders 12–13, 174–77, 184, 191, 194–95, 271, 424–26, 449 of last resort 249 professional 182, 188, 194 lending function 177 secured 11, 25, 36–38, 114–15, 196, 444 lessees 74–75, 128–29, 136, 146, 149, 155, 162, 214–34 lessors 40, 74, 128–30, 146, 149, 155, 216–23, 225–32 head 227–28 letters of credit 29, 243, 316, 322–23, 374–78, 385, 388–91, 393–403 back-to-back 400 and distributed ledger technology 404–5 documentary 390, 393–94, 398, 402 legal nature 395–98 non-performance 398–400 right of reimbursement of issuing bank 394–95 standby 243, 400, 402, 404 transferable 400 types 392–93 leverage 305, 310, 313, 376 high 249 ratio 456 lex commissoria 73, 79, 97, 146, 148–49 Netherlands 72 lex commissoria tacita 72, 81, 148 lex concursus 64, 161, 163–64, 170, 209, 344, 372, 454 lex contractus 187, 222, 367 lex executionis 163, 170 lex fori 166, 366, 368–69 lex mercatoria 18–19, 55–57, 333–34, 373–75, 402–4, 434–35, 438–40, 457 approach 206, 400, 404, 438 old 56 operation 55, 402, 435, 438 transnational 27, 40, 50, 55, 400, 402, 434–35, 439 lex monetae 382–83 lex rei sitae, see lex situs lex situs 40, 57, 59–60, 159–63, 187–88, 222, 225, 228

lex societatis 161 liability 11, 138, 141, 159–60, 229–30, 269–71, 301, 303 product 230 side 2–3, 269, 290 swaps 270–71, 358 liberalisation 309, 379, 384 liberating payments 191–92, 197, 210, 315, 320–21, 323 liens 46–48, 51, 62–63, 99–100, 121, 181–82, 193–94, 196 hidden 194, 196 judicial 127, 182 perfected 121, 194 statutory 46, 62–63, 78, 99–100, 121 tax 46, 48, 51, 127, 181 unperfected 63, 123 life insurance 301 lifestyle 381 LIFFE 275, 279 limited liability 159–60 limited partnerships 302–3 limited proprietary rights 50, 96, 107, 112, 161 lip service 183 liquid markets 442 liquidation 9, 60, 64, 99, 163, 180, 237, 415 liquidity 2–3, 189–90, 192–93, 213–15, 240, 250, 282–83, 329–31 coverage ratio 456 crisis 252 management 240, 313, 456 requirements 2, 243 risk 234, 240, 243, 310, 330, 337–39, 455 liquidity-providing function 23, 160, 237, 436 listing 15–16 litigation 215, 218, 345–46, 348–49, 351, 366, 368, 375 loan agreements 105, 132–33, 175, 177, 215, 235, 263, 268 loan assets 234, 236, 242, 245, 247, 255 loan books 249 loan data 263–64 loan financing 53, 74, 76, 102, 136, 158, 215 secured 37 loan portfolios 235–36, 238–40, 242–43, 268 loan tokens 263–65 loans 11, 112–16, 131–33, 135–37, 175–78, 234–43, 246–49, 254–55 bank 11, 113, 121, 126, 240 secured 37–38, 134, 136–37, 156, 160, 208, 255, 444–45 student 234 subordinated 89, 238 local laws 17, 19, 22–23, 26–27, 40, 207, 209, 374 location 59–60, 159, 187–88, 204–5, 213, 225–26, 257, 384–85 Loi Dailly 80, 88–89, 179, 184–85

476 Index London Stock Exchange, see LSE losses 139, 157, 192, 252, 255–57, 266–67, 292, 384 Luxembourg 170, 197, 346 management 48–49, 158–59, 261–62, 275–76, 302–3, 306–7, 309–10, 312–14 investment 158, 300–2, 305, 457 risk, see risk management managers 48, 239, 250, 301–2, 305, 307–10, 313–14 hedge fund 308, 310–11 mandatory rules 220, 222, 229, 344, 346, 374, 379 manipulation, market 256, 427 manufactured goods 106, 116, 161, 187 margin 260, 274–75, 277, 280–81, 299, 424–26, 433–34, 451–53 accounts 69, 280, 299, 364 buyers 428–30 calls 245, 275, 282–83, 285–86, 298, 456 requirements 277–78, 281–83, 295, 449, 451 trading 439 margining 257, 451–52 mark-to-market values 248, 250, 261 market abuse 426 market conditions 40, 146 market forces 7, 246, 256, 286–87, 380 market integrity 2, 16 market interest rates 273 market makers 15–16, 274–75, 277–80, 282, 285–86, 294–95, 431, 433 market manipulation 256, 427 market participants 245, 288, 297, 299 market prices 266, 270, 272–73, 278, 283, 294, 448, 451 market risk 234, 268, 294, 306 market value 45, 114, 136, 244, 269, 272, 449, 452 markets 14–17, 245–48, 259–62, 264–65, 268–75, 286–88, 407–8, 424–27 derivatives 15, 265, 269, 273–81, 284–86, 289, 428, 433 domestic 21, 154 eurobonds 14, 16, 55, 432, 448, 451, 456 financial 15–17, 262, 430 foreign exchange 16, 376–77, 380 interbank 249, 456 official 312, 370, 419 OTC 4, 15–16, 275, 286, 289–90, 415 primary 15, 309, 442 regular 285, 290, 293–94 repo 10, 16, 352, 446, 448, 455–56 secondary 15, 441–43 securities 275, 281, 287, 300, 425, 433, 442, 451 swap, see swap markets master agreements 135, 244, 352, 361, 363, 448, 453–54, 457 repo 293, 350, 356, 361, 373, 450 swap 244, 290–91, 294, 358, 360, 369 mature claims 201, 347, 349

maturity 241, 243, 267–68, 289, 298–99, 353–54, 386, 392–93 dates 11, 144, 246, 266, 291, 298, 322–23, 345 transformation 442 mere description 104 mergers 182 methodology 250 Mexico 64 minimum standards 8, 42, 368, 370 international 7, 263 minimum supervision 314 mispricing 248, 307 mobile equipment 42, 165–66, 168–69, 171, 173, 183, 234 model laws 44, 146, 164–65, 167–68, 210, 400 models 55, 63, 233, 238, 264, 334, 341, 442 modern finance sales 38–39, 49, 117, 133, 172, 214 modern lex mercatoria, see new lex mercatoria modern private law, see private law monetary claims 18, 22, 46, 185–87, 191–93, 344, 347, 353 assignment 190–94 monetary policy 307 money 11, 174–77, 273, 315–16, 318–23, 325–27, 385–90, 406–10 recycling 11, 14, 249 short-term 261 as unit of account or unit of payment 318–19 money laundering 261, 315, 338, 340, 342, 371, 406–14 and EU (European Union) 411–14 international action 409–11 remedies and objectives of combating 408–9 techniques and remedies 405–8 money market funds 242, 343 moral hazard 257, 259, 307, 309 mortgagees 31, 111–12, 116 mortgages 11, 13, 30–31, 106, 109–13, 115, 140, 143 chattel 31–33, 36, 105–6, 111, 114–15, 140 common law 13, 105, 108–9, 111–12, 158 equitable 105 real estate 3, 30–32, 99–100, 113, 174 mortgagors 31, 105, 108 most characteristic performance 204 movable property 11–12, 48, 50, 79, 150, 152, 174, 188–89 law 10, 12, 23, 48, 50, 152–53, 172, 183 movables 11–12, 22, 24, 27, 31–33, 66, 79, 187–88 multilateral netting 245, 266, 277–78, 286, 358, 360, 366, 369 multilateral trading facilities, see MTFs multiple assignments 60, 205 mutual claims 4, 40, 44, 47, 134, 331, 424 mutual funds 302, 304 mutuality 291, 346–47

Index 477 naked credit default swaps 256–57 naked options 288, 308 narrow banking 160 NASDAQ 265 national laws 18, 21–22, 57, 61, 166–67, 219, 370, 372 nationalisation 203 nationalism 18, 60 natural persons 43 negligence 141–42, 150, 229, 300–1, 304, 346, 392 negotiable instruments 3, 28, 55–56, 241, 294–95, 322, 451, 453 negotiation 193, 316, 390, 392–93 net balances 290, 292, 356 net payments 293, 350, 355, 369, 432, 454 net settlement 329, 333, 355 Netherlands 29–30, 34, 65–79, 152, 155–56, 201–3, 218, 366–67; see also Dutch law bankruptcy law 25, 448 conditional and temporary ownership 72–76 lex commissoria 72–76 open or closed system of proprietary rights 77–78 reservation of title 69 security substitutes and floating charges 69–72 netting 16–20, 134–35, 277–78, 289–95, 330–32, 349–61, 363–73, 452–54 agreements 51–53, 55, 293, 295, 353–54, 356–57, 364–67, 454–55 arrangements 17, 41, 317, 350, 352, 371 clauses 8, 23, 44–45, 292–93, 357, 359–60, 363, 370 expansion of set-off through 353–56 in swaps and repos 357–61 domestic and international regulatory aspects 371 facilities 1–3, 15, 17, 23–24, 50, 52–53, 371, 453–54 multilateral 245, 266, 277–78, 286, 358, 360, 366, 369 novation 282, 289–90, 293, 295, 331, 355–58, 363, 367–69 principle 289, 293, 359, 374, 439, 455 and private international law 364–68 repo 17, 63, 363, 454 settlement 260, 278, 289–90, 331, 354–55 swap 63, 135, 288–90 and transnational law 368–70 Nigeria 197, 208, 223 nineteenth century 11, 30–33, 35–36, 110 nodes 264, 297, 335 nominal values 198–99, 221 nominated banks 390–94, 396 nominating banks 397–98 non-bankrupt parties 4, 97, 289, 291–93, 344, 360 non-defaulting parties 147, 274, 292, 296, 360, 364 non-payment 46, 72–73, 148–49, 198, 256, 386, 398–99, 401 non-possessory charges 57–58, 67, 80, 110, 167, 183 non-possessory interests 36, 82, 105, 167 non-possessory pledges 66, 69–70, 94

non-possessory security interests 12, 30–37, 70–71, 79–80, 99, 119–20, 127–28, 174–76 in chattels 24, 33–34, 36, 59, 80, 106, 131, 167 non-recourse factoring 195, 197–98, 209 normativity 333 norms 18, 166, 190, 214, 262, 293, 369, 403–4 notification 32–33, 67–69, 87–89, 186–87, 201–4, 209–10, 235–36, 344–46 requirements 69, 87–88, 191, 202, 213, 345, 347, 350 novation 210–11, 234–36, 276–77, 279–80, 315–18, 326–27, 354–57, 370 netting 289–91, 293, 295, 331, 354–58, 363, 367–69, 371 numerus clausus 22, 41, 50, 59, 134, 137, 151, 154 objectivation 55 objective criteria 65 objective law 18, 21–22, 50, 54–55 objective standards 284, 369 obligations 192–93, 210–12, 293–98, 315–16, 327–31, 351–56, 389–90, 401–3 characteristic 162, 204, 223, 231, 258, 370 contractual 203–4, 208, 257–58, 286, 293, 298, 367, 370 delivery 165, 346, 448, 454 law of 47, 72, 204, 208, 223, 258, 370 payment 316, 318–20, 322–23, 326–27, 364, 380–81, 397, 403–4 primary 395–96, 401, 403 obligatory rights 31, 57, 201, 203, 431 off-blockchain pingers 300 off-ledger assets 337, 441, 443 off-ledger securities 442, 444 trading 440 official exchanges 433 official markets 312, 370, 419 offshore tax havens 314, 410 opacity 263–64 open-ended funds 309, 313 open positions 421, 439 openness 52, 151, 262 operational leases 128–29, 146, 218–19, 224, 226, 230, 232, 234 operational risk 234, 250, 306, 311, 339 operational standardisation 276, 284, 286 option exchanges 273, 275 options 82, 147, 215–17, 220–21, 265–74, 276, 293–95, 447–48 call 265, 269–70, 294, 298–99, 445, 447 credit spread 242, 244 financial 265–67, 275 naked 288, 308 repurchase 81–82, 86, 142, 147 standardised 272, 274, 285 ordinary commercial flows 6, 51–52, 183 original contract 236, 280, 285

478 Index originating banks 238–42, 259 originators 89, 237–43, 247–49, 253–55, 261, 263, 334 ostensible ownership 127 OTC (over-the-counter) 266, 282, 456 derivatives 245, 286–87, 293, 297, 428 markets 15–16, 275, 286, 289–90, 415 products 274, 287 outsiders 6, 27, 51, 183, 244, 252, 305, 313 bona fide 6, 51, 234 over-collateralisations 253, 456 over-leveraging of society 249, 307 over-the-counter, see OTC overdrafts 11, 19, 113 overleveraged society 249 overvalue 13, 36–38, 109–10, 112–15, 138–41, 146–47, 167–68, 429–30 return of 33, 37–38, 40, 46, 54, 113, 123, 126 owners 32–33, 60, 73–74, 99, 140–43, 148–51, 265–67, 416–17 conditional 33, 74, 141, 144–45, 151–52, 217 full 37, 45, 96–97, 132, 148, 445 legal 220, 416, 432 original 99, 141, 152, 438 unconditional 26, 102, 171 ownership 36–41, 72–75, 96–100, 107–8, 133–37, 146–57, 215–20, 226–28 apparent 51, 183 concepts 26, 107, 150, 154 conditional 24, 79–80, 104, 133–34, 147, 172–73, 217, 219–20 dual 104, 137, 153–54, 217, 220, 445 duality of 73, 75, 95–96, 99–100, 149–52, 154, 154–57, 217–18 full 30, 37, 99–100, 149–50, 152, 155–56, 216, 218–20 interests 123, 147, 158 ostensible 127 protection 50–51, 107–8, 134, 142, 149–51, 155–56, 171–72, 216–17 reputed 81, 83, 87, 111 rights 39–41, 46–50, 77, 106–8, 134, 150–51, 153–57, 216–17 conditional 72–77, 106–7, 133–34, 147–48, 150–51, 153–54, 172, 216–17 temporary 13, 47, 49, 72, 75, 77, 147–48, 153 split 39, 83, 91, 104–6, 134, 137, 145, 172 structures 48, 50, 100, 156 suspensive 150, 156 temporary 39, 72, 153, 425, 429, 437, 445 transfer of 39–40, 73, 87, 100–1, 108, 148, 153–54, 218–20 ownership-based financing/funding 38–40, 54, 56, 135–37, 146–47, 154, 156, 172 paper currencies 319, 339, 376–78 par conditio creditorum 9 parent companies 268, 362, 401

participants 259–61, 285–87, 302–4, 329–31, 337, 355, 432–33, 440–41 market 245, 288, 297, 299 participation certificates 302, 415 participations 158, 241, 252, 288, 298, 406, 423 parties, see also Introductory Note bankrupt 289, 359–60, 366 defaulting 40, 147, 154, 330, 454 non-defaulting 147, 274, 292, 296, 360, 364 original 200, 279–80 swap 271, 292, 359–60 third 27–29, 49–50, 121–22, 141–43, 181–82, 227–30, 242–43, 367–68 partners 47, 145, 151, 237, 290, 303–4, 454 partnerships 47, 302–3, 305 limited 302–3 party autonomy 4–9, 17–19, 27, 40–41, 49–57, 171–73, 187–89, 212–13 degree of 9, 35, 40 pass-through certificates 238 passporting 314 passports 304, 313–14 payees 257, 316–18, 320–23, 325–29, 332–33, 377–79, 388, 419 paying banks 391–92, 397–98 payment circuit 324, 327, 402, 404, 421 payment finality 2–3, 14, 56, 61, 275, 314, 321, 344 payment guarantees 93, 198, 374, 402 payment instructions 298, 316–17, 320, 323–24, 326, 335, 337, 371 payment obligations 316, 318–20, 322–23, 326–27, 364, 389, 397, 403–4 primary 389, 397 redenomination 380–84 single 363–64 payment protection 375, 384–85, 397 payment risks 364, 375, 385–86, 388–89 reduction 385–92, 400–2 payment services 14 payment systems 6–7, 249, 314–15, 322–24, 329, 333–35, 338–39, 419–20 payments 315–43; see also Introductory Note and CBDCs (central bank digital currencies) 316–17, 337, 339–43 clearing and settlement in banking system 329–32 coupon 298 electronic 329 and fintech 334–39 immediate 241, 266, 294, 329, 387, 397, 450 incoming 335 instalment 113, 140 interest 11, 25, 102, 157, 235, 238, 240, 271 international aspects 332–33 legal aspects 319–23 liberating 191–92, 197, 210, 315, 320–21, 323 net 293, 350, 355, 369, 432, 454 notion and modes of payment 315–18

Index 479 in open account 384–85 proper 148, 218, 260, 332, 375 regular 214–15, 217, 298, 433 regulatory aspects 333 substitute 426, 449–50 transnationalisation 333–34 payors 271, 315–18, 320–23, 325–29, 332, 346, 360, 376–79 peer-to-peer networks 299, 335, 337 pension funds 300–1 pension livrée 84–86, 89 perfected security interests 121, 123, 395 perfection 25, 32, 119–22, 126–28, 161, 419, 428, 436–37 performance 119–20, 123, 204, 206, 230–31, 315–16, 398, 401–3 beginning of 47 bonds 398, 401 characteristic 204 most characteristic 204, 370 permission-less systems 334–36, 338, 440–41 permissioned blockchains 334, 339, 440 permissioned distributed ledger network 297 permissioned systems 337, 339 perpetuities 107–8, 416 personal property 26–27, 30, 33, 110–11, 120, 124, 216, 220 Pfandbriefe 253 physical delivery 142, 415 physical existence 65, 426 physical movable assets 68, 80 physical possession 31–33, 36, 73–74, 100, 102, 107, 141–44, 149–51 physical transfers 58, 268 placement 15, 406 activity 15 private, see private placement placements, private 265, 314 pledgees 70, 121, 140–41, 143 pledges 11–12, 32–33, 109–10, 112, 246–47, 424–25, 434–35, 437 non-possessory 66–67, 69–70, 94 possessory 29–32, 99–100, 157 pledgors 70, 75, 141, 143, 437 Poland 330 politicians 250, 287 pooling 47–48, 178, 256, 360 pools 89, 175, 179–80, 203–4, 240–42, 248, 263–64, 422 token 263–64 portfolios 125, 196–201, 208–9, 212, 235, 243–44, 269–70, 449 investment 13, 259 loan 235–36, 238–40, 242–43, 268 receivable 133, 185, 194, 196–97 underlying 242, 249 Portugal 220

position risk 265, 268 positive law 160 possession 31–33, 36, 73–74, 107–11, 121–23, 140–45, 147–53, 226–30 constructive 110, 181 delivery of 73, 92, 121, 141 legal 107, 150 physical 31–33, 36, 73–74, 100, 102, 107, 141–44, 149–51 quiet 227, 229–30, 234 possessory interests 182, 427 possessory pledges 29–32, 99, 157 possessory security interests 30, 51 powers 24–25, 107, 109, 163–64, 350, 352, 374, 383 practices 9–10, 18–20, 40–41, 58–60, 165–67, 294–96, 368–69, 402–4 best 245, 411 practitioners 58 pragmatism 171 precedence 46, 123, 166, 194 predictability 61 preferences 4–6, 16–17, 45–46, 48, 60, 62–63, 98–99, 102–3 statutory 51–53, 180, 220 premiums 85, 256, 265, 268, 308, 362 prescription, acquisitive 107, 150 presentation 319, 387–88, 390, 392–93, 397–98, 400 presenting banks 387–88, 392 price formation 260 prices 139–40, 265–73, 275–76, 284–85, 298, 304, 401, 448–52 agreed 15, 265–66, 272, 294, 375, 445 fixed 266, 268 market 266, 270, 272–73, 278, 283, 294, 448, 451 purchase 36, 71, 105, 108, 140, 142, 144–45, 155 striking 265, 268–70, 272–73, 447 PRIMA approach 161, 438 primary guarantees 243, 401 primary market 15, 309, 442 prime brokerage 300, 307, 311–12 prime brokers 159, 310–12 priority 33–35, 44–46, 62–64, 119–21, 127–28, 177–80, 182–83, 212–13 rights 48, 51, 62, 121 privacy 265, 409–10 private blockchains 298–99 private control 45, 180 private equity 302, 306, 312–14 funds 308, 310, 314 private international law 56, 160, 166, 206–7, 224–25, 229–30, 364–65, 402–3 modern 26, 56, 332, 368 rules 56, 165–66, 206–7, 222, 224–25, 364–65, 368, 403 private keys 298, 335–37, 441

480 Index private law 16, 20, 50, 53, 60, 63, 262, 314 intervention 314 nature 262, 333 transnationalisation of 333 uniform 63 private placements 265, 314 proceedings 64, 78, 87, 162–64, 222, 228, 230, 312 enforcement 50, 163, 189 insolvency 7, 18, 64, 83, 344, 352 reorganisation 9, 44–45, 49, 53, 62, 178, 180, 228 product liability 230 products commoditised 5–6, 12, 27, 50–51, 55, 60, 166, 172 derivative 13, 54, 284, 362 finished 33, 164, 174–75, 181, 184 investment 170, 241 securitised 15, 238, 256 standardised 260, 275, 283 professional dealings 18, 41, 43, 61, 146, 186, 256–57, 348 professional insiders 5, 27, 51, 55, 177, 183 professional investors 241, 271 professional parties 5–6, 8, 10, 46, 48, 50, 146–47, 182–83 professional sphere 5, 19, 24, 50, 61, 84, 166–67, 189 professionals, see professional parties profits 266, 268–69, 287, 292, 303–4, 308, 312–13, 405 project financing 11, 17, 186, 189, 211 promises 110, 179, 234, 319, 324, 334, 338, 347 promissory notes 28–29, 186, 189–90, 192–93, 235, 315–18, 323, 415 proof 291, 338, 394 proof-of-identity consensus mechanisms 337 proof-of-work validation process 337–38 proper disclosure 262, 309, 330 proper payment 148, 218, 260, 332, 375 property 10–12, 30–31, 47–48, 141–44, 167–68, 177–79, 181–83, 303 after-acquired 94, 121–22, 128, 143 immovable 6, 11, 31, 58, 220 law 47–48, 107–8, 141–43, 149–50, 152–53, 169–70, 172–73, 178–79 movable 11–12, 48, 50, 150, 152, 174, 177, 188–89 rights 41, 45–47, 50–52, 77, 91–92, 104–6, 159–61, 447–48 property-based funding 57, 117, 156 property-based protection 113–14 proportionality 147 proprietary effect 38, 59, 96, 105–6, 147–48, 155, 166, 172 proprietary expectancy 57, 71, 95–96, 134, 152, 217, 449 proprietary interests 35, 51–52, 62, 64–67, 76–77, 149, 151, 161–64 equitable 32, 35, 51, 134, 190, 218, 221, 425 foreign 19, 162–64 hidden 66, 71, 129

proprietary issues/matters 16, 55–56, 169, 171, 202–4, 207–8, 212–13, 433–34 proprietary protection 4–5, 18, 50, 107, 135, 142, 154–56, 227–28 proprietary rights 41, 45–47, 50–52, 77, 90–92, 149–51, 159–61, 232–34 conditional 222, 448 foreign 161, 163, 222 limited 50, 96, 107, 112, 161 proprietary status 4–5, 56–57, 70, 73, 75, 156–57, 220, 222 proprietary structures 27, 51, 64, 150, 154, 209, 435, 444 proprietary trading 259, 305–7 prospectuses 304, 309 protection bankruptcy 5, 41, 47, 50, 52, 221, 252 basic 113, 451 bona fide purchasers 28–29, 32, 35, 51–52, 55–56, 60–61, 140, 142 buyers 243–46, 248, 256–57, 259, 297 givers 243, 245, 259 payment 375, 384–85, 397 property-based 113–14 proprietary 4–5, 18, 50, 107, 135, 142, 154–56, 227–28 providers 254 retail investor 308–9 sales credit 171 sales-price 6, 27, 30, 38, 53–54, 66, 102, 167 sellers 244–46, 257–58, 296 special protections 8, 13, 113, 314, 411 prudential supervision 304, 309 public companies 272, 313 public interest 6, 350, 358, 382 public keys 298, 335, 441 public order 9, 23, 50, 60, 170, 173 requirements 55, 60, 170 public placements 237 public policy 6–7, 17–18, 41–42, 52, 55, 64, 323, 382–83 domestic 23, 52, 212 local 18–19 test 104 transnational 7, 27, 55 publication requirements 25, 29, 31, 79, 112, 224, 228 publicity 32, 67, 79, 87, 92, 181, 183, 445 pull systems 323–25, 420 purchase money security 43, 120–21, 167–68 purchase prices 36, 71, 105, 108, 140, 142, 144–45, 155 purchasers 5–6, 50–52, 60–61, 121–22, 142–43, 145, 172–73, 182–83 bona fide, see bona fide purchasers purposive interpretation 263, 439 push systems 323, 325, 335, 419

Index 481 QE (quantitative easing) 380 quality 242, 259, 262, 375, 385, 393–94, 398–99, 401 certificates 390, 398 requirements 393, 395 quantitative easing (QE) 380 quiet possession 227, 229–30, 234 rank 34–35, 44–45, 67, 121–23, 162, 164, 179–80, 239 original 4, 12–13, 24, 34, 58, 66, 181, 235 ranking 44–46, 49, 60, 63–64, 67, 120–21, 163–64, 181 rating agencies 237, 239, 243, 250, 252, 262–64 ratings 237–39, 241–42, 250, 264, 306, 456 Raumsicherungsvertrag 96, 180 re-characterisation 36, 154–55, 168, 171–72, 194–95, 215–16, 218, 254–56 risk 131, 154, 172, 254–55 re-hypothecation, see rehypothecation re-transfer 37, 85, 135, 201, 336 real estate 11–12, 31, 110, 144, 158, 179, 215, 220 leasing 215, 224–25, 227, 232 mortgages 3, 30–32, 99–100, 113, 174 real-time gross settlement, see RTGS reasonable description 106, 127, 176, 178, 184, 213, 235 reasonableness 78, 173, 437 reasoning, legal, see legal reasoning rebalancing 418, 420–21, 431 receivables 57–60, 64–68, 87, 89–93, 125–26, 172–81, 183–202, 208–13 financing and factoring 10, 39, 110, 119–20, 123–26, 131–33, 184, 189–214 assignment of monetary claims 190–94 domestic and international regulatory aspects 212 international aspects 202–6 origin and approaches 194–98 UNIDROIT and UNICTRAL Conventions 206–12 portfolios 133, 185, 194, 196–97 trade 3, 37, 67, 132, 165, 193, 210, 243 recharacterisation, see re-characterisation reciprocal transactions 40, 157 reciprocity 346 recognition 18–19, 57, 63–64, 76–77, 161–64, 187, 213, 222 recommendations 409–10 reconciliation 263, 299, 405, 418, 443 recourse 48, 196, 198, 200, 213, 216, 386–88, 392–93 factoring 195, 197, 209, 213, 216 financing 200 recovery 33, 46, 110, 139–40, 203, 230, 244, 246 rights 51, 144 separate 46, 110 recycling 11, 14 money 11, 14, 249 redelivery 360, 430 redemption 13, 105–6, 108–9, 111–15, 139, 312, 430 equity of 105–6, 109, 112–15

redenomination 332, 380, 382–83 refinancing 11, 305, 313 reforms 69, 250, 288 structural 381 registered assignments 70 registered chattels 111, 220 registered securities 416, 440 registers 6, 13, 56, 80, 90, 161, 169, 416 general debt 51, 127, 182 registrable charges 116 registration 67–69, 106, 110, 116, 161, 167–69, 182–83, 310 requirements 31, 34 regular derivatives markets 275–76, 279, 284, 289, 456 regular exchanges 266–68, 276, 286, 295 regular information supply 304, 309 regular markets 285, 290, 293–94 regular payments 214–15, 217, 298, 433 regulation 63–64, 157–59, 203–4, 249–51, 260–63, 301–10, 312–14, 367–70 double 304 financial 16, 61, 251, 262, 303, 307, 309 home-country 263 judgment-based, see judgment-based approach modern 242, 282 regulators 53, 249–50, 257–59, 284–85, 308–11, 313, 412–14, 426–27 bank 243, 293 host 304 regulatory co-operation 16 regulatory control 312 regulatory frameworks 159, 265, 300 regulatory interests 189, 232, 371 regulatory intervention 287, 314 regulatory reforms 259 regulatory regimes 64 rehypothecation 424, 428–29, 434, 440–41, 446 reimbursement 199, 324, 389, 391–95, 399 release 29, 33, 109, 192, 235, 315–16, 318–24, 347 reliability 265, 283 reliance 56, 61, 207, 212, 300, 302, 322, 327–28 justified 302, 322, 327 remainders 73, 105, 107, 150, 196 remedies 99, 169, 231, 383, 408–9, 445 remitting banks 387, 392 rental agreements 102, 129, 218, 220 rentals 129, 214, 220–21, 226–27, 229–31, 234 reorganisation 9, 62, 99, 123, 127, 345, 349–50, 357 proceedings 9, 45, 49, 53, 62, 178, 180, 228 repayments 82, 84, 87, 98–100, 108–9, 175, 177, 262–63 replacement assets 4, 12, 65, 67–68, 177, 179, 184, 189 replacement goods 34–35, 46–48, 53–54, 58–59, 70–71, 176, 179, 181 replacement intermediaries 418 replacement inventory 174–75 replacement swaps 274, 289, 292

482 Index replacement values 274, 285 repledging 143, 415, 424, 427–30, 446–47, 457 repo rates 136, 445–46, 449–51 repos 36–41, 75–76, 130–37, 155–57, 427–29, 434–37, 444–48, 450–57 buyers 136, 155, 157, 422, 445, 447–48, 450–52, 457 development 449–51 domestic and international regulatory aspects 455–56 and GMRA 453–54 international aspects 454–55 investment securities 38–39, 59, 84, 123, 128, 133–34, 155–56, 444–57 margining 451–52 markets 10, 446, 448, 455–56 master agreements 293, 350, 356, 361, 373, 450 netting 63, 363, 452–54 as prime alternative to secured lending 444–48 sellers 36, 100, 136, 155, 311, 429, 446–47, 452 transnationalisation 456–57 repossession 11, 13, 46, 85–86, 99, 131, 180, 227 immediate 107, 217 rights 46, 48–49, 99, 228 repudiation 145, 155, 346, 349, 354, 358, 447, 456 repurchase 25–26, 80–81, 84, 132, 200–1, 444–45, 448, 450–52 agreements 37–38, 74–76, 80, 82, 85, 113, 444–48, 456–57 date 152, 447, 450–52, 454 duty 137, 142, 450 options 81–82, 147 prices 36–37, 85, 132–34, 136, 152, 155, 444–45, 447–53 transactions 85–86 reputation 111, 297 reputed ownership 81, 83, 87, 111 resale 121, 139, 178, 384, 395, 406, 446 rescinding conditions 72–73, 148–49 rescission 81, 96, 113, 453 rescues 74, 290 resecuritisation transactions 261 reservation of title 37–41, 69–74, 81–84, 92–94, 96–100, 102–6, 134–35, 148–52 extended 84, 103, 116 France 82–84, 86 Netherlands 69 United Kingdom 116–17 reserves 43, 339, 362 reshuffling 52, 55, 182, 189 residence 166, 225, 228, 293, 370–71, 453 residual rights 46, 74, 214, 217 resolution 350, 364 resolutive condition 73, 148–50, 217 restitution 47 retail 302, 308–9, 330 clients/customers 261, 302, 308, 329, 342 investors 304–6, 308–9, 440

retention 33–34, 43, 46, 54, 66–67, 78, 105, 394 rights 46–47, 107 retirees 252 retransfer 37, 82–83, 85, 200–1, 364, 416, 428 automatic 200–1 obligation 85–86, 135 retrieval rights 217, 430 retroactivity 83–84, 345, 347, 353–55, 358, 360, 366, 373 return 11–13, 36–37, 105, 107–8, 113–15, 151–54, 200–1, 447–49 automatic 81, 94, 114, 227 of overvalue 33, 37–38, 40, 46, 54, 113, 123, 126 reversion 105, 114, 368, 429, 446, 457 reversionary interests 73, 81, 107, 150, 429, 445 reverters 105, 115 revindication 81, 83, 94, 145 rights 78, 81, 103 revocability 335 reward structures 36, 38, 137, 171–72, 208–9, 215–16, 254, 256 rights contractual 155, 157, 218, 228, 234, 240, 243, 294–95 direct 221, 231, 253, 303, 418 equitable 108, 134 obligatory 31, 57, 201, 203, 431 personal 85, 344 priority 48, 51, 62, 121 property 6, 18, 54, 60, 77, 95, 104–5, 358 recovery 51, 144 repledging 447, 457 repossession 46, 48–49, 99, 228 residual 46, 74, 214, 217 retention 46–47, 107 retrieval 217, 430 revindication 78, 81, 103 set-off 47, 186, 191–92, 208, 211, 236–37, 455 split-ownership 134, 137, 172 temporary ownership 13, 66, 72, 75, 77, 148, 150, 153 voting 310, 417, 419, 426, 440 ring-fencing 90, 125, 158, 236 risk assets 237, 240, 245–46, 254, 261, 268 risk concentrations 259, 295 risk control 330–31 risk exposure 236, 268, 388 risk layering 236, 240–42, 249, 252–53, 255, 257, 259, 261 risk management 1–5, 7, 9, 16–17, 52–53, 55, 261–62, 283 facilities 17, 33, 43, 65, 134, 287 modern 6, 24, 366 requirements 171, 337 systems 309 tools 13–16, 53, 61, 234, 277, 343–44, 367–68, 370–71

Index 483 risks 13–15, 196, 246–47, 249–52, 257–62, 268–71, 306–8, 374–78 collection 197, 200, 386 counterparty 276, 281–82, 286–87, 319, 375, 385–86, 441–42, 444 credit 191–92, 195–98, 200–1, 243–47, 264–65, 329–30, 337–38, 386–88 cross-border payments 374–76 currency 270, 380 default 182 financial 19 layering 240–42, 252 legal 7, 14, 17, 23, 53, 61, 364, 373 liquidity 234, 240, 243, 310, 330, 337–39, 455 market 234, 268, 294, 306 operational 234, 250, 306, 311, 339 position 265, 268 settlement 267–69, 275, 277–78, 294–95, 329, 331, 333, 431–32 swaps 288 systemic 53, 306–7, 310–11, 329–30, 342, 344, 352, 357 transferability 332, 375 rogue traders 249, 279 Roman law 28–29, 31, 106, 108, 112, 143, 146, 150 ius commune 31, 106, 146 Romania 330 RTGS (real-time gross settlement) 329–30 Russia 407 safeguards 7, 43, 113–14, 133, 218, 236, 249, 375 safety 279, 333 sale of goods 111, 116, 140, 142, 178–79, 193, 203–4, 206 sales agreements 81, 83, 92–94, 146, 148, 206, 209, 382 conditional 29–31, 33–39, 74–75, 96–98, 104–6, 111–15, 139–44, 201–2 contracts 276–78, 316, 389, 398, 433 credit 105, 112–13, 116, 119–20, 135–36, 145, 147 fiduciary 25, 57, 66, 69 instalment 113 prices 46, 85, 87, 117, 134–36, 388–89, 391, 449–51 temporary 35, 49, 59, 69, 132, 153, 425 sales-price protection 6, 27, 30, 38, 53–54, 66, 102, 167 savings 215, 381 scalability 265, 300, 342, 443–44 scanned paper documents 263 scholarship, see legal scholarship Scotland 35, 106, 257 sea waybills 393–95 search duty 6, 32, 51, 80, 122, 169, 177–78, 183 secondary markets 15, 441–43 secured assets 24, 29, 31, 37, 121, 168, 175, 185 secured claims 28–29, 37, 45, 62, 121, 127 secured creditors 28, 44, 49–51, 62–64, 99, 119, 122, 179–82

secured financing 37, 127, 169, 191, 196 secured interests 24, 29, 80, 99, 107, 123, 161, 170–71 secured lending 11, 25, 36–38, 114–15, 196, 444 secured loans 37–38, 134, 136–37, 156, 160, 208, 255, 444–45 securities 11–14, 29–30, 52–54, 172–77, 201–4, 416–33, 436–44, 446–53 activities 312 asset-backed 3, 238 bearer 434, 440, 442–43 borrowed 424, 449 borrowers 311, 422, 425, 451 entitlements 415, 417, 420, 430, 432, 435–36, 438, 440 fungible 84, 424, 432, 440, 449, 456 intermediated 165–66, 433, 440 investment 14–16, 37–41, 84–85, 135–36, 415–19, 426–30, 444–46, 448–54 lenders 311, 425, 449, 451 lending 85, 311, 420, 424, 427, 441, 449–50, 456 markets 275, 281, 287, 300, 425, 433, 442, 451 off-ledger 442, 444 purchase money 121, 167–68 registered 416, 440 repos, see repos transferable 295, 304 transfers 177–78, 180, 190–91, 193, 201, 211, 418–23, 431–32 underlying 134, 302, 416–17, 425, 429, 434–35, 438, 456 securitisation 2–3, 6, 10, 88–89, 91–92, 125–26, 184, 234–65 cycle 263, 265 domestic and international regulatory aspects 258–61 and financial engineering 234–36 and fintech 263–65 France 88–89 international aspects 257–58 re-characterisation risk 254–55 synthetic 242–43, 246 securitised products 15, 238, 256 security accounts 10, 416, 419–20, 424–25, 428, 450 security agreements 121–22, 125–28, 141, 167–68, 176–77, 182, 199, 238 security assignees 68, 78 security assignments 67–68, 89, 126, 174, 195, 201–2, 211, 238 security entitlements 165, 295, 415–57 security holders 3, 87, 121, 179 security interests 24–26, 28–37, 55–64, 119–24, 126–28, 140–43, 174–90, 216–18 creation 56 domestic 64, 154, 168 holders 28, 45, 182 perfected 121, 123, 395

484 Index possessory 30, 51 true 66, 74, 105, 110 unperfected 123, 162 security substitutes 38, 59, 66, 69, 74, 77, 147, 153 segregation 1–3, 5, 17–18, 90–91, 417, 421, 435, 438 facilities 1, 4, 7, 47 proper 236, 253 structures 17 self-assessment 261 self-dealing 420–21, 439 self-help 28, 34, 63, 99 self-regulation 310 sellers 36–37, 80–85, 96–99, 139–46, 148–51, 277–81, 384–401, 443–47 conditional 113, 142, 144–45 original 85, 100, 142–43, 157 repo 136, 155, 311, 429, 446–47, 452 short 311, 425–26 senior bondholders 239 SEPA (Single European Payments Area) 330 separate recovery 46, 110 separation 1–2, 4, 44–45, 47–49, 211–12, 235–36, 246, 253 servicers 237, 242, 248, 255, 264 services 1–3, 14–16, 136, 195–97, 375–77, 379, 382–87, 449–50 servitudes 5, 32 set-off 4–6, 43–48, 289–92, 315–18, 343–52, 354–61, 363–71, 373–74 automatic 344, 346–47 bankruptcy 346, 351, 354, 363 bilateral 4, 424 equitable 23, 349 expansion through contractual netting clauses 353–57 extended 86, 135, 354 facilities 5, 7, 44, 47, 100, 284, 349, 353 as form of payment and risk management tool 343–48 international aspects 364–68 principle 52, 55, 135, 349, 352–54, 357, 363, 455 evolution and use 348–53 rights 47, 186, 191–92, 208, 211, 236–37, 455 settlement 15–16, 273–76, 286–87, 299–301, 329–31, 352–57, 371, 430–35 agents 431–32, 441, 443 cash 43, 244–45, 273, 298–99 costs 286, 432 date 273, 286, 289, 354–55, 424 finality 346, 351, 358, 364, 372, 441, 443 instantaneous 287, 300, 441 net 329, 333, 355 netting 260, 278, 289–90, 331, 354–55 risk 267–69, 275, 277–78, 294–95, 329, 331, 333, 431–32 systems 136, 275–76, 300, 329–30, 339, 354, 360, 432 severability 185, 211, 235

shams 106, 114, 133, 444 shareholders 123, 239, 252, 302 shares 3–4, 14, 161, 268–69, 415–17, 420–22, 426, 432 sharia banking 160 financing 38, 132, 157–60 law 157, 159–60 short positions 269–70, 421, 449–50 short sales, see shorting short sellers 311, 425–26 short selling, see shorting short-term funding 160, 242, 248, 307 short-term money 261 shorting 256, 305, 311, 424–30, 439 Sicherungsübereignung 34–36, 57, 59–60, 66, 87, 93–94, 97–100, 102–4 Sicherungszession 66, 93, 97, 99, 103 sight bills of exchange 388 simplification 314, 432 simultaneity 384–85, 431 simultaneous exchange 388 single assignments 125–26 Single European Payments Area, see SEPA single name CDS 244 Single Resolution Mechanism 372, 454 situs 22, 26–27, 59–60, 161–64, 187–88, 210, 222 SIVs (special investment vehicles) 241–42, 247–50 skin in the game 242, 257, 261 slicing 240–41, 248, 250 small investors 170, 307 smart contracts 65, 263–65, 297–300, 338, 405, 441 embedded 443 soft law 373 software 311, 339 solvabilité apparente 81–82, 87 solvency 60, 260, 281, 284 South Africa 64, 348 sovereign debt 383 sovereignty 170 Spain 220, 253, 380 special investment vehicles, see SIVs special purpose vehicles, see SPVs specificity 11, 31, 111, 117, 136, 143, 184, 189 split ownership 39, 83, 91, 104–6, 134, 137–45, 172, 445 practical issues and relevance 145–47 SPVs (special purpose vehicles) 14, 123, 158–59, 234, 246–47, 251–55, 258, 261–64 and credit enhancement 237–40, 247 stability 16, 19, 52–53, 282, 285, 306–7, 313, 317 financial 50, 53, 55, 342, 352, 357, 371, 373 standard contracts 269, 273 standardisation 65, 245, 260, 265, 274, 276, 281–86, 298 operational 276, 284, 286 standardised options 272, 274, 285 standardised products 260, 275, 283

Index 485 standards 217, 283, 314, 391, 400, 456 accounting 260 international 262 minimum 8, 42, 368, 370 objective 284, 369 standby letters of credit 243, 400, 402, 404 state intervention, see intervention status 4, 6, 21, 46, 75–79, 164, 256, 363 international 164, 225 legal 123, 295, 365, 386, 438 transnational 369, 376 statutory interpretation, see interpretation statutory law 30, 35, 147, 171, 173, 179, 321–22, 348 statutory liens 46, 62–63, 78, 99–100, 121 statutory preferences 51–53, 180, 220 stock exchanges 304, 415, 421 official 433 stock index futures 269, 271, 273 stock lending 85, 312, 426 strict compliance 395, 397, 402 striking prices 265, 268–70, 272, 284, 298–99, 447 agreed 265, 269, 273 structural reforms 381 student loans 234, 271 sub-custodians 416, 432 sub-participations 236, 240 sub-prime mortgage market 247, 249, 305 subordinated loans 89, 238 subordination 44, 49, 89, 238, 248 equitable 49, 103, 123 subsidiaries 233, 237, 401 substantive law 205, 223 substitute payments 426, 449–50 substitutes 30, 38, 56, 74, 147, 304, 323, 354 security 38, 59, 66, 69, 74, 77, 147, 153 successors 32, 111, 113, 142 bona fide 161, 188 sui generis character 325–26, 328, 332, 334, 417, 422, 429, 439–40 sukuk 159 supervision 16, 157, 282, 288, 309, 379, 414 and authorisation 309 banking 307 home-country 313 minimum 314 prudential 304, 309 supplementation 166, 169, 206–7, 210, 212–14, 223, 225, 229 suppliers 127–29, 194, 208–10, 217–19, 221, 223–27, 229–32, 400 supply 174, 194, 225, 230, 375, 380, 384, 397 agreements 217–19, 221, 223, 226–27, 229–33 contracts 221, 223, 231–32 sureties 29, 395–96, 401–2, 404 suspending/suspensive conditions 72–73, 148–50, 217 suspensive interests 73, 149–50

suspensive ownership 150, 156 suspensive title 149–50, 156 swap contracts 294, 297, 357, 359 swap markets 267, 275, 281, 285, 294, 455 central clearing and standardisation 281 swap master agreements 244, 290–91, 294, 358, 360, 369 swap netting 63, 135, 288, 290 swap parties 271, 292, 359–60 swap partners 271, 274, 289–91, 359 swap warehouses 294–95 swaps 1–2, 13–17, 267–72, 274, 281–86, 288–95, 355–64, 368–70 cocktail 267 currency 87, 265, 267, 270, 289, 357, 362 default 238, 265, 268 documentation 357–58, 361 interest rate 260, 267, 273, 286, 318, 355, 357, 362–63 legal aspects 290–93 liability 270–71, 358 replacement 274, 289, 292 risk and netting 288 synthetic 291, 295 total return 242, 244–46, 286, 297, 456 Sweden 330, 343 SWIFT 330, 384 Switzerland 410 syndicates 15 synthetic securitisation 242–43, 246 synthetic swaps 291, 295 system thinking 8, 12, 66, 69, 105, 118 systemic risk 53, 306–7, 310–11, 329–30, 342, 344, 352, 357 takeovers 11, 246, 426 tangible assets 4, 27, 67, 92, 103, 119, 187–88, 193 TARGET 2 330 tariffs 377, 383 tax 48, 63, 99, 121, 141, 239–40, 408, 410 avoidance 410 evasion 338, 340, 342, 408, 410, 412 havens 222, 233, 314, 410 liens 46, 48, 51, 127, 181 treatment 136, 160, 307 taxation 48, 63, 99, 121, 141, 239–40, 408, 410–11 withholding taxes 453 taxpayers 455 technology 11, 18–19, 164, 263, 265, 311, 339–41, 442 temporary ownership 13, 39, 72, 424–25, 429, 437, 445, 448 rights 13, 66, 72, 75, 77, 148, 150, 153 temporary sales 35, 49, 59, 69, 132, 153, 425 temporary transfers 50, 90–92, 133, 152–53, 211, 445, 454, 456 tendering 36–37, 142, 157, 321

486 Index termination 227, 281, 350–51, 359–62, 364, 370, 372, 451–52 automatic 101, 361 early 245, 296, 448 terminology 15, 96, 98, 124, 127, 243, 245, 446 terrorism 406, 408–9, 411–12 terrorist financing 340, 342, 412–14 third countries 161, 163, 225, 382 third parties 27–29, 49–50, 121–22, 141–43, 181–82, 227–30, 242–43, 367–68 third-party effect 77, 82, 92, 104, 107–8, 193, 213, 218 tiered systems 418–19, 421, 440 tiers 288, 416–18, 431, 434 higher 418–19, 421, 426 time bills of exchange 386, 392 time deposits 11, 266, 272–73 title 37–41, 69–74, 81–87, 92–106, 134–38, 142–46, 148–53, 216–22 absolute 108, 141–42, 144 conditional 105, 142–43, 151, 162 documents of 3, 56, 172, 384 full 83, 128–29, 142, 144–45, 149, 220–21, 227, 233 reservation of, see reservation of title suspensive 149–50, 156 titrisation 88, 179, 184–85 token-based CBDCs 340–41 token pools 263–64 token transfer 264, 338 tokens 263–65, 337–38, 340–42, 441–43 tort 36, 108, 127, 150, 193, 211, 346–47 total return swaps (TRs) 242, 244–46, 286, 297, 456 tracing 47, 66, 69–70, 157, 178–79, 424, 429, 446–47 facilities 173, 236 rights 421, 425 tradability 3, 50, 241 trade receivables 3, 37, 67, 132, 165, 193, 210, 243 trade repositories 286, 297, 456 traders 15, 241, 243, 248, 279, 305 rogue 249, 279 trading accounts 298–99 activities 250, 259, 424 culture 259, 294 electronic, see electronic trading margin 439 platforms 260 proprietary 259, 305–7 trafficking, drugs 406, 408–12 tranches 240–41, 247–49, 264 tranching 240–41 transaction costs 164, 301, 304, 314, 340, 373 transaction messages 335–37, 443 transactions bitcoin 339, 413 chained 326, 332, 420, 425 commercial 43 cross-border 17, 53, 154, 330, 333

derivative 85, 252, 297 foreign exchange 348, 355 funding 33, 57, 131–32, 213, 449 international 20, 23, 374, 376, 378, 391, 396, 417–18 reciprocal 40, 157 reporting 247 repurchase 85–86 Transatlantic Trade and Investment Partnership (TTIP) 377 transferability 2, 5, 244, 319–20, 333, 375–76, 378, 388 risks 332, 375 transferable letters of credit 400 transferable securities 295, 304 transferees 6, 85, 98, 100, 102, 108–9, 111, 134 bona fide 185, 422–23 transferors 6, 98, 102, 105, 108–9, 111, 179, 184 transferred assets 85, 239, 254 transfers 89–94, 192–93, 199–201, 275–76, 319–22, 324–28, 419–23, 437–51 of assets 31, 154, 234, 237, 246, 320, 322 automatic 181, 210, 226, 233 bank, see bank transfers 316–23, 325–26, 334, 371, 384, 387, 397 in bulk 58, 173, 178, 213 conditional 92–93, 97, 101, 103, 147–48, 152–53, 200–1, 211 credit 321, 324–25, 332–33, 335, 419 debit 323–24, 335, 420 delayed 84, 148, 152, 272, 431 fiduciary 66, 74 interbank 321, 324 of ownership 69, 86, 105, 108, 148, 172, 218–20 physical 58, 268 securities 177–78, 180, 190–91, 193, 201, 418–19, 421, 431–32 temporary 50, 90–92, 133, 152–53, 211, 445, 454, 456 title 82–83, 93–94, 151–53, 319–20, 322, 364, 431, 437–38 of value 342, 405 transnational floating charges 14 transnational public policy 7, 27, 55 transnational status 369, 376 transnationalisation 9–10, 18–20, 26–27, 60–62, 171–73, 213–14, 257–58, 433–35 bills of exchange, letters of credit, etc. 402–4 derivatives 294–97 effects 160 finance leasing 232–34 floating charges 189–90 investment management 314 investment securities 439–40 legal 7–10, 14, 16, 18, 35, 164–65, 173, 439 payments 333–34 receivables financing and factoring 212–14 repos 456–57 securitisation 261–63

Index 487 transparency 51, 259–60, 262, 264, 282–83, 285–87, 294–95, 309–10 transport documents 394 transportation 340, 375, 385, 406 treasury operations 306 treaty law 42, 165–66, 186, 190, 199, 213, 223, 358 uniform 18, 42, 165–66, 186, 199, 213, 402 tripartite agreements 235, 276, 316–17 TRs, see total return swaps trust assets 90–91 trust deeds 58, 119 trust structures 4–5, 17, 49, 92, 110, 200, 240, 440 trustees 47–48, 90–91, 93–94, 97, 99, 145, 162–63, 447–48 bankruptcy 70, 134, 145, 155, 180, 358–59, 417–18, 447–48 trusts 47, 77–79, 90–91, 108, 178–79, 217–18, 236–37, 302–3 constructive 2, 4–6, 9, 23, 29, 47–48, 70, 178–79 France 89–91 TTIP (Transatlantic Trade and Investment Partnership) 377 UCITS (Undertakings for Collective Investments in Transferable Securities) 43, 304, 309–11, 313–14 UK, see United Kingdom umbrella funds 302, 305 unbundling 50–51, 172 uncertainties 22, 26, 58–61, 126–27, 249, 252–53, 288, 290 UNCITRAL (United Nations Commission on International Trade Law) 165–67, 186, 190, 192–93, 197–99, 201–2, 205–7, 404 unconditional owners 26, 102, 171 under-collateralisation 245–46 underlying agreements 113, 185, 193, 209, 235, 401 underlying assets 46–47, 154–56, 158–59, 264–66, 268–70, 272–73, 277–78, 451–52 underlying cash flows 239–41, 248, 289 underlying claims 203, 208, 367, 369 underlying contracts 185, 208, 234–35, 243, 257, 395–96, 401–2 underlying instruments 4 underlying intent 318, 383 underlying investments/investment securities 244, 267, 301, 416, 418, 425, 435, 438 underlying portfolios 242, 249 underlying securities 134, 302, 416–17, 425, 429, 434–35, 456 undertakings 388–89, 395–98, 402 Undertakings for Collective Investments in Transferable Securities, see UCITS undervalue 28, 30, 33, 36, 109, 112, 138 underwriters 15, 269 underwriting 15, 56 unemployment 380

UNIDROIT 164–65, 168–70, 186, 192–93, 197–98, 201–2, 206–11, 223 unification 20, 43, 53, 60, 63, 165–67, 214 uniform law 33, 164–66, 186, 206, 211, 223, 438 uniform rules 126, 207–10, 213, 223–24, 231, 403, 436 Uniform Rules for Collection, see URC uniform treaty law 18, 42, 165–66, 186, 199, 213, 402 unintended consequences 261, 456 unitary approach 59, 119, 123, 156, 170, 187, 195, 254 unitary system 119, 171, 333 United Kingdom 23–25, 30–35, 104–7, 112–14, 179–81, 302–3, 347–50, 353–54 conditional or split-ownership interests 106–12 conditional sales and secured transactions distinguished 112–16 differences from civil law 104–6 English law 29, 105–6, 113, 115, 117–19, 360, 362, 453–54 finance sales 117–19 FSA (Financial Services Authority) 307 reservation of title 116–17 United Nations 409–10 United States 23–27, 29–31, 33–39, 62–65, 137–41, 193–97, 215–18, 220–24 Art 9 UCC 119–28 banks 456 DTC (Depository Trust Company) 416, 432 Federal Reserve 259, 306, 329–30 proprietary characterisations 128–30 unitary functional approach and finance sales 123–28 units of account 315, 318–19, 336, 375, 377 unity 58, 62, 187–88, 190, 207, 225, 396, 419 unjust enrichment 47, 70, 78, 320, 328 unperfected liens 63, 123 unsecured claims 28–29, 89, 292, 384 unsecured creditors 35, 44, 51, 110, 121, 127, 179, 182 unsophisticated investors 257 updating 176 URC (Uniform Rules for Collection) 21, 387, 389, 392, 402–4 US/USA, see United States usage 212, 375 users 5, 45–46, 107–8, 134, 214–15, 218, 298, 340 usufructs 32, 75, 80, 107, 147, 153, 445, 454 utility 286 validation 335–38 validity 67–68, 126, 190–91, 203–4, 235–36, 292–93, 320–21, 344–45 contractual 101, 228, 293, 349 valuation(s) 250, 272, 274, 284–85, 304, 307–9, 360, 362 clauses 5, 46, 348, 372 proper 47, 62, 176, 437

488 Index values 175, 243–47, 252, 269–74, 318–19, 375–77, 447–48, 452 intrinsic 240, 302, 304, 376 market 45, 114, 136, 244, 269, 272, 449, 452 nominal 198–99, 221 replacement 274, 285 Venezuela 341, 343 vente à reméré 79, 82 venture capital 306, 312 Verarbeitungsklausel 97, 180 verification 275–76, 282, 331, 443 verlängerter Eigentumsvorbehalt 94, 203 vetos 2, 235, 266, 276 viability 261 virtual currencies 335, 412–14

volatility 269, 271–72, 283 Vorausabtretungsklausel 97, 180 voting rights 310, 417, 419, 426, 440 vulnerabilities 76, 298, 300, 356 wallet providers 413, 441 wallets 335–37, 443 warehouse receipts 56, 384, 394 warehouses, swap 294–95 waybills, sea 393–95 Windscheid, B 72, 96 withholding taxes 453 working capital advances 4 World Bank 372, 404 WTO (World Trade Organization) 187