Dalhuisen on Transnational Comparative, Commercial, Financial and Trade Law Volume 3: Financial Products, Financial Services and Financial Regulation 9781509926541, 9781509926534, 9781509926565

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DALHUISEN ON TRANSNATIONAL COMPARATIVE, COMMERCIAL, FINANCIAL AND TRADE LAW VOLUME 3 This is the seventh edition of the leading work on transnational and comparative commercial, financial, and trade law, covering a wide range of complex topics in the modern law of international commerce and finance. As a guide for students and practitioners it has proven to be unrivalled. The work is divided into three volumes, each of which can be used independently or as part of the complete work. Volume 3 deals with financial products and financial services; the structure and operation of banking and of the capital markets; the role of modern commercial and investment banks; and financial risk, stability and regulation, including the fallout from the 2008 financial crisis and the subsequent regulatory responses in the US and Europe. In sections on products and services, the blockchain and its potential are noted in the payment system, in the custodial holdings of investment securities, and in the derivative markets. A section on regulation critically reviews the need for macro-prudential supervision and an independent macro-prudential supervisor, the role of resolution authorities, the operation of the shadow banking system, and the extraterritorial reach and international recognition of financial regulation. All three volumes may be purchased separately or as part of a single set.

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Dalhuisen on Transnational Comparative, Commercial, Financial and Trade Law Volume 3 Seventh Edition Financial Products, Financial Services and Financial Regulation

Jan H Dalhuisen Professor of Law, Dickson Poon School 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

HART PUBLISHING Bloomsbury Publishing Plc Kemp House, Chawley Park, Cumnor Hill, Oxford, OX2 9PH, UK HART PUBLISHING, the Hart/Stag logo, BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc First published in Great Britain 2019 Copyright © Jan Dalhuisen, 2019 Jan 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/, 1998–2019. A catalogue record for this book is available from the British Library. ISBN: HB: 978-1-50992-654-1 ePDF: 978-1-50992-656-5 ePub: 978-1-50992-655-8 Typeset by Compuscript Ltd, Shannon

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To my Teachers and my Students

vi

Table of Contents Table of Cases xxiii Table of Legislation and Related Documentsxxxi Chapter 1:  Financial Products and Services

1

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 Crossborder 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

1 1 7 12

19 26 32

35

41

47

51

57

viii  Table of Contents

1.2

1.3

1.4

1.5

1.1.12 Autonomous Transnational and Domestic Legal Developments 62 1.1.13 Uncertainty in International Financial Dealings. The Idea and Technique of Transnationalisation in Asset-backed Funding 67 1.1.14 The Impact of the Applicable Domestic Bankruptcy Regime in International Financial Transactions. The US Approach and the EU Bankruptcy Regulation 71 1.1.15 Fintech and its Challenges and Possibilities. The Legal Consequences. A New World of Finance? 74 The Situation in the Netherlands 75 1.2.1 Introduction: The New Civil Code of 1992 75 1.2.2 Security Substitutes and Floating Charges. The Reservation of Title 79 1.2.3 Conditional and Temporary Ownership: The Lex Commissoria82 1.2.4 Open or Closed System of Proprietary Rights 87 The Situation in France 90 1.3.1 Introduction: The Vente à Reméré and Lex Commissoria. The Modern Floating Charge 90 1.3.2 The Impact of the Notion of the Solvabilité Apparente92 1.3.3 The Modern Repurchase Agreement or Pension Livrée94 1.3.4 The Reservation of Title 96 1.3.5 Finance Sales, Extended Reservation of Title, the Effect of the Loi Dailly, and the Implementation of the EU Collateral Directive 98 1.3.6 Securitisation or Titrisation (Fonds Communs de Créances) and the Transfer of Intangible Assets in Finance Schemes 100 1.3.7 The Introduction of the Trust or Fiducie in France 101 1.3.8 Open or Closed System of Proprietary Rights 104 The Situation in Germany 105 1.4.1 Introduction: The Development of the Reservation of Title and Conditional Transfers; Floating Charges 105 1.4.2 Sicherungsübereignung and the Conditional Sale 110 1.4.3 Finance Sales 113 1.4.4 Curbing Excess: Open or Closed System of Proprietary Rights. Newer Charges 115 The Situation in the UK 118 1.5.1 Introduction: Differences from Civil Law 118 1.5.2 Basic Features of Conditional or Split-ownership Interests. Equitable and Floating Charges. An Open System of Proprietary Rights in Equity 120 1.5.3 The Distinction Between Conditional Sales and Secured Transactions in English Law. Publication Requirements and their Meaning 127 1.5.4 Reservation of Title 131 1.5.5 Finance Sales 133

Table of Contents ix

1.6 The Situation in the US 1.6.1 Introduction: The Approach of Article 9 UCC and its Unitary Functional Approach 1.6.2 The Unitary Functional Approach and Finance Sales: Problem Areas in Article 9 UCC 1.6.3 Proprietary Characterisations

134 134 138 144

Part II  Financial Products and Funding Techniques. Private, Regulatory and International Aspects 2.1 Finance Sales as Distinguished from Secured Transactions: The Re-characterisation Risk 2.1.1 Introduction 2.1.2 The Practical Differences Between Security and Ownership-based Funding. The Re-characterisation Issue Revisited 2.1.3 Legal Differences Between Security- and Ownership-based Funding. The Operation of Split-ownership Rights in England and the US 2.1.4 Practical Issues and Relevance 2.1.5 Nature, Use and Transfers of Conditional and Temporary Ownership Rights. The Difference Between Them 2.1.6 The Duality of Ownership in Finance Sales and the Unsettling Impact of the Fungibility of the Underlying Assets 2.1.7 Finance Sales and Sharia Financing 2.1.8 International Aspects: Private International Law Approaches to the Law Applicable to Proprietary Rights. Bankruptcy Effects 2.1.9 International Aspects: Uniform Laws and Model Laws on Secured Transactions. The EBRD Effort 2.1.10 International Aspects: The 2001 UNIDROIT Convention on International Interests in Mobile Equipment 2.1.11 Domestic and International Regulatory Aspects 2.1.12 Concluding Remarks. Transnationalisation and the Issue of Party Autonomy in Proprietary Matters. The EU Collateral Directive 2.2 Modern Security Interests: The Example of the Floating Charge 2.2.1 Types of Floating Charges or Liens. Problem Areas 2.2.2 Different Approaches. Comparative Legal Analysis 2.2.3 Modern Publication or Filing Requirements. Their Meaning and Defects. Ranking Issues in Respect of Floating Charges 2.2.4 Special Problems of the Assignment in Bulk 2.2.5 International Aspects of Floating Charges. Limited Unification Attempts 2.2.6 Domestic and International Regulatory Aspects 2.2.7 Concluding Remarks. Transnationalisation

149 149

153

156 164 167 175 178

182 186 191 193

193 197 197 201 206 209 213 215 215

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2.3 Receivable Financing and Factoring. The 1988 UNIDROIT Factoring Convention and the 2001 UNCITRAL Convention on the Assignment of Receivables in International Trade 217 2.3.1 Assignment of Monetary Claims in Receivable Financing and Factoring. The Issue of Liquidity 217 2.3.2 Receivable Financing and Factoring: Origin and Different Approaches222 2.3.3 Factoring: The Contractual Aspects 226 2.3.4 Factoring: The Proprietary Aspects 227 2.3.5 International Aspects. The UNCITRAL and UNIDROIT Conventions. Internationality and Applicability 231 2.3.6 The UNIDROIT and UNCITRAL Conventions. Their Content, Field of Application, Interpretation and Supplementation. Their Role in the Lex Mercatoria236 2.3.7 Details of the UNIDROIT Factoring Convention 238 2.3.8 Details of the UNCITRAL Convention. Its Operational Insufficiency240 2.3.9 Domestic and International Regulatory Aspects 243 2.3.10 Concluding Remarks. Transnationalisation 243 2.4 Modern Finance Sales: The Example of the Finance Lease. The 1988 UNIDROIT Leasing Convention 245 2.4.1 Rationale of Finance Leasing 245 2.4.2 Legal Characterisation 247 2.4.3 Comparative Legal Analysis 251 2.4.4 International Aspects of Finance Leasing 254 2.4.5 Uniform Substantive Law: The UNIDROIT (Ottawa) Leasing Convention of 1988. Its Interpretation and Supplementation 256 2.4.6 The Leasing Convention’s Sphere of Application, its Definition of Finance Leasing 258 2.4.7 The Proprietary Aspects of Finance Leasing Under the Convention 261 2.4.8 The Enforcement Aspects in Finance Leasing Under the Convention 261 2.4.9 The Contractual Aspects of Finance Leasing Under the Convention 263 2.4.10 The Collateral Rights in Finance Leasing Under the Convention 265 2.4.11 Domestic and International Regulatory Aspects 267 2.4.12 Concluding Remarks. Transnationalisation 267 2.5 Asset Securitisation and Credit Derivatives. Covered Bonds 269 2.5.1 Asset Securitisation and Financial Engineering 269 2.5.2 The Layering of Risk 276

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2.5.3

Synthetic Securitisation. Credit Derivatives or Credit Default Swaps. The Total Return Swap, Credit Spread Options, and Credit Linked Notes 2.5.4 Excess of Financial Engineering? The 2007–09 Banking Crisis 2.5.5 Abuse of Financial Engineering? The Enron Debacle 2.5.6 Covered Bonds 2.5.7 The Re-characterisation Risk in Securitisations 2.5.8 The Characterisation Issue and Insurance Analogy in CDS 2.5.9 International Aspects 2.5.10 Domestic and International Regulatory Aspects 2.5.11 Concluding Remarks. Transnationalisation 2.5.12 Impact of Fintec 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 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 2.6.10 Domestic and International Regulatory Aspects 2.6.11 Concluding Remarks. Transnationalisation 2.6.12 Impact of Fintec. 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

279 285 289 291 292 295 296 297 302 303

306 306 310 314

316 323 328 330

332 335 336 336 339 342 342 344 347 348 354 355 357 358

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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 359 3.1.1 The Notion and Modes of Payment 359 3.1.2 The Notion of Money as Unit of Account or Unit of Payment. Money as Store of Value 362 3.1.3 Legal Aspects of Payment. The Need for Finality 363 3.1.4 Bank Transfers and Payment Systems. Pull and Push Systems, Credit and Debit Transfers 368 3.1.5 The Legal Nature and Characterisation of Modern Bank Transfers. Their Sui Generis Character 370 3.1.6 Clearing and Settlement of Payments in the Banking System 374 3.1.7 International Aspects of Payment 378 3.1.8 Regulatory Aspects of Domestic and International Payments 379 3.1.9 Concluding Remarks and Transnationalisation 380 3.1.10 The Impact of Fintec. Permission-less and Permissioned Blockchain Payment Systems with or without the Use of Crypto Currencies. Promises and Perils 380 3.2 The Principles and Importance of Set-off and Netting 386 3.2.1 Set-off as a Form of Payment and Risk Management Tool 386 3.2.2 The Evolution of the Set-off Principle 390 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 394 3.2.4 Use of Contractual Netting Clauses in Swaps and Repos: Contractual Netting and Bankruptcy. The EU Settlement Finality Directive 397 3.2.5 The ISDA Swap and Derivatives Master Agreements. The Notion of Conditionality and ‘Flawed Assets’ as an Alternative to the Set-off. The EU Collateral Directive 401 3.2.6 International Aspects: The Law Applicable to Set-offs and Contractual Netting Under Traditional Private International Law. Jurisdiction Issues 404 3.2.7 International Aspects: The Law Applicable to Netting Under Transnational Law 408 3.2.8 Domestic and International Regulatory Aspects of Netting 411 3.2.9 Concluding Remarks 412 3.3 Traditional Forms of International Payment 413 3.3.1 Cross-border Payments and Their Risks 413 3.3.2 Paper Currencies, Modern Currency Election and Gold Clauses415 3.3.3 Freely Convertible and Transferable Currency 417 3.3.4 The Effects of a Currency Collapse. Redenomination of Payment Obligations 420

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3.3.5

Payment in Open Account. Re-establishing Simultaneity Through the Use of Intermediaries 424 3.3.6 Various Ways to Reduce Payment Risk in International Transactions425 3.3.7 Ways to Reduce Payment Risk Internationally: The Accepted Bill of Exchange 426 3.3.8 Ways to Reduce Payment Risk Internationally: Collection 427 3.3.9 Ways to Reduce Payment Risk Internationally: Letters of Credit. The Different Banks Involved 430 3.3.10 The Types of Letters of Credit 434 3.3.11 The Documents Required Under a Documentary Letter of Credit 436 3.3.12 The Right of Reimbursement of the Issuing Bank Under a Letter of Credit 437 3.3.13 The Letter of Credit as Independent and Primary Obligation: Legal Nature of Letters of Credit. The ‘Pay First, Argue Later’ Notion438 3.3.14 Non-performance Under Letters of Credit: The Exception of ‘Fraud’ 441 3.3.15 Transferable Letters of Credit and Back-to-Back Letters of Credit 443 3.3.16 Ways to Reduce Payment Risk Internationally: Autonomous Guarantees. Standby Letters of Credit 444 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 446 3.3.18 Transnationalisation: The UNCITRAL Convention on International Guarantees and the World Bank Standard Conditions 448 3.4 Money Laundering 448 3.4.1 Techniques and Remedies 448 3.4.2 Why Action? Remedies and the Objectives of Combating Money Laundering 451 3.4.3 International Action. The G-10, the Council of Europe and the United Nations 453 3.4.4 The EU 454 Part IV  Security Entitlements and Their Transfers through Securities Accounts. Securities 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

457

457

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4.1.2

Securities Transfers: Tiered or Chained Transfer Systems. The Legal Character of the Securities Transfer and its Finality 461 4.1.3 Securities Shorting, Securities Lending, Pledging and Repledging of Securities. The Notion of Rehypothecation 466 4.1.4 Modern Clearing and Settlement. Central Counterparties and Their Significance 474 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 Mercatoria478 4.1.6 Regulatory Aspects 483 4.1.7 Concluding Remarks. Transnationalisation 484 4.1.8 Impact of Fintec. Permission-less Frameworks and Permissioned Blockchain Off-ledger Securities Trading 484 4.2 Investment Securities Repos 489 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 489 4.2.2 The Development of the Repo in Fungible Investment Securities. Securities Lending and the Buy/Sell Back Transaction494 4.2.3 Margining 497 4.2.4 The Netting Approach in Repos. Close-out 498 4.2.5 The TBMA/ISMA Global Master Repurchase Agreement 499 4.2.6 International Aspects 500 4.2.7 Domestic and International Regulatory Aspects 502 4.2.8 Concluding Remarks. Transnationalisation 503 Chapter 2:  Financial Risk, Financial Stability and the Role of Financial Regulation

505

Part I  Financial Services, Financial Service Providers, Financial Risk and Financial Regulation 1.1 Financial Services and Their Regulation 505 1.1.1 The Recycling of Money. Commercial Banking and Capital Markets505 1.1.2 Financial Services and Financial Risks. Systemic Risk and Financial Stability 509 1.1.3 The Issues of Banking Illiquidity and Insolvency. Types of Banking Risk 512 1.1.4 Liquidity Management and Management of Balance-sheet Risk 515 1.1.5 Risk Management, Hedging and the Commoditisation of Risk 518 1.1.6 The Role of Central Banks as Lenders of Last Resort. Government Support Systems 521

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1.1.7

The Role of Regulation and the Major Regulatory Concerns: Financial Stability, Depositors and Investor Protection, Market Integrity524 1.1.8 The Basic Structure of Modern Financial Regulation. The Type of Recourse 527 1.1.9 Deregulation and Re-regulation of Modern Financial Activity. The Institutional and Functional Approach to Financial Regulation. Monetary, Liquidity and Foreign Exchange Policies Distinguished 533 1.1.10 The Different Aims of Modern Financial Regulation 538 1.1.11 Conflicting Regulatory Objectives. Lack of Clarity in Statutory Regulatory Aims 545 1.1.12 Financial Regulation and the Issue of Moral Hazard. The Operation and Effects of Deposit and Investor Guarantee Schemes 549 1.1.13 The Pro-cyclical Nature of Banking and Banking Regulation 551 1.1.14 Principle-based Regulation and Judgement-based Supervision in the UK. Micro- and Macro-prudential Supervision 556 1.1.15 The ‘Too Big to Fail’ Issue 563 1.1.16 Universal Banks, Conglomerate Risks and the Effect on Regulatory Supervision 565 1.1.17 The Shadow Banking System 567 1.1.18 Other Ways to Recycle Money. Fintech, Virtual Payment and Lending Systems: Bitcoin and Crowdfunding. The Potential Effect on Commercial Banking 571 1.1.19 Official and Unofficial Financial Markets. Regulatory Issues 575 1.1.20 Market Abuse, Insider Dealing and Misleading Financial Structures. The Regulatory Response 578 1.2 International Aspects of Financial Regulation 582 1.2.1 When are Financial Services International? EU Approach, Home or Host Country Rule between Member States 582 1.2.2 The EU Approach to Third Country Activity, Access to the EU and Export from the EU 585 1.2.3 Regulation of the Activities of Foreign Banks in the US 586 1.2.4 The US Regulatory Approach to Issuing Activity and to Investment Services Rendered in the US by Foreign Issuers and Intermediaries 587 1.2.5 The Basel Concordat Concerning International Commercial Banking Regulation. Efforts to Achieve a Framework for International Financial Conglomerate Supervision. The Joint Forum 590 1.2.6 The Modern International Financial Architecture. The Advent of Macro-prudential Supervision, the Financial Stability Board (FSB) and its Significance 593

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1.3 The 2008 Financial Crisis and its Effect on Financial Regulation 596 1.3.1 What Do We Mean by Financial Stability and Systemic Risk? 596 1.3.2 Financial Crises and Immediate Causes of Regulatory Failure 599 1.3.3 The Lack of Academic Models  601 1.3.4 The Regulatory Picture in 2008. Shortage of Regulation? 604 1.3.5 Policy Issues 607 1.3.6 The Modern Credit Culture. The Democratisation of Credit 611 1.3.7 A New Theme in Public Policy and a New Paradigm in Banking? 614 1.3.8 Different Attitudes towards the 2008 Financial Crisis and its Resolution 617 1.3.9 Problems with the Reform of Financial Regulation and Prudential Supervision After 2008 624 1.3.10 Areas for Regulatory Reform 626 1.3.11 Effect of Internationalisation. The Lack of an International Safety Net. The Emergence of the Eurozone Banking Union and the Mutualisation of Banking Debt in the Eurozone 634 1.3.12 The US and European Regulatory Responses to the Financial Crisis640 1.3.13 Ways Ahead 645 1.4 The Essentials of Commercial Banking 647 1.4.1 Major Aspects of Banking. Supervision and the Role of Banks of Last Resort 647 1.4.2 Types of Banks and Their Operations. Non-banks and the Shadow Banking System 650 1.4.3 Commercial Banking Products, Unsecured and Secured Loans, Leasing, Repos, Receivable Financing, Syndicated Loans, Trade and Project Finance 652 1.4.4 Commercial Banking Risks 656 1.4.5 Risk Management in Banks 660 1.4.6 Broad and Narrow Banking. Sharia Banking. Market-based Monitoring of Banks 663 1.4.7 Commercial Banking Regulation and Banking Regulators. International Aspects 666 1.4.8 Intermediation and Disintermediation of Commercial Banks 669 1.4.9 The Banking or Current Account Relationship and Agreement 670 1.4.10 The Democratisation of Financial Services and its Effects. A Human Right to Credit and a Public Function for Banks? 675 1.4.11 Fintech and the Potential Effect on Commercial Banking 678 1.5 Capital Markets. The Essentials of the Investment Securities Business and its Regulation 679 1.5.1 Major Types of Securities. Negotiable Instruments, Transferable Securities and Investments. Book-entry Systems and Securities Entitlements 679 1.5.2 Securities Markets and Their Organisation. Official Markets 686

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1.5.3 1.5.4 1.5.5 1.5.6 1.5.7 1.5.8 1.5.9 1.5.10 1.5.11

1.5.12 1.5.13 1.5.14 1.5.15

Unofficial Markets, Globalisation of Markets, Euromarkets 689 The Primary Market and Security Issuers. International-style Offerings693 The Secondary Market and its Trading Techniques 693 Internet or Electronic Issuing and Trading. ATSs and MTFs. Black Pools, HFTs and Crowd-funding 695 Modern Clearing, Settlement and Custody 701 The Role of Investment Banks as Underwriters and Market-makers 704 The Role of Investment Banks as Brokers and Investment Managers. Investors’ Protection, Fiduciary Duties 708 Insolvency of Securities Brokers. The Notion of Segregation, Tracing and Constructive Trust in Respect of Client Assets 711 Other Activities of Investment Banks. Fund Management, Prime Brokerage, Corporate Finance, and Mergers and Acquisitions. Valuations 715 The Risks in the Securities Business. Securities Regulation and its Focus. The European and US Approaches 718 Securities Regulators 720 International Aspects of Securities Regulation 722 Fintech and the Capital Markets 724

Part II  International Aspects of Financial Services Regulation: The Effects of Globalisation and the Autonomy of the International Capital Markets. The Developments in GATT/WTO, the EU and BIS/IOSCO/IAIS 2.1 The Globalisation of the Financial Markets and the Informal Liberalisation of Finance 2.1.1 Autonomy of the International Capital Markets. Its Extent and Meaning 2.1.2 The Eurobond Market and its Main Features. Euro Deposits 2.1.3 The Legal Status of Euromarket Instruments and Underwriting Practices 2.1.4 Central Bank Involvement 2.2 The Formal Regime for the Freeing of the Movement of Goods, Services, Current Payments and Capital After World War II 2.2.1 Cross-border Movement of Goods. GATT 2.2.2 Cross-border Payments and Movement of Capital. IMF 2.2.3 Cross-border Movement of Services. GATS 2.2.4 The WTO 2.3 The Creation of the EEC in Europe and its Evolution into the EU 2.3.1 The European Common Market and Monetary Union 2.3.2 The EU Institutional Framework and Legislative Instruments 2.3.3 The EU Internal Market: Definition of Cross-border Services. Connection with Free Movement of Goods and Persons and with the Right of Establishment

725 725 726 730 731 731 731 734 735 739 740 740 747

750

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2.3.4

Early Failure of Full Harmonisation of Regulated Financial Services in the EU and the 1985 Breakthrough: Mutual Recognition of Home Regulation. The European Passport in Finance 2.4 The Effects of Autonomous Globalisation Forces on Financial Activity and its Regulation in the EU 2.4.1 Effects of the Free Flow of Capital in the EU. The 1988 Directive on the Free Movement of Capital 2.4.2 The 1988 Directive and the Redirection of Savings and Tax Avoidance Issues. The 2003 Savings Tax Directive 2.4.3 The 1988 Directive and the Movement of Financial Products and Services 2.4.4 The 1988 Directive and Monetary and Exchange Rate Aspects of the Free Flow of Capital. The 1997 Stability Pact 2.4.5 The Single European Market for Financial Services and its Relationship to the Euromarkets 2.5 Developments in the BIS, IOSCO and IAIS. The International Harmonisation of the Capital Adequacy Regime (Basel I, II and III) 2.5.1 The Functions of the BIS, IOSCO and IAIS 2.5.2 The BIS Capital Adequacy Approach for Banks. The Basel I Accord. Criticism. Basel II 2.5.3 Credit Risk, Position Risk, Settlement Risk, and Operational Risk. Liquidity Risk 2.5.4 The Risk Assets Ratio, Risk Weightings, and Qualifying Capital Under Basel I 2.5.5 1993 BIS Proposals for Netting, Market Risk and Interest Rate Risk. The 1996 Amendment. VaR 2.5.6 The Building Block Approach 2.5.7 Capital for Derivatives 2.5.8 Contingent Assets and Liabilities. Off-balance-sheet Exposures. Credit Conversion Factors 2.5.9 Capital Adequacy Calculations Under Basel I. The Level Playing Field for Banks and the Effect of a Change in the Minimum Capital Requirement 2.5.10 Criticism of Basel I. The 1999 BIS Consultation Document and the 2001 BIS Proposals. Inclusion of Operational Risk. Basel II (2008) and the American Shadow Committee 2.5.11 Continuing Criticism and the 2008 Crisis 2.5.12 The Situation After Basel II. Basel III. Increased Capital, the Leverage Ratio, and a Regulatory Approach to Liquidity Risk 2.5.13 Derivatives, Contingencies and Other Off-balance-sheet Exposures After Basel III 2.5.14 Capital Adequacy Calculations Under Basel II and Basel III 2.5.15 Evaluation

755 756 756 757 760 761 762 762 762 764 768 770 771 774 775 775

777

780 786 788 793 794 799

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Part III  The EU Regulations and Directives Concerning the Internal Market in Financial Services: Early Action, the European Passport, the 1998 EU Action Plan for a Single Market in Financial Services, and Further Action Following the 2008 Financial Crisis 3.1 Early EU Concerns and Action in the Regulated Financial Service Industries803 3.1.1 Regulatory Restrictions on the Operation of the Internal Market. The Effect of Home and Host Regulation. The Concept of the General Good 803 3.1.2 Case Law Concerning the Notion of the General Good in Support of Host-country Financial Regulation 807 3.2 The Early EU Achievements in the Regulation of Financial Services 808 3.2.1 Banking 808 3.2.2 Details of the Early Banking Directives and Recommendations 809 3.2.3 Mortgage Credit 810 3.2.4 The Early Securities and Investments Recommendations and Directives 811 3.2.5 UCITS 814 3.3 The European Passport for the Financial Services Industry 815 3.3.1 The Third Generation of EU Directives. The Development of the Passport 815 3.3.2 The Reduction of the Role of the General Good Supporting Host-country Rule in the Third Generation Directives 818 3.3.3 Division of Tasks. No Single EU Regulator. Regulatory Competition820 3.3.4 Interaction with GATS 821 3.3.5 The Early EU Reciprocity Requirements. Relation with Third Countries. National Treatment and Effective Market Access 822 3.4 The 1998 EU Action Plan for Financial Services 823 3.4.1 The Main Features 823 3.4.2 The Lamfalussy Report and its Implementation. The Role of Comitology 828 3.4.3 The 2005 White Paper on Financial Services 830 3.5 The Details of the Third Generation Directives and Their Revamping Under the 1998 Action Plan. The Period up to the 2008 Financial Crisis and the Continuation of the Basic Framework 831 3.5.1 The Second Banking Directive/Credit Institution Directives (SBD/CIDs): Home Country Rule Reach. Residual Host-country Powers 831 3.5.2 Scope of the Banking Passport. Universal Banking and the Procedure for Obtaining the Passport. Home- and Host-country Communications 833

xx  Table of Contents

3.5.3 3.5.4

ISD/MiFID: Basic Structure. Background and Scope Home-country Rule, Authorisation, Capital, Prudential Rules. Procedure for Obtaining the Passport. The Concept of the General Good Revisited 3.5.5 ISD/MiFID I: Conduct of Business 3.5.6 Home or Host-country Authority in Matters of Conduct of Business 3.5.7 Regulated Markets, Concentration Principle and Stock Exchange Membership. The Competition of Modern Informal Markets or MTFs. Best Execution and Internalisation 3.5.8 Clearing and Settlement, CCP Access After MiFID 3.5.9 ISD/MiFID: Member States’ Committee 3.5.10 CARD and the 2003 Prospectus Directive. The Issuer’s Passport 3.5.11 The 2003 Transparency Directive 3.5.12 The EU Approach to Capital Adequacy 3.5.13 The Market Abuse Directive (MAD) and 2014 Regulation (MAR) 3.5.14 UCITS and Fund Management 3.6 Other EU Regulatory Initiatives in the Financial Area 3.6.1 Large Exposures 3.6.2 Deposit Protection and Investor Compensation 3.6.3 Winding up of Credit Institutions. The Alternative of an EU Resolution Regime in the Eurozone 3.6.4 Pension Funds 3.6.5 International Banking Supervision. Basel Concordat, EU Implementation 3.6.6 Consolidated Supervision. International Co-operation and the 2011 Amendments 3.6.7 The E-commerce Directive 3.6.8 Long-distance Selling of Financial Products to Consumers 3.6.9 The Takeover Bids Directive 3.6.10 Other Parts of the 1998 Action Plan: Electronic Money, Money Laundering, Settlement Finality, Cross-border Use of Collateral, and Taxation of Savings Income 3.6.11 Mortgage Credit 3.6.12 Payment Services Directive: SEPA 3.6.13 The Consumer Credit Directive 3.6.14 EU Activities in the Field of Clearing and Settlement 3.7 The EU During and After the 2008 Financial Storm 3.7.1 The General Scene 3.7.2 The New Committee Structure: The European System of Financial Supervisors (ESFS). The Single Rule Book 3.7.3 The Amended Capital Adequacy and Liquidity Regime (CRD 2–3)

834

837 838 841

842 845 846 846 850 851 852 852 853 853 853 854 855 856 857 859 860 861

862 863 863 864 865 868 868 877 879

Table of Contents xxi

3.7.4

The New Credit Institutions Directive and the Consolidation of the Capital Requirements for Banks and Investment Firms (CCR and CRD 4) 880 3.7.5 The 2014 Amendments to MiFID. MiFID II and MiFIR and the 2016 Commission Delegated Directive 880 3.7.6 The European Market Infrastructure Regulation (EMIR) 882 3.7.7 The Alternative Investment Fund Management Directive (AIFMD)885 3.7.8 The Securities Law Directive and the Central Securities Depository Regulation (SLD and CSDR) 885 3.7.9 The Regulation on Short Selling and Certain Aspects of Credit Default Swaps (CDS) 886 3.7.10 Other Product Intervention Powers 889 3.7.11 The Issue of Trading in Banks. The Volcker Rule in the EU 890 3.7.12 The Shadow Banking System. The Securities Financing Transactions Reporting Regulation (SFTR) 893 3.7.13 The Credit Rating Agency Regulation (CRAR) 894 3.7.14 The Replacement of the Prospectus Directive (PR3) 894 3.7.15 The Project for a Capital Markets Union (CMU) 895 3.7.16 Orderly Resolution, State Aid, an International Safety Net, and International Co-operation. The EU Bank Recovery and Resolution Directive (BRRD) 895 3.7.17 The New Regime Concerning Relations with Third Countries. The Notion of Equivalence 898 3.7.18 The EU Securitisation Regulation 903 3.7.19 Public Regulation and Private Law Consequences in the EU: The Impact of the EU Regulatory System on Private Law 904 4.1 The European Banking Union 907 4.1.1 Introduction 907 4.1.2 The Single Supervisory Mechanism (SSM) and Resolution Regime (SRM) 908 4.1.3 The Single Resolution Mechanism (SRM), the ECB, the Single Resolution Board (SRB) and the Single Resolution Fund (SRF) 910 4.1.4 The Single Deposit Guarantee Scheme (SDGS) 911 4.1.5 The Commingling of Competences and the Lack of a Robust Legal Framework of Recourse in the Eurozone Banking Supervision and Resolution Regime 911 4.1.6 The Issue of Proportionality in the Application of the EU Financial Regulatory Framework in the Eurozone 917 5.1 Summary, Evaluation and Conclusion 920 5.1.1 The Applicable Regulatory Regime Concerning Banking and Capital Market Activity Under the Latest EU Directives and Regulations 920

xxii  Table of Contents

5.1.2

The Institutional Aspects of the EU Regulatory Framework and Process 5.1.3 The Passport and the Technique of Passporting 5.1.4 The EU Regulatory Involvement in the Market Infrastructure 5.1.5 The Aim of Financial Stability 5.1.6 The Issue of Conduct of Business Protection 5.1.7 The Matter of Market Integrity, including Abuse, Money Laundering and Tax Avoidance Issues 5.1.8 Third Country Activity 5.1.9 Evaluation 5.1.10 Public Policy or a System of Legal Rules?

922 923 925 926 927 927 928 928 930

Index935

Table of Cases Arbitration Cases Kozara, The [1974] Journal of Business Law��������������������������������������������������������������������������������������� 378 Kraut v Albany Fabrics Ltd [1976] Journal of Business Law�������������������������������������������������������������� 378

Australia Comrs of the State Savings Bank of Victoria v Permewan, Wright Co Ltd (1915) 19 CLR 457������� 648 IATA v Ansett [2005] VSC 113, [2006] VSCA 242, and [2008] HCA 38������������������������������������ 397, 413

Belgium Cour de Cass 9 February 1933 [1933] I Pas, 103������������������������������������������������������������������������������������������������������ 92 27 November 1981 [1981–82] RW 2141�������������������������������������������������������������������������������������������� 98 22 September 1994 [1994–95] RW 1264������������������������������������������������������������������������������������������� 92 17 October 1996 [1995–96] RW 1395����������������������������������������������������������������������������������������������� 98 3 December 2010, Bank Fin 2011, no 2, 120–27������������������������������������������������������������������������������� 98 Tribunal de Commerce of Brussels, 16 Nov 1978��������������������������������������������������������������������������������� 24

European Union Case 9/56 Meroni ECR 133 (1957/58)������������������������������������������������������������������������������������������������� 644 Case 62/70 Coditel [1980] ECR 881����������������������������������������������������������������������������������������������������� 807 Case 2/74 Reyners v Belgian State [1974] ECR 631���������������������������������������������������������������������������� 741 Case 8/74 Procureur du Roi v Dassonville [1974] ECR 837������������������������������������������������������� 741, 753 Case 33/74 Van Binsbergen v Bedrijfsvereniging Metaalnijverheid [1974] ECR 1299���������������������� 741 Case 14/76 De Bloos [1976] ECR 1497������������������������������������������������������������������������������������������������ 751 Case 23/78 Nicholas Meeth v Glacetal [1978] ECR 2133�������������������������������������������������������������������� 405 Case 33/78 Somafer [1978] ECR 2183������������������������������������������������������������������������������������������������� 751 Cases 110/78 and 111/78 Van Wesemael [1979] ECR 35�������������������������������������������������������������������� 807 Case 120/78 Rewe-Zentral AG v Bundesmonopolverwaltung für Branntwein [1979] ECR 649������������������������������������������������������������������������������������������������������������������������� 816 Case 139/80 Blanckaert & Willems 1981] ECR 819���������������������������������������������������������������������������� 751 Case 203/80 Guerino Cassati [1981] ECR 3211���������������������������������������������������������������������������������� 742 Case 279/80 Webb [1981] ECR 3305��������������������������������������������������������������������������������������������������� 807 Cases 286/82 and 26/83 Luisi and Carbone [1984] ECR 377����������������������������������������������������� 742, 751 Case 205/84 Commission v Germany [1986] ECR 3755�������������������������������������������������������������������� 807 Case 221/85 Commission v Belgium [1987] ECR 719������������������������������������������������������������������������ 753 Case 198/86 Conradi [1987] ECR 4469����������������������������������������������������������������������������������������������� 753 Case C-362/88 GB-Inno-BM [1990] ECR I-667��������������������������������������������������������������������������������� 806 Case C-180/89 Commission v Italy [1991] ECR 709�������������������������������������������������������������������������� 807 Case C-340/89 Vlassopoulou [1991] ECR I-2357������������������������������������������������������������������������������� 753 Case C-353/89 Mediawet [1991] ECR I-4069������������������������������������������������������������������������������������� 807 Case C-76/90 Saeger v Dennemeyer [1991] ECR I-4221������������������������������������������������������������ 752, 806 Case C-204/90 Bachman [1992] ECR 249������������������������������������������������������������������������������������������� 807

xxiv  Table of Cases

Case C-106/91 Ramrath [1992] ECR I-3351��������������������������������������������������������������������������������������� 753 Cases C-267/91 and C-268/91 Keck and Mithouard [1995] ECR I-6097���������������������������� 753–54, 820 Case C-330/91 Commerzbank [1993] ECR I-4017����������������������������������������������������������������������������� 753 Case C-19/92 Kraus [1993] ECR I-1663���������������������������������������������������������������������������������������������� 753 Case C-275/92 Schindler [1995] ECR I-1039�������������������������������������������������������������������������������������� 807 Case C-1/93 Halliburton [1994] ECR I-1137�������������������������������������������������������������������������������������� 753 Case C-55/93 Van Schaik [1994] ECR I-4837������������������������������������������������������������������������������ 807, 820 Case C-341/93 Danvaern Production A/S v Schuhfabriken Otterbeck GmbH&Co [1995] ECR I-2053�������������������������������������������������������������������������������������������������������������������� 405 Case C-384/93 Alpine Investments BV v Minister van Financien [1995] ECR I-1141�������������752, 807, 818, 820, 838 Case C-415/93 Union Royale Belge des Sociétés de Football Association ASBL and others v Jean-Marc Bosman [1995] ECR I-4921���������������������������������������������������� 753 Case C-439/93; Lloyd’s Register of Shipping v SociétéCampenon Bernard [1995] ECR 1-1961�������������������������������������������������������������������������������������������������������������������������������� 751 Opinion 1/94 [1994] ECR 1-5276�������������������������������������������������������������������������������������������������������� 740 Case C-55/94 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165����������������������������������������������������������������������������������������751, 753, 806 Case C-101/94 Commission v Italy [1996] ECR I-2691��������������������������������������������������������������������� 806 Case C-272/94 Reisebüro Broede v Gerd Sandker [1996] ECR I-6511���������������������������������������������� 807 Case C-3/95 Reisebüro Broede v Gerd Sandker [1996] ECR I-6511�������������������������������������������������� 807 Case C-111/01 Gantner Electronic GmbH v Basch Exploitatie Maatschappij BV [2003] ECR I-4207�������������������������������������������������������������������������������������������������������������������� 405 Case C-222/02 Peter Paul ECLI:EU:C2004:606����������������������������������������������������������������������������������� 904 Case C-604/11Genil 48 SL et al v Bankinter SA et al, 30 May 2013��������������������������������������������������� 906 Case C-441/14 Danks Industri (DI), acting on behalf of Ajos A/S v Estate of Karsten Eigil Rasmussen, EU:C:2016:278������������������������������������������������������������������������������������������������������ 906

France Cour Administrative d’Appel de Paris, 30 March 1999���������������������������������������������������������������������� 532 Cour de Cass 13 February 1834, s 1.205 (1834)����������������������������������������������������������������������������������������������������� 104 24 June 1845, D 1.309 (1845)������������������������������������������������������������������������������������������������������������� 92 19 August 1849, D 1.273 (1849)��������������������������������������������������������������������������������������������������������� 99 31 January 1854, D 2.179 (1855)�������������������������������������������������������������������������������������������������������� 92 11 March 1879, D 1.401 (1879)�������������������������������������������������������������������������������������������������� 93, 155 21 July 1897, DP.1.269 (1898)������������������������������������������������������������������������������������������������������ 96–97 16 January 1923, D 1.177 (1923)�������������������������������������������������������������������������������������������������������� 99 28 March/22 October 1934, D 1.151 (1934)�������������������������������������������������������������������������������������� 96 21 March 1938, D 2.57 (1938)���������������������������������������������������������������������������������������������������� 93, 155 24 October 1950 [1950] Bull civil 1, 155������������������������������������������������������������������������������������������� 93 21 July 1958 [1958] II JCP 10843������������������������������������������������������������������������������������������������������� 97 21 November 1972, D jur 213 (1974)���������������������������������������������������������������������������������������������� 210 14 October 1975, Bull Civ IV, 232 (1975)���������������������������������������������������������������������������������������� 210 20 November 1979 (1980)������������������������������������������������������������������������������������������������������������������ 97 14 October 1981���������������������������������������������������������������������������������������������������������������������������������� 24 8 March 1988, Bull IV, no 99 (1988)�������������������������������������������������������������������������������������������������� 96 15 March 1988, Bull Civ IV, 106 (1988)��������������������������������������������������������������������������������������������� 96 20 June 1989, D Jur 431 (1989)���������������������������������������������������������������������������������������������������������� 96 9 January 1990, (1990) Gaz Pal 127������������������������������������������������������������������������������������������� 98, 252

Table of Cases xxv

5 Nov 1991, Bull Civ, IV, no 328 (1992)��������������������������������������������������������������������������������������������� 24 15 December 1992, Bull IV no 412 (1992)���������������������������������������������������������������������������������������� 96 5 March 1996, Bull IV, no 72 (1996)�������������������������������������������������������������������������������������������������� 97 Court of Appeal, Versailles, 20 September 1995������������������������������������������������������������������������������������ 91 Tribunal de la Seine, 30 May 1958, R 731 (1958); 18 December 1967, G.1-2.108 (1968)����������������� 378

Germany BGH 25 October 1952, BGHZ 7, 365 (1952)�������������������������������������������������������������������������������������������� 116 28 June 1954, BGHZ 14, 117 (1954)������������������������������������������������������������������������������������������������ 107 24 November 1954, [1955] NJW 339����������������������������������������������������������������������������������������������� 392 22 February 1956, BGHZ 20, 88 (1956)������������������������������������������������������������������������������������������� 107 30 April 1959, BGHZ 30, 149 (1959)����������������������������������������������������������������������������������������������� 116 38 BGHZ 254 (1962)������������������������������������������������������������������������������������������������������������������������ 408 14 October 1963, BGHZ 40, 156 (1963)������������������������������������������������������������������������������������������ 117 1 July 1970, 54 BGHZ 214���������������������������������������������������������������������������������������������������������������� 106 5 May 1971, BGHZ 56, 123 (1971)�������������������������������������������������������������������������������������������������� 106 BGHZ 71, 189��������������������������������������������������������������������������������������������������������������������������� 115, 252 9 July 1975, BGHZ 64, 395 (1975)��������������������������������������������������������������������������������������������������� 117 6 July 1978, [1981] NJW 2244���������������������������������������������������������������������������������������������������������� 393 23 September 1981 [1981] NJW 275����������������������������������������������������������������������������������������������� 112 11 July 1985 [1985] NJW 2897��������������������������������������������������������������������������������������������������������� 408 BGHZ 95, 39����������������������������������������������������������������������������������������������������������������������������� 115, 252 OLG Cologne, 2 February 1971, 47 NJW 2128 (1971)����������������������������������������������������������������������� 378 RG 2 June 1890; RGZ 2, 173 (1890)������������������������������������������������������������������������������������������������������� 110 23 December 1899, RGZ 45, 80 (1899)�������������������������������������������������������������������������������������������� 111 10 October 1917, RGZ 91, 12 (1917)����������������������������������������������������������������������������������������������� 111 5 November 1918, RGZ 94, 305 (1918)������������������������������������������������������������������������������������������� 111 20 March 1919, RGZ 79, 121 (1912)������������������������������������������������������������������������������������������������ 111 4 April 1919, RGZ 95, 244 (1919)���������������������������������������������������������������������������������������������������� 108 11 June 1920, RGZ 99, 208 (1920)��������������������������������������������������������������������������������������������������� 116 14 October 1927, RGZ 118, 209 (1927)������������������������������������������������������������������������������������������� 111 9 April 1929, RGZ 124, 73 (1929)���������������������������������������������������������������������������������������������������� 111 9 April 1932, RGZ 136, 247 (1932)�������������������������������������������������������������������������������������������������� 116 4 April 1933, RGZ 140, 223 (1933)�������������������������������������������������������������������������������������������������� 107

Netherlands Amsterdam Court of Appeal 9 July 1991 [1994] NJ 79, [1992] NIPR 418�������������������������������������������������������������������������������������� 88 16 April 1931, W 12326 (1931)���������������������������������������������������������������������������������������������������������� 79 Crt Alkmaar, 7 November 1985, NIPR, no 213 (1986)����������������������������������������������������������������������� 407 Crt Arnhem, 19 December 1991, NIPR nr 107 (1992)����������������������������������������������������������������������� 407 HR 13 November 1737���������������������������������������������������������������������������������������������������������������������������� 120 25 January 1929 [1929] NJ 616���������������������������������������������������������������������������������������������������������� 79 21 June 1929 [1929] NJ 1096������������������������������������������������������������������������������������������������������������� 79 3 Jan 1941 NJ 470 (1941)�������������������������������������������������������������������������������������������������������������������� 79 13 March 1959 [1959] NJ 579������������������������������������������������������������������������������������������������������������ 79 17 June 1960 [1962] NJ 60����������������������������������������������������������������������������������������������������������������� 79

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17 Apr 1964 [1965] NJ 23����������������������������������������������������������������������������������������������������������� 25, 231 6 March 1970 [1971] NJ 433�������������������������������������������������������������������������������������������������������� 76, 79 8 December 1972, NJ 377 (1973), 22 Ars Aequi 509 (1973)����������������������������������������������������������� 378 7 March 1975 [1976] NJ 91���������������������������������������������������������������������������������������������������������������� 79 3 October 1980 [1981] NJ 60����������������������������������������������������������������������������������������������������� 79, 112 22 May 1984 (1985) NJ 607���������������������������������������������������������������������������������������������������������������� 24 18 September 1987 [1988] NJ 876����������������������������������������������������������������������������������������������������� 79 19 May 1989 [1990] NJ 745�������������������������������������������������������������������������������������������������������������� 411 11 June 1993 [1993] NJ 776������������������������������������������������������������������������������������������������������� 25, 231 5 November 1993 [1994] NJ 258������������������������������������������������������������������������������������������������������� 79 18 January 1994 [1994] RvdW 61������������������������������������������������������������������������������������������������������ 81 19 May 1995 [1996] NJB 119������������������������������������������������������������������������������������������������������������� 85 17 February 1996, Mulder v CLBN [1996] NJ 471��������������������������������������������������������������������������� 78 5 September 1997 [1998] NJ 437������������������������������������������������������������������������������������������������������� 80 16 May 1997 [1997] RvdW 126�������������������������������������������������������������������������������������������������� 25, 231 16 June 2000, NJ 733 (2000)��������������������������������������������������������������������������������������������������������������� 80 17 February 2012, Dix v ING [2012] NJ 261������������������������������������������������������������������������������������� 79 1 Feb 2013 NJ 156 (2013)������������������������������������������������������������������������������������������������������������������� 77 14 Aug 2015, NJ 253 (2016)���������������������������������������������������������������������������������������������������������������� 80 3 June 2016 NJ 290(2016)������������������������������������������������������������������������������������������������������������������ 81

United Kingdom Aectra Refining and Manufacturing Inc v Exmar NV [1994] 1 WLR 1634��������������������������������������� 405 Alderson v White (1858) 2 De G &J 97������������������������������������������������������������������������������������������������ 129 Aluminium Industrie Vaassen BV v Romalpa Aluminium Ltd [1976] 2 All ER 552������������������������ 131 Aneco Reinsurance Underwriting Ltd v Johnson & Higgins Ltd [2002] 1 Lloyd’s Rep 157������������� 343 Armour and Others v Thyssen Edelstahlwerke AG mour and Others v Thyssen Edelstahlwerke AG;> [1990] All ER 481����������������������������������������������������������������������������������� 120 Automobile Association (Canterbury) Inc v Australasian Secured Deposits Ltd [1973] 1 NZLR 417�������������������������������������������������������������������������������������������������������������������������������� 130 Bank of Baroda v Vysya Bank Ltd [1994] 2 Lloyd’s Rep 87���������������������������������������������������������������� 434 Barclays Bank v Levin Brothers 1976] 3 All ER 900���������������������������������������������������������������������������� 378 Baring v Corrie 2 B & Ald 137 (1818)�������������������������������������������������������������������������������������������������� 714 Bechuanaland Exploration Co v London Trading Bank [1898] 2 QBD 658������������������������������� 23, 730 Beckett v Towers Assets Co [1891] 1 QB 1������������������������������������������������������������������������������������������ 127 Borden (UK) Ltd v Scottish Timber [1979] 3 All ER 961������������������������������������������������������������������� 131 British Eagle International Airlines Ltd v Compagnie Nationale [1975] 2 All ER 390��������������������� 397 Caparo Industries Plc v Dickman [1990] 2 AC 605���������������������������������������������������������������������������� 343 Carreras Rothman Ltd v Freeman Matthews Treasure Ltd [1985] 1 All ER 155����������������������� 130, 391 Carreras Rothmans Ltd v Freeman Matthew Treasure Ltd [1985] 1 Ch 207������������������������������������� 391 Chase Manhattan Bank v Israel British Bank [1979] 3 All ER 1025��������������������������������������������������� 131 Chaw Yoong Hong v Choong Fah Rubber Manufactory [1962] AC 209������������������������������������������� 129 Clayton’s Case (1816) 35 ER 767���������������������������������������������������������������������������������������������������������� 672 Clough Mill Ltd v Martin [1985] 1 WLR 111������������������������������������������������������������������������������������� 130 Compaq Computer Ltd v The Abercorn Group Ltd (1991) BCC484������������������������������������������ 131–32 Crestsign v The Royal Bank of Scotland, [2014] EWHC 3043 (Ch)�������������������������������������������������� 710 Crumlin Viaduct Works Co Ltd, In re [1879] II Ch 755��������������������������������������������������������������������� 123 Despina R, The [1977] 3 All ER 374���������������������������������������������������������������������������������������������������� 378 Dublin City Distillery v Doherty [1914] AC 823�������������������������������������������������������������������������������� 125 Farina v Home (1846) 153 ER 1124����������������������������������������������������������������������������������������������������� 123 Foley v Hill (1848) 2 HCL 28��������������������������������������������������������������������������������������������������������������� 648

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G&E Earle Ltd v Hemsworth RDC (1928) 140 LT 69������������������������������������������������������������������������� 132 George Inglefield Ltd, Re [1933] Ch 1����������������������������������������������������������������������������������������� 127, 129 Goodwin v Roberts [1876]1 AC 476������������������������������������������������������������������������������������������������������ 23 Government Stock v Manila Rail Co [1897] AC 81���������������������������������������������������������������������������� 124 Green v Farmer (1768) 98 ER 154 (KB)���������������������������������������������������������������������������������������������� 390 Harlow and Jones Ltd v American Express Bank Ltd & Creditanstalt-Bankverein ;> [1990] 2 Lloyd’s Rep 343������������������������������������������������������������������������������������������������������������������������� 24 Helby v Matthews [1895] AC 471�������������������������������������������������������������������������������������������������������� 133 Holroyd v Marshall [1862] 10 HL Cas 191���������������������������������������������������������������������������������� 124, 132 Illingworth v Houldsworth [1904] AC 355����������������������������������������������������������������������������������������� 124 Independent Automatic Sales v Knowles & Foster [1962] 1 WLR 974���������������������������������������������� 131 Interview Ltd, Re [1973] IR 382����������������������������������������������������������������������������������������������������������� 131 IRC v Rowntree and Co Ltd [1948] 1 All ER 482�������������������������������������������������������������������������������� 129 JH Rayner &Co v Hambros Bank Ltd [1943] 1 KB 37������������������������������������������������������������������������ 433 Joachimson v Swiss Bank Corp [1921] 3 KB 110������������������������������������������������������������������������ 648, 673 Kelcey, Re [1899] 2 Ch 530������������������������������������������������������������������������������������������������������������������� 132 Lehman Brothers International (Europe), Re [2009] EWHC 2545 (Ch)������������������������������������������ 472 Lehman Brothers International (Europe), Re [2012] EWHC 2997 (Ch)���������������������������������� 472, 481 Libyan Arab Foreign Bank v Bankers Trust United Kingdom������������������������������������������������������������ 730 Lloyds & Scottish Finance Ltd v Cyril Lord Carpet Sales Ltd (1979) 129 NLJ 366��������������������������� 130 Manchester, Sheffield and Lincolnshire Railway Co v North Central Wagon Co (1888)13 App Cas 554������������������������������������������������������������������������������������������������������������������������������� 130 McEntire v Crossley Brothers Ltd [1895] AC 457������������������������������������������������������������������������������� 130 Miliangos v George Frank (Textiles) Ltd [1975] 3 All ER 801������������������������������������������������������������ 378 Miller v Pace (1758) 1 Burr 452����������������������������������������������������������������������������������������������������������� 362 Momm v Barclays Bank International Ltd [1977] QB 790����������������������������������������������������������������� 365 MS Fashions Ltd v BCCI [1993] Ch 425���������������������������������������������������������������������������������������������� 130 National Westminster Bank plc v Spectrum Plus Ltd [2005] 2 AC 680 and UKHL 41��������������������� 124 North Western Bank v Poynter [1895] AC 56, no 3051; [1895] All ER 754��������������������������������������� 120 Ocean Estates Ltd v Pinder [1969] 2 AC 19����������������������������������������������������������������������������������������� 122 Olds Discount Co Ltd v John Playfair Ltd [1938] 3 All ER 275��������������������������������������������������������� 129 Picker v London and County Banking Co (1887) 18 QBD 512 (CA)�������������������������������������������������� 23 Polsky v S&A Services [1951] 1 All ER 185������������������������������������������������������������������������������������������ 129 Power Curber Int’l Ltd v Nat’l Bank of Kuwait SAK [1981] 2 Lloyd’s Rep 394����������������������������������� 24 Raffeisen Zentralbank Osterreich AG v Five Star General Trading LLC [2001] 3 All ER 257������������ 25 Rogers v Challis (1859) 27 Beav 175���������������������������������������������������������������������������������������������������� 132 Rubenstein v HSBC, [2011] EWHC 2304 (QB)���������������������������������������������������������������������������������� 710 Ryall v Rolle (1749) 1 Atk 165�������������������������������������������������������������������������������������������������� 93, 122–23 Salomon v A Salomon & Co Ltd [1897]AC 22������������������������������������������������������������������������������������ 124 SCF Finance Co Ltd v Masri (No 2) [1987] QB 1002������������������������������������������������������������������������� 648 Service Europe Atlantique v Stockholm Rederiaktiebolog Svea, The Folias [1977] 1 Lloyd’s Rep 39������������������������������������������������������������������������������������������������������������������������� 378 Sewell v Burdick (1884) 10 AC 74�������������������������������������������������������������������������������������������������������� 127 Sharpe, Re [1980] 1 All ER 198������������������������������������������������������������������������������������������������������ 93, 123 Shipton, Anderson & Co (1927) Ltd v Micks Lambert & Co [1936] 2 All ER 1032�������������������������� 391 Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142�������������������������������������������� 130 South Australia Asset Management Corp v York Montague Ltd [1997] AC 191������������������������������� 343 Stein v Blake [1995] 2 WLR 710��������������������������������������������������������������������������������������������130, 387, 391 Syrett v Egerton [1957] 3 All ER 331��������������������������������������������������������������������������������������������������� 132 Tatung (UK) Ltd v Galex Telesure Ltd (1989) 5 BCC 325������������������������������������������������������������������ 131 Thomas v Searles [1891] 2 QB 408������������������������������������������������������������������������������������������������������ 123

xxviii  Table of Cases

Three Rivers District Council and Others v Governor and Company of the Bank of England [2000] 2 WLR 1220������������������������������������������������������������������������������������������������ 532 Twyne’s Case (1601) 76 ER 809������������������������������������������������������������������������������������������������������������ 123 United Railways of Havana and Regla Warehouses Ltd, Re [1961] AC 1007������������������������������������� 378 Watson, Re (1890) 25 QBD 27������������������������������������������������������������������������������������������������������������� 129 Welsh Development Agency Ltd v Export Finance Co (Exfinco) BCC 270 (1992)������������������� 127, 129 Wickham Holdings Ltd v Brooke House Motors Ltd [1967] 1 All ER 117���������������������������������������� 125 Wilson v Day [1759] 2 Burr 827����������������������������������������������������������������������������������������������������������� 123 Winkfield, The [1900–03] All ER 346�������������������������������������������������������������������������������������������������� 133 Yorkshire Woolcombers Association Ltd, Re [1903] 2 Ch 284����������������������������������������������������������� 124 Zahnrad Fabrik Passau GmbH v Terex Ltd [1986] SLT 84��������������������������������������������������������� 182, 214

United States Adler v Ammerman Furniture Co 100 Conn 223 (1924)������������������������������������������������������������������� 158 Agnew, Re 178 Fed 478 (1909)������������������������������������������������������������������������������������������������������������� 163 Appleton v Norwalk Library Corp 53 Conn 4 (1885)������������������������������������������������������������������������� 161 Babbitt & Co v Carr 53 Fla 480 (1907)������������������������������������������������������������������������������������������������ 157 Bamberger Polymers International Bank Corp v Citibank NA 477 NYS 2d 931 (1983)������������������ 433 Bank of California v Danamiller 125 Wash 225 (1923)���������������������������������������������������������������������� 161 Barbour Plumbing, Heating &Electric Co v Ewing 16 Ala App 280 (1917)�������������������������������������� 156 Barton v Mulvane 59 Kan 313 (1898)�������������������������������������������������������������������������������������������������� 158 Beatrice Creamery Co v Sylvester 65 Colo 569(1919)������������������������������������������������������������������������� 162 Beck v Blue 42 Ala 32 (1868)���������������������������������������������������������������������������������������������������������������� 158 Begier v Internal Revenue Service 496 US 53 (1990)�������������������������������������������������������������������������� 471 Benedict v Ratner 268 US 353 (1925)�������������������������������������������������������������������������������������������������� 140 Benner v Puffer 114 Mass 376 (1874)�������������������������������������������������������������������������������������������������� 162 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)��������������������������������������������������������������������������������������������������������� 139 Blackford v Neaves 23 Ariz 501 (1922)������������������������������������������������������������������������������������������������ 159 Blackwell v Walker Bros 5 Fed 419 (1880)������������������������������������������������������������������������������������� 161–62 Brainerd &H Quarry Co v Brice 250 US 229 (1919)���������������������������������������������������������������������������� 33 Brian v HA Born Packers’Supply Co 203 Ill App 262 (1917)������������������������������������������������������������� 161 Bryant v Swofford Bros Dry Goods 214 US 279 (1909)���������������������������������������������������������������������� 158 Burch v Pedigo 113 Ga 1157 (1901)����������������������������������������������������������������������������������������������������� 158 Burrier v Cunningham Piano Co 135 Md 135 (1919)������������������������������������������������������������������������ 161 Call v Seymour 40 Ohio St 670 (1884)������������������������������������������������������������������������������������������������ 159 Carolina Co v Unaka Sporings Lumber Co 130 Tenn 354 (1914)������������������������������������������������������ 161 Chase & Baker Co v National Trust & Credit Co 215 F 633 (1914)��������������������������������������������������� 141 Chicago R Equipment Co v Merchant’s Nat Bank 136 US 268 (1890)���������������������������������������������� 159 Clinton v Ross 108 Ark 442 (1912)������������������������������������������������������������������������������������������������������ 162 Cohen v Army Moral Support Fund (In re Bevill, Breslett and Schulman Asset Management Corp) 67 BR 557 (1986)������������������������������������������������������������������������������������� 139 Columbus Buggy Co, Re 143 Fed 859 (1906)�������������������������������������������������������������������������������������� 158 Competex SA v La Bow [1984] International Financial Law Review������������������������������������������������� 378 Coonse v Bechold 71 Ind App 663 (1919)������������������������������������������������������������������������������������������� 160 Cushion v Jewel 7 Hun 525 (1876)������������������������������������������������������������������������������������������������������ 157 Davis v Giddings 30 Neb 209(1890)���������������������������������������������������������������������������������������������������� 159 Day v Basset 102 Mass 445 (1869)������������������������������������������������������������������������������������������������������� 157 Donald v Suckling (1866) LR 1 QB 585����������������������������������������������������������������������������������������������� 162 Dunlop v Mercer 156 Fed 545 (1907)�������������������������������������������������������������������������������������������������� 158

Table of Cases xxix

Elliott v Capital City State Bank 103 NW 777 (Iowa 1905)���������������������������������������������������������������� 676 Executive Growth Investment Inc, Re 40 BR 417 (1984)�������������������������������������������������������������������� 141 Fairbanks v Malloy 16 Ill App 277 (1885)������������������������������������������������������������������������������������������� 157 Faist v Waldo 57 Ark 270 (1893)���������������������������������������������������������������������������������������������������������� 163 Ferguson v Lauterstein 160 Pa 427(1894)�������������������������������������������������������������������������������������������� 158 Fields v Williams 91 Ala 502 (1890)����������������������������������������������������������������������������������������������������� 161 Finlay v Ludden & B Southern Music House 105 Ga 264 (1898)������������������������������������������������������� 157 Frank v Batten 1 NY Supp 705 (1888)������������������������������������������������������������������������������������������������� 163 Frank v Denver & RGR Co 23 Fed 123 (1885)������������������������������������������������������������������������������������ 158 Franklin Motor Car Co v Hamilton 113 Me 63 (1915)���������������������������������������������������������������������� 157 General Electric Credit Corp v Allegretti 515 NE 2d 721 (III App Ct 1987)��������������������������������������� 33 General Ins Co v Lowry 412 F Supp 12 (1976)����������������������������������������������������������������������������������� 138 Goldstein v Securities and Exchange Commission, DC Cir 23 June 2006 451 F3d 873�������������������� 353 Goodell v Fairbrother 12 RI 233 (1878)���������������������������������������������������������������������������������������������� 163 Grand Union Co, In re 219 F 353(1914)���������������������������������������������������������������������������������������������� 141 Granite Partners, LP v Bear, Stearns &Co 17 F Supp.2d 275, 300–04 (SDNY 1998)������������������������� 489 Grants Pass & Josephine Bank v City of Grants Pass 28 P 2d 879 (Oregon 1934)���������������������������� 676 Green v Darling 10 Fed Cas 1141 (DRI 1828)������������������������������������������������������������������������������������� 392 Hall v Nix 156 Ala 423 (1908)�������������������������������������������������������������������������������������������������������������� 158 Hanesley v Council 147 Ga 27 (1917)�������������������������������������������������������������������������������������������������� 162 Hanson v Dayton 153 Fed 258 (1907)������������������������������������������������������������������������������������������������� 157 Harkness v Russell & Co 118 US 663 (1886)��������������������������������������������������������������������������������������� 159 Hatch v Lamas 65 NHS 1 (1888)���������������������������������������������������������������������������������������������������������� 157 HB Claflin Co v Porter 34 Atl 259 (1895)�������������������������������������������������������������������������������������������� 159 Holt Manufacturing Co v Jaussand 132 Wash 667 (1925)������������������������������������������������������������������ 161 Home Bond Co v McChesney 239 US 568 (1916)������������������������������������������������������������������������������ 141 Horn v Georgia Fertilizer & Oil Co 18 Ga App 35 (1916)������������������������������������������������������������������ 161 Howland, Re 109 Fed 869 (1901)��������������������������������������������������������������������������������������������������������� 163 Hydraulic Press Manufacturing Co v Whetstone 63 Kan 704 (1901)������������������������������������������������ 157 ITT Commercial Finance Corp v Tech Power, Inc 51 Cal Rptr 2d 344 (1996)���������������������������������� 199 Ivers & P Piano Co v Allen 101 Me 218 (1906)����������������������������������������������������������������������������������� 159 James Baird Co v Gimbel Bros, Inc 64 F 2d 344, 46 (1933)���������������������������������������������������������������� 138 Jonas v Farmers Bros Co (In re Comark) 145 BR 47, 53(9th Cir, 1992)�������������������������������������������� 139 Jordan v National Shoe and Leather Bank 74 NY 467 (1878)������������������������������������������������������������ 392 JWD Inc v Fed Ins Co 806 SW 2d, 327 (1991)�������������������������������������������������������������������������������������� 33 Kentucky Wagon Manufacturing Co v Blanton-Curtis Mercantile Co 8 Ala App 669 (1913)��������� 161 Kham & Nate’s Shoes No 2 v First Bank of Whiting 908 F 2d 1351 (1990)��������������������������������������� 138 KMC v Irving Trust Co 757 F2d 752 (1985)���������������������������������������������������������������������������������������� 201 Knowles Loom Work v Knowles 6 Penn (Del) 185 (1906)����������������������������������������������������������������� 159 Krause v Com 93 Pa 418 (1880)����������������������������������������������������������������������������������������������������������� 158 Lombard-Wall, In re 23 BR 165 (1982)����������������������������������������������������������������������������������������������� 140 Lombard Wall Inc v Columbus Bank & Trust Co No 82-B-11556 Bankr. SDNY 16 Sept 1982������� 140 Louisville & NR Co v Mack 2 Tenn CCA 194(1911)��������������������������������������������������������������������������� 161 Lutz, Re 197 Fed 492 (1912)����������������������������������������������������������������������������������������������������������������� 158 Lyon, Re Fed Cas No 8, 644 (1872)������������������������������������������������������������������������������������������������������ 161 Major’s Furniture Mart Inc v Castle Credit Corp 602 F 2d 538 (1979)��������������������������������������������� 141 Mann Inv Co v Columbia Nitrogen Corp 325 SE 2d 612 (1984)������������������������������������������������������� 144 Marine Bank v Weaver 455 US 551 (1982)������������������������������������������������������������������������������������������ 684 Maxson v Ashland Iron Works 85 Ore 345 (1917)������������������������������������������������������������������������������ 158 Midland-Guardian Co v Hagin 370 So 2d, 25(1979)���������������������������������������������������������������������������� 33 Murray v Butte-Monitor Tunnel Min Co 41 Mont 449 (1910)���������������������������������������������������������� 159

xxx  Table of Cases

National Live Stock Bank v First Nat’l Bank of Geneseo 203 US 296 (1906)�������������������������������������� 33 Nationsbank of North Carolina v Variable Annuity Life Insurance Co 115 Sup Ct 810 (1995)������ 652 Nebraska Dept of Revenue v Loewenstein 115 SCt 557 (1994)���������������������������������������������������������� 140 Newell Bros v Hanson 97 Vt 297 (1924)���������������������������������������������������������������������������������������������� 161 Newhall v Kingsbury 131 Mass 445 (1881)����������������������������������������������������������������������������������������� 161 Oriental Pac (US) Inc v Toronto Dominion Bank 357 NYS2d 957 (NY 1974)����������������������������������� 24 Otto v Lincoln Savings Bank 51 NYS 2nd 561 (1944)������������������������������������������������������������������������ 392 Paris v Vail 18 Vt 277 (1846)���������������������������������������������������������������������������������������������������������������� 162 Perkins v Metter 126 Cal 100 (1899)���������������������������������������������������������������������������������������������������� 159 Peter Water Wheel Co v Oregon Iron & Steel Co 87 Or 248 (1918)�������������������������������������������������� 161 Pfeiffer v Norman 22 ND 168 (1911)�������������������������������������������������������������������������������������������������� 157 Phillips v Hollenburg Music Co 82 Ark 9 (1907)�������������������������������������������������������������������������������� 160 Pittsburgh Industrial Iron Works, Re 179 Fed 151 (1910)������������������������������������������������������������������ 162 Prentiss Tool & Supply Co v Schirmer 136 NY 305 (1892)���������������������������������������������������������������� 163 Reese v Beck 24 Ala 651 (1854)������������������������������������������������������������������������������������������������������������ 158 Rodgers v Rachman 109 Cal 552 (1895)���������������������������������������������������������������������������������������������� 161 RTC v Aetna Cas & Sur Co of Illinois 25 F 3d 570, 578–80 (7th Cir, 1994)�������������������������������������� 489 Savall v Wauful 16 NY Supp 219 (1890)���������������������������������������������������������������������������������������������� 163 Scott v Farnam 55 Wash 336 (1909)���������������������������������������������������������������������������������������������������� 157 Sears, R & Co v Higbee 225 Ill App 197 (1922)����������������������������������������������������������������������������������� 159 SEC v WJ Howey Co 328 US 293 (1946)��������������������������������������������������������������������������������������������� 683 Sinclair v Holt 88 Nev 97 (1972)������������������������������������������������������������������������������������������������������������ 33 Smith v Gufford 36 Fla 481(1895)������������������������������������������������������������������������������������������������������� 161 Smith v Long Cigar & Grocery Co 21 Ga App 730 (1917)����������������������������������������������������������������� 163 Sound of Market Street, Inc v Continental Bank International 819 F 2d 384 (1987)����������������������� 432 Spina v Toyota Motor Credit Corp 703 NE 2d 484(1998)������������������������������������������������������������������ 472 State ex rel Malin Yates Co v Justice of the Peace Ct 51 Mont 133 (1915)����������������������������������������� 159 State v Automobile 122 Me 280(1925)������������������������������������������������������������������������������������������������� 161 State v White Furniture Co 206 Ala 575 (1921)���������������������������������������������������������������������������������� 160 Swann Davis Co v Stanton 7 Ga App 688 (1910)�������������������������������������������������������������������������������� 161 Thayer v Yakima Tire Service Co 116 Wash 299 (1921)���������������������������������������������������������������������� 161 Thomas Furniture Co v T&C Furniture Co >120 Ga 879 (1909)������������������������������������������������������ 162 Tufts v Stone 70 Miss 54 (1892)����������������������������������������������������������������������������������������������������������� 158 Undercofler v Whiteway Neon Ad Inc 152 SE Ed 616, 618 (1966)����������������������������������������������������� 145 Union Machinery & Supply Co v Thompson 98 Wash 119 (1917)���������������������������������������������������� 163 Van Bommel v Irving Trust Co (In re Hoyt) 47 F2d 654 (SDNY 1931)�������������������������������������������� 470 Van Marel v Watson 235 Pac 144 (1925)��������������������������������������������������������������������������������������������� 161 Whitsett v Carney 124 SW 443 (1910)������������������������������������������������������������������������������������������������� 158 Winton Motor Carriage Co v Blomberg >84 Wash 451 (1915)��������������������������������������������������������� 158 Young v Phillips 202 Mich 480 (1918)������������������������������������������������������������������������������������������������� 159

Table of Legislation and Related Documents Australia Payment System and Netting Act 1998, s 16���������������������������������������������������������������������������������������� 401

Belgium Bankruptcy Act 1997, Art 101���������������������������������������������������������������������������������������������������������������� 92 CC (Civil Code), Art 1690�������������������������������������������������������������������������������������������������������������� 77, 100

Canada Charter of Rights 1985�������������������������������������������������������������������������������������������������������������������������� 676 Uniform Personal Property Security Act 1982������������������������������������������������������������������������������������ 253

European Union Accounting Modernisation Directive�������������������������������������������������������������������������������������������������� 828 Accounting Regime Directive 2013/34/EU������������������������������������������������������������������������������������������ 876 Admission Directive���������������������������������������������������������������������������������������������������������������� 812–14, 827 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 812 Art 10������������������������������������������������������������������������������������������������������������������������������������������������� 812 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 813 Alternative Investment Fund Management Directive (AIFMD)������������������ 50, 354, 357, 571, 643, 645, 815, 826, 852, 868, 876, 885–86, 898, 902, 924 Art 4(1)���������������������������������������������������������������������������������������������������������������������������������������������� 467 Bankruptcy Regulation 1346/2000��������������������������������������������������������������������������������������������������� 71, 73 Art 2(g)���������������������������������������������������������������������������������������������������������������������������������������� 73, 233 BRRD (Bank Recovery and Resolution Directive)��������������������������������������������������563–64, 638–39, 668, 879, 895–97, 915 Preamble������������������������������������������������������������������������������������������������������������������������������������ 910, 918 Art 2(1)(44)��������������������������������������������������������������������������������������������������������������������������������������� 897 Art 27������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 31(2)�������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 32(1)(c)��������������������������������������������������������������������������������������������������������������������������������������� 897 Art 32(5)������������������������������������������������������������������������������������������������������������������������������������ 897, 918 Art 34������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 34(1)(f)��������������������������������������������������������������������������������������������������������������������������������������� 897 Art 34(1)(g)��������������������������������������������������������������������������������������������������������������������������������������� 897 Art 36������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 37(100)���������������������������������������������������������������������������������������������������������������������������������������� 897 Art 37(3)�������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 37(9)�������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 44������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 44(3)������������������������������������������������������������������������������������������������������������������������������������ 915, 918 Art 88������������������������������������������������������������������������������������������������������������������������������������������������� 897

xxxii  Table of Legislation and Related Documents

Art 91������������������������������������������������������������������������������������������������������������������������������������������������� 898 Art 92������������������������������������������������������������������������������������������������������������������������������������������������� 898 Brussels Convention����������������������������������������������������������������������������������������������������������������������������� 405 Art 16(5)�������������������������������������������������������������������������������������������������������������������������������������������� 182 Capital Adequacy Directive������������������������������������������������������������������� 643, 767, 773, 787, 818, 851, 879 Capital Requirements Directives������������������������������������������������������������������ 515, 519, 529, 561, 585, 605, 615, 631, 643, 774, 799, 851, 853, 857, 859, 878–80, 900, 903, 907, 921, 923 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 918 Art 1(21)�������������������������������������������������������������������������������������������������������������������������������������������� 853 Art 17������������������������������������������������������������������������������������������������������������������������������������������������� 923 Art 35������������������������������������������������������������������������������������������������������������������������������������������� 923–24 Art 36������������������������������������������������������������������������������������������������������������������������������������������������� 924 Art 36(1)�������������������������������������������������������������������������������������������������������������������������������������������� 924 Art 36(1)–(3)������������������������������������������������������������������������������������������������������������������������������������� 923 Art 37������������������������������������������������������������������������������������������������������������������������������������������������� 923 Art 39������������������������������������������������������������������������������������������������������������������������������������������������� 924 Arts 40–46����������������������������������������������������������������������������������������������������������������������������������������� 923 Art 43������������������������������������������������������������������������������������������������������������������������������������������������� 923 Art 47������������������������������������������������������������������������������������������������������������������������������������������������� 898 Art 48������������������������������������������������������������������������������������������������������������������������������������������������� 898 Art 49������������������������������������������������������������������������������������������������������������������������������������������������� 923 Arts 74–75����������������������������������������������������������������������������������������������������������������������������������������� 923 Art 92������������������������������������������������������������������������������������������������������������������������������������������� 917–18 Art 131����������������������������������������������������������������������������������������������������������������������������������������������� 792 CARD (Consolidated Admission and Reporting Directive)����������������� 689, 758, 812, 814, 827, 846–47, 850, 864, 921 Art 8������������������������������������������������������������������������������������������������������������������������������������������� 847, 849 Central Securities Depository Regulation������������������������������������������������������������������������������������� 885–86 Charter of Fundamental Rights��������������������������������������������������������������������������������������������562, 915, 918 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 909 Art 52����������������������������������������������������������������������������������������������������������������������������������������� 911, 916 Collateral Directive 2002/47/EC����������������������������������������������������������� 10, 47, 49–50, 53, 61, 79, 98, 100, 153, 193, 196–97, 205, 214–15, 401, 404, 412, 467, 472, 478, 481, 483, 492, 502, 504, 828, 863, 904 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 481 Art 2(1)(a)����������������������������������������������������������������������������������������������������������������������������������������� 467 Art 2(1)(d)���������������������������������������������������������������������������������������������������������������������������������������� 481 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 482 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 482 Consolidated Supervision Directive������������������������������������������������������������������������������������������������ 808–9 Consolidation of the Capital Requirements for Banks and Investment Firms Regulation (CCR)�������������������������������������������������������������������������������������������������������880, 921, 923 Consumer Credit Directive (87/101) Art 4(3)�������������������������������������������������������������������������������������������������������������������������49, 643, 861, 864 Art 7����������������������������������������������������������������������������������������������������������������������������������������������������� 49 Ann I���������������������������������������������������������������������������������������������������������������������������������������������������� 49 Consumer Rights Directive 2011��������������������������������������������������������������������������������������������������������� 860

Table of Legislation and Related Documents xxxiii

CRA Directive (CRAD)������������������������������������������������������������������������������������������������������������������������ 894 Credit Institutions Directives����������������������������������������������������������������� 533, 548, 592, 667–68, 731, 742, 751–52, 767, 776, 787, 794–95, 808–9, 817, 822, 824, 831, 835, 851, 853–54, 857, 859, 879–80, 896 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 648 Art 1(2)���������������������������������������������������������������������������������������������������������������������������������������������� 836 Arts 6ff����������������������������������������������������������������������������������������������������������������������������������������������� 831 Art 23����������������������������������������������������������������������������������������������������������������������������������������� 822, 833 Art 24������������������������������������������������������������������������������������������������������������������������������������������������� 833 Art 25(2) and (3)������������������������������������������������������������������������������������������������������������������������������ 834 Art 26������������������������������������������������������������������������������������������������������������������������������������������������� 834 Art 26(1)�������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 27������������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 834 Art 29������������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 31������������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 33������������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 37������������������������������������������������������������������������������������������������������������������������������������������������� 832 Art 40������������������������������������������������������������������������������������������������������������������������������������������������� 831 Art 42������������������������������������������������������������������������������������������������������������������������������������������������� 667 Art 47������������������������������������������������������������������������������������������������������������������������������������������������� 823 Art 48������������������������������������������������������������������������������������������������������������������������������������������������� 823 Art 132����������������������������������������������������������������������������������������������������������������������������������������������� 667 Art 139����������������������������������������������������������������������������������������������������������������������������������������������� 667 Credit Rating Agency Regulation (CRAR)�����������������������������������������������������������876, 878, 886, 894, 904 Art 35(a)�������������������������������������������������������������������������������������������������������������������������������������������� 894 Cross-Border Insolvency Regulation 1346/2000��������������������������������������������������������������������������� 73, 854 DCFR (Draft Common Frame of Reference)������������������������������������������������������49, 61, 74–75, 118, 156, 172, 194, 196, 207, 214, 217, 269, 412, 724 Deposit Protection Directive 94/19/EEC��������������������������������������������������������������������������������������������� 853 Directive 70/50, Art 3���������������������������������������������������������������������������������������������������������������������������� 741 Directive 2000/35/EC combating late payment in commercial transactions�������������������������������������� 49 Art 4(3)������������������������������������������������������������������������������������������������������������������������������������������������ 49 Directive 2006/73/EC���������������������������������������������������������������������������������������������������������������������������� 839 Art 19������������������������������������������������������������������������������������������������������������������������������������������������� 467 Directive 2009/111/EC���������������������������������������������������������������������������������������������������643, 853, 857, 879 Art 1(30)�������������������������������������������������������������������������������������������������������������������������������������������� 519 Art 122(a)������������������������������������������������������������������������������������������������������������������������������������������ 519 Directive 2010/78/EU��������������������������������������������������������������������������������������������������������������������������� 877 Directive 2017/593/EU����������������������������������������������������������������������������������������������������������������� 852, 880 Directive on consumer protection in the indication of prices 98/06/EC������������������������������������������� 860 Directive on financial collateral������������������������������������������������������������������������������������������������������ 50, 207 Directive on free movement of capital and money 88/361 EEC���������������������������� 757–58, 760–61, 804 Art 5(6)���������������������������������������������������������������������������������������������������������������������������������������������� 759 Directive on insider dealing 89/592/EEC��������������������������������������������������������������������������������������������� 821 Directive on money laundering 91/308/EEC�������������������������������������������������������������������������������������� 821 Directive on tax co-operation 77/799/EEC����������������������������������������������������������������������������������������� 759 Directive on taxation of savings income 2003/48/EC����������������������������������������������������������������� 758, 760

xxxiv  Table of Legislation and Related Documents

Directive on the activities and supervision of institutions for occupational retirement provision 2003/41/EC������������������������������������������������������������������������������������������������������� 354, 856 Directive on the prevention of the use of the financial system for the purpose of money laundering����������������������������������������������������������������������������������������������������������������� 454 Art 3��������������������������������������������������������������������������������������������������������������������������������������������������� 455 Art 6��������������������������������������������������������������������������������������������������������������������������������������������������� 455 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 455 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 455 Art 11������������������������������������������������������������������������������������������������������������������������������������������������� 455 Art 13������������������������������������������������������������������������������������������������������������������������������������������������� 455 Directive on the sale of consumer goods and associated guarantees 98/44/EC�������������������������������� 860 Distance Selling Directive 97/7/EC������������������������������������������������������������������������������������������������������ 860 E-commerce Directive�������������������������������������������������������������������������������������������������������������������� 859–60 Art 3������������������������������������������������������������������������������������������������������������������������������������������� 701, 859 Art 3(4)(a)(iii)���������������������������������������������������������������������������������������������������������������������������������� 859 EBA Regulation (EU) No 1093/2010��������������������������������������������������������������������������������������������������� 877 EBRD Model Law on Secured Transactions������������������������������������������������������������������������������������������ 50 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 150 Art 1.1������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 1.2������������������������������������������������������������������������������������������������������������������������������������������������ 189 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 189 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 189 Art 4.3.4��������������������������������������������������������������������������������������������������������������������������������������������� 189 Art 4.4������������������������������������������������������������������������������������������������������������������������������������������������ 189 Art 4.5������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 5.4������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 5.7������������������������������������������������������������������������������������������������������������������������������������������������ 190 Arts 5.8–5.9��������������������������������������������������������������������������������������������������������������������������������������� 190 Art 5.9������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 6.8������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 8.1������������������������������������������������������������������������������������������������������������������������������������������������ 190 Art 9������������������������������������������������������������������������������������������������������������������������������������������� 150, 189 Art 12.1���������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 17������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 17.3���������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 18(1)�������������������������������������������������������������������������������������������������������������������������������������������� 150 Art 21������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 24������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 24(1)�������������������������������������������������������������������������������������������������������������������������������������������� 150 Art 26������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 190 Art 28.3.6������������������������������������������������������������������������������������������������������������������������������������������� 190 ECB Statute, Art 18.1���������������������������������������������������������������������������������������������������������������������������� 494 ESFS Regulation Art 1(2)���������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 16������������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 18������������������������������������������������������������������������������������������������������������������������������������������������� 889

Table of Legislation and Related Documents xxxv

ESMA Regulation (EU) No 1095/2010������������������������������������������������������������������������������������������������ 877 ESRB Regulation (EU) No 1092/2010��������������������������������������������������������������������������510, 559, 877, 897 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 564 Art 2(c)���������������������������������������������������������������������������������������������������������������������������������������������� 510 European Contract Principles (PECL)������������������������������������������������������������������������������������������������ 412 European Insurance and Occupational Pension Authority Regulation (EU) No 1094/2010����������� 877 European Market Infrastructure Regulation (EMIR)��������������������������������� 301, 317, 323, 327, 330, 518, 542, 643, 645, 703, 845, 865, 868, 876, 878, 880–86, 893, 900–2, 904, 921, 923, 926 Art 2(1)���������������������������������������������������������������������������������������������������������������������������������������������� 324 Art 2(3)���������������������������������������������������������������������������������������������������������������������������������������������� 324 Art 12(3)�������������������������������������������������������������������������������������������������������������������������������������������� 884 Financial Conglomerate Directive������������������������������������������������������������������������������������������������� 858–59 First Banking Directive������������������������������������������������������������������������������������533, 808–10, 816, 846, 856 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 648 Art 4(1)���������������������������������������������������������������������������������������������������������������������������������������������� 816 First Consolidated Banking Supervision Directive����������������������������������������������������������������������������� 592 Fiscal Stability Treaty�������������������������������������������������������������������������������������������������������������������� 875, 907 Fourth Company Directive������������������������������������������������������������������������������������������������������������������� 828 Fourth Money Laundering Directive��������������������������������������������������������������������������������������������������� 456 Insurance Directives���������������������������������������������������������������������������������������������������������������������� 742, 808 Investment Services Directive�������������������������������������������������������� 548, 668, 684–85, 687, 710, 714, 716, 723–24, 731, 742, 760, 762, 767, 806, 808, 815, 817–20, 823–24, 827, 830, 833–36, 838–39, 842–43, 846, 849, 851, 857, 859 Preamble�����������������������������������������������������������������������������������������������������������������������������548, 668, 838 Art 1(1)���������������������������������������������������������������������������������������������������������������������������������������������� 834 Art 1(13)�������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 1(2)���������������������������������������������������������������������������������������������������������������������������������������������� 834 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 2(1)���������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 2(2)���������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 3��������������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 3(3)���������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 3(4)���������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 3(7)(e)����������������������������������������������������������������������������������������������������������������������������������������� 837 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 822 Art 10������������������������������������������������������������������������������������������������������������������������������������������� 837–39 Art 11��������������������������������������������������������������������������������������������������������������������������� 548, 838–39, 860 Art 11(2)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 11(3)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 13������������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 14(3)�������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 14(4)�������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 843 Art 15(3)�������������������������������������������������������������������������������������������������������������������������������������������� 843 Art 15(4)�������������������������������������������������������������������������������������������������������������������������������������������� 843 Art 16������������������������������������������������������������������������������������������������������������������������������������������������� 843

xxxvi  Table of Legislation and Related Documents

Art 17(4)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 18(2)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 19(2)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 19(4)�������������������������������������������������������������������������������������������������������������������������������������� 838–39 Art 19(6)�������������������������������������������������������������������������������������������������������������������������������������������� 838 Art 20������������������������������������������������������������������������������������������������������������������������������������������������� 843 Art 21������������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 21(2)�������������������������������������������������������������������������������������������������������������������������������������������� 843 Art 24������������������������������������������������������������������������������������������������������������������������������������������� 838–39 Large Exposures Directive 92/121/EEC����������������������������������������������������������������������������������������������� 853 Art 6��������������������������������������������������������������������������������������������������������������������������������������������������� 853 Listing Particulars Directive����������������������������������������������������������������������������������������������������������� 812–14 Market Abuse Directive (MAD)����������������������������������������������������������������������������579, 643, 830, 852, 881 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 581 Market Abuse Regulation (MAR)��������������������������������������������������������� 581, 852, 876, 878, 881, 921, 927 MiFID (Markets in Financial Instruments Directive)�������������������������������� 548, 583, 643, 668, 685, 687, 695, 699, 709–10, 714, 716, 723–24, 731, 742, 762, 808, 817–20, 824, 826–28, 830, 835–45, 847, 849, 852, 857, 859, 867, 880–82, 886, 921 Preamble�����������������������������������������������������������������������������������������������������������������������������835, 841, 843 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 1(1)���������������������������������������������������������������������������������������������������������������������������������������������� 836 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 4(1)���������������������������������������������������������������������������������������������������������������������������������������������� 835 Art 4(1)(26)��������������������������������������������������������������������������������������������������������������������������������������� 842 Art 4(1)(7)����������������������������������������������������������������������������������������������������������������������������������������� 836 Art 4(1)(8)����������������������������������������������������������������������������������������������������������������������������������������� 836 Art 4(15)�������������������������������������������������������������������������������������������������������������������������������������������� 836 Art 4(18)�������������������������������������������������������������������������������������������������������������������������������������������� 684 Art 4(2)���������������������������������������������������������������������������������������������������������������������������������������������� 835 Arts 5–15������������������������������������������������������������������������������������������������������������������������������������������� 836 Art 5(1)���������������������������������������������������������������������������������������������������������������������������������������������� 699 Art 5(2)�������������������������������������������������������������������������������������������������������������������������������� 836–37, 843 Art 5(2)`��������������������������������������������������������������������������������������������������������������������������������������������� 699 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 11����������������������������������������������������������������������������������������������������������������������������������������� 836, 843 Art 12������������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 13����������������������������������������������������������������������������������������������������������������������������������� 836–37, 844 Art 13(7)�������������������������������������������������������������������������������������������������������������������������������������������� 467 Art 14����������������������������������������������������������������������������������������������������������������������������������� 836–37, 844 Art 14(1)�������������������������������������������������������������������������������������������������������������������������������������������� 836 Art 15����������������������������������������������������������������������������������������������������������������������������������822, 836, 843 Art 19������������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 21������������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 21(2)�������������������������������������������������������������������������������������������������������������������������������������������� 840 Art 22����������������������������������������������������������������������������������������������������������������������������������������� 842, 844 Art 24������������������������������������������������������������������������������������������������������������������������������������������������� 845 Art 24(1)�������������������������������������������������������������������������������������������������������������������������������������������� 836 Art 25������������������������������������������������������������������������������������������������������������������������������������������������� 842

Table of Legislation and Related Documents xxxvii

Art 27����������������������������������������������������������������������������������������������������������������������������������� 841–42, 844 Art 28������������������������������������������������������������������������������������������������������������������������������������������� 841–42 Art 29����������������������������������������������������������������������������������������������������������������������������������699, 837, 844 Art 30����������������������������������������������������������������������������������������������������������������������������������699, 837, 844 Art 31����������������������������������������������������������������������������������������������������������������������������������������� 835, 837 Art 31(2)�������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 31(5)������������������������������������������������������������������������������������������������������������������������������������ 699, 843 Art 31(6)������������������������������������������������������������������������������������������������������������������������������������ 699, 843 Art 32������������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 32(7)�������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 33������������������������������������������������������������������������������������������������������������������������������������������������� 837 Art 34����������������������������������������������������������������������������������������������������������������������������������������� 837, 845 Art 35������������������������������������������������������������������������������������������������������������������������������������������������� 837 Arts 36ff��������������������������������������������������������������������������������������������������������������������������������������������� 699 Art 44������������������������������������������������������������������������������������������������������������������������������������������������� 844 Art 45������������������������������������������������������������������������������������������������������������������������������������������������� 844 Art 45(5)�������������������������������������������������������������������������������������������������������������������������������������������� 840 Art 46(1)�������������������������������������������������������������������������������������������������������������������������������������������� 840 Arts 56ff��������������������������������������������������������������������������������������������������������������������������������������������� 668 Art 61������������������������������������������������������������������������������������������������������������������������������������������������� 842 Art 62������������������������������������������������������������������������������������������������������������������������������������������������� 842 Ann I�������������������������������������������������������������������������������������������������������������������������������������������������� 835 MiFID II Directive������������������������������������������������������������������ 548, 574, 684–85, 695, 700, 731, 742, 808, 817–18, 820, 824, 876, 880–82, 884, 886, 889–90, 899–902, 921, 923–28 Preamble���������������������������������������������������������������������������������������������������������������������700, 823, 898, 925 Art 2(1)(b)��������������������������������������������������������������������������������������������������������������������������������� 700, 925 Art 4(1)(1)����������������������������������������������������������������������������������������������������������������������������������������� 923 Art 4(1)(38)������������������������������������������������������������������������������������������������������������������������������� 700, 925 Art 4(1)(44)��������������������������������������������������������������������������������������������������������������������������������������� 889 Art 4(44)�������������������������������������������������������������������������������������������������������������������������������������������� 685 Art 4(49)�������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 5(2)���������������������������������������������������������������������������������������������������������������������������������������������� 925 Art 16(3)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 24��������������������������������������������������������������������������������������������������������������������������710, 881, 904, 927 Art 24(2)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 25������������������������������������������������������������������������������������������������������������������������������������������������� 710 Art 27������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 927 Arts 39ff������������������������������������������������������������������������������������������������������������������������������������� 823, 898 Art 69(2)������������������������������������������������������������������������������������������������������������������������������������ 906, 927 Ann I���������������������������������������������������������������������������������������������������������������������������700, 889, 923, 925 MiFIR (MiFID Implementing Regulation)��������������������������������������������������������� 742, 817, 876, 880, 886, 889–90, 899, 902, 921, 923 Preamble�����������������������������������������������������������������������������������������������������������������������������823, 898, 927 Art 2(1)(29)��������������������������������������������������������������������������������������������������������������������������������������� 889 Art 2(1)(d)�������������������������������������������������������������������������������������������������������������������������������� 700, 925 Art 3��������������������������������������������������������������������������������������������������������������������������������������������� 926–27 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 926 Arts 4ff����������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 927

xxxviii  Table of Legislation and Related Documents

Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 10������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 12������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 13������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 18������������������������������������������������������������������������������������������������������������������������������������������������� 927 Art 39������������������������������������������������������������������������������������������������������������������������������������������������� 900 Art 40������������������������������������������������������������������������������������������������������������������������������������������������� 889 Arts 40–42����������������������������������������������������������������������������������������������������������������������������������������� 889 Art 40(3)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 40(8)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 41������������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 41(3)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 41(7)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 41(8)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 42������������������������������������������������������������������������������������������������������������������������������������������������� 889 Art 42(2)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 42(6)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 42(7)�������������������������������������������������������������������������������������������������������������������������������������������� 890 Art 46������������������������������������������������������������������������������������������������������������������������������������������������� 900 Art 46(1)������������������������������������������������������������������������������������������������������������������������������������ 823, 898 Art 47������������������������������������������������������������������������������������������������������������������������������������������������� 900 Art 50������������������������������������������������������������������������������������������������������������������������������������������������� 890 Mortgage Credit Directive (MCD)���������������������������������������������������������������������������������������������� 643, 863 Mutual Recognition Directive������������������������������������������������������������������������������������������������ 812–13, 846 Own Funds Directive�������������������������������������������������������������������������������������������������������������767, 817, 851 Payment Services Directive����������������������������������������������������������������������������������������������������� 643, 863–64 Prospectus Directives������������������������������������������������������������������������ 541–42, 548, 575, 584, 689–90, 693, 705, 719, 762, 812–14, 819, 826–28, 830, 846, 849, 876, 894 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 846 Art 2(1)���������������������������������������������������������������������������������������������������������������������������������������������� 690 Art 2(1)(c)(iii)����������������������������������������������������������������������������������������������������������������������������������� 847 Art 2(1)(d)���������������������������������������������������������������������������������������������������������������������������������������� 847 Art 2(1)(m)��������������������������������������������������������������������������������������������������������������������������������������� 849 Art 2(4)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 2(a)���������������������������������������������������������������������������������������������������������������������������������������������� 684 Art 3��������������������������������������������������������������������������������������������������������������������������������������������������� 847 Art 3(2)���������������������������������������������������������������������������������������������������������������������������������������������� 847 Art 3(f)�������������������������������������������������������������������������������������������������������������������������������������� 690, 728 Art 4(1)���������������������������������������������������������������������������������������������������������������������������������������������� 847 Art 4(2)���������������������������������������������������������������������������������������������������������������������������������������������� 847 Art 5(1)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 5(2)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 5(2)(d)���������������������������������������������������������������������������������������������������������������������������������������� 848 Art 5(3)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 5(4)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 5(5)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 7(2)(e)����������������������������������������������������������������������������������������������������������������������������������������� 848 Art 9(1)���������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 10(4)�������������������������������������������������������������������������������������������������������������������������������������������� 848

Table of Legislation and Related Documents xxxix

Art 11(3)�������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 13(1)�������������������������������������������������������������������������������������������������������������������������������������������� 849 Art 14(1)�������������������������������������������������������������������������������������������������������������������������������������������� 849 Art 14(8)�������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 15(7)�������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 16(1)�������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 17(1)�������������������������������������������������������������������������������������������������������������������������������������������� 849 Art 19(2)�������������������������������������������������������������������������������������������������������������������������������������������� 849 Art 19(3)�������������������������������������������������������������������������������������������������������������������������������������������� 849 Art 20������������������������������������������������������������������������������������������������������������������������������������������������� 902 Art 20(3)�������������������������������������������������������������������������������������������������������������������������������������������� 848 Art 21(3)(a)��������������������������������������������������������������������������������������������������������������������������������������� 849 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 846 Art 29������������������������������������������������������������������������������������������������������������������������������������������������� 846 Prospectus Regulation 2017����������������������������������������������������������������������������������575, 684, 689, 693, 826 Art 1(4)���������������������������������������������������������������������������������������������������������������������������������������������� 894 Art 2(a)���������������������������������������������������������������������������������������������������������������������������������������������� 684 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 895 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 894 Art 13������������������������������������������������������������������������������������������������������������������������������������������������� 894 Art 14������������������������������������������������������������������������������������������������������������������������������������������������� 895 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 895 Art 23������������������������������������������������������������������������������������������������������������������������������������������������� 895 Regular Financial Reporting of Listed Companies Directive������������������������������������������������������������� 813 Regulation 17���������������������������������������������������������������������������������������������������������������������������������������� 749 Regulation (EC) No 1103/97, Art 3������������������������������������������������������������������������������������������������������ 423 Regulation (EC) No 1287/2006������������������������������������������������������������������������������������������������������������ 839 Regulation (EU) No 1096/2010������������������������������������������������������������������������������������������������������������ 877 Regulation (EU) No 260/2012 establishing technical requirements for credit transfers and direct debits in euro����������������������������������������������������������������������������������������������������������� 864 Regulation (EU) No 575/2013���������������������������������������������������������������������������794–95, 799, 817–18, 858 Regulation (EU) No 876/2013�������������������������������������������������������������������������������������������������������� 884–85 Regulation (EU) No 1024/2013 conferring specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions����������������������������� 876, 907 Regulation (EU) No 285/2014�������������������������������������������������������������������������������������������������������������� 885 Regulation (EU) No 2015/2365������������������������������������������������������������������������������������������������������������ 893 Regulation (EU) No 2016/892������������������������������������������������������������������������������������������������������ 852, 880 Regulation (EU) No 2017/565, Art 8(e)����������������������������������������������������������������������������������������������� 889 Regulation on jurisdiction and enforcement of judgments in civil and commercial matters (Brussels I) 2002, Art 22(5)����������������������������������������������������������182, 405, 408, 424, 751 Regulation on prudential requirements for credit institutions and investment firms (CRR) (EU) No 575/2013�������������������������������������������������������������������������������561, 817, 852, 879–80, 903, 907 Art 4(1)���������������������������������������������������������������������������������������������������������������������������������������������� 648 Art 4(1)(1)����������������������������������������������������������������������������������������������������������������������������������������� 923 Regulation on short selling and certain aspects of credit default swaps�������������������������������������� 886–89 Regulation on the law applicable to contractual obligations (Rome I) 2008������������232, 256, 297, 335, 338, 411, 447, 752 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 233 Art 4(1)(h)���������������������������������������������������������������������������������������������������������������������������������������� 411 Art 6��������������������������������������������������������������������������������������������������������������������������������������������������� 833

xl  Table of Legislation and Related Documents

Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 418 Art 12������������������������������������������������������������������������������������������������������������������������������������������������� 411 Art 12(1)(d)�������������������������������������������������������������������������������������������������������������������������������������� 407 Art 14����������������������������������������������������������������������������������������������������������������������������������188, 238, 297 Art 14(1)�������������������������������������������������������������������������������������������������������������������������������������������� 232 Art 14(1) and (2)������������������������������������������������������������������������������������������������������������������������������ 231 Art 17������������������������������������������������������������������������������������������������������������������������������������� 407–9, 411 Rome Convention on the Law Applicable to Contractual Obligations 1980����������������25, 188, 231–33, 256, 407, 411, 447 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 752 Art 10(1)(d)�������������������������������������������������������������������������������������������������������������������������������������� 407 Art 12����������������������������������������������������������������������������������������������������������������������������������������� 232, 238 Art 12(1)�������������������������������������������������������������������������������������������������������������������������������������������� 232 Art 12(1) and (2)������������������������������������������������������������������������������������������������������������������������������ 231 Art 12(2)�������������������������������������������������������������������������������������������������������������������������������������� 232–33 Savings Tax Directive�������������������������������������������������������������������������������������������������������������757, 760, 928 Second Banking Directive��������������������������������������������������������������� 592, 668, 731, 742, 751–52, 760, 767, 806, 808, 811, 817, 823–24, 831–35, 837–38, 857 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 668 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 648 Art 6��������������������������������������������������������������������������������������������������������������������������������������������������� 856 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 822 Art 14������������������������������������������������������������������������������������������������������������������������������������������������� 856 Second Money Laundering Directive������������������������������������������������������������������������������������������ 456, 863 Securities Financing Transactions Regulation����������������������������������������������������������������������������� 503, 893 Securities Law Directive (SLD)���������������������������������������������������������������������������������������������� 867, 885–86 Settlement Finality Directive���������������������������������������������������������������������� 10, 50, 53, 153, 205, 397, 412, 465–66, 475, 478, 480, 482, 502, 828, 862–63, 867, 904 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 3��������������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 3(1) and (2)�������������������������������������������������������������������������������������������������������������������������������� 480 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 401 Art 9(1)���������������������������������������������������������������������������������������������������������������������������������������������� 480 Art 9(2)���������������������������������������������������������������������������������������������������������������������������������������������� 501 Seventh Company Directive����������������������������������������������������������������������������������������������������������������� 828 Short Selling Regulation�������������������������������������������������������������������������� 644–45, 876, 878, 902, 921, 926 Single European Act���������������������������������������������������������������������������������������������� 536, 743, 745, 748, 755, 804, 811, 823, 834 Solvency Directive����������������������������������������������������������������������������������������������������������767, 776, 817, 851 Ann 2������������������������������������������������������������������������������������������������������������������������������������������������� 851 SRM Regulation�������������������������������������������������������������������������������������������������������������� 564, 917, 919–20 Preamble������������������������������������������������������������������������������������������������������������������������������ 914–16, 918 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 18(1)(c)��������������������������������������������������������������������������������������������������������������������������������������� 639 Art 18(5)�������������������������������������������������������������������������������������������������������������������������������������������� 918 Art 27������������������������������������������������������������������������������������������������������������������������������������������������� 897

Table of Legislation and Related Documents xli

Art 27(5)������������������������������������������������������������������������������������������������������������������������������ 915, 917–18 Art 85������������������������������������������������������������������������������������������������������������������������������������������������� 897 Art 86������������������������������������������������������������������������������������������������������������������������������������������������� 897 SSM Regulation����������������������������������������������������������������������������������������������������������������������������� 548, 561 Preamble������������������������������������������������������������������������������������������������������������������������������������ 562, 913 Art 5������������������������������������������������������������������������������������������������������������������������560, 562, 908–9, 933 Art 5(1)���������������������������������������������������������������������������������������������������������������������������������������������� 913 Art 5(2)�������������������������������������������������������������������������������������������������������������������������������������� 909, 913 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 908 Art 14������������������������������������������������������������������������������������������������������������������������������������������������� 908 Art 22����������������������������������������������������������������������������������������������������������������������������������������� 562, 909 Art 24������������������������������������������������������������������������������������������������������������������������������������������������� 909 Takeover Bids Directive������������������������������������������������������������������������������������������������������������������ 861–62 Third Money Laundering Directive (2005/60/EC)����������������������������������������������������������������������������� 456 Transparency Directive������������������������������������������������������������������ 376, 548, 762, 814, 830, 850, 876, 921 Art 2(1)(i)������������������������������������������������������������������������������������������������������������������������������������������ 850 Treaty on European Union (TEU)����������������������������������������������������������������������������������������741, 743, 922 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 744 Art 3(b)���������������������������������������������������������������������������������������������������������������������������������������������� 748 Art 5������������������������������������������������������������������������������������������������������������������������������������������� 744, 917 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 747 Art 16������������������������������������������������������������������������������������������������������������������������������������������������� 829 Art 17������������������������������������������������������������������������������������������������������������������������������������������������� 829 Art 17(1)�������������������������������������������������������������������������������������������������������������������������������������������� 829 Art 50������������������������������������������������������������������������������������������������������������������������������������������������� 424 Treaty on the Functioning of the European Union (TFEU)������������������������������� 583, 741, 750, 816, 820, 829, 906–7, 922 Art 21(2)�������������������������������������������������������������������������������������������������������������������������������������������� 741 Art 26������������������������������������������������������������������������������������������������������������������������������������������������� 741 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 742 Arts 28ff������������������������������������������������������������������������������������������������������������������������������� 741–42, 804 Art 29������������������������������������������������������������������������������������������������������������������������������������������������� 742 Art 34����������������������������������������������������������������������������������������������������������������������������������� 741–42, 750 Arts 34ff��������������������������������������������������������������������������������������������������������������������������������������������� 741 Art 36����������������������������������������������������������������������������������������������������������������������������������������� 743, 804 Art 39������������������������������������������������������������������������������������������������������������������������������������������������� 753 Art 45����������������������������������������������������������������������������������������������������������������������������������������� 741, 753 Art 49��������������������������������������������������������������������������������������������������������������������������� 741, 752–53, 804 Art 52������������������������������������������������������������������������������������������������������������������������������������������������� 804 Art 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63(2)�������������������������������������������������������������������������������������������������������������������������������������������� 741 Art 107����������������������������������������������������������������������������������������������������������������������������������������������� 895 Art 114����������������������������������������������������������������������������������������������������������������������������������� 583, 905–6 Art 114(2)���������������������������������������������������������������������������������������������������������������������������741, 748, 753 Art 115����������������������������������������������������������������������������������������������������������������������������������������������� 756 Art 127(4)������������������������������������������������������������������������������������������������������������������������������������������ 828

xlii  Table of Legislation and Related Documents

Art 127(6)������������������������������������������������������������������������������������������������������������������������������������������ 828 Art 136����������������������������������������������������������������������������������������������������������������������������������������������� 907 Arts 228ff������������������������������������������������������������������������������������������������������������������������������������������� 744 Art 235����������������������������������������������������������������������������������������������������������������������������������������������� 747 Art 258��������������������������������������������������������������������������������������������������������������������������������������� 748, 829 Art 259����������������������������������������������������������������������������������������������������������������������������������������������� 748 Art 263��������������������������������������������������������������������������������������������������������������������������������� 748–49, 916 Art 267��������������������������������������������������������������������������������������������������������������������������������������� 749, 916 Art 288����������������������������������������������������������������������������������������������������������������������������������������������� 749 Art 290����������������������������������������������������������������������������������������������������������������������������������������������� 901 Art 291����������������������������������������������������������������������������������������������������������������������������������������������� 901 Art 294����������������������������������������������������������������������������������������������������������������������������������������������� 748 Art 340��������������������������������������������������������������������������������������������������������������������������������������� 909, 914 UCITS (Undertakings for Collective Investments in Transferable Securities) Directives����������������������������������������������������������������������������������� 346, 352, 354, 357, 643, 760, 812, 814–16, 829, 835, 852, 868, 876–77, 885 Preamble�������������������������������������������������������������������������������������������������������������������������������������������� 815 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 815 Art 14������������������������������������������������������������������������������������������������������������������������������������������������� 814 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 814 Art 22������������������������������������������������������������������������������������������������������������������������������������������������� 470 Art 44������������������������������������������������������������������������������������������������������������������������������������������������� 815 Art 45������������������������������������������������������������������������������������������������������������������������������������������������� 815

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Table of Legislation and Related Documents xliii

Art 1692����������������������������������������������������������������������������������������������������������������������������������������������� 33 Art 2011��������������������������������������������������������������������������������������������������������������������������������������������� 102 Arts 2011–2031��������������������������������������������������������������������������������������������������������������������������������� 102 Art 2014��������������������������������������������������������������������������������������������������������������������������������������������� 102 Art 2015��������������������������������������������������������������������������������������������������������������������������������������������� 102 Art 2018(2)���������������������������������������������������������������������������������������������������������������������������������������� 102 Art 2023��������������������������������������������������������������������������������������������������������������������������������������������� 102 Art 2062����������������������������������������������������������������������������������������������������������������������������������������������� 99 Art 2074����������������������������������������������������������������������������������������������������������������������������������������������� 99 Art 2075����������������������������������������������������������������������������������������������������������������������������������������������� 90 Art 2078��������������������������������������������������������������������������������������������������������������������������������������� 98, 126 Art 2085����������������������������������������������������������������������������������������������������������������������������������������������� 36 Art 2279����������������������������������������������������������������������������������������������������������������������������������������������� 92 Art 2367����������������������������������������������������������������������������������������������������������������������������������������������� 96 Art 2371����������������������������������������������������������������������������������������������������������������������������������������������� 97 Arts 2372-1–6�������������������������������������������������������������������������������������������������������������������������������������� 91 Art 2372–3������������������������������������������������������������������������������������������������������������������������������������������� 91 Arts 2488-1–6�������������������������������������������������������������������������������������������������������������������������������������� 91 CMF (Monetary and Financial Code)������������������������������������������������������������������������67, 101–2, 252, 401 Art L211��������������������������������������������������������������������������������������������������������������������������������������������� 100 Arts L213-43 to L214-49������������������������������������������������������������������������������������������������������������������� 100 Arts L214-43 to L214-49������������������������������������������������������������������������������������������������������������������� 101 Arts L313-7 to L313-11��������������������������������������������������������������������������������������������������������� 98–99, 252 Arts L313-23 to L313-35��������������������������������������������������������������������������������������������������������������������� 77 Art L431-7��������������������������������������������������������������������������������������������������������������������������������� 334, 393 Art L432-6������������������������������������������������������������������������������������������������������������������������������������������� 94 Art L432-7������������������������������������������������������������������������������������������������������������������������������������������� 95 Art L432-15����������������������������������������������������������������������������������������������������������������������������������������� 94 Code de Commerce Art 91��������������������������������������������������������������������������������������������������������������������������������������������������� 99 Art 109������������������������������������������������������������������������������������������������������������������������������������������������� 99 Art L311-3����������������������������������������������������������������������������������������������������������������������������������������� 372 Art L621-28��������������������������������������������������������������������������������������������������������������������������������������� 334 Decree 89-158��������������������������������������������������������������������������������������������������������������������������������������� 100 Decree 93-589��������������������������������������������������������������������������������������������������������������������������������������� 100 Decree 97-919��������������������������������������������������������������������������������������������������������������������������������������� 100 Decree 98-1015������������������������������������������������������������������������������������������������������������������������������������� 100 Financial Securities Act 2003���������������������������������������������������������������������������������������������������������������� 566 Law of 8 August 1913������������������������������������������������������������������������������������������������������������������������������ 91 Law of 21 April 1932������������������������������������������������������������������������������������������������������������������������������� 91 Law of 29 December 1934���������������������������������������������������������������������������������������������������������������������� 90 Law of 22 February 1944������������������������������������������������������������������������������������������������������������������������ 90 Law of 18 January 1951�������������������������������������������������������������������������������������������������������������������������� 90 Loi 66-455������������������������������������������������������������������������������������������������������������������������������������������������ 98 Loi 83-1, Art 47��������������������������������������������������������������������������������������������������������������������������������������� 94 Loi 87-416������������������������������������������������������������������������������������������������������������������������������������������������ 94 Loi 88-1201�������������������������������������������������������������������������������������������������������������������������������������������� 100 Loi 92-868������������������������������������������������������������������������������������������������������������������������������������������������ 94 Loi 93-1444�������������������������������������������������������������������������������������������������������������������������������������������� 100 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 334 Arts 12ff����������������������������������������������������������������������������������������������������������������������������������������������� 94

xliv  Table of Legislation and Related Documents

Loi 93-6�������������������������������������������������������������������������������������������������������������������������������������������������� 100 Loi 94-475������������������������������������������������������������������������������������������������������������������������������������������������ 96 Loi 96-597���������������������������������������������������������������������������������������������������������������������������������������� 94, 100 Loi 98-546���������������������������������������������������������������������������������������������������������������������������������������������� 100 Loi 2007-211������������������������������������������������������������������������������������������������������������������������������������������ 102 Loi 2010-658������������������������������������������������������������������������������������������������������������������������������������������ 103 Loi Dailly 1981�����������������������������������������������������������������������������������������������������77, 91, 98–101, 203, 210 Ordonnance no 2006–346 du 23 mars 2006 relative aux sûretés��������������������������������������������������������� 91

Germany Banking Act, s 1(1)�������������������������������������������������������������������������������������������������������������������������������� 648 Bankruptcy Act, s 54����������������������������������������������������������������������������������������������������������������������������� 392 BGB (Bürgerliches Gesetzbuch)������������������������������������������������������������50, 105–6, 108–10, 115, 155, 378 s 137��������������������������������������������������������������������������������������������������������������������������������������������������� 117 s 138��������������������������������������������������������������������������������������������������������������������������������������������������� 229 s 138(1)���������������������������������������������������������������������������������������������������������������������������������������������� 116 s 139��������������������������������������������������������������������������������������������������������������������������������������������������� 117 s 158��������������������������������������������������������������������������������������������������������������������������������������� 105, 108–9 ss 158–63������������������������������������������������������������������������������������������������������������������������������������������� 172 s 159��������������������������������������������������������������������������������������������������������������������������������������������������� 109 s 161������������������������������������������������������������������������������������������������������������������������������� 105, 108–9, 117 s 163��������������������������������������������������������������������������������������������������������������������������������������������������� 173 s 242��������������������������������������������������������������������������������������������������������������������������������������������������� 674 s 244(2)���������������������������������������������������������������������������������������������������������������������������������������������� 378 s 388������������������������������������������������������������������������������������������������������������������������������������387, 390, 392 s 389��������������������������������������������������������������������������������������������������������������������������������������������������� 390 s 398����������������������������������������������������������������������������������������������������������������������������������������������� 106–7 s 401����������������������������������������������������������������������������������������������������������������������������������������������������� 33 s 413��������������������������������������������������������������������������������������������������������������������������������������������������� 107 s 449������������������������������������������������������������������������������������������������������������������������������������������� 105, 154 s 566��������������������������������������������������������������������������������������������������������������������������������������������������� 252 s 870������������������������������������������������������������������������������������������������������������������������������������������� 113, 160 s 925(2)������������������������������������������������������������������������������������������������������������������������������������������������ 88 s 929��������������������������������������������������������������������������������������������������������������������������������������������������� 107 s 931������������������������������������������������������������������������������������������������������������������������������������������� 113, 160 s 932������������������������������������������������������������������������������������������������������������������������������������������� 107, 112 ss 932ff����������������������������������������������������������������������������������������������������������������������������������������������� 107 s 950��������������������������������������������������������������������������������������������������������������������������������������������������� 106 s 1229������������������������������������������������������������������������������������������������������������������������������������������������� 126 ss 1234ff��������������������������������������������������������������������������������������������������������������������������������������������� 126 Code of Civil Procedure, s 771������������������������������������������������������������������������������������������������������������� 163 Consumer Credit Act 1991, s 3(2)(1)��������������������������������������������������������������������������������������������������� 252 HGB (Commercial Code), s 340b�������������������������������������������������������������������������������������������������������� 114 Insolvency Act 1999�����������������������������������������������������������������������������������������������������������55, 96, 106, 205 s 47��������������������������������������������������������������������������������������������������������������������������������������������� 106, 111 s 50����������������������������������������������������������������������������������������������������������������������������������������������������� 111 s 51��������������������������������������������������������������������������������������������������������������������������������������������� 107, 111 s 91����������������������������������������������������������������������������������������������������������������������������������������������������� 109 s 94��������������������������������������������������������������������������������������������������������������������������������������������� 392, 401 s 96����������������������������������������������������������������������������������������������������������������������������������������������������� 392

Table of Legislation and Related Documents xlv

s 103������������������������������������������������������������������������������������������������������������������������������������������� 106, 163 ss 103–105����������������������������������������������������������������������������������������������������������������������������������������� 106 s 104����������������������������������������������������������������������������������������������������������������������������114, 494, 498, 500 s 104(2)���������������������������������������������������������������������������������������������������������������������������������������������� 393 s 104(3)���������������������������������������������������������������������������������������������������������������������������������������������� 393 s 107��������������������������������������������������������������������������������������������������������������������������������������������������� 163 s 107(1)�������������������������������������������������������������������������������������������������������������������������������������� 106, 109 s 173��������������������������������������������������������������������������������������������������������������������������������������������������� 111 Kapitalanlagegesellschaftsgesetz 1970�������������������������������������������������������������������������������������������������� 714 Reorganisation Act 1935, s 27(2)���������������������������������������������������������������������������������������������������������� 111

International Basel Concordat��������������������������������������������������������������� 587, 590–94, 668, 762, 810, 856, 898, 900, 924 Basel I��������������������������������������������������������������������������������������� 412, 517, 551–53, 562, 594, 597, 599–600, 607–8, 612, 624, 645, 657, 762–65, 767–72, 776–77, 780–81, 788, 790, 794, 797, 800, 817, 851, 869, 904, 919, 933 Basel II��������������������������������������������������������������������������������� 288, 421, 517, 535–36, 551–53, 562, 594–95, 599–601, 603, 607–8, 612–15, 624, 640, 645, 657, 763–72, 775, 777, 779–81, 783, 785–91, 794, 799–800, 817, 851, 879, 919, 933 Basel III������������������������������������������������������������������������������������ 503, 517–18, 520, 524, 547, 556, 559, 561, 563–64, 567, 569–70, 594, 598, 607, 613–15, 619, 628–29, 640–41, 643, 650, 657, 665, 670, 763, 765–68, 771, 773, 775, 779, 787–94, 800, 817–18, 851, 870, 875, 880, 933 Bretton Woods Agreements 1944�������������������������������������� 309, 419, 537, 593, 595, 734–35, 740–42, 757 CISG (Convention on the International Sale of Goods)��������������� 191, 235, 237, 240, 242, 257–59, 266 Art 1(1)(b)����������������������������������������������������������������������������������������������������������������������������������������� 235 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 236 Art 7(2)���������������������������������������������������������������������������������������������������������������������������������������������� 447 Council of Europe Criminal Law Convention on Corruption����������������������������������������������������������� 454 GATS (General Agreement on Trade in Services)�����������������������������������416, 582–83, 591, 635, 722–23, 735–40, 750, 804, 822–23, 896, 902 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 750 Art II(2)��������������������������������������������������������������������������������������������������������������������������������������������� 736 Art XV����������������������������������������������������������������������������������������������������������������������������������������������� 896 Art XVII:1������������������������������������������������������������������������������������������������������������������������������������������ 896 GATT (General Agreement on Tariffs and Trade)������������������������������������������416, 725, 731–34, 736–41, 757, 804, 821–22 Geneva Convention on Substantive Rules for Intermediated Securities 2009�������������������������� 187, 478 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 188 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 188 Art 11������������������������������������������������������������������������������������������������������������������������������������������������� 187 Art 31(3)©����������������������������������������������������������������������������������������������������������������������������������������� 187 Hague Convention on the Law Applicable to Agency������������������������������������������������������������������������� 447 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary����������������������������������������������������������������������������������65, 182, 478, 482 Hague Convention on the Law Applicable to Trusts and their Recognition����������66, 88, 104, 195, 256 ICC Uniform Rules for a Combined Transport Document 1991������������������������������������������������������ 436

xlvi  Table of Legislation and Related Documents

ICC Uniform Rules for Collection������������������������������������������������������������ 24, 428, 431, 434, 436, 446–48 Art 3(a)(iii)���������������������������������������������������������������������������������������������������������������������������������������� 428 Art 3(a)(iv)���������������������������������������������������������������������������������������������������������������������������������������� 428 ICC Uniform Rules for Contract Guarantees�������������������������������������������������������������������������������������� 447 ICC Uniform Rules for Demand Guarantees Art 2(b)���������������������������������������������������������������������������������������������������������������������������������������������� 447 Art 20������������������������������������������������������������������������������������������������������������������������������������������������� 447 IMF Articles of Agreement Art VIII���������������������������������������������������������������������������������������������������������������������������������������������� 419 Art VIII-2-a��������������������������������������������������������������������������������������������������������������������������������������� 419 Art VIII-2-b��������������������������������������������������������������������������������������������������������������������������������������� 419 Art XIV���������������������������������������������������������������������������������������������������������������������������������������������� 419 Art XXX-d����������������������������������������������������������������������������������������������������������������������������������������� 419 International Currency Options Market Terms���������������������������������������������������������������������������������� 401 International Foreign Exchange Master Agreement��������������������������������������������������������������������������� 401 International Opium Convention 1912����������������������������������������������������������������������������������������������� 454 ISDA Master Confirmation Agreement����������������������������������������������������������������������������������������������� 402 ISDA Swap and Derivatives Master Agreements������������������������������������� 4, 16, 19, 23, 281, 308, 324–25, 329–32, 337, 400–4, 410, 412, 868 Marrakesh Agreement��������������������������������������������������������������������������������������������������������������������������� 736 North American Free Trade Agreement (NAFTA)������������������������������������������������������������������������������ 738 OECD Multilateral Agreement on Investment (MAI)������������������������������������������������������������������������ 738 Overseas Securities Lenders Agreement����������������������������������������������������������������������������������������������� 401 PSA/ISMA Global Master Repurchase Agreement�������������������������������������������������23, 134, 412, 494, 500 Statute of the International Court of Justice, Art 38(1)���������������������������������������������������������������� 20, 764 TBMA/ISMA Master Agreement���������������������������������������������������������� 4, 11, 19, 401, 494, 499–502, 504 Art 1©������������������������������������������������������������������������������������������������������������������������������������������������ 500 Art 6(a)���������������������������������������������������������������������������������������������������������������������������������������������� 500 Art 6(i)����������������������������������������������������������������������������������������������������������������������������������������������� 500 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 500 Art 10(a)�������������������������������������������������������������������������������������������������������������������������������������������� 500 Art 10©���������������������������������������������������������������������������������������������������������������������������������������������� 500 Ann II������������������������������������������������������������������������������������������������������������������������������������������������ 500 TRIMS������������������������������������������������������������������������������������������������������������������������������������������� 736, 740 TRIPS��������������������������������������������������������������������������������������������������������������������������������������� 736, 739–40 UCP (Uniform Customs and Practice for Documentary Credits)��������23–24, 70, 431–38, 441, 445–48 Art 4������������������������������������������������������������������������������������������������������������������������������������������� 438, 446 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 438 Art 6(b)���������������������������������������������������������������������������������������������������������������������������������������������� 434 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 433 Art 8©(ii)������������������������������������������������������������������������������������������������������������������������������������������� 435 Art 9��������������������������������������������������������������������������������������������������������������������������������������������������� 432 Art 9(a)(iv)���������������������������������������������������������������������������������������������������������������������������������������� 435 Art 9(b)(iv)���������������������������������������������������������������������������������������������������������������������������������������� 435 Art 12������������������������������������������������������������������������������������������������������������������������������������������������� 432 Art 12©���������������������������������������������������������������������������������������������������������������������������������������������� 433 Art 13������������������������������������������������������������������������������������������������������������������������������������������������� 434 Art 14(b)�������������������������������������������������������������������������������������������������������������������������������������������� 433 Art 14©���������������������������������������������������������������������������������������������������������������������������������������������� 433 Arts 14ff��������������������������������������������������������������������������������������������������������������������������������������������� 432 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 446

Table of Legislation and Related Documents xlvii

Art 16(a)�������������������������������������������������������������������������������������������������������������������������������������������� 433 Art 18������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 19������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 20������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 21������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 22������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 23������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 24������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 25������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 436 Art 38������������������������������������������������������������������������������������������������������������������������������������������������� 443 UK–Italian Full Faith and Credit Treaty���������������������������������������������������������������������������������������������� 378 UNCITRAL Arbitration Rules 2010, Art 21(3)����������������������������������������������������������������������������������� 405 UNCITRAL Convention on International Guarantees����������������������������������������������������������������������� 448 UNCITRAL Convention on the Assignment of Receivables in International Trade 2001������������������������������������������������������������������ 23, 48, 175, 187–88, 196, 208, 211–12, 214, 216–17, 220, 225–27, 230, 234, 236–37, 240–41, 244–45, 448 Art 1������������������������������������������������������������������������������������������������������������������������������������������� 188, 234 Art 1(3)���������������������������������������������������������������������������������������������������������������������������������������������� 235 Art 1(a)���������������������������������������������������������������������������������������������������������������������������������������������� 235 Art 2������������������������������������������������������������������������������������������������������������������������������������������� 230, 241 Art 2(a)���������������������������������������������������������������������������������������������������������������������������������������������� 241 Art 3������������������������������������������������������������������������������������������������������������������������������������������� 234, 241 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 212 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 241 Art 6��������������������������������������������������������������������������������������������������������������������������������������������������� 242 Art 7������������������������������������������������������������������������������������������������������������������������������������������� 236, 242 Art 7(2)���������������������������������������������������������������������������������������������������������������������������������������������� 242 Art 8������������������������������������������������������������������������������������������������������������������������������������������� 212, 242 Art 9������������������������������������������������������������������������������������������������������������������������������������� 220, 241–42 Art 11������������������������������������������������������������������������������������������������������������������������������������������������� 237 Art 11(2) and (3)������������������������������������������������������������������������������������������������������������������������������ 242 Art 15������������������������������������������������������������������������������������������������������������������������������������������������� 220 Art 18������������������������������������������������������������������������������������������������������������������������������������������� 241–42 Art 19������������������������������������������������������������������������������������������������������������������������������������������������� 241 Art 22������������������������������������������������������������������������������������������������������������������������������������������������� 242 Art 27����������������������������������������������������������������������������������������������������������������������������������������� 212, 242 Art 28������������������������������������������������������������������������������������������������������������������������������������������������� 242 Art 29������������������������������������������������������������������������������������������������������������������������������������������������� 237 Art 30����������������������������������������������������������������������������������������������������������������������������������������� 237, 242 Art 42������������������������������������������������������������������������������������������������������������������������������������������������� 242 Ann���������������������������������������������������������������������������������������������������������������������������������������������������� 243 UNCITRAL Model Law on Credit Transfers��������������������������������������������������������������������������������������� 369 UNCITRAL Model Law on International Commercial Arbitration�������������������������������������������������� 189 Art 17������������������������������������������������������������������������������������������������������������������������������������������������� 443 UNIDROIT Convention on International Interests in Mobile Equipment 2001����������������� 48, 191–93, 196, 208, 269 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 191 Art 2(3)���������������������������������������������������������������������������������������������������������������������������������������������� 191 Art 3������������������������������������������������������������������������������������������������������������������������������������������� 188, 192

xlviii  Table of Legislation and Related Documents

Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 191 Art 8��������������������������������������������������������������������������������������������������������������������������������������������������� 192 Art 10������������������������������������������������������������������������������������������������������������������������������������������������� 192 Art 16������������������������������������������������������������������������������������������������������������������������������������������������� 191 Art 29������������������������������������������������������������������������������������������������������������������������������������������������� 192 Art 30������������������������������������������������������������������������������������������������������������������������������������������������� 192 UNIDROIT Factoring Convention���������������������������������������������������������� 49, 187, 217, 220, 225–26, 230, 236–41, 245, 257 Art 1��������������������������������������������������������������������������������������������������������������������������������������������������� 238 Art 1(1)()������������������������������������������������������������������������������������������������������������������������������������������� 239 Art 1(2)�������������������������������������������������������������������������������������������������������������������������������������� 212, 227 Art 1(2)©������������������������������������������������������������������������������������������������������������������������������������������� 237 Art 1(2)©������������������������������������������������������������������������������������������������������������������������������������������� 212 Art 2��������������������������������������������������������������������������������������������������������������������������������������������������� 235 Art 3��������������������������������������������������������������������������������������������������������������������������������������������������� 235 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 240 Art 4(2)���������������������������������������������������������������������������������������������������������������������������������������������� 239 Art 5��������������������������������������������������������������������������������������������������������������������������������������������������� 237 Art 5(b)�������������������������������������������������������������������������������������������������������������������������������������� 212, 239 Art 6������������������������������������������������������������������������������������������������������������������������������������������� 237, 239 Art 7��������������������������������������������������������������������������������������������������������������������������������������������������� 240 Art 8����������������������������������������������������������������������������������������������������������������������������� 212, 237, 239–40 Art 9������������������������������������������������������������������������������������������������������������������������������������������� 237, 239 Art 10������������������������������������������������������������������������������������������������������������������������������������������������� 240 UNIDROIT Principles of International Commercial Contracts�������������������������������������������������������� 412 Vienna Convention on the Law of Treaties, Art 53������������������������������������������������������������������������������� 20

Netherlands Bankruptcy Act 1896, Art 35(2)��������������������������������������������������������������������������������������������������� 203, 239 CC (Civil Code)�������������������������������������������������������������������������������9, 39, 43, 47, 75–78, 82, 91, 122, 152, 154, 168, 177, 203, 216, 231, 387 Art 3.13(2)������������������������������������������������������������������������������������������������������������������������������������������� 89 Art 3.38������������������������������������������������������������������������������������������������������������������������������������������������ 82 Art 3.38(2)������������������������������������������������������������������������������������������������������������������������������������������� 82 Art 3.53������������������������������������������������������������������������������������������������������������������������������������������������ 82 Art 3.81������������������������������������������������������������������������������������������������������������������������������������������ 47, 87 Arts 3.84(2)����������������������������������������������������������������������������������������������������������������������������������������� 78 Art 3.84(3)������������������������������������������������������������������������������ 44, 78–79, 84–85, 87, 173, 231, 250, 491 Art 3.84(4)��������������������������������������������������������������������������������������������� 44, 47, 81–84, 86–88, 106, 108, 117, 167–68, 491 Art 3.85�������������������������������������������������������������������������������������������������������������������86–87, 167, 173, 491 Art 3.86������������������������������������������������������������������������������������������������������������������������������������������������ 82 Art 3.91���������������������������������������������������������������������������������������������������������������������������������������� 84, 160 Art 3.92�����������������������������������������������������������������������������������������������������������������������������44, 47, 82, 154 Art 3.92(2)������������������������������������������������������������������������������������������������������������������������������������������� 81 Art 3.94(1)������������������������������������������������������������������������������������������������������������������������������������������� 77 Arts 3.94(3) and (4)���������������������������������������������������������������������������������������������������������������������������� 78 Arts 3.94–97���������������������������������������������������������������������������������������������������������������������������������������� 77 Art 3.110�������������������������������������������������������������������������������������������������������������������������������������������� 713 Art 3.115(3)����������������������������������������������������������������������������������������������������������������������������������������� 84

Table of Legislation and Related Documents xlix

Art 3.129�������������������������������������������������������������������������������������������������������������������������������������������� 390 Art 3.231���������������������������������������������������������������������������������������������������������������������������������������������� 80 Art 3.235���������������������������������������������������������������������������������������������������������������������������������������������� 81 Art 3.237���������������������������������������������������������������������������������������������������������������������������������������������� 77 Art 3.239���������������������������������������������������������������������������������������������������������������������������������������� 77–78 Art 3.242�������������������������������������������������������������������������������������������������������������������������������������������� 162 Art 3.246���������������������������������������������������������������������������������������������������������������������������������������������� 79 Art 3.246(1)����������������������������������������������������������������������������������������������������������������������������������������� 78 Art 3.246(5)����������������������������������������������������������������������������������������������������������������������������������������� 78 Art 3.247�������������������������������������������������������������������������������������������������������������������������������������������� 159 Art 3.295�������������������������������������������������������������������������������������������������������������������������������������������� 122 Art 4����������������������������������������������������������������������������������������������������������������������������������������������������� 88 Art 5.14(2)������������������������������������������������������������������������������������������������������������������������������������������� 80 Art 5.15������������������������������������������������������������������������������������������������������������������������������������������������ 80 Art 5.16������������������������������������������������������������������������������������������������������������������������������������������������ 79 Art 6.22������������������������������������������������������������������������������������������������������������������������������������������������ 82 Art 6.127�������������������������������������������������������������������������������������������������������������������������������������������� 387 Art 6.142���������������������������������������������������������������������������������������������������������������������������������������������� 33 Art 6.203���������������������������������������������������������������������������������������������������������������������������������������������� 82 Art 6.236(f)��������������������������������������������������������������������������������������������������������������������������������������� 388 Art 6.236(g)��������������������������������������������������������������������������������������������������������������������������������������� 388 Art 6.269���������������������������������������������������������������������������������������������������������������������������������������������� 82 Art 7.39������������������������������������������������������������������������������������������������������������������������������������������������ 83 Arts 7.39ff�������������������������������������������������������������������������������������������������������������������������������������������� 83 Art 7.53������������������������������������������������������������������������������������������������������������������������������������������������ 79 Art 7.53(3)����������������������������������������������������������������������������������������������������������������������������������������� 492 Art 7.54������������������������������������������������������������������������������������������������������������������������������������������������ 79 Arts 7.420–7.421������������������������������������������������������������������������������������������������������������������������������� 714 Art 7A.1576(h)������������������������������������������������������������������������������������������������������������������������������������ 82 Art 7A.1576(t)������������������������������������������������������������������������������������������������������������������������������������� 82 Law concerning the Supervision of Transactions in Investment Securities, Art 2������������������������������ 87

Switzerland Private International Law Act 1987, Art 148(2)���������������������������������������������������������������������������������� 408 ZGB Art 717������������������������������������������������������������������������������������������������������������������������������������������������� 89 Art 717(2)�������������������������������������������������������������������������������������������������������������������������������������������� 89 Arts 884–887��������������������������������������������������������������������������������������������������������������������������������������� 89

United Kingdom Bank of England Act 1998�����������������������������������������������������������������������������������������������������537, 546, 559 Banking Act 1987�������������������������������������������������������������������������������������������������������������������539, 546, 548 s 3����������������������������������������������������������������������������������������������������������������������������������������������� 533, 648 Bills of Sale Act 1882��������������������������������������������������������������������������������������������������������������� 125–26, 128 s 4������������������������������������������������������������������������������������������������������������������������������������������������������� 125 Collective Investment Schemes Order 2001, Art 21���������������������������������������������������������������������������� 346 Common Law Procedure Act 1854, s 78���������������������������������������������������������������������������������������������� 122 Companies Act 1989����������������������������������������������������������������������������������������������������������������������������� 392 Companies Act 2006����������������������������������������������������������������������������������������������������������������������������� 124 s 678��������������������������������������������������������������������������������������������������������������������������������������������������� 506

l  Table of Legislation and Related Documents

Enterprise Act 2002������������������������������������������������������������������������������������������������������������������28, 124, 204 sch B1, para 3������������������������������������������������������������������������������������������������������������������������������ 28, 124 Factoring Act 1823�������������������������������������������������������������������������������������������������������������������������������� 222 Financial Services (Banking Reform) Act 2013����������������������������������������������������������������������������������� 893 Financial Services Act 1986������������������������������������������������������������������������������������������������������������������ 728 Financial Services Act 2012���������������������������������������������������������������������������������������������������������� 531, 558 Financial Services and Markets Act 2000�������������������������������352, 537, 546, 556, 579, 630, 648, 684, 893 s 2(2)�������������������������������������������������������������������������������������������������������������������������������������������������� 548 s 3(2)(a)��������������������������������������������������������������������������������������������������������������������������������������������� 549 s 22����������������������������������������������������������������������������������������������������������������������������������������������������� 549 s 118(1)���������������������������������������������������������������������������������������������������������������������������������������������� 580 s 235��������������������������������������������������������������������������������������������������������������������������������������������������� 345 s 236(1)���������������������������������������������������������������������������������������������������������������������������������������������� 345 s 237(1)���������������������������������������������������������������������������������������������������������������������������������������������� 345 s 286��������������������������������������������������������������������������������������������������������������������������������������������������� 549 sch 2��������������������������������������������������������������������������������������������������������������������������������������������������� 549 Financial Services Reform Act 2013����������������������������������������������������������������������������������������������������� 630 Hire Purchase Act 1965������������������������������������������������������������������������������������������������������������������������� 125 Insolvency Acts�������������������������������������������������������������������������������������������������������������������������93, 109, 131 s 15(2), (3) and (9)������������������������������������������������������������������������������������������������������������������������������ 52 s 107��������������������������������������������������������������������������������������������������������������������������������������������������� 391 s 175(2)���������������������������������������������������������������������������������������������������������������������������������������������� 391 s 283��������������������������������������������������������������������������������������������������������������������������������������������� 93, 123 s 323��������������������������������������������������������������������������������������������������������������������������������������������������� 391 s 323(2)���������������������������������������������������������������������������������������������������������������������������������������������� 130 Insolvency Rules 1986��������������������������������������������������������������������������������������������������������������������������� 391 Limited Liability Partnership Act 2000������������������������������������������������������������������������������������������������ 346 Partnership Act 1890����������������������������������������������������������������������������������������������������������������������������� 346 Pawnbrokers Acts 1872–1960��������������������������������������������������������������������������������������������������������������� 124 Sale of Goods Act 1979������������������������������������������������������������������������������������������������������������������������� 125 s 16����������������������������������������������������������������������������������������������������������������������������������������������������� 204 s 17����������������������������������������������������������������������������������������������������������������������������������������������������� 123 s 19����������������������������������������������������������������������������������������������������������������������������������������������������� 131 s 24��������������������������������������������������������������������������������������������������������������������������������������������� 123, 126 s 25(2)������������������������������������������������������������������������������������������������������������������������������������������������ 125 s 29(4)������������������������������������������������������������������������������������������������������������������������������������������������ 123 Statute of Frauds 1677�����������������������������������������������������������������������������������������������������������123, 125, 156 Torts (Interference with Goods) Act 1977, s 3(2)�������������������������������������������������������������������������������� 122

United States Alternative Mortgage Transaction Parity Act 1982����������������������������������������������������������������������������� 607 Bank Holding Companies Act s 4(c)(8)��������������������������������������������������������������������������������������������������������������������������������������������� 586 s 4(k)�������������������������������������������������������������������������������������������������������������������������������������������������� 586 s 13��������������������������������������������������������������������������������������������������������������������������������������������� 630, 892 Bankruptcy Code�����������������������������������������������������������������������7, 10, 71–72, 95, 138, 140, 146, 151, 204, 293, 306, 327, 336, 355, 392, 397, 491, 633 2005 amendments������������������������������������������������������������������������������������������������������������������������������� 50 Ch XV�������������������������������������������������������������������������������������������������������������������������������������������������� 73 s 101��������������������������������������������������������������������������������������������������������������������������������������������������� 392

Table of Legislation and Related Documents li

s 101(25)�������������������������������������������������������������������������������������������������������������������������������������������� 306 s 101(47)�������������������������������������������������������������������������������������������������������������������������������������������� 489 s 101(53B)����������������������������������������������������������������������������������������������������������������������������������������� 334 s 361����������������������������������������������������������������������������������������������������������������������������������������������������� 71 s 362��������������������������������������������������������������������������������������������������������������������������52, 56, 74, 141, 146 s 362(a)(5)������������������������������������������������������������������������������������������������������������������������������������������� 71 s 362(a)(7)����������������������������������������������������������������������������������������������������������������������������������������� 392 s 362(d)������������������������������������������������������������������������������������������������������������������������������������������������ 71 s 363��������������������������������������������������������������������������������������������������������������������������������������������� 74, 141 s 363(b), (c) and (f)���������������������������������������������������������������������������������������������������������������������������� 52 s 364��������������������������������������������������������������������������������������������������������������������������������������������������� 141 s 364(d)������������������������������������������������������������������������������������������������������������������������������������������������ 72 s 365����������������������������������������������������������������������������������������������������������������������������146, 163, 204, 401 s 365(e)�������������������������������������������������������������������������������������������������������������������������������������� 146, 392 s 365(e)(1)����������������������������������������������������������������������������������������������������������������������������������������� 334 s 503(b)(1)(A)������������������������������������������������������������������������������������������������������������������������������������� 72 s 506����������������������������������������������������������������������������������������������������������������������������������������������������� 72 s 506(b)������������������������������������������������������������������������������������������������������������������������������������������������ 71 s 506(c)������������������������������������������������������������������������������������������������������������������������������������������������ 72 s 506(d)������������������������������������������������������������������������������������������������������������������������������������������������ 71 s 510��������������������������������������������������������������������������������������������������������������������������������������56, 117, 138 s 522(f)������������������������������������������������������������������������������������������������������������������������������������������������ 72 s 544��������������������������������������������������������������������������������������������������������������������������������������������� 72, 137 s 547��������������������������������������������������������������������������������������������������������������������������������������������� 72, 294 s 548����������������������������������������������������������������������������������������������������������������������������������������������������� 72 s 553����������������������������������������������������������������������������������������������������������������������������������������53, 56, 392 s 554����������������������������������������������������������������������������������������������������������������������������������������������������� 72 s 555��������������������������������������������������������������������������������������������������������������������������������������������������� 502 ss 555ff����������������������������������������������������������������������������������������������������������������������������������������������� 146 ss 556ff������������������������������������������������������������������������������������������������������������������������������������������������� 72 s 559�������������������������������������������������������������������������������������������� 147, 194, 292, 392, 494, 500, 502, 504 s 560������������������������������������������������������������������������������������������������������������������������������������147, 334, 392 s 561������������������������������������������������������������������������������������������������������������������������������������306, 334, 392 s 562��������������������������������������������������������������������������������������������������������������������������������������������������� 392 s 1129��������������������������������������������������������������������������������������������������������������������������������������������������� 72 s 1325��������������������������������������������������������������������������������������������������������������������������������������������������� 72 California Civil Code, s 2874������������������������������������������������������������������������������������������������������������������ 33 Community Reinvestment Act����������������������������������������������������������������������������������������������������� 607, 646 Dodd-Frank Act 2010��������������������������������������������������������������������� 278, 301, 317, 327, 330, 503, 526–27, 553, 563–64, 587, 597, 623, 636, 641–42, 646, 651, 675, 722, 864, 870–71, 882, 886, 892 s 102(a)(7)����������������������������������������������������������������������������������������������������������������������������������������� 564 s 112������������������������������������������������������������������������������������������������������������������������������������������� 560, 564 ss 401–410����������������������������������������������������������������������������������������������������������������������������������������� 353 s 724(a)�������������������������������������������������������������������������������������������������������������������������������������� 470, 643 Electronic Funds Transfer Act������������������������������������������������������������������������������������������������������ 369, 374 Federal Consumer Protection Act�������������������������������������������������������������������������������������������������������� 369 Federal Tax Lien Statute (FTLS)����������������������������������������������������������������������������������������������������������� 137 ss 6321ff��������������������������������������������������������������������������������������������������������������������������������������������� 137 s 6323(h)(1)��������������������������������������������������������������������������������������������������������������������������������������� 137

lii  Table of Legislation and Related Documents

Financial Services Modernisation Act (Gramm-Leach-Bliley Act)�������������������������������������������� 586, 651 Foreign Bank Supervisory Enhancement Act (FBSEA)�������������������������������������������������������� 586–87, 592 Homeownership and Equity Protection Act (HOEPA)���������������������������������������������������������������������� 607 International Banking Act 1978����������������������������������������������������������������������������������������������������� 586–87 Investment Advisers Act 1940�������������������������������������������������������������������������������������������������������������� 587 Investment Advisors Act 1940�������������������������������������������������������������������������������������������������������������� 353 Investment Company Act 1940������������������������������������������������������������������������������������������������������������ 587 JOBS Act������������������������������������������������������������������������������������������������������������������������������������������������ 699 McFadden Act������������������������������������������������������������������������������������������������������������������������������� 586, 751 National Bank Act��������������������������������������������������������������������������������������������������������������������������������� 648 Public Utility Holding Company Act 1935������������������������������������������������������������������������������������������ 587 Restatement (Second) of Contracts 1981, s 340(2)������������������������������������������������������������������������������� 33 Sarbanes-Oxley Act��������������������������������������������������������������������������������������������������������301, 581, 641, 850 s 401(c)�������������������������������������������������������������������������������������������������������������������������������������� 294, 297 s 705������������������������������������������������������������������������������������������������������������������������������������������� 297, 626 Securities Act 1933 (Glass-Steagall Act)������������������������������������������������� 521, 535, 562, 571, 586–87, 599, 630, 636, 651, 670, 684, 722, 919 s 2(a)�������������������������������������������������������������������������������������������������������������������������������������������������� 683 s 2(a)(10)������������������������������������������������������������������������������������������������������������������������������������������� 588 s 4(2)�����������������������������������������������������������������������������������������������������������������������������������588, 590, 705 s 4(a)(2)��������������������������������������������������������������������������������������������������������������������������������������������� 720 s 5������������������������������������������������������������������������������������������������������������������������������������������������������� 588 s 20����������������������������������������������������������������������������������������������������������������������������������������������������� 650 Securities Exchange Act 1934����������������������������������������������������������������������������������������� 587–88, 590, 722 s 3(a)�������������������������������������������������������������������������������������������������������������������������������������������������� 683 s 3(a)(1)��������������������������������������������������������������������������������������������������������������������������������������������� 711 s 3(a)(4)��������������������������������������������������������������������������������������������������������������������������������������������� 711 s 3(a)(5)��������������������������������������������������������������������������������������������������������������������������������������������� 711 s 4(2)�������������������������������������������������������������������������������������������������������������������������������������������������� 698 s 15����������������������������������������������������������������������������������������������������������������������������������������������������� 711 Tax Equity and Fiscal Responsibility Act������������������������������������������������������������������������������������� 590, 727 Trust Indenture Act 1939���������������������������������������������������������������������������������������������������������������������� 587 Trust Receipt Act 1922���������������������������������������������������������������������������������������������������������������������������� 38 UCC (Uniform Commercial Code)����������������������������������������������������8, 24, 28, 33, 38, 40, 45, 50, 66, 80, 121, 133, 135–36, 138–41, 144–45, 150–51, 156–58, 160, 162, 164–65, 174, 177, 189–90, 194, 201, 203–4, 206, 220, 228, 230, 242, 257, 260, 265, 292, 367, 432–33, 439, 459, 471, 473, 491, 682 Art 2��������������������������������������������������������������������������������������������������������������������������������������66, 139, 141 Art 2A������������������������������������������������������������������������������������������ 8, 44, 66, 139, 145–46, 151, 176, 194, 202, 206, 250–51, 253, 292, 399, 494 Art 4��������������������������������������������������������������������������������������������������������������������������������������������������� 369 Art 4A��������������������������������������������������������������������������������������������������������� 8, 66, 366–67, 369, 372, 374 Art 5����������������������������������������������������������������������������������������������������������������������������������������������� 8, 431 Art 8����������������������������������������������������������������������������������������������������������������66, 140, 458–59, 465, 572 Art 9����������������������������������������������������������������������������������������7–8, 14, 29, 38, 44, 47, 51, 59, 66–67, 71, 93, 118, 123–24, 126, 134–47, 151, 175–77, 181, 190, 192–94, 197, 199, 206–7, 215–16, 222–25, 230, 237, 239, 244, 247–50, 253–54, 292, 294, 471, 491, 653, 660

Table of Legislation and Related Documents liii

s 1-201(20)���������������������������������������������������������������������������������������������������������������������������������������� 677 s 1-201(29)���������������������������������������������������������������������������������������������������������������������������������������� 136 s 1-201(35)���������������������������������������������������������������������������������������������������������������������������������� 66, 134 s 1-201(37)������������������������������������������������������������������������������������������������������������������������������������������ 66 s 1-201(9)������������������������������������������������������������������������������������������������������������������������������������������ 136 s 1-201(a)(35)������������������������������������������������������������������������������������������������������������135, 141, 144, 249 s 1-203��������������������������������������������������������������������������������������������������������������������������������������� 141, 144 s 1-209(9)������������������������������������������������������������������������������������������������������������������������������������������ 202 s 1-301����������������������������������������������������������������������������������������������������������������������������������������������� 189 s 1-302����������������������������������������������������������������������������������������������������������������������������������������������� 136 s 1-304��������������������������������������������������������������������������������������������������������������������������������������� 136, 138 s 1-309����������������������������������������������������������������������������������������������������������������������������������������������� 677 s 2-105����������������������������������������������������������������������������������������������������������������������������������66, 135, 202 s 2-106(1)������������������������������������������������������������������������������������������������������������������������������������������ 139 s 2-210������������������������������������������������������������������������������������������������������������������23, 211, 216, 220, 242 s 2A-103��������������������������������������������������������������������������������������������������������������������������������������������� 139 s 2A-103(1)���������������������������������������������������������������������������������������������������������������������������������������� 145 s 2A-103(1)(g)����������������������������������������������������������������������������������������������������������������������������������� 145 s 2A-103(1)(j)������������������������������������������������������������������������������������������������������������������������������������ 253 s 2A-103(l)(g)������������������������������������������������������������������������������������������������������������������������������������ 253 s 2A-209(1)���������������������������������������������������������������������������������������������������������������������������������������� 253 s 2A-301������������������������������������������������������������������������������������������������������������������������������146, 250, 254 s 2A-307(2)�������������������������������������������������������������������������������������������������������������������������146, 250, 254 s 4A-108����������������������������������������������������������������������������������������������������������������������������������������� 8, 369 s 4A-207��������������������������������������������������������������������������������������������������������������������������������������������� 374 s 4A-209��������������������������������������������������������������������������������������������������������������������������������������������� 365 s 4A-211��������������������������������������������������������������������������������������������������������������������������������������������� 365 s 4A-303��������������������������������������������������������������������������������������������������������������������������������������������� 367 s 4A-405��������������������������������������������������������������������������������������������������������������������������������������������� 365 s 5-102(9)(b)����������������������������������������������������������������������������������������������������������������������������������������� 8 s 5-103����������������������������������������������������������������������������������������������������������������������������������������������� 438 s 5-107����������������������������������������������������������������������������������������������������������������������������������������������� 432 s 5-108(e)������������������������������������������������������������������������������������������������������������������������������������������� 433 s 5-109����������������������������������������������������������������������������������������������������������������������������������������������� 446 s 5-109(a)������������������������������������������������������������������������������������������������������������������������������������������ 441 s 8-102(a)(15)��������������������������������������������������������������������������������������������������������������������������� 572, 724 s 8-102(a)(15)(iii)(A)����������������������������������������������������������������������������������������������������������������������� 724 s 8-102(a)(7)������������������������������������������������������������������������������������������������������������������������������������� 458 s 8-106(d)������������������������������������������������������������������������������������������������������������������������������������������ 470 s 8-502����������������������������������������������������������������������������������������������������������������������������������������������� 465 s 8-503����������������������������������������������������������������������������������������������������������������������������������������������� 459 s 8-503(e)������������������������������������������������������������������������������������������������������������������������������������������� 465 s 8-504(a)������������������������������������������������������������������������������������������������������������������������������������������ 460 s 8-504(b)���������������������������������������������������������������������������������������������������������������������������������� 459, 470 s 8-510����������������������������������������������������������������������������������������������������������������������������������������������� 465 s 9-101(1)������������������������������������������������������������������������������������������������������������������������������������������ 233 s 9-102��������������������������������������������������������������������������������������������������������������������������������������� 142, 206 s 9-102(1)(a) and (2) (old)����������������������������������������������������������������������������������������������������������������� 44 s 9-102(2)(42)����������������������������������������������������������������������������������������������������������������������������������� 142 s 9-102(44)���������������������������������������������������������������������������������������������������������������������������������������� 142 s 9-102(a)(11)����������������������������������������������������������������������������������������������������������������������������� 33, 136 s 9-102(a)(52)��������������������������������������������������������������������������������������������������������������������� 136–37, 145

liv  Table of Legislation and Related Documents

s 9-103(3)������������������������������������������������������������������������������������������������������������������������������������������ 233 s 9-108����������������������������������������������������������������������������������������������������������������������������������������������� 202 s 9-109����������������������������������������������������������������������������������������������������������������������������������44, 141, 144 s 9-109(a)������������������������������������������������������������������������������������������������������������������������������������������ 134 s 9-109(a)(3)����������������������������������������������������������������������������������������������������������������������������� 140, 142 s 9-109(a)(5)������������������������������������������������������������������������������������������������������������������������������������� 139 s 9-109(a)(5–6)��������������������������������������������������������������������������������������������������������������������������������� 249 s 9-109(d)(13)��������������������������������������������������������������������������������������������������������������������������������������� 8 s 9-109(d)(4)��������������������������������������������������������������������������������������������������������������������������������������� 66 s 9-109(d)(7)������������������������������������������������������������������������������������������������������������������������������������� 142 s 9-19(a)(1)����������������������������������������������������������������������������������������������������������������������������������������� 66 s 9-201��������������������������������������������������������������������������������������������������������������������������������������� 135, 142 s 9-202����������������������������������������������������������������������������������������������������������������������������������������������� 134 s 9-203����������������������������������������������������������������������������������������������������������������������������������33, 135, 137 s 9-203(1)(c)������������������������������������������������������������������������������������������������������������������������������������� 143 s 9-203(b)������������������������������������������������������������������������������������������������������������������������������������������ 137 s 9-203(b)(2)����������������������������������������������������������������������������������������������������������������������������� 137, 202 s 9-203(b)(3)(A)����������������������������������������������������������������������������������������������������������������������� 135, 202 s 9-204��������������������������������������������������������������������������������������������������������������������28, 66, 140, 143, 201 s 9-204(a)������������������������������������������������������������������������������������������������������������������������������������������ 135 s 9-204(b)������������������������������������������������������������������������������������������������������������������������������������������ 135 s 9-204(c)������������������������������������������������������������������������������������������������������������������������������������������� 135 s 9-205����������������������������������������������������������������������������������������������������������������������������������������������� 140 s 9-206(1) (old)����������������������������������������������������������������������������������������������������������������������������������� 33 s 9-207(c)(3)������������������������������������������������������������������������������������������������������������������������������������� 471 s 9-308����������������������������������������������������������������������������������������������������������������������������������������������� 137 s 9-308(a)���������������������������������������������������������������������������������������������������������������������������������� 135, 201 ss 9-308ff������������������������������������������������������������������������������������������������������������������������������������������� 136 s 9-309��������������������������������������������������������������������������������������������������������������������������������������� 135, 145 s 9-309(2)���������������������������������������������������������������������������������������������������������������������������������� 140, 142 s 9-310��������������������������������������������������������������������������������������������������������������������������������������� 135, 145 s 9-312����������������������������������������������������������������������������������������������������������������������������������������������� 437 s 9-314��������������������������������������������������������������������������������������������������������������������������������������� 470, 472 s 9-314(c)������������������������������������������������������������������������������������������������������������������������������������������� 471 s 9-315����������������������������������������������������������������������������������������������������������������������������������55, 136, 202 s 9-315(a)������������������������������������������������������������������������������������������������������������������������������������������ 136 s 9-317����������������������������������������������������������������������������������������������������������������������������������������� 136–37 s 9-317(a)(2)����������������������������������������������������������������������������������������������������������������������������� 137, 145 s 9-320��������������������������������������������������������������������������������������������������������������������������������136, 145, 202 s 9-320(a)������������������������������������������������������������������������������������������������������������������������������������������ 136 s 9-320(b)������������������������������������������������������������������������������������������������������������������������������������������ 136 s 9-322����������������������������������������������������������������������������������������������������������������������������������������� 135–36 s 9-322(a)(3)������������������������������������������������������������������������������������������������������������������������������������� 141 s 9-322(d)������������������������������������������������������������������������������������������������������������������������������������������ 137 s 9-323��������������������������������������������������������������������������������������������������������������������������������� 136–37, 145 s 9-324����������������������������������������������������������������������������������������������������������������������������������������������� 136 ss 9-324ff������������������������������������������������������������������������������������������������������������������������������������������� 136 s 9-330����������������������������������������������������������������������������������������������������������������������������������������������� 136 s 9-336��������������������������������������������������������������������������������������������������������������������������������������� 136, 202 s 9-404������������������������������������������������������������������������������������������������������������������������������������������������� 23 ss 9-404ff������������������������������������������������������������������������������������������������������������������������������������������� 220

Table of Legislation and Related Documents lv

s 9-406(d)������������������������������������������������������������������������������������������������������������������������������������������ 242 s 9-502����������������������������������������������������������������������������������������������������������������������������������������������� 143 s 9-503����������������������������������������������������������������������������������������������������������������������������������������������� 143 s 9-504����������������������������������������������������������������������������������������������������������������������������������������������� 143 s 9-513������������������������������������������������������������������������������������������������������������������������������������������������� 33 s 9-601����������������������������������������������������������������������������������������������������������������������������������������������� 134 s 9-601(a)(2)������������������������������������������������������������������������������������������������������������������������������������� 437 s 9-603����������������������������������������������������������������������������������������������������������������������������������������������� 136 s 9-607����������������������������������������������������������������������������������������������������������������136, 142, 194, 225, 292 s 9-607(c)������������������������������������������������������������������������������������������������������������������������������������������� 140 s 9-607(c) and (d)����������������������������������������������������������������������������������������������������������������������������� 224 s 9-608��������������������������������������������������������������������������������������������������������������������������������136, 142, 225 s 9-609����������������������������������������������������������������������������������������������������������������������������������������������� 136 ss 9-609ff������������������������������������������������������������������������������������������������������������������������������������������� 202 ss 9-610ff������������������������������������������������������������������������������������������������������������������������������������������� 144 s 9-618����������������������������������������������������������������������������������������������������������������������������������������������� 157 s 9-503(43)������������������������������������������������������������������������������������������������������������������������������������������ 33 Uniform Conditional Sales Act 1918������������������������������������������������������������������������� 38, 158–59, 161–62 s 3������������������������������������������������������������������������������������������������������������������������������������������������������� 162 s 6������������������������������������������������������������������������������������������������������������������������������������������������������� 157 s 7������������������������������������������������������������������������������������������������������������������������������������������������������� 163 s 9������������������������������������������������������������������������������������������������������������������������������������������������������� 162 s 16����������������������������������������������������������������������������������������������������������������������������������������������������� 158 s 20����������������������������������������������������������������������������������������������������������������������������������������������������� 158 s 24����������������������������������������������������������������������������������������������������������������������������������������������������� 157 s 27����������������������������������������������������������������������������������������������������������������������������������������������������� 160

lvi

1 Financial Products and Services 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 the previous two Volumes that the evolution of modern commercial law is now largely finance- rather than trade- or mercantile- driven. Much of what was said earlier 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 and other preferential, segregation or bankruptcy-resistant aspects of modern financial products and facilities, their creation, transfer, and effect or protection, especially in an insolvency of the counterparty. In German, that is the issue of Insolvenzfestigkeit, in truth 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, like in common law countries in floating charges or finance sales. They complement as we shall see the older secured transactions, but parties may also be able to extend the preferences like in the use of set-off/ netting clauses, or create other forms of separation or segregation as in (constructive) trust facilities. The distinction between contractual and proprietary rights is typical for civil law, less common and sharp in common law where the accent is in this connection rather 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, especially in asset-backed financing and in set-off and netting facilities. The contractual or proprietary characterisations or the issues of separation and segregation 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, or to achieve payment, but the financial products also operate as risk management tools. This is true in secured transactions and finance sales but also for

2  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

swaps and other derivatives when operating as hedging instruments, and these products then have a dual function. Another double use is the set-off, which is a way of payment but has also become a most important risk management facility. For banks, risk management of this nature is a central issue in which modern contract and movable property law is indeed used and adjusted around an expanded notion of party autonomy in the creation of newer proprietary rights or preferences, especially in floating charges, finance sales, trust structures and modern netting facilities to enhance precisely the notion of separation and segregation in order to protect better against the insolvency of counterparties. To demonstrate how these products work and legally operate, also transnationally, will be the main subject of this chapter. The next chapter will deal with the regulation of the intermediaries, especially commercial and investment banks that use these products and facilities in their different functions, a discussion that will center on the issues of financial stability, conduct of business and market integrity. 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 other preferences or segregation facilities by contract or otherwise, and the use of hedging instruments (notably in swaps, options and futures) and their liquidity, form one comprehensive narrative in the provision of funding and financial services in international flow of goods, services, money, information and technology. For bank management, this narrative is often geared to the regulatory capital adequacy and liquidity requirements, as will be discussed more extensively in Chapter 2 below. 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 function. Except for money transfers, this is basically contract. So are the related services, even the basic hedging instruments, like swaps, options, and futures. Trading is one other major aspect of modern banking business: commercial banks that deal in foreign exchange, swaps and repos must also trade in them. Especially in respect of swaps and repos, but also other derivatives, like options and futures, that raises the important issue of their liquidity or transferability and how that is or may be done. Even loans are at least to some extent traded in securitisations.1 One consequence of the contractual nature of many of these products is, however, that they are difficult to transfer; it is a constant concern in the banking industry as we shall see and a serious challenge to the liquidity of banking products. The basic rule is that assets can trade but liabilitees cannot, thus in a contract the asset side is tradable without consent of the counterparty, but the liability side is not, so that a contract as a whole is not transferable without consent, it is simply a matter of credit risk: to 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 to you is a

1  It raises the further question of the effect on the connected security and similar asset-backed protection. See for this issue n 24 below.

PART I  Secured Transactions, Finance Sales and Other Financial Products 3

matter of credit risk and you are unlikely to be indifferent and allow your debtor to put someone else in his place without your consent. It means that in contract the asset side must be separated from the liability side in order to trade and this is often not possible as both are likely to be closely related. Yet as we shall see, 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. For other contracts like derivatives, as we shall see, special trading facilities may be created and put in place in central counterparties or CCPs, see ­section 2.6.5 below for futures and swaps. Again, it is the issue of liquidity. In the capital markets, we have other services and products and the situation looks simpler. The financial products are here in essence few: bonds and shares, the one promissory notes, the other participation certificates, both, when expressed to bearer or order, operating as documents of title or proprietary instruments. They transcend any contractual nature in the underlying relationships and are pieces of property or assets in that sense and 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 market place has accepted. One important consequence is that these products when properly worded are easily transferable, in the international marketplace often, like the eurobond, as an instrument of transnational law (see Volume 1, chapter 1, s­ ection 3.2.3), although as we shall see, the way in which these instruments are now mostly held in custodial systems may still create complications in this legal characterisation and transnationalisation process, see s­ ection 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 That is liquidity (see Volume 2, chapter 2, ­section 1.1.3). Another consequence is that in a bankruptcy of the holder or custodian, the owner can retrieve these assets (in principle). There is segregation or bankruptcy resistance in this context. Similarly, if such assets have been given as security for debt, the lender or security holder can retrieve them out of a bankruptcy of the investor/owner. Again, this is in the nature of a proprietary right that can ignore all others unless older (except the ones of the grantor which were surrendered). 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. Importantly (and often confusingly) even contractual rights may do so and then figure as assets in their own right, as we have already seen, at least on the right (not obligation side, which again raises the issue of separation), eg receivables or other monetary claims or other contractual claims that can be reduced to money. In so-called floating charges, these security interests may extend to 2  Again, all rights supporting the asset (in 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 24 below.

4  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

entire classes of assets (either in the form of property or contractual right), which may be in transformation, allowing for a better protection of working capital advances to make the production process possible. This remains contentious in many legal systems mainly because assets are no longer individualised and may even be future. The interest may also shift into the replacement asset retaining its original rank. This is well known in equity in common law countries as we have already seen in Volume 2, ­chapter 2, which countries may have here the advantage, see further also the discussion below, particularly in ­section 2.2. There are other forms of risk management in the form of proprietary protection as already noted also, see further Volume 2, chapter 2, s­ ection 1.10, 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 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 and further in ­section 2.1, and are 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, eg in client accounts and collection arrangements. The proprietary status of finance leases as another type of finance sale, even of repos may thus remain uncertain, precisely because it may not be clear whether they are proprietary or contractual and their status remains problematic in many countries. They could still be purely contractual, which suggests a different status and legal treatment, especially in the manner of their protection and (re)transfer. It only confirms that legally, there often still is ambivalence, especially in the contractual and proprietary aspects of many financial products, and there are here important characterisation issues. They may even arise in purely proprietary matters: conditional or finance sales, even if not considered merely contractual, may still be re-characterised as secured transactions, a fundamentally different proprietary structure as will also be discussed more extensively below in ­section 2.1. In fact, when it is less clear whether a financial structure is contractual or proprietary, as may be the case for repos, the financial practice has accepted 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 (TBMA/ISMA) industry master netting agreement in place. It re-emphasises the central importance of set-off and netting in this connection, which has become a major risk management tool, again especially if the underlying instruments are or may remain contractual but operate between the same parties. For swaps where the contractual nature was never in doubt, we have the ISDA Master Agreement promoting bilateral set-off also. Both in the ISDA and TBMA/ISMA Master Agreements, the essence is that they reduce the mutual exposure between the same parties engaging in transactions of this nature between themselves, 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 5

accounted for 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. As we shall see, there is a modern tendency to broaden this set-off facility in order to make risk management in this manner in banking more effective, which then becomes a matter 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. It proved nevertheless a particularly effective form of the extension of protection and promotion of risk management. But there is more. In fact, it was already said in Volume 2, chapter 2, ­section 1.1.3 that all contractually created user, enjoyment and income rights tend towards proprietary protection, which becomes a matter of transferability and a liquidity issue, potentially promoting at the same time better risk management in finance. This was shown to be so in rights of way which may operate as servitudes even if only contractual or in contractual temporary income rights which (in the Netherlands) may become like usufructs.3 As already mentioned, the combination of contract and property poses in particular the question of the use of party autonomy in proprietary matters and to create preferences and other forms of segregation, conceivably allowing new types of protected funding to arise. At least in the professional sphere, user, enjoyment, and income rights may thus become enforceable against third parties or at least against certain classes of them though party autonomy finding subsequently a wider recognition in the community or trade it concerns. That is custom, domestically 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. Again, party autonomy also supports the status of contractual netting clauses, their possible expansion of the setoff facility and the (extended) preferences so created, and their effect in terms of risk management and bankruptcy protection or resistance when properly accepted in the relevant trade. It was already said that the equitable principles as developed in common law countries serve here best 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. They may ignore them, meaning that they need not worry about these charges when they buy goods. In this manner, private parties may be able to create all kinds of collateral backing for indebtedness, leading to priorities in execution subject to the protection of the public at large against these facilities, therefore operative only between insiders like banks and major suppliers. Party autonomy of this nature becomes a major risk management tool for them,

3 

Rather than treating them as finance sales proper, see the discussion at n 286 below.

6  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

but again the key is that it is not allowed to affect the normal commercial flows and the liquidity of the assets operating therein. They are thus protected against these types of interests (whether in movable or even immovable property or in intangible claims, such as receivables). To repeat, in common law terms, these charges are equitable and only have this limited reach, but they are notably effective against 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. They have a search duty but these intererests do not affect outsiders, therefore the public, who may ignore them and have no investigation duty either, even if there is a register or other form of filing: see more particularly the discussion in Volume 2, ­chapter 2, ­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. In the area of set-off and netting, we also face public policy issues when through party autonomy the reach of this protection is extended although these public policy issues may be differently resolved. To repeat, the set-off itself implies an important preference in an insolvency of the counterparty, in the sense that a creditor is protected in this manner to the extent it owes the bankrupt something, see further ­section 3.2 below. Thus mutual claims are offset with the result that the non-bankrupt party will only be a creditor for the difference (if any), which means that its exposure in bankruptcy may be much reduced. 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, it may be possible in many legal systems to extend the set-off to immature and other claims (eg 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. These are the already mentioned netting agreements, particularly important as risk management tools in the swap and repo markets. Again, it is a form of party autonomy through which extra protection is created, which is equitable 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 s­ ection 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. It may be repeated in this connection that the operation of equitable rights to support commerce and finance has long been a most important common law feature (see Volume 1, chapter 1, s­ection 1.1.3). Traditionally, we are here mostly concerned with trust structures and issues of separation, in finance particularly relevant in respect of the holding of client assets. Other facilities in their modern form are often connected, such as the notion of tracing and of proprietary interest shifting into

PART I  Secured Transactions, Finance Sales and Other Financial Products 7

replacement assets extra supporting the non-possessory floating charges. Again, they are well known but are better developed in equity in common law countries, sometimes further elaborated by statutory law, in respect of floating charges particularly in the US in Article 9 UCC. This statutory support may also be available for the setoff and netting concepts under netting clauses. The technique may be further refined in bankruptcy laws, particularly under the US Bankruptcy Code as will be discussed further below. Thus 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, but then also repos and finance leases, 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 systems. To repeat, this chapter will principally be concerned with the operation and characterisation of these newer products and facilities into law (local or more rationally transnational customary law as we shall see) and their status in bankruptcy, which remains local (and in international cases poses the question of proper bankruptcy jurisdiction), see further s­ ection 1.1.14 below. The reason that bankruptcy remains local longer is that enforcement is a typical sovereignty issue, which cannot easily be transnationalised; the alternative is a broader recognition in insolvency proceedings of transnationalised security interests, floating charges, finance sales, (constructive) trust and set-off facilities. In particular, the legal risk concerning modern financial products or techniques will be considered, while discussing the most important financial products, including their social and economic settings. It may now also be asked whether fintech might affect this newer approach and fundamentally change it. This discussion will be started 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, see further also ­section 1.1.15 below. It is conceivable but cannot yet be predicted with certainty that radical change may be at hand which could have a far-reaching effect, for banks affecting not only their role in the payment system but then 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, chapter 1, s­ ection 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

8  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

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 is 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 and 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 is often the better guide and analogy as was more fully discussed in Volume 2, chapter 2 and is to the extent necessary repeated and summarised in this chapter. As we have seen, it centres on the issue of party autonomy in the creation of proprietary and other preferential or segregation facilities, but where third parties are affected it may need the support of customary law, meaning recognition in the trade or community it concerns, here the globalised business community. It is subject to the protection of the ordinary flows of commoditised products which cannot be so charged or encumbered and protects the purchasing public or consumer. Transnational public policy may dictate minimum standards. In this connection, important other trends have also already been identified. First, the law in this area is professional law as most clearly borne out in the US by the UCC.4 It is best, therefore, always to clearly separate the discussion from consumer issues (important as they may be, also in finance). Another aspect of these modern developments, driven by modern finance, is that the legal regime, meant to provide security or similar support 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 2, chapter 2. In this connection, it is quite possible, and is in fact the US approach, to maintain different proprietary notions and concepts according to product.5 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 system thinking in that sense. This was also identified as a special feature of modern transnational professional law— see Volume 1, chapter 1, s­ ection 1.1.6 and Volume 2, chapter 2, 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, it is necessary not to confuse

4  See Art 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, ch.1, s 1.1.10 and for relationship thinking Vol 2, ch 1, s 1.1.1. 5  This has also already been noted in Vol 1, ch. 1, s 1.1.10 and Vol 2, ch 2, ss 1.1.6 and 1.10.1.

PART I  Secured Transactions, Finance Sales and Other Financial Products 9

the discussion with issues concerning the protection of common creditors and equality amongst all creditors. This discussion is also to be separated from the special protection of more in particular bona fide creditors, which was traditionally often connected with the concept of the debtor’s appearance of creditworthiness (in France) or of apparent ownership (in England). This was already mentioned and is important in the context of netting clauses but 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, but in this connection it should be realised that in business practice 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 creditors usually get nothing or at best a small percentage. That is their risk, is commonly well understood, and was always so.6 Thus, although the 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 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. 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 was never true; it was always about ranking and consequently risk management. 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. But it also affects the segregation possibilities and the different priorities or preferences in the context of

6  Even where, as in the new 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.

10  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

­ istribution of the bankrupt estate’s proceeds after the sale of its assets. Again, transd nationally they are reinforced by modern floating charges, finance sales and set-off and netting concepts or facilities, which have strong party autonomy and customary law overtones. It is possible that as a consequence of the foregoing, bankruptcy will play out quite differently among professionals, especially if they benefit from forms of party autonomy in rearranging their risks in the manner described. Indeed, it is now not uncommon for bankruptcy statutes to give way to special needs in this connection, especially in the area of set-off and netting, in which connection the US Bankruptcy Code was already mentioned. Its various amendments in these areas testify to this, as did earlier the Settlement Finality Directive and Collateral Directive in the European Union. (On the other hand, in bankruptcy reorganisations concessions may have to be made by various, even secured, creditors in that context.) Transnationally operating funding operations and set-off/netting facilities or constructive trust protections may also increasingly impose themselves on domestic bankruptcies and force recognition, an issue already mentioned in the previous section. These facilities and notably the increasing role of party autonomy supported by customary law in this context were previously mentioned in Volume 1, chapter 1, ­section 1.1.6 and in Volume 2, chapter 2, s­ ection 1.10. Besides the separation of contractual monetary claims from the rest of the contract, the move towards greater proprietary protection of contractual income, user and enjoyment rights generally as a liquidity issue also mentioned in the previous ­section, puts them at the heart of legal flexibility in the area of modern financial products and facilities. Thus party autonomy may provide greater sensibility in international finance, it is submitted, especially when international pools or classes of assets located in different countries or moving between them as part of international supply, production and distribution chains, are used as asset backing, or when claims in different countries must be set off. Again, it allows in particular for the use of international commercial/cashflows, originating in different countries to back up modern financing, but it also promotes conditional or finance sales and favours the set-off, of which the TBMA/ISMA and ISDA Swap Masters are the most significant illustration, as we have seen. Party autonomy as one of the sources of the modern lex mercatoria is thus an important tool in the transnationalisation of the law concerning these facilities as will be shown throughout, even though in order to be truly effective against third parties it may need customary law support in order to achieve a form of proprietary expression especially in domestic bankruptcies. Although this transnationalisation trend is only in its infancy at least in civil law perceptions, it challenges in particular the traditional numerus clausus notion of proprietary rights (always subject to better protection of the commercial flows against these newer charges) and more limited notions of set-off and netting, at the same time as redefining the notion of paritas creditorum. In terms of international market practice or custom, it increasingly has significant consequences in modern bankruptcy. Even if bankruptcy itself may remain a matter of domestic law, as submitted in the previous section, it cannot ignore the international marketplace nor should it frustrate greater party autonomy for professionals to manage their risk at the international level.

PART I  Secured Transactions, Finance Sales and Other Financial Products 11

We have seen the early manifestation and consequences of transnationalisation in the legal characterisation of the eurobond, see Volume 1, chapter 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 TBMA/ISMA Master Agreement confirming the set-off and netting practices in the repo markets, also already mentioned, see further sections 4.2.4/5 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 see the consequences no less in the law of assignments for financial purposes, as in receivable financing and in securitisations (see s­ ection 2.2.4 below), where bulk assignments of future claims become necessary and consequently individual notice requirements 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 2, chapter 1, ­section 1.5. Finally, new thinking is also apparent at the transnational level in the area of payments, see s­ ection 3.1 below and in the types of investment securities (shares and bonds) and their holding through security accounts in custodial holdings and their transfer in modern book-entry systems, discussed in Volume 2, chapter 2, Part III, which in many respects resembles payment through the banking system. They will be further discussed 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. This has long been the case in common law jurisdictions like the US but pragmatically now also in civil law countries like France through a multitude of incidental statutory amendments geared towards special products such as repos and securitisations, see ­section 1.3 below. It was identified as another form of asset-backed financing and 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—is 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, chapter 1, s­ ection 1.1.6, it has already been said that these developments and the dynamics they bring to movable property law are moving to the centre of the transnationalisation of the law among professionals, particularly important in their financial dealings. 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 become increasingly redundant or unmanageable as we have already seen.

12  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

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. These are the two environments in which capital is recycled from savers or capital providers to those who are in need of capital: see more particularly chapter 2, ­section 1.1.1 below. 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 will take deposits from the public, become in fact owners of this money, leaving the depositors as contractual claimants only, and issue loans out of the moneys so obtained to their deserving—ie creditworthy—customers or borrowers. It follows that they 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 c­hapter 2, ­section 1.4. Deposits and loans are the most important banking products, the one forming the main liability class for a bank and the other the main asset class. 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 13

outstanding claims out of the sale proceeds and return the overvalue, if any after costs, to the debtor.7 This is also called repossession. 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 also 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 2, chapter 2, sections 1.1.3 and 1.7.1. The pledge as a specific possessory security interest in 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 2, chapter 2, Part III and ­section 4.1.1 below. 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. Again, 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, nonpossessory security interests had to be developed but also had to cover more ground. In common law countries, often these security interests are floating charges, already mentioned before, 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. This dispenses with identification, individualisation and specificity 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 also 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 realestate 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 take free of such charges. Yet it is better than nothing and now very common in common law jurisdictions. Rather than legally invalidating them altogether, in common law countries it is left to the creditors, usually banks, to decide whether they are helpful to them. Yet they are still substantially restrained in many civil law 7  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.

14  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

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 of assets. 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). 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, 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 that these assets could automatically be sold free and clear of the charge (to make these assets readily saleable), in return for new inventory being automatically included in the security. Legally, this gave rise to the notion of tracing and of the shifting lien. The same goes for it continuation at the original rank in the receivables, if credit is extended for a purchase; the charge could 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 here; the trade-off was that purchasers in the ordinary course of business were protected against these charges. So the public could buy cars and bicycles out of inventory free and clear and did not have a search duty as already noted. Only other banks or suppliers had and normally are better able to do so. ­Registers of these charges could help find them, but again the general public could ignore even 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. 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 the more statutory approach. English case law (in equity) comes close, but still gives the resulting charge a very low priority, see ­section 1.5.2 below. Other countries must rely on contractual 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 15

All creditors may attempt to negotiate these types of security interests (to the extent developed under applicable law), 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 s­ ection 2.6.4 below. It was already said that derivative products such as options, futures and swaps have become important modern marketrisk 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, they may also use the technique and facility of asset securitisation, or seek to balance their credit risk with credit derivatives especially credit default swaps (CDS), as we shall see in s­ ection 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. 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: see Part III below.

16  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

In the international flows these are also key facilities and it is essential that transnational 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 and connected sales and collection process to be given as security for its financing by way of a transnationalised floating charge. It may be recalled 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 and proprietary 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 a proprietary issue. An international payment and money transfer system is a key banking function in a globalised environment and requires an important form of transnationalisation of the applicable law to be credible and safe, so requires in fact 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. 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 substantially under a transnationalised regime, see Volume 1, chapter 1, ­section 3.2.3. Here one finds no banking intermediation. Entities in need of capital—usually governments, companies and 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. In capital market transactions they are likely to provide a multitude of services (see more particularly chapter 2, ­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, in which capacity they help in pricing, marketing and listing of the relevant investment security on the exchanges (if such listing is being sought). These advisory—primary market or new issues market— functions may, however, be supplemented by an underwriting facility. This is very common and 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 I  Secured Transactions, Finance Sales and Other Financial Products 17

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 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 eurosecurities 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 chapter 2 below, but a number of legal issues in particular connected with the holding or custody and transfer of modern investment securities, already discussed in Volume 2, chapter 2, Part III, will be summarised in this chapter, 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). Another issue here is the settlement risk, which may be reduced through 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 when 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. 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 asked 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 banks normally operate as advisors but, as already explained, they may an own 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 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

18  VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

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 banks take. Financial markets are more in particular connected with trading and 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 as we have seen, for example, for eurobonds, see further chapter 2, s­ ection 1.1.17 below. The relevant market services may also include listing, regular publication (of financial news) facilities, clearing and settlement. They need not, or no longer, 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 at the level of private law. Legally the question will often be whether these are contractual or proprietary, more so than whether a risk is being taken by the relevant financial intermediary, especially commercial or investment banks, or if so whether the exposure is contractual or proprietary. Services are normally contractual. Much bank exposure also is, eg 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 s­ ection 1.1.1 above, the particular problems associated with the transfer of contract positions were already mentioned in this connection, 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 similar protection effects, as we have also 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 chapter 2, s­ ection 1.1.2 below, especially those connected with the stability of the financial system and the protection of investors or depositors. 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 also consider the considerable legal challenges financial regulation presents. They will be discussed in this chapter only to the extent that regulation is product specific.

PART I  Secured Transactions, Finance Sales and Other Financial Products 19

1.1.4  Different Credit Cultures. Domestic Law Thinking. The Issues of Legal Transnationalisation and of Transactional and Payment Finality Crossborder Revisited It has already been said that the subject of this chapter will be foremost commercial banking products and facilities, particularly their proprietary status if the financing is asset-backed, the 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. Customary law support may be additionally needed to create third party effect. There is also the status of netting agreements and of other preferences and separation facilities to consider, and no less the operation of derivatives. 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 well beyond the contractual, now increasingly favoured even by public policy and at least for swaps and repo netting under the ISDA and TBMA/ISMA Master Agreements supported by transnational ­custom. 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. The legal issues that arise in these connections are again more proprietary in nature. In all of this, 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. 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 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 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 traditionally 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 under which these products function and are protected locally. This has already been noted

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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, 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 market place. Yet 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, especially when (a) assets located in different countries are involved in asset-backed schemes, (b) payments or investment securities transfers must be effectuated between entities in different countries, or (c) a netting of obligations arising in different countries is envisaged. It has already been pointed out that the characterisation of modern financial products into national laws is one of the major concerns of this chapter, 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. This is the operation of transnational law or, in commerce and finance, of the new lex mercatoria or law merchant, one of the main subjects of this book. It was submitted in Volume 1 and it is crucial for a proper understanding of what is happening, that we borrow here the method, although not the rules, of public international law as enunciated in Article 38(1) of the Statute of the International Court of Justice (and Article 53 of Vienna the Convention on the Law of Treaties for peremptory rules or fundamental principle), supplemented by a view on the hierarchy of the norms that thus become applicable to transnational transactions and finds recognition in local enforcement proceedings. 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. 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 asset-backed and other funding is 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 as this protection is obtained at the expense of others, in this case notably other creditors. It has already been said many times that the search for an o ­ bjective

PART I  Secured Transactions, Finance Sales and Other Financial Products 21

law in property is not wrong and party autonomy is here a limited concept that can only work if there is a good protection of the ordinary commercial and financial flows against such interests as a public policy issue, but this concept of party autonomy supported by custom, could still be transnational. However, since this still remains contested, proprietary protection can in the view of many only be achieved under a national law, in principle the lex situs of the asset, 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. Again, this is still thinking of property rights as physical, an approach based on an identification of the asset and the right and rejected earlier in this book: 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 proper location, quite apart from the fact that many, like monetary claims but also services are intangible, and, even where goods are physical they may be in constant movement and transformation, as just mentioned, but may also include intangible services and technology. In fact, a service contract may be economically more important than the asset it serves. It may also be repeated that all international flows of goods, services, 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 to 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, chapter 1, ­section 3.2.2 in the context of the emergence of the modern lex mercatoria and further discussed in Volume 2, chapter 2, ­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 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 2, ­chapter 2, 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. Sometimes local bankruptcy law is already formally amended in such situations as under international pressure many such laws have allowed broader notions of set-off and netting, increasingly promoted or even formulated at the ­transnational

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level: see also sections 3.2.6ff below. This is a continuing process and would then apply generally to all transnationalised financial products and claims or facilities suggesting respect for their operation and therefore greater scope for their recognition even locally barring public policy considerations of which the simple preserving of local laws could not or no longer be one. It has in fact already been posited in this connection that true globalisation of financial products substantially depends on our acceptance of new 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.8 This was very much the message of the first two 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 market place. The pitfalls in terms of financial risk and stability are increasingly clear, and are discussed in chapter 2 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. In view of the immense size of the international commercial and financial flows (the international swap market alone being thought to cover US$ equivalent of more than 500 trillion outstanding), 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 chapter. Increased reliance in this connection on party autonomy, first to determine the applicable law, started in assets like receivables, which have no proper place because they are not physical (and have no natural lex situs mandatorily to determine the applicable law), or in assets like ships and aircraft, which, by their very nature, move and therefore have no fixed situs either, at least not in a physical sense, but this discussion has acquired a more general significance: see also Volume 2, chapter 2, sections 1.8.1 and 1.9.4. Ultimately international custom and practice has here the last word, still subject however to transnationalised notions of public order and policy in terms of transnational minimum standards in the international market place. It was already repeatedly stated that the true challenge in legal transnationalisation is in this area of minimum standards and their articulation. In this connection, it has been noted in Volume 1, chapter 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,

8  See for the objectivation of the notion of party autonomy in this connection, supporting its transnational status, especially Vol 2, ch 1, ss 1.1.4 and 1.1.5.

PART I  Secured Transactions, Finance Sales and Other Financial Products 23

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,9 negotiable instruments (especially eurobonds) and euromarket practices including clearing and settlement,10 the law of international assignment,11 of set-off and netting,12 of letters of credit (Uniform Customs and Practice for Documentary Credits—UCP) and trade terms (Incoterms).13

9  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. 10  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 transnationalised is the way these instruments are repoed or given in security, cleared and settled. 11  Important issues of 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 are 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 2, ch 2, 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 any ratifications and is certainly not as clear and advanced as it could have been: see s 2.3.8 below. 12  In this connection, in the swap and repo markets, the ISDA Swap Master Agreements and the PSA/ISMA 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 nettingout 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 ch 2, 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). 13  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 at a 1962 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 view always in the context of some national law. See for France, Y Loussouarn and JD Bredin, Droit du commerce international 48 (Paris, 1969). 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;

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The important and connected issue of finality also arises and has already been mentioned several times.14 It may be seen that we are here concerned with the key legal infrastructure of the international 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.15 However, in the absence or through a denial of such a transnational approach, in international financings it would still be a question of private international law to

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. 14  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 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. 15  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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 25

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 2, chapter 2 sections 1.8. and 1.9, in proprietary matters it will then normally 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 and is the consequence of the continuation of a physical approach to property law, also in respect of movable assets and fingated for claims. 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. A greater measure of party autonomy may then be introduced to overcome these problems,16 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 already seen). In s­ ection 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. Again, 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 depends on some 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 per country (see also more particularly Volume 2, chapter 2, s­ ection 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

16  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 also 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).

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tool, it may also lead to substantive limitation. The set-off implies a strong preference as we have seen and as will be discussed more extensively below in ­section 3.2. It is the traditional argument against party autonomy in these matters which may through netting clauses expand the preference and attendant protection. As noted before, modern needs to manage risk better have allowed more room for party autonomy in these areas, which was more developed in equity in England and later in the US, subject always to a better protection of the commercial flows (or of bona fide purchasers and of buyers in the ordinary course of business of commoditised products) against charges so agreed, although at the expense of bona fide or unsuspecting (other) (common) creditors. The same liberal attitude is taken to netting agreements as we have also seen, again induced by the need for banks to manage their risks better (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 function of banks, which is now perceived as a necessary facility if we wish to exploit and retain the full benefit of globalisation. That is to say that development of transnationalised legal structures is necessary 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 is not in 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, chapter 1, s­ ection 1.1.6—with its concepts of trusts (including resulting and constructive trusts), conditional and temporary ownership rights, and floating charges: see further Volume 2, chapter 2, in particular sections 1.1.1 and 1.10.2 and s­ ection 1.5 below. It also maintains a more liberal approach in the equitable set-off. However, since the law of the situs of the assets is still mostly seen as applying to the proprietary interests to be created or maintained in them, the international financial practice continues to depend on local laws, therefore especially in proprietary matters prima facie on the lex situs, whatever its problems, and the concept of transnationalisation supported by international practice remains as yet insufficiently tested, although, it was submitted all along, is the way forward. Globalisation, if it is here to stay, and the limiting of legal risk at that level require it. Nevertheless, the handicap of dominance of local laws cannot 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 27

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 aspects. Affected parties must continue to work with the substantial differences and limitations local law then presents and with the often parochial approaches domestic law follows, or otherwise try to work and structure around them as best they can.17 But the result is that the international financial business is handicapped for no obvious reason except legal peculiarism and will continue to find it particularly hard to use classes of assets located in different countries or cashflows originating in different countries to back up and protect indebtedness, like attracting 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. 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;

17  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).

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(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 type 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. 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. 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 various facilities. In England, the implicit power of house banks, benefiting from floating charges covering 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.18 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.19 Under the US

18  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. 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. 19  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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 29

Bankruptcy Code (s 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 recharacterising them as secured transactions (often even finance leases and presumably also repos, as we shall see in s­ ection 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 particularly 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 1980.20 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.21 In France, nonpossessory security interests in chattels were limited to certain types of assets only. As in the Netherlands, floating charges were discouraged until a change in the law in 2005, and much was originally done to leave more room for unsecured creditors, but that policy is increasingly abandoned. 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. 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. 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 to him an admission of misjudgement and an undesirable ending, even if better than nothing. 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

20  21 

See s 1.3.4 below. See Vol 2, ch 2, n 532.

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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 2, chapter 2, ­section 1.7. This led to the Sicherungsübereignung in Germany as we shall seein s­ ection 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 the 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 funding needs subject to a right to regain the assets later, while he may retain the use of them in the meantime, an aspect that may be discounted in an extra reward for the financier. 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 are still 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 wellknown concept of future interests. They were later transferred in equity to chattels and intangible assets (or personal property): see further Volume 2, chapter 2, ­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 before, 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 but, 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 31

This 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 the more suitable domestic law (thus abandoning by contract the lex situs principle); see also Volume 2, chapter 2, ­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 2, chapter 2, s­ ection 3.2.2), may likewise sooner be considered subject to transnationalisation (supported by a form of party autonomy backed up by 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, 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 why can freely buy the relevant products free and clear of any such charge. As has been said before, this concerns important issues of finality of transactions.22 It requires further support by established practices or industry custom transnationally—see for this evolution Volume 1, chapter 1, ­section 3.2.2, Volume 2, chapter 2, s­ection 3.2.3 and s­ection 1.1.10 below—the key of which is 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 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 2, chapter 2, s­ ection 1.7 and there will be further elaboration in s­ ection 2.1 of this chapter, preceded by detailed comparative law studies of the Netherlands, France, Germany, the UK and the US. 22 

See n 14 above.

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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 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 the same 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 especially 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 2, chapter 2, s­ ection 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 2, chapter 2, ­section 1.1.1); (c) allow the secured creditor to seize or repossess the asset upon the default of his debtor (if he has not already taken possession),23 therefore in principle as a 23  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

PART I  Secured Transactions, Finance Sales and Other Financial Products 33

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).24

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. 24  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 230 and 272 below, and may need agreement of the parties or statutory support. Where the assignor in the assignments of 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 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 75 and 160 below but cf also n 125 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 230 below and for the US also n 272 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 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

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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. As mentioned in the previous section, 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 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 may be released from its debt if there is undervalue; (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; 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.

on the assignor’s behalf even though for his 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 35

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 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 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 and 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. 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. 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 as a consequence required the creditor to take physical possession of the asset for the security interest to be valid. At least for movable property it seemed the more natural situation as it gives the creditor tangible protection while the latter does not then need to fear that other creditors may create similar interests in it or that the asset may be hidden, 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

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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, chapter 1, s­ ection 1.2.4 and chapter 2, section 1.1.6 note 27)—had been 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 traditional non-possessory interest in chattels, although sometimes, as 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 nonpossessory security interests rather than conditional sales and also became subject to publication requirements: see ­section 2.1.3 below. 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 2, chapter 2, ­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 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 2, chapter 2, ­section 1.10.3 and ­section 1.1.1 above. 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 systems 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 37

were abolished altogether and the nineteenth-century civil law codifications eliminated them in favour of the possessory pledge only. Security of this nature involving monetary claims as collateral was largely ignored. Thus nineteenth-century civil law no longer encouraged hidden non-possessory proprietary rights like security interests or even usufructs (life interests) in chattels. 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 2, chapter 2, sections 1.4.8–1.4.9). As explained before, 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 then often 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 2, chapter 2, ­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 to the debtors under the relevant receivables were deemed invalid during much of the nineteenth century.25 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 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.

25  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.

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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 and 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 1.1.1 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 considerable overvalue, which could easily arise, particularly when other goods were incorporated. 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 then 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 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 even 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 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 39

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 guise of conditional sales. The result was, however, greater divergence and variation in detail, eg 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 2, ­chapter 2, ­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 s­ ection 1.2.1 below.26 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, already identified before, is the inclusion of future assets, and therefore of assets that do not 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 2, chapter 2. 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 is not part of this

26  In Germany, this meant in bankruptcy a shift from the stronger Aussonderungsrecht to the weaker Absonderungsrecht, see also text at nn 159 and 172 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 66 and 168 below.

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s­ ystem 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.27 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 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), but, for professionals, English law only requires publication of 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, 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 the creditor. But it is also apparent that this domestic law sometimes had to change to accommodate new (international) financing needs. The transnationalisation of the funding practices in the 27  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 62ff 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 41

c­ ommercial 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 new 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 as already noted. 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 s­ ection 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, with the exception of Germany, this is also the case elsewhere in civil law countries even in the newest codifications, cf eg the Brazilian Civil Code of 2002. In the EU, the Draft Common Frame of Reference (DCFR) that figures as some model for an EU civil code, is also regressive as we have seen in Volume 2, chapter 2, ­section 1.10.

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 2, chapter 2, ­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, 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 very different. This is so not only because the financier in a conditional sale would normally not obtain possession and use of the relevant assets. There was therefore a great advantage for the party needing the financing when chattels were used in this way in financing schemes

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whilst non-possessory security in them remained impossible. That was indeed mostly the motivation for these conditional sales to resurface 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 was a very 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. Thus the arrangement could lead to physical possession by either seller or buyer, but 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 (whether as a right or duty) or to accept the goods when tendered by the buyer. In civil law, the buyer could then 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 any 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 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,

PART I  Secured Transactions, Finance Sales and Other Financial Products 43

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 his timely tender of the repurchase price (whether or not accepted). The justification for this different approach is ultimately in the recognition of a 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, in this manner this party may raise a larger amount of money, 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. 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 chapter. 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 these finance sales and their effects on the title transfer should be handled, at least in civil law. Nevertheless, there remains considerable confusion in the area of characterisation of these 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 set-up, 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

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c­ onnection 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 s­ ection 9-102(1)(a) and (2) (old). The latest text of 1999 in s­ ection 9-109 is less explicit on the point, but there is no change. It follows that 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 his 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.28 The federal Bankruptcy Code, s­ ection 559, clarifies these issues now also, at least for investment securities repos. 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 the new 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 now 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.29 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, and leaves, as just mentioned, for all such financing, including equipment leasing, serious doubt as to their proprietary status. The legal approach, notably in England, has indeed been to appreciate the different risk and reward structures in security- and ownership-based financing, as we have seen, 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.30 In other words a formal criterion is used here and the courts do not normally look

28  See text at nn 242 and 245 below. See also S Vasser, ‘Derivatives in Bankruptcy’ (2005) 60 The Business Lawyer 1507. 29  See text at nn 84ff below. 30  See ss 1.5.3–1.5.4 below.

PART I  Secured Transactions, Finance Sales and Other Financial Products 45

behind the declared structure.31 Even so, the conditional sales approach is seldom fully developed in the modern finance sales in common law: see s­ ection 1.5.2 below and for the extensive old case law in the US on the subject, s­ ection 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 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.32 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 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.

31  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 198 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 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. 32  See also n 234 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 nn 270ff below.

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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 under a reservation of title and 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 (eg because of inflation) 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 are habitually countered by netting agreements, as already mentioned before. 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. Here there may be more room for convergence and harmonised transnational interpretation in the area of finance sales. 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. This 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 47

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 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, but it remains debatable how third parties might be affected in their rights by this type of party autonomy. Alternatively, these assets could be deemed to be located at the place of the owner to achieve a unitary regime under a 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. 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. In civil law, there is another problem. For public policy reasons, it tends to limit (often by statute) the types of proprietary rights, as was discussed more fully in ­Volume 2, chapter 2, ­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 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. For them to prevail, international recognition, which could take the form of acceptance of established transnational custom or practice supporting transnational proprietary rights, would have to become apparent. 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 likely to be lost anyway 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

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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 crossborder remains, remains a major legal concern and substantial source of ingenuity and income for lawyers in terms of legal risk management. In modern, large-scale, internationally promoted finance structures, the differences and uncertainties are becoming more obvious and are 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 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 has hardly been consulted on the present 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 49

Short of adverse international public policy considerations, they should facilitate rather than curtail the international funding practices and the flexibility they seek and need. As just mentioned, at EU level the disparities have not elicited great concern so far, 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.33 The efforts in the 2008–09 Draft Common Frame of Reference (DCFR) made by an EU-supported group—see Volume 1, chapter 1, ­section 1.4.21 and Volume 2, chapter 2, ­section 1.11— in this area as part of what this group sees as a fuller codification of private law in the EU, even for professional dealings, is not convincing if only because finance sales are 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 remains unexplored. Equitable interests and their operation are limited to formal trusts and for the rest barely understood, even in a project that was also intended for E ­ ngland: see again Volume 2, chapter 2, ­section 1.11. On the other hand, the example of the US until the

33  Within the EU, some efforts at harmonisation were made in the past: see also Drobnig (n 17) 32. As early as the 1960s, there was a proposal from the banking industry to deal with the extraterritorial effect of nonpossessory 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 17) 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 concluded that unification of the law of security interests in goods was in all likelihood unattainable, after the emergence of the UNIDROIT Factoring Convention of 1988, 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 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 are considered in the 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.

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introduction of the UCC has shown that great differences may subsist in this area per 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.34 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. Fund management under UCITS or the AIFMD in the EU, see chapter 2, sections 3.5.14 and 3.7.7, may also get involved. The Collateral Directive was not particularly geared to any form of 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 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 can notably not have any retroactive effect in regard of the collateral or set-off facilities so created). 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. The Collateral Directive meant to enhance the risk management facility in the financial service industry. Earlier the EU had adopted the Settlement Finality Directive (see Volume 2, chapter 2, s­ ection 3.1.5 and further s­ ection 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.35 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.

34  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 2, ch 2, s 3.1.5 and also s 4.1.5 below. 35  See also the observation in n 34 above for similar needs in the US.

PART I  Secured Transactions, Finance Sales and Other Financial Products 51

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 chapter, for financiers the key issues 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 or 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 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 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 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 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. Thus 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 2, chapter 2, s­ ection 1.1.1 and further also s­ ection 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 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.

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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.36 What we are concerned with here is a proprietary right but only a limited one (a security interest in the underlying asset). Again, the situation is different in

36  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 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 action and timing. This is not so in Germany, where there is for the nonpossessory charge (Sicherungsübereignung) in a bankruptcy of the counterparty only a right to a priority in the proceeds (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 2, ch 2, 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 53

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. Here 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 means that all subsequent owners who have this 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 (eg because of ­filing) of these interests. They are usually other professional creditors, notably funding providers like banks. 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. 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. 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 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 eg 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 full or more limited proprietary rights in his 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

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t­ ypical bankruptcy or default remedies: see also Volume 2, chapter 2, ­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 nevertheless 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 2, chapter 2 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 and is 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, particularly when the partnership acquires corporate form, 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 2, chapter 2, s­ ection 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 assets or pools, which may be connected with the purpose that they mean to serve and is then a dynamic concept.

PART I  Secured Transactions, Finance Sales and Other Financial Products 55

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 ever 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 2, chapter 1, ­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, however, 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. They exist especially in civil law for some special types of creditor, 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 non-possessory security in movable property, even allowing for floating charges, but in bankruptcy not as a self-help remedy, as we have seen. However, 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. 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

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rearrange the priorities and adjust repossession rights.37 The key here is 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.38 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,39 also relevant for loans of unlimited partners.

37  See for the German Sicherungsübereignung, s 1.4.2 below. See for Dutch case law extending preferences n 63 below. See for the principles of priority n 36 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 receivers under floating charges was outlawed in 2002, but largely in order not to interfere with reorganisation proceedings, see n 200 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. 38  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. 39  cf s 510 US Bankruptcy Code.

PART I  Secured Transactions, Finance Sales and Other Financial Products 57

In modern finance sales as true conditional 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.40

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 As we have seen, in finance sales, conditional 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 the conditional 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 all the time; this is an important activity for transaction lawyers. It ultimately becomes a question of better risk management, the reason why regulators often favour this development especially in connection with setoff 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

40 

See text at n 279 below.

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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—the effect of any new structures in this regard on third parties 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 2, chapter 2 and earlier in Volume 1, chapter 1, s­ ection 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. 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 and this appears to be an important trend, also promoting the tradeability or liquidity in the underlying assets (see Volume 2, chapter 2, ­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 all assets (not only chattels, therefore) or, in the case of assets that commonly trade, all purchasers in the ordinary course of business. It assumes a robust regime concerning transactional finality: see for its foundations and underpinning ­section 1.1.4above 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, 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,

PART I  Secured Transactions, Finance Sales and Other Financial Products 59

where it used to be strong—see ­section 1.3.2 below—and provided for them the original protection against hidden charges or interests, especially against reservations of title.41 In more modern times, it also allows for the operation of netting agreements at the expense of 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, not all, notably not possessory security interests and reservation of title in consumer goods. Equipment leases, tax liens and statutory preferences are other exceptions. The 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 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.42 This is so for practical historical 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 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 also, 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, the last two concerning in particular the financial flows: (a) the protection of bona fide purchasers or purchasers in the ordinary course of business; 41  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. 42  See for some remaining constraints Vol 2, ch 2, s.1.1.3.

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(b) the finality of transactions; (c) the position of bona fide common creditors; and finally (d) 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 common creditors, although the latter can expect very little in a bankruptcy of the debtor: see also s­ ection 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. 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 which allow for greater party autonomy subject to a better protection of the ordinary commercial flows against the interests so created. These are the true reason 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 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 severe pressure. At the more fundamental level, it has already been noted in ­section 1.1.1 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 of all kinds). To repeat, it is equitable, not equal distribution that is the key of modern bankruptcy liquidation and this assumes priority and ranking, 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. It is a key regulatory concern which has to do with systemic risk, as we shall see in chapter 2 below, 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. That is also clear from the fact that so far no serious stability concerns have been expressed in respect of the development of floating charges, leasing, repos and other finance sales, and receivable financing. It may now be different for securitisations and derivatives

PART I  Secured Transactions, Finance Sales and Other Financial Products 61

including swaps. But 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 also 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 also applauded by regulators for much the same reasons as we have seen. Hence their increasingly undisputed survival, even in a bankruptcy of the counterparty, and 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 legally 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 s­ ection 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 third parties (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 DCFR, as an academic model for an EU private law codification, is 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 EBRD issued a set of general principles of a Modern Secured Transactions Law, but they deal 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 underline 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 takes a broader view. Notably, it distinguishes finance sales from secured transactions and also promotes 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. 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 discouraged, as it could leave considerable differences in the manner in which it would be absorbed in each Member State.43 This view is reversed in the DCFR, but it is hardly

43  Professor Drobnig, in his contribution referred to in n 17 above, earlier rejected for the EU the uniform UCC approach for secured transactions in movables as politically unfeasible.

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aware of the more modern financial environment and has no conceptual contribution to make. It is an update of the German BGB and largely reflects 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. 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 sets the reservation of title apart and does not 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 and their meaning. 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 with the return of overvalue to the buyer, or will 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 protected 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 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 eg 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, which could still be custom. That is understandable in principle as property rights have a direct effect on unrelated third parties, who must respect them regardless. As we have seen, in bankruptcy this has a special consequence and importance. Parties with a proprietary right may retake the assets (subject to any stay provisions, 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 63

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.44 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. Although squeezed out by codification thinking, custom, especially if transnational, therefore operating in the operation of the international market place and its financing, may be considered part of the objective law 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 an issue of public order also in the international marketplace. The support for netting agreements and their extended proferences may be considered a matter of financial stability as such also a public policy issue. It follows that the objective law does not always have to be statutory or interpreting case law, while the ensuing custom or public order requirements may gain 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, ­chapter 1, ­section 1.4.9—helped by its objectivation, as was argued in Volume 2, ­chapter 1, ­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

44  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. Yet 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 also Vol 2, ch 2, ss 1.2.1 and 1.2.2.

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arising (see Volume 1, chapter 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 chapter 2, s­ ection 2.1.2 below) produced a prime model of an autonomous transnational development 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 2, chapter 2, 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, 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 11 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 in finance. That is even true for negotiable stocks and shares, especially in modern book-entry systems. 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, such as oil rigs on the high seas: see also Volume 2, c­ hapter 2, ­section 1.10.2 (under (w)) and note 12 above. It has already been noted that the recent emergence of book-entry systems for stocks and shares (see Volume 2, chapter 2, ­section 3.1.4 and further ­section 4.1 below) seems to de-emphasise ownership rights of the interest holders and also 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 65

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 2, chapter 2, ­section 3.2.2. It reemphasises 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 interest bears this out. As suggested above, party autonomy may 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, but progress in this direction may be more subtle. First, at least the transfers of 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.45 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 non-possessory 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 2, chapter 2, s­ ection 1.8.3. 45 

See Vol 2, ch 2, s 1.9.2.

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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. 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 2, chapter 2, ­section 1.8.4. This is a 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. 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 rights. It may well be in the process of being recast. It was noticed in this connection in Volume 2, chapter 2, s­ ection 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 2, chapter 2, 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 and credit protections, whatever practitioners’ needs, thus eliminating even the finance sales in a unitary functional approach. Yet, as we have already seen, such a restrictive, 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.46 but the unity imposed here proved artificial and it became clear that notably the finance lease and the repurchase agreement hardly fitted into this system. In fact, as we shall see below and as was noted above in ­section 1.1.1, a product approach now more properly prevails in the US and proprietary notions may play out quite differently in the various Articles of the UCC.47

46  See ss 1-201(35), 1-201(37), 9-19(a)(1) and 9-109(d)(4) UCC; see also the text at n 237 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). 47  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 Art 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 Art 9 in respect of security interest in future assets (s 9-204), while Art 2A on finance leases, Art 4A on electronic payments and Art 8 on interests in security entitlements and their transfer maintain different approaches again, none of which are interconnected.

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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 2, chapter 2, s­ ection 1.10.2 (w), that in respect of rigs on the high sea, for example, there is often not much more than some documents that show who has control. In such cases, the proprietary right goes back to the more primitive common law notion of possession 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.48 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 particular issue is also 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

48  It has already been said in n 27 above that new Dutch security law, eg, 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.

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then be considered undesirable security substitutes, as such deprived of all proprietary effect in the Netherlands. This has already been briefly discussed above and will be covered in greater detail below in s­ ection 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 in particular the question of the position of either party under them, although there may be more flexibility here as compared to the situation for secured transactions: see more particularly s­ ection 2.1.3 below. Since there is less law in this area, perversely there may be fewer obstacles to reaching satisfactory solutions. As suggested before, 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. One may 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.49 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, 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 then 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 security interest, for example a floating charge in respect of all worldwide receivables for, say, the English 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.50 In so doing they may fit in foreign security or similar interests, perhaps in breach of any numerus clausus idea as already noted. They 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 flows, therefore in the protection of bona fide purchasers or purchasers in the ordinary course of business of commoditised products, here receivables and assignees, and 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.

49  50 

Among commercial lawyers this is in fact the more common approach as we saw in Vol 2, ch 2, s 1.9.4. See Vol 2, ch 2, ss 1.8.2 and 1.9.4.

PART I  Secured Transactions, Finance Sales and Other Financial Products 69

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 have seen in Volume 2, chapter 2, ­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 to their proper recognition by bankruptcy courts elsewhere and the 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, 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 could be expected increasingly to cooperate 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 and it is not true that they have a natural right to more. It was said above that 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.51 In truth, whatever the aims of nineteenth-century nationalism in ­private 51 

Vol 1, ch 1, ss 1.1.2 and 3.2.2.

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law, unification through an autonomous process of transnationalisation, therefore through the force of practices and market custom in private law, especially in international professional dealings, was never entirely eradicated, including in civil law countries, see also Volume 1, chapter 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 s­ ection 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 2, chapter 2, ­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—the usual argument against it, as we have seen in Volume 1, chapter 1, s­ection 1.1.7—although parties are normally professionals in specialised financing schemes who may be able to live with some uncertainty rather than with unsuitable alternatives 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 also 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) reasonable reliance notions are here used transnationally to support this type of finality, and it is submitted that transnational law is here at least as efficient as domestic laws are. In any event, professionals often must take certain 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. It has also 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, 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 71

1.1.14  The Impact of the Applicable Domestic Bankruptcy Regime 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, differ considerably. These differences are 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. This being said, local bankruptcy laws generally take a different attitude to foreign or new proprietary interests, and especially may re-rank priorities, even purely domestically, impose stays or in reorganisation proceedings reallocate the interest. 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 2, chapter 2, ­section 1.8.3. On the other hand, in this manner, newer transnationalised interests could be considered or indeed be allowed to prevail on the basis of transnational custom and practice. 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, while even limiting the field in respect of finance sales in its unitary functional approach, 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. 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

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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 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 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, which include 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 73

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.52 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 transborder aspects in other Member States. It therefore concerns bankruptcies that mean to cover the activities and the assets of the debtor abroad (here especially in other EU countries). The EU now means to deal in this centralised conflicts of laws manner with the interests of creditors in these activities or in these assets. Under the Regulation, the foreign bankruptcy trustee’s position in a bankruptcy opened in a EU country is in principle accepted and automatically recognised in the other EU countries that become so involved, provided the bankruptcy is opened in the place of the main activities of the debtor and subject always to the public policy exception. Secondary bankruptcies may be opened elsewhere. They are not extraterritorial but may 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 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 1997.53 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

52  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. 53  See Look Chan Ho (ed), Cross-Border Insolvency: A Commentary on the UNCITRAL Model Law (London, 2006).

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­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. They will therefore be considered first 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 newest effort did not produce great new insights and may even be considered regressive, largely, it is submitted, 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, which was discussed in Volume 2, chapter 2, s­ ection 1.11. It is too tentative a proposal to merit much further attention here. 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.

1.1.15  Fintech and its Challenges and Possibilities. The Legal Consequences. A New World of Finance? At the end of s­ ection 1.1.1 it was already asked whether fintech might affect the newer approaches and fundamentally change finance, international finance and its products

PART I  Secured Transactions, Finance Sales and Other Financial Products 75

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 potentially 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 all 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 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 newest 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 there proved to be hardly coherent. In retrospect there were many policy mistakes. 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 (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 the commercial contract. 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 respect of 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 suffers from the same problems as we have seen in Volume 2, chapter 2, s­ ection 1.11. Only in France as we shall see and now also in Belgium under new codification proposals was there some more movement. The overall result was an inadequate response,

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which was fatally caught up in system thinking, which itself proved wholly insufficient or inadequate to deal satisfactorily with the legitimate requirements of modern commerce and finance and to move it forward in a responsive and reliable legal framework.54 A particular feature and central theme in the new Dutch CC was 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 have seen in sections 1.1.7/8 above. This older fiduciary sale and transfer was comparable to, although, as we shall see, as a security right often stronger than, the comparable German Sicherungsübereignung and Sicherungszession as they developed from similar origins.55 All were based on case law development and 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 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, doing away with finance sales at the same time, although the government repeatedly attempted to appease opponents by suggesting that no substantial change was meant,56 which in the end had significant consequences for new case law, which was forced to re-adopted some of the old ways.57 The new pledge does not cover or transfer to replacement goods or proceeds. This was left to contractual elaboration.58 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 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 interests, including security rights, 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 the earlier drafts, it appeared impossible to define the notion of asset class and the effort was abandoned.

54  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. 55  See HR 6 March 1970 (Pluvier), NJ 433 (1970), and for Germany see the text at n 167 below. 56  See Parliamentary History, Introduction Statute Book III, 1197 (Dutch text). 57  See n 63 below. 58  See n 68 below.

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There is therefore no legal framework allowing for bulk transfers. It is thus 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 s­ ection 1.2.2 below. It appears that the legal practice in this regard has been given greater freedom in Germany.59 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.60 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.61 However, the relationship out of which the debt arises must exist so that (if properly described) the security can attach before the emergence of the debtor but the interest holder cannot enforce the security before the debtor emerges. 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.62

59 

See ss 1.4.2 and 1.4.4 below. See Art 3.237 CC for tangibles and Art 3.239 CC for intangibles. 61  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. 62  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 in existence, which under Dutch law allowed such prospective claims also be to be included in principle, even if the claim had not yet emerged and 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 64 below. Reference was made by the Supreme Court 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 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. 60 

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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 (or since 2004 for other registered assignments as we shall see), without it, the pledgor/assignor still remains entitled to retain the proceeds, as confirmed in case law, albeit subject to a preferred claim of the assignee, while the account debtor is fully liberated upon payment to him.63 In the meantime, Dutch law, through amendment of the Code of 1992 in 2004, has accepted for financial transactions the need for assignments without notification also for other than registered security purposes. The end result was an alternative form of assignment through registration of the assignment deed.64 This tracks the Dutch method of creating registered security interests in receivables.

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.8 63  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 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. 64  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 63 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 and 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 79

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) predecessor, which had no statutory base and developed through case law from 192965 in the nature of a conditional sale but subsequently applied security law principles by analogy to the extent that made sense.66 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.67 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.68 It has already been said that Dutch law also continues that a registered 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 is still no full clarity on this point, but it determines whether, in a subsequent bankruptcy, the proceeds will benefit secured or general creditors. It remains curious that in 2004 the earlier situation was not simply restored. Apparently some importance is still attached to further formalities for assignment if no notification is given, now in terms of registration. It is less clear why this should be necessary and shows the narrowing impact of system thinking. It does not conform with practices elsewhere. 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 its 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 be 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. 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. 65  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 contrat de remère (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, nn 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 63 above). 66  HR 3 Jan 1941, Hazerswoudse 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. 67 See Parliamentary History, Introduction Statute Book II, 1197 (Dutch text) and also W Snijders (the draftsman of the present text of Art 3.84(3) CC), Minutes Meeting Vereeniging Handelsrecht 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 clausus, therefore systemic considerations, although there was later an implicit bias in the new Code to limit the various creditors’ preferences. 68  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

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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 registration date.69 As already mentioned in the previous section, floating charges are, therefore, not easily created either. Unlike in Germany,70 purely contractual enhancements and extensions of the non-possessory security right appear limited in their effectiveness as they 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 has required that all assets that enter into the ownership of a debtor after its bankruptcy are part of the bankrupt estate, which affects their transfers out of the estate, including security transfers of both absolutely and relatively future assets acquired by the debtor after its bankruptcy. It might be different, however, if they are conditionally transferred: see Volume 2, chapter 2, s­ ection 1.7.5. It is certainly a more restrictive approach than that adopted under common law in general and by the UCC in the US in particular: see ­Volume 2, chapter 2, s­ ection 1.7.8 and s­ ection 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 has acquired a life of its own and is impervious to practical needs.

it covers eg 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 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 in 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, yet in case law it is not altogether unknown: 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. 69  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 64, No 206, but part of the claims even if described in the contract may not suffice as a sufficient identification. 70  See for the more liberal German approach, the text at n 161 below.

PART I  Secured Transactions, Finance Sales and Other Financial Products 81

The new Dutch Code also covers the reservation of title, formerly also a product of case law.71 Here it presumes 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.72 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 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 like nonpossessory pledges or published in any way. It remains therefore a 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),73 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.74 There is no execution sale, but rather appropriation of the asset by the seller upon default.75 Since the sales agreement must be rescinded for the asset to be

71 

Art 3.92 CC. The Dutch Supreme Court in a decision of June 3 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. 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 means that his financier can put the purchase price and acquire the entire property as his security. 73  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 24 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 he may be deemed to have paid the seller for or on behalf of the purchaser so that the reservation in any event lapses: Art 3.92 CC. See for the different French approach n 126 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 91 below. 74  See n 68 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. 75  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 24 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 198 below) require some sale and the return of any excess value to the debtor as his 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 76 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 72 

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repossessed by the seller, it appears that any instalments paid have to be returned to the buyer at the same time.76 A similar construction applies to hire-purchase.77

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

pledge but also that it could entail a conditional ownership right (pactum reservati dominii). In notarial deeds of those times, both were often negotiated at the same time. Roman law did not considered the position of the reclaiming right in bankruptcy and medieval law had no clear answer. According to writers like Straccha, in salesprice 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 157 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 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 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 148 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 2, ch 2, s 1.7.3. See for France, n 113 below. 76  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, eg 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. 77  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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 83

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 more generally to protect against non-payment upon a sale—it could also be deemed implied: the lex commissoria tacita.78 In a sale, at least in the case 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 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.79 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? Has the future interest, the reversionary interest or any remainder, as the

78  Cf n 75 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 76 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 2, ch 2, 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 163 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 75 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. 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 75) who rejects the duality of ownership notion (p 344), accepted by most Dutch authors. He accepts, however, the proprietary nature of the expectancy (p 348). See, however, for the latest Dutch case law that now accepts it, n 72 above. See for the duality of ownership in French legal writing, at one stage commonly accepted in France, n 113 below. It is more unusual to find references to it in Germany, but it is not unknown: see n 163 below. 79  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.

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case may be, proprietary status? Logically it appears to follow as is, in principle, the case in common law,80 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 the seller in a reservation of title) the transfer of his 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.81 Thus there is substantial clarification since the Supreme Court case of 2016, in regard the conditional sale. What remains clear on the other hand 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.82 There remain, however, the taste and history of an abhorrence of these substitutes in some quarters.83 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 new Code has introduced a potential contradiction. What is allowed, and what is not? In the crossfire, some of the most important

80  The tendency in the Netherlands was towards recognition of the proprietary or in rem nature of the expectancy, see also n 72 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 162 below and for common law the text following n 191 below. But see again the Dutch Supreme Court in 2016, n 72 above, recognising the duality of the ownership instead. 81  Under the 2016 Supreme Court case, see n 72 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. 82  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 61 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. 83  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 65 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 85

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.84 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. 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. There are voices that would give the lessee at least the status of a pledgor (and therefore proprietary protection in that manner)85 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.86 It is unlikely that the new Code’s treatment of temporary ownership rights as usufructs (rather than security interests) will prove any less artificial, except perhaps if there is a clearly fixed

84 

HR, 19 May 1995 [1996] NJB 119. SCJJ Kortmann and JJ van Hees, ‘Van fudicia-fobie naar fiducia-filie’ [From fiducia-phobia to fiduciaphilia] 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. 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. 86  See for references n 66 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. 85 

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term, although, as elsewhere,87 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 so agree specifically pursuant to Article 3.84(4) CC.88 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.89 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.90 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.91 In line with what the Supreme Court

87  See eg for France, n 130 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. 88  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. 89  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. 90  See n 72 above. 91  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 56 above. It creates all kinds of other problems, such as the need for the assignor to continue to carry the receivables on his 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 87

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.

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). 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,92 it seems to lose all flexibility at the theoretical level even

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 estate in the case of a bankruptcy of the factor, although Beuving, at 73, 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 spectre 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. 92  Art 3.81 CC; see also the text at n 67 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 2, ch 2, 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

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if it does not deny in principle the existence of conditional ownership rights. However, 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. As we have seen, this becomes increasingly necessary under the influence of the globalisation and transnationalisation of the modern financial products.93 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.94 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).95 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.96 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 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 2, chapter 2, s­ection 1.3.8—and

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. 93  See further JH Dalhuisen, Wat is vreemd recht? [What is foreign law?] Inaugural Address, Utrecht (­Deventer, 1992) 20. 94  See n 72 above. 95  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. 96  From the Comments to the Introductory Statute, it is clear that the government intends to leave the fitting-in process to the judiciary, while limiting on purpose the possible public policy corrections to the­ recognition (Art 4): see also Vol 2, ch 2, s 1.6.7, n 292 and s 1.8.4.

PART I  Secured Transactions, Finance Sales and Other Financial Products 89

may meet a considerable practical need in civil law countries, a situation even now seemingly accepted in the German fiduziarische Treuhand.97 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 s­ ection 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.98 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.99 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 segregation,100

97  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. 98  See n 68 above in fine. 99  See also n 63 above and further the text at n 182 below. 100  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.

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and the operation of floating charges, there was 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 is now also 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 has become smaller and more domestic.

1.3  The Situation in France 1.3.1  Introduction: The Vente à Reméré and Lex Commissoria. The Modern Floating Charge Generally in France, the situation in respect of asset-backed funding using movable property is hardly clearer than elsewhere on the European Continent especially with respect to the status of conditional sales and ownership rights, their use in financing and their relationship to secured transactions. First, in France, for security interests in movable assets there was 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.101 This system was amended (from 2006) with a more general fl ­ oating

101  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 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 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. 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 may 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 91

charge facility, the details of which are still not fully settled.102 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 2009.103 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 bona fide purchasers are protected. 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. An important question is how this facility relates to conditional sales. In France, there is a type of repurchase agreement mentioned in the Code, the so-called vente a remère.104 It has a long history, was copied from the Corpus Iuris105 and is cast in terms of an option for the seller to repurchase the asset (for a period of five years maximum). Has it 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

is registered in the local courts. In the case of a fixture attached to mortgaged real estate, the dates of the respective registrations will determine the relative priorities. Material, equipment and furniture of hotels could also 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 and 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. See, for the situation regarding the pledging of receivables after the Loi Dailly of 1981, text at n 136 below and for the alternative of the fiducie-sûreté, n 102 below. See for the assignability of future receivables also Vol 2, ch 2, s 1.5.6. See, for a more recent discussion of the gage automobile 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. 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. 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. 102  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. It was followed in 2009 by the introduction of the fiducie-sûreté, in 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). A transfer in bulk would also appear to be possible upon an adequate description of the underlying asset (class). 103  See further the previous footnote. 104  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 65 above and for Germany n 158 below. 105  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 also n 75 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. In any event, Roman law never dealt with the effects in a bankruptcy.

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on French contract law, dwell on this point at some length.106 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 he may alienate or give as security or in usufruct.107 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 rule being that conditions can no longer mature against a debtor upon the opening of its bankruptcy proceedings. The French rule is 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.108

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 used 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). Traditionally, French law protects them, especially if these signs are 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 with a revindication right upon default.109 The other 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 traditionally limits its effect in bankruptcy, and provides an important check on the proliferation of hidden security or revindication rights in France. It was similar to

106 

J Ghestin and B Desche, Traité des contrats, la vente (Paris, 1990) 635. P Malaurie, Encyclopédie Dalloz, Droit civil V, Vente (elem const) no 776. 108  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 new 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. 109  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 121 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). 107 

PART I  Secured Transactions, Finance Sales and Other Financial Products 93

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 1986.110 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.111 This suggests itself some in rem effect and its effectiveness in a bankruptcy of the buyer barring the effects of the solvabilité apparente. The option is traditionally clearly distinguished from a security right 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.112 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 (some) 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 prohibited under the original sales agreement. Thus there are many facets to this option under the vente à reméré, but French law, as well as French authors, remain unclear or divided about 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.113

110  See s 283 Insolvency Act 1986 and n 199 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 199 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. 111  Cour de Cass, 24 October 1950 [1950] Bull civil 1, 155. 112  Cour de Cass, 21 March 1938, D 2.57 (1938), earlier 11 March 1879, D 1.401 (1879). 113  See for the concept of conditional ownership and its history in civil law also n 75 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

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1.3.3  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 indeed automatic upon the mere repayment of the advance. It then appears to imply a right as well as a duty of the seller to repurchase. In France, this is called the pension livrée and was reinforced by statute at the end of 1993 for repos in the professional sphere,114 but neither its legal nature and the aspect of its conditionality, nor the consequences of a bankruptcy of the financier/buyer were clearly discussed in terms of proprietary or personal rights. 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). The more interesting question is, however, whether in the case of 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. Other aspects to consider here are 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. In this connection, Article L 432-15 CMF still talks of a retrocession, which may suggest that there is no automaticity in the retransfer of title upon payment of

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 75, 164, noting that the duality of ownership approach is in retreat in France. See for the modern repo and reservation of title in France, nn 115, 131ff, and 121 below plus accompanying text. 114  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 3 January 1983 (originally introduced as Art 47bis 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 95

the repurchase price but that an act of retransfer is necessary, which is somewhat unlikely in view of the practice under the vente à remère. It means that in a bankruptcy of the buyer/financier the complication with the French Bankruptcy Act (in that it does not generally allow conditions to mature after bankruptcy) would still have to be taken into account, while it could be questioned whether the exception for defaulted sales would apply in this type of financial transaction, especially since the buyer is in possession.115 Also, the residual effect of the theory of ‘the appearance of creditworthiness’ would have to be considered. The statute does not go into any of these aspects and the question of an in rem right of the original seller against the buyer does not seem to have 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. Personal rights to damages obviously supplement this system, also to restrain socalled ‘cherry-picking’, a facility of the trustee of a bankrupt buyer who commonly has the option to repudiate contracts if merely executory and not resulting in proprietary rights. Yet 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,116 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. 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,117 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,

115  As mentioned in n 108 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. 116  See the text following n 85 above. 117  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.

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and in the German Insolvency Act of 1994, effective 1999, as will be discussed more extensively below.118 It means, however, that if there are not enough counterbalancing transactions between the parties, the netting is to little avail.

1.3.4  The Reservation of Title The nature of the reservation of title in France may provide further clarification of the possible qualification of repurchase agreements (or finance sales) as conditional sales and should therefore also be considered. 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.119 Whether or not the reservation of title could benefit from the exception to the rule that conditions could not mature after bankruptcy, it was still faced with the doctrine of the appearance of creditworthiness of the buyer, the notion of the solvabilité apparente, as we have seen. Therefore it was not considered effective in a French bankruptcy120 until the amendment of the French Bankruptcy Act of 1967 in 1980, later reinforced in the French Bankruptcy Act of 1985.121 Since the Ordonnance no 2006-346 of 23 March 2006, the ­reservation of title is now covered by Articles 2367–2372 of the French Civil Code. In France, on the basis of this statutory law, the reservation of title is now mostly considered a conditional sale,122 fully 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.123 The Cour de Cassation sees it, however, as an accessory right to the debt,124 now confirmed in Article 2367 CC. As we have seen in ­section 1.1.4 above, this points in the direction of a security interest, which is somewhat incongruous and certainly not the view elsewhere in Western Europe.125 This accessory nature

118 

See text at n 177 and ss 2.1.1 and 4.2.4 below. See Art 1584 CC. 120  See Cour de Cass, 21 July 1897, DP 1.269 (1898) and 28 March/22 October 1934, D 1.151 (1934). 121  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 108) 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). It preserved the right in converted or commingled property. 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). 122  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 107) 588ff. It is equally possible to see the reservation of title as achieving no more than a delayed transfer (see n 128 below and accompanying text), which appears also to be the prevailing view in England (see the text at n 208 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. 123  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). 124  Cour de Cass, 15 March 1988, Bull Civ IV, 106 (1988). 125  See for the Netherlands n 75 above, for Germany n 160 below and for England the text at n 230 below. In the meantime, the French Cour de Cassation now also holds that overvalue must be returned to the buyer upon 119 

PART I  Secured Transactions, Finance Sales and Other Financial Products 97

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.126 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 sale 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.127 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 of any retransfer to the buyer and the liability for the risk of the loss of the asset.128 As mentioned above,129 the reservation of title is sometimes also 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.130

his 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. 126  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 75 above. 127  See, however, also the approach to conditionality more generally of the writers cited in n 113 above. 128  See for an overview, see Ghestin and Desche (n 106) 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. 129  See n 122 above. 130  See Malaurie (n 107) fnn 766ff and Ghestin and Desche (n 106) no 600. Following Art 1179(1) CC, in France it is 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 agree 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 106) 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.

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1.3.5  Finance Sales, Extended Reservation of Title, the Effect of the Loi Dailly, and the Implementation of the EU Collateral Directive In France, it seems that in modern writings there is no great inclination to see the conditionality of ownership as a broader concept. This is borne out by the discussion of repurchase agreements and the pension livrée legislation in this connection, as well as the reservation of title, see the previous sections. The subject is not much raised in the context of the finance lease either, whatever the legal qualification of the reservation of title, which is the closest related structure.131 Although in France, the conditional sale structure may be used to create a transfer of ownership in the nature of a fiduciary transfer132 in the former Dutch sense or Sicherungsübereignung in the German sense, subject therefore to its lapse in the case of repayment of the sales price, it 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 reputed ownership theory. Moreover, the Cour de Cassation has insisted that appropriation of the underlying assets in bankruptcy is unlawful under this type of transfer,133 much as in Germany and earlier in the Netherlands. It 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 connection with the vente à reméré,134 and (as yet) the reservation of title, as we have seen. The explicit introduction of the fiducie in the French Commercial

131  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 96) 55, 77. 132  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 2, ch 2, n 498. A decision of 2010 left open the possibility of conversion into an ordinary 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. 133  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 112 above. 134  See, however, the text at n 104 above.

PART I  Secured Transactions, Finance Sales and Other Financial Products 99

Code (see ­section 1.3.7 below) may reinforce the difference from secured transactions. Especially the fiducie-sûreté allows appropriation (since 2009) and is much more in the nature of the conditional sale for funding purposes. In the meantime, in the reservation of title, the focus is now on the suspension of the buyer’s title pending payment, as we have seen, giving the seller the stronger position in a bankruptcy of the buyer but also the risk of damage to or loss of the asset. In the case of other conditional transfers, such as the older fiducia, the emphasis may be on the rescission of the buyer’s title upon compliance with the terms of the agreement, including the repayment of the price, giving the latter the stronger position in the case of a bankruptcy of the erstwhile seller, but also the risk of loss of the asset. Again, the prospective (possibly in rem) rights of the other party (in this case the fiduciary seller) are not much considered either. Also here, the duality of ownership remains, for the time being, substantially unexplored in French legal thinking. The extended reservation of title or reservation of title that transfers into (future) replacement assets (or receivables) is here not considered. French law appears traditionally much less averse, however, to the conditional transfer of receivables, probably because in its system it required notification, 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. It dispenses in this connection with the formalities attached to pledging receivables, which is traditionally also possible but requires an official document or the registration of an informal document, except if this gage is in the commercial sphere.135 The conditional transfer of receivables as an alternative 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, already achieved through the Loi Dailly (see also the next section) and introducing the fiducie for movable assets as proposed first through a new Article 2062 CC (in various drafts since 1990)136 and ultimately achieved through a more elaborate

135  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 superseded by the facility available since 2009 under the fiducie-sûreté in France: see n 102 above. See for the different Belgian attitude, n 132 above. 136 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 is available only to French licensed credit institutions or similar EU institutions as assignees and not therefore to, eg, 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 the 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 2, ch 2, s 1.5.6. Here the new floating charge legislation of 2005 and the fiducie-sûreté of 2009 see n 102 above and n 141 below) may provide relief as may the new legislation concerning securitisation: see the next section.

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amendment of the CC in 2007, further supplemented by the fiducie-sûreté in 2009 (see s­ ection 1.3.7 below) could in practice eliminate the differences from the fiduciary transfer in movables, whether or not allowed, and in any event reinforce the conditional sale concept, while party autonomy would come, in allowing 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 s­ ection 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. In all this, the special and simplified assignment facility under the Loi Dailly dispensing with notification (but having its own limitations as just mentioned) operates alongside the traditional civil assignment and is of special interest where future claims are concerned. Whether the true impact and meaning of assigning or setting aside future claims (under modern amending statutes in respect of certain financial instruments) in terms of recovery rights by the creditors of the assignor (and their curtailment) was fully understood is another matter. At least in floating charges, a limitation to replacement assets would not have been uncommon. The true meaning and impact of the assignability of future claims and what they are remains, therefore, an important issue in French law.

1.3.6  Securitisation or Titrisation (Fonds Communs de Créances) and the Transfer of Intangible Assets in Finance Schemes New legislation was introduced from 1988 onwards for a form of asset securitisation (titrisation) through the creation or facilitation of fonds communs de créances (FCCs), New 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 he must expressly receive at the same time together with all rights, causes of action, priorities and mortgages supporting the receivable. This approach still remains common in France especially in factoring of receivables—see Lamy Droit du financement, Affacturage (Paris 1996) 1344, 1347, but 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, 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 101

now contained in Articles L 214-43 to L 214-49 CMF. 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. It may be seen as a form of securitisation (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 chapter 2, s­ ection 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.137 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 receivable, present or future. The inclusion of future receivables is an important departure, also shown in the new legislation concerning the floating charge and fiducie,138 and might ultimately mean a broadening of the present regime under the CC altogether. 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. In any event, the assignment of future receivables may 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 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.139 In fact, it was shown there that it had never ­completely 137 

See n 136 above. See n 102 above. 139  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 138 

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­disappeared140 and continued to operate especially in conditional sales of receivables, but the types of ownership rights that it created remained largely obscure. Reintroduction was achieved by a special statute to the effect of 19 February 2007,141 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.142 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 responsible 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.

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. 140  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). 141  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, ch 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. 142  Decree no 2016-567 of May 10 2016.

PART I  Secured Transactions, Finance Sales and Other Financial Products 103

Some attention has been given in the literature to what a fiducie of this type might achieve and 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.143 Upon the revival of the project in the French Senate in 2004,144 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,145 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 own for professional activity without the need to create a legal entity.146 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.147 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. His creditors do not have a right in the trust assets either. 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

143 

See Professor Remy cited in n 139 above. In 2009 a fiducie gage was specially introduced, see n 102 above. By Philippe Marini; see for his list of possible uses, French Senate, Séance of 17 October 2006. 145  See n 102 above. 146  Law No 2010-658, June 10 2010. 147  See also A Arsac, The fiduciary property: nature and regime, Thesis Pantheon-Sorbonne 2013. 144 

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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 2, chapter 2, ­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 also limited to more formal trust structures.

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 and not through another more objective act, such as delivery of possession, as under Dutch and German law.148 Parties are thus able to create conditional sales and transfers149 but their power freely to create proprietary interests is no less ­limited,150 although their freedom in this respect was originally fully upheld in proprietary matters.151 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.152 This conforms to the situation elsewhere in civil law but French law may still imply some greater measure of flexibility, which may well go beyond, for example, the present more recent official Dutch position.153 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 is 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.

148 

See U Drobnig, ‘Transfer of Property’ in Hartkamp et al (n 91) 345ff. 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. 150  See Ghestin and Desche (n 106) fnn 542 and 612. 151  Cour de Cass, 13 February 1834, s 1.205 (1834). 152  Ghestin and Desche (n 106) no 612 and A Weill, Les Biens (Paris, 1974) no 10. 153  See F Terre and P Simler, Droit civil, les biens (Paris, 1998) no 41; see for the modern, more restrictive approach, text at n 95 above. 149 

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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 transfers154 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,155 the reservation of title is normally considered a conditional sale,156 borne out by the reference to it in the BGB. At least this is so in the case of doubt,157 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 N ­ etherlands, in ­Germany the concept of the conditional transfer is caught up in the abstract system of title transfer: see Volume 2, chapter 2, ­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 also started out as a conditional sale and transfer, but developed more in the direction of a security interest as we have already seen. It is commonly distinguished from the Sicherungszession, which entails, however, a similar facility for receivables. It may be expressly organised as a conditional sale and transfer, although this is now uncommon.158 In the reservation of title, there is certainly no 154  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 2, ch 2, 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 78 above and Vol 2, ch 2, s 1.4.6. 155  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). 156  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. 157  Section 449 BGB. Any conditionality of the title transfer in a sale is in Germany normally explained as 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 76 and 78 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 2, ch 2, 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. 158  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, therefore all securities in movables without actual possession of the security holder or his agent.

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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 Act159 and automatic. It does not therefore 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 through the 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.160 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.161

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 65 above for the situation in the Netherlands, and at n 105 and text at n 134 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 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 172 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 184 below for limiting considerations, especially in connection with the appropriation right. 159  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 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 154 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. 160  BGH, 5 May 1971, BGHZ 56, 123 (1971). See for the situation in the Netherlands and France, nn 75 and 125 above and for England the text at n 230 below and for the US n 24 above and 272 below. 161  See also text at n 168 below. These facilities are first the so-called Verarbeitungsklausel, leading to the sellers’ joint ownership of processed, assembled or mixed goods, title to which, under s 950 BGB, is normally acquired by the manufacturer except

PART I  Secured Transactions, Finance Sales and Other Financial Products 107

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 verlängerter Eigentumsvorbehalt. In a bankruptcy of the buyer, it 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. In the meantime, the right of the buyer pending full payment of the price has been clearly qualified as proprietary in case law.162 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.163

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 seller only has 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 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 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 182 below and accompanying text. They have been forbidden since 1 January 1999. 162  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 156) 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 bona fides and possession of the asset under s 932 BGB. Dingliche Einigung (see n 163 below) 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 possession of the acquirer under the general rule of ss 932ff BGB, even if he buys in the ordinary course of business. 163  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 169 below. The idea of a duality of ownership resulting from the conditional title could be only one further step in the discussion of the Anwartschaft. This discussion on this point is often fierce as implementation of the concept of

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The ­discussions on this subject are sometimes thought somewhat metaphysical and there is still some resistance to the idea,164 but the concept would appear to be real enough and firmly established.165 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 149) 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 2, ch 2, 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 185 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, 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, eg, 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 79 above. That is the causal system. As we have seen in Vol 2, ch 2, s 1.4.7, the notion of abstraction is by no means a universal civil law principle but 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 arises in other types of conditional ownership and therefore 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 n 164, 75, 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 75 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 78 above. 164  Wolf (n 158) 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 n 162 below. 165  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 155) 1362, who supports the need for

PART I  Secured Transactions, Finance Sales and Other Financial Products 109

The floating charge has no base in statutory or case law and must be gathered together on the basis of contractual clauses. In Germany, the situation compares closely to the verlängerter and erweiterter Eigentumsvorbehalt situation. There are in this connection the so-called Raumsicherungsvertrag, 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.166 As in the ­Netherlands,

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 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 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 164) 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, see the case law referred to in n 162 above and the new 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 estate. Nevertheless if no more acts are required of the bankrupt counterparty or his 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 they are with the bankrupt, they can still be validly reclaimed by the non-bankrupt party on the basis of his 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. 166  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 2, ch 2, s 1.4.5. In Germany an assignment does not require any other formal steps.

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a conditional transfer in respect of future assets may protect the financier better: see Volume 2, chapter 2, s­ ection 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 1890.167 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 never coherently considered at legislative level and it remains a device praeter legem based on customary law.168 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 rank according to time.169 The financier is still considered the transferee, however, and technically advances the purchase price to the transferor rather than extending a loan to him, but 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 s­ ection 1.1.6 above, would 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 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 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 he would have no automatic repossession right. As he has the money, this will be a disadvantage only if the assets have increased

167 

RG, 2 June 1890; RGZ 2, 173 (1890); see also n 173 below. 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, however, 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. 169  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. The second buyer need not be bona fide under the circumstances: see Quack (n 155) 787. Another, probably better, way of looking at this problem is to recognise the proprietary expectancy of the seller (dingliche Anwartschaft) and his right to dispose of it even to (second) purchasers who are aware of the (first) fiduciary transfer. 168 

PART I  Secured Transactions, Finance Sales and Other Financial Products 111

in value. As in the case of equipment or even inventory that is seldom the case, this structure may in practice prove adequate for the parties. If there is a proper conditional sale, however, 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 is also effective in the event of a bankruptcy of the financier. It then results in a so-called Aussonderungsrecht for him.170 The transferee/financier is not considered to have an appropriation right upon default of the transferor, however, and must conduct an execution sale with a return of overvalue. 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.171 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 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.172 In a bankruptcy of the seller, 170  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). 171  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 ownership rights and ignore the bankruptcy of his counterparty. The thought appears to be that in a bankruptcy of the seller his 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 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 but 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. 172  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. Reservation of title is supposed to give the seller an Aussonderungsrecht, assuming it is also part of the Einigung. It leads to a self-help remedy. Absonderung is typical for 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

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he is therefore dependent in timing on the bankruptcy trustee who is in charge of the asset and of his 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.173 It implies that the seller remains the true owner and that the asset still belongs to his 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.174 Most importantly, the buyer/financier in a Sicherungsübereignung or Sicherungszession may also legally on-sell or assign the assets. It may subject him to any claims for damages by the original owner, although they would not affect the title of purchasers/assignees. He thus appears to have full disposition rights and the conditional ownership rights (if any) of the seller do not figure here. 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).175 Both of those would be indispensable for the protection of the transferee if 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

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 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. 173  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 repayment claim, although this may be agreed: see Quack (n 156) 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 75 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 in rem status as a consequence and only retains a personal right to retrieval but this is countered by case law. 174  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 173 above, and for a similar attitude in France, s 1.3.6 above in fine. 175  cf n 161 above.

PART I  Secured Transactions, Finance Sales and Other Financial Products 113

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 character 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 an, 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—see below. 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 seems not to be one of the concerns. Appropriation of the asset is possible, except perhaps if there

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is a clear loan structure when the need for an execution sale and return of the overvalue is often deemed implied in the contract and 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 structured as a true conditional sale with an appropriation facility also effective in bankruptcy (Aussonderung).176 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 s­ ection 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, although this is not much discussed in connection with finance leasing and the repo business.177 176  See nn 158, 164 and 167 above plus accompanying text. See for the good morals concern n 182 below and accompanying text. 177  See for the proprietary aspects also the references to Wolf in nn 158 and 164 above. See, however, for the lack of an extensive discussion of the Anwartschaft notion in connection with conditional ownership in Germany n 163 in fine and n 165 above, and this crucial notion does not 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 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, however, 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 also 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 115

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 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 s­ ection 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. 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 transferor is not perceived to have much of a title for the time being,178 even though he still has physical possession. The opposite is the case for the seller under a reservation of title, who has no physical possession but is deemed to retain ownership. Under German law both have an in rem retrieval right (or Aussonderungsrecht) in the bankruptcy of their counterparty. In a reservation of title in Germany, on the other hand, the buyer has an in rem expectation (dingliche Anwartschaft). This appears less likely for the buyer/financier under a Sicherungsübereignung,179 probably because his expectation of becoming unconditional owner is so much less realistic than in the case of the buyer under a reservation

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 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. 178 

cf n 171 above. The possibility of the seller having an expectancy (Anwartschaft) which may be subject to the recovery rights of his creditors has, however, been suggested: see Quack (n 155) 781. 179 

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of title and it is certainly not the intention. Rather if the Sicherungsübereignung were structured as a true conditional sale, the transferor may still have an Anwartschaftsrecht. Even if it is not so structured, 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 increasingly ignored.180 This re-characterisation was logical in a situation where, economically speaking, there was loan financing and an interest rate agreed. 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 converted assets or proceeds. As such, it may achieve a floating charge on future cash flows.181 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). The concept is traditionally less restrictive for reservation of title than for a conflicting Sicherungsübereignung, which could be invalid for the same reasons.182 It is the German way of curbing charges, which in the case of a Sicherungsübereignung give a preference, in principle, as at the moment

180 

See text at n 66 above. See text at n 161 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 61 in fine above). As in the case of an extended reservation of title, see n 161 above, the Verarbeitungsklausel and the Vorausabtretungsklausel will attempt to cover situations of conversion of the assets in manufactured goods and of resale. 182  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 suppliers who may refuse to deal with him 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 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. 181 

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of the original agreement, even if it involves future debt and assets. Others, like the Dutch and the French, 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.183 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 s­ ection 1.6 below. In Germany, 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, as just mentioned, there does not seem to be much concern on this point.184 The intent of the parties dominates. The modern repurchase agreement in respect of investment securities could be characterised as an example of such a conditional sale and appropriation facility in a bankruptcy of the seller. 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 of true conditional ownership with a dual ownership structure, and the modern German approach to the trust or Treuhand,185 all suggest some flexibility.186 Even if parties may not directly change the possibilities here, it is generally accepted that customary law may do so.187 Yet, for conditional sales the splitownership 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

183 

See for the Netherlands text at n 73 above and for France text at n 109 above. See also Quack (n 155) 90. See the text at n 97 above. 186  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. 187  Case law will express this, see also Säcker (n 155) 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 transfer may not be: see BGH, 9 July 1975, BGHZ 64, 395 (1975). It goes back to the German concept of dingliche Einigung and the principle of abstraction: see also n 163 above. It is also possible in a reservation of title so that this reservation may be introduced at the moment of the transfer only: see Westermann (n 156) 125. As mentioned in n 78 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. 184  185 

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morals (gute Sitten) to the use of the device and the determination of its rank when conflicts arise.188 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 2, chapter 2, ­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 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 him to do so later if 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 188 

See n 182 above.

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(d)

(e)

(f)

(g)

(h)

(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. 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 he is also releases his defaulting counterparty if there is a shortfall. That is the other side of the conditional sale. 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 (nonpossessory) 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, as in reservation of title and hire-purchases and finance sales. 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. In this regard, English law is fairly flexible and relaxed about the way parties go about their affairs and 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 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. 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

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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,189 an attitude mostly respected by the House of Lords, now the Supreme Court, which is also the supreme appeal body for Scotland.190

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 law against perpetuities.191

189  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. 190  See in particular Armour and Others v Thyssen Edelstahlwerke AG [1990] All ER 481. 191  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).

PART I  Secured Transactions, Finance Sales and Other Financial Products 121

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 law, their protection is 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 from the title holder are protected as we have seen. In England, these future interests in chattels are now mostly 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. The approach to split, conditional or future interests in this manner, supported by a variety of actions, highlights an underlying concern with user, 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)192 was always strongly protected, often more than ownership as we have also seen. 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 2, chapter 2, s­ ection 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 indeed accepted in Germany.193 192 

See Vol 2, ch 2, s 1.3.2 and also n 272 below. 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 holder pursuant to a contractual right may still 193 

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It may mark a return to the more Germanic or Saxon physical concepts of possession, abandoned 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 title194 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.195 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 2, chapter 2, s­ ection 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 reconveys to the transferor upon repayment of the advance and the agreed interest.196 defend this right as his 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 he has not been paid for the repairs—this position: see Art 3.295 CC and also Vol 2, ch 2, s 1.4.10. 194 

See Lord Diplock in Ocean Estates Ltd v Pinder [1969] 2 AC 19. 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). Also 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 holdership. The possessor in common law may be better off here, although it should be remembered that in the case of chattels, common law allows no true revindication right. Moreover, 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 2, ch 2, s 1.3.4. 196  Interestingly, the common law mortgage was compared to the repurchase facility under Justininan Roman Law (C.4.54.2; see also nn 65, 105 and 158 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. 195 

PART I  Secured Transactions, Finance Sales and Other Financial Products 123

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.197 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 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 fair and equitable. In normal circumstances the courts are greatly in favour of this right. In this approach, there is thus 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 r­ edemption),198 which results in a judicial appropriation199 with a release of the debtor for any

197  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 bona fides: see s 24 of the Sale of Goods Act. 198  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 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 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 191) 162. 199  The transferee lacking possession was vulnerable to charges of reputed ownership of the transferor and could thereby be deprived of his 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 110 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 123 above. The legal suspicion of secret interests went back to Twyne’s Case (1601) 76 ER 809, in which a debtor sold all his goods to one of his 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 2, ch 2, 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 2, ch 2, s 1.7.7.

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­ ndervalue. The other feature of the old common law mortgage is that it never u depended on actual possession either. One of the key elements of that mortgage was therefore that the transferor remained in physical possession, although without power to dispose. This distinguished it from the pledge, which is possessory, and relates it to equitable charges,200 notably floating charges in personal (movable) property, which, like the pledge, are otherwise much more in the nature of a true security interest201 with an implied power of sale upon default, subject to the return of any overvalue.

200  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 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 204 below. 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 very low and may induce the chargee bank or financier to solicit fixed charges on individual assets, eg 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 2, ch 2, 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 and deal with the rights of all creditors in that context: see sch B1 para 3 and is an officer of the court. 201  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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 125

Under ­common law though, the pledge as a possessory instrument could also be created through mere constructive possession, usually through the use of a third-party bailee.202 All the same, the conditional or finance sales remain 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 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.203 In fact, the Act covers any document giving someone other 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 transfer204 but it is relevant as the

202  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 25 above) but not in England. See for the Scottish law development n 190 above and accompanying text. 203  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 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 110 and 199 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 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. 204  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

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­ ortgagee under the Bills of Sale Act does not have the protection for the bona fide m purchaser of s­ ection 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.205 In civil law, on the other hand, the mortgagee has only a limited proprietary right. It is always subject to an execution sale and there is never any appropriation.206 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,207 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

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 protections, as there is no search duty). This type of equitable mortgage is still very 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. 205  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. 206  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 75 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 120 above, in Germany s 1229 BGB and n 159 above. 207  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 189 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.

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finance sale,208 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, he surrenders any claim for undervalue if he chooses appropriation (unless otherwise agreed). This is still likely to be so for all conditional or finance sales in England.209

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. Professor Goode, in his well-known book on English commercial law, sees a fundamental difference between loan and sales credit.210 That English law makes this distinction is probably pragmatic and also eases the problems connected with the difference between charges and sale protection. It has been defined in a line of cases starting with Re George Inglefield Ltd211 and ending for the time being with the Court of Appeal’s decision in Welsh Development Agency Ltd v Export Finance Co (Exfinco).212 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 realestate 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.

208  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 198) 666. 209  See n 198 above. 210  See Goode (n 198) 578, 618. 211  Re George Inglefield Ltd [1933] Ch 1. 212  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.

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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 (which 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. Thus, deferred payment clauses may lead to property-based protection for the seller of the goods, like deferred and conditional sales, 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. Upon rescission of the underlying agreement because of default, there would be a personal action for the return of the instalment payments only (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 a security or charge than the reservation of title,213 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, at least in such cases, more properly considered a conditional sale.

213 

See for the question when a reservation of title might be considered a charge, the text at n 229 below.

PART I  Secured Transactions, Finance Sales and Other Financial Products 129

Common 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.214 The choice is usually considered a matter of business judgement at least when operating between professional parties, to be respected by the courts. Nothing else should be put in its place,215 although even then there are limits and mere shams are avoided.216 English law will thus 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 propertybased 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. A similar approach is taken in the US.217 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 onsales would have to be separately agreed and construed. This would be necessary to avoid the sales being considered mere arrangements to curtail the equity of redemption or retain the overvalue, which would in truth suggest a chattel mortgage or charge.218 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.219 The whole of the transaction needs to be considered. 214  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 198) 721. 215 See Welsh Development Agency v Exfinco (n 212). 216 See Re George Inglefield Ltd (n 211). 217  See s 1.6.2 below. 218  This was often considered the message from Re George Inglefield Ltd (n 211). 219  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

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In this regard, it is fully accepted 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.220 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.221 If, however, there is an agreed interest rate structure, it is submitted that a loan must 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 requalified 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.222 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. Finally, it may be of interest to look at the various types of registration and their impact in England. There are many registers,223 registration does not always mean the ­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. 220  Clough Mill Ltd v Martin [1985] 1 WLR 111. See h 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. 221  Automobile Association (Canterbury) Inc v Australasian Secured Deposits Ltd [1973] 1 NZLR 417. 222  See for a further discussion, Goode (n 198) 605ff and n 234 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 177 above and for the US the text at n 245 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 on the 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 cherry-pick and keep claims outside a bankruptcy set-off. 223  Goode (n 198) 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.

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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,224 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.225

1.5.4  Reservation of Title It is also necessary to give some attention to the modern development of the reservation of title in England. It was technically always possible as a delayed title transfer under s­ ection 19 of the Sale of Goods Act 1979, and under s­ ection 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 1976.226 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.227 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 imply an equitable charge, which as such needs registration in the Companies Register.228 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.229 It is clear that such

224 

See s 298 of the Companies Act 1986. See also text following n 204 above. 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 109, 110 and 199 above. 227  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 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 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. 228 See Clough Mill Ld v Martin (n 220). 229  See n 224 above. 225  226 

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charges are not necessarily supporting loans but normally relate to sales credit, which introduces an element of confusion. 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 to the one it does in civil law. It is not commonly seen as an essential element or an indication of a security interest, as distinguished from a conditional sale. In 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.230 Indeed it may also be so in the civil law of conditional sales and their operation then depends on the nature of the condition and 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 charge231 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.232

230 See Compaq Computer Ltd v The Abercorn Group Ltd (n 228). See for the situation in the Netherlands, France and Germany respectively nn 75, 125 and 160 above. Instead of automaticity, common law appears to think more in terms of the creditor being able to transfer his security with his underlying advance or claim if, and only if, so agreed between the parties: see Goode (n 198) 642 and also n 24 above. 231  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 198) 618 and 696ff. 232  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 198) 635 and is in the case of floating charges dependent on crystallisation into a fixed charge, usually upon a default, see n 200 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 202 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 228 above.

PART I  Secured Transactions, Finance Sales and Other Financial Products 133

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.233 How they fit in the English system as outlined above is hardly ever discussed in any detail, English law by its very nature not being preoccupied with system thinking.234

233 

See respectively nn 219 and 214 above. 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 198) 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 2, ch 2, 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 198) 391; see also Vol 2, ch 2, n 96, and for the US before the UCC n 272 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, he normally has no satisfactory statutory remedy if the buyer becomes insolvent and defaults. Goode (n 198) 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 to give title, and this is not considered 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 bankruptcy (unless under the terms of the bailment it comes to an end upon insolvency). It is considered an original action and not a sub-right, only reduced by the bailee’s duties towards the bailor, which are mainly contractual. When it comes to the return of the property, the courts traditionally have 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 co-ordinated 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 many mutual repos positions as may be the case between the major banks, see s 4.2.5 below. 234 

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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. What the effects are in a bankruptcy of either party remains, however, little discussed. At least in repos there is reliance on contractual close-out netting under standard repo documentation, which in England is the PSA/ISMA 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.235 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 doubt. As mentioned in note 219 above, in the case of chattels, the law of bailment is also relevant and likely to provide some further guidance but also complicates. 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: The Approach of 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. It notably purports to convert reservations of title, conditional sales, trust deeds substituting securities, and assignments of receivables (other than for collection purposes) into security interests. Consequently, it treats them all as such, see sections 1-201(35) and 9-109(a) UCC (originally 9-102(1)(a) and (2), which expressed the principle more clearly).236

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 198) 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. 235 

See for a fuller description of factoring in this connection s 2.3 below. The idea is that parties may agree whatever they like but if their relationship may be qualified as a secured transaction, the pertinent sections of Art 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 Art 9 appears mandatory: see also s 9-601. 236 

PART I  Secured Transactions, Finance Sales and Other Financial Products 135

This means that they are subject to its formalities, especially in terms of documentation to achieve their perfection, which establishes the priority, as distinguished from the 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 exceptional 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). The conversion of conditional sales, including reservations of title, into security interests is here a typical feature adeviates from the common law approach in England as we have seen. It results from the professed unitary functional 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’.237 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, s­ ection 9-601 (9-501 old) 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. Another dominant feature of the secured transaction regime of Article 9 UCC is the advance filing facility.238 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 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 still dates back to the date of the filing. 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), but cf ­section 2-105 for the sale of goods, which

237 

See s 1-201(a)(35). See for a critique of the US filing requirement, Vol 2, ch 2, s 1.7.8, n 315 and for English proposals to follow this approach n 200 above. 238 

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is stricter (insisting on existence and identification, which may still have some relevance in this connection, although s­ ection 9-108 accepts any description as specific if it reasonably identifies what is described).239 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 just mentioned, notably priority rights of third parties against unperfected liens cannot be challenged (see s­ ection 9-317) and the disposition provisions upon default cannot be varied either (except as to manner if not manifestly unreasonable: s­ ection 9-603). 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. 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. It is accompanied by the facility of the security interest liberally shifting into replacement and commingled goods 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)). 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 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 equally protected (­section 9-320(b)). The good faith requirement is here purely subjective (the ‘empty head, pure heart’ test). The protection of 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

239 

See for third-party rights in assets left with the debtor, Vol 2, ch 2, s 1.7.7, n 314.

PART I  Secured Transactions, Finance Sales and Other Financial Products 137

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 strong-arm statute of s­ ection 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. 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 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. Few security interests may only perfect by taking possession. Examples are security interests in money or instruments.240 Another question is whether the secured creditors take subject to unknown thirdparty rights in the 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 any such interests unknown to him; that is the ordinary rule in respect of equitable interests and is 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)). 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.241 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.

240  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 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). 241  See for a broader discussion of this aspect of publicity, Vol 2, ch 2, ss 1.7.7–1.7.8.

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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 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 s­ ection 1.4.4 above. The good faith adjustment under the UCC has been used to subordinate priorities created by filing creditors aware of competing unperfected interests and gaining an unfair advantage in the race for perfection.242 This subordination facility sometimes assumed by the 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 are automatically converted into secured interests if supporting payment or the performance of an obligation. 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.

242  See for Germany n 182 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 own security interest in these shares through perfection based on his 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. Art 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. S 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.

PART I  Secured Transactions, Finance Sales and Other Financial Products 139

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. So 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,243 where a new Article 2A was eventually introduced into the UCC to make some distinctions. However, the legal status of investment securities repos has also 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 for finance leases, 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 financing. If the buyer/financier (usually a special purpose vehicle or SPV, created to function as assignee) is guaranteed a certain return by the seller, a danger exists that the sale will not be considered complete, but that the transaction will be re-characterised as a loan arrangement secured by the income stream, see for this danger ­section 2.5.7 below. 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 consideration’; or still as a security interest in the above terms.244 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 is no longer 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 facts, as a secured transaction, although as already observed, the latter appears less common.245 It could also be considered a mere

243  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. 244  See respectively ss 2-106(1), 2A-103 and 9-109(a)(5). Art 2A dates from 1987 and is now introduced in most States. The terminology remains confusing. Art 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 Art 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. 245 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

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c­ ontractual arrangement, but that would not explain the disposition rights of the repo buyer. A similar qualification problem affects 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 9.246 Except for mere collection, ­section 9-109(a)(3) no longer makes any distinction and covers all assignments of accounts for whatever purpose, 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 just 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.247

­ rovide replacement goods, the fungibility issue may be less urgent. All now translates into entitlements, which p 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 2, ch 2, 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 260 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, thBankruptcy 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. 246  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 Art 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 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 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 Art 9 goes further and brings all assignments of receivables within its reach, as will be discussed shortly below. 247  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

PART I  Secured Transactions, Finance Sales and Other Financial Products 141

Where there is a finance sale such as this rather than a secured transaction, it is likely to be conditional. It is an example of the typical common law tolerance towards splitting the ownership in ways 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,248 and (b) the borderline with secured transactions. In any event, it is clear that there may 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,249 in which the intention of the parties may also figure.250 Article 9 especially in its latest 1999 version has a tendency to buckle under its own sophistication. The uncertainty it leaves under its unitary functional approach in respect of major financial instruments like leases and repos is one aspect. No less

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 247) 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 he may have at best a position just above the unsecured creditors but below all others as his interest is attached but not perfected: see s 9-322(a)(3) (9-312(5)(b) old) UCC. 248  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 the reformulation of the approach to the nemo dat rule, a subject beyond the scope of this chapter— see, however, Vol 2, ch 2, 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. 249  See for the emphasis on the facts of the case in particular in connection with leases: ss 1-201(a)(35) and 1-203. 250  See White and Summers (n 244) 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’.

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c­ urious in this respect is the treatment of assignments of accounts or receivables. All these assignments are covered by Article 9, whatever their purpose. Thus an outright assignment of a claim (rather than a security assignment) of the type covered by­ Article 9 is also governed by it. 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 is, however, still fully recognised. As we have seen, 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 2, chapter 2, s­ ection 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, factoring and perhaps even securitisations 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 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 arises, 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.

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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 could 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 dispository 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.251 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 interest at all may result.

251 

See also n 190 above and the earlier references in nn 109 and 110 above.

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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 than 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, it is beyond the scope of this book. The 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 remains 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 9-109.252 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.253

252  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). 253  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 205 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

PART I  Secured Transactions, Finance Sales and Other Financial Products 145

At the other end of the spectrum are 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 between the rental agreement and secured transaction under Article 9. Most leases need therefore 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 s­ ection 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 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, however.254 Indeed, any future interest of the lessee in the title may be construed as an indication of a secured transaction, as just mentioned,255 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. That the position of the l­essee

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 Art 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 Art 2A. This was done on purpose and is a consequence of the interest of the lessor being outside the scope of Art 9. It means that whatever interest 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). 254  Cf also JB Vegter, ‘The Distinction between True Leases and Secured Transactions under the Uniform Commercial Code’ in 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. 255  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.

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itself is stronger than contractual256 follows, however, 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.257 It would also be subject to a stay of all unilateral action (subject to any relief from it under the special provisions of s 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.258 Again, like in England, bailment protection is also conceivable for the lessee.259 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

256 

See also comment in n 248 above. 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. 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. 258  cf also J Dolan, ‘The UCC Framework’ (1979) 59 Boston University Law Review, 828. 259  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 192 and 234 and text at n 244 above and n 272 below for the situation in England and earlier in the US. 257 

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of Article 9, at least in bankruptcy.260 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.

260  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 Art 9 UCC.

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Part II  Financial Products and Funding Techniques. Private, Regulatory and International Aspects 2.1  Finance Sales as Distinguished from Secured Transactions: The Re-characterisation Risk 2.1.1 Introduction Part I of this chapter was a long, but as far as this author can see a necessary, general 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. Others, such as mortgages, pledges or non-possessory security interests in chattels or floating charges wherever allowed to operate, and finance sales, include a proprietary element and are expressions of asset-backed funding. Especially repos and finance leases may depend on further characterisation as either contractual or proprietary. 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 a full appropriation of the assets themselves upon default of the counterparty. In this part several of these products and techniques will be more extensively ­discussed, further to be elaborated for 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 in the context of the operation of custodial systems and investment securities entitlements. Asset-backed funding is particularly important in respect of modern commercial banking activity to manage risk in funding operations. Legally, it foremost concerns secured transactions (including floating charges) and finance sales and the distinction between them. It was already 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 operate. This concerns largely their proprietary effect and status in a bankruptcy of the party needing funding. 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,

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the essence of which is that if the seller does not tender the repurchase price on the appointed date, the repurchase right will lapse261 and the buyer/financier will become the full owner of the sold assets and appropriate any overvalue. It was already 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 re-­characterisation 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. It is crucial in this connection to understand that not all funding is lending and that there are many 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 below in ­section 2.1.7. Undoubtedly others will develop. We are stuck with the competition between both types of asset-backed funding and must define the legal difference.262 In line with what is largely believed to be the English practice (see sections 1.1.8 and 1.5.3 above), this book advocates263 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, there is no loan, and there will be no security for a loan either. The funding transaction will then

261  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 75, 105 and 160 above; (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 163, 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, as we shall see. 262  It is of interest that the EBRD Model Law on Secured Transactions does 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 (Art 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)). 263  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.

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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. 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, which maintains a unitary functional approach and 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.264 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 were exempted from the reach of Article 9 UCC through amendment of the federal Bankruptcy Code, and factoring received special treatment even within Article 9 in that pure collection agreements were exempted from its reach while for other forms of factoring of receivables a special 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 any overvalue to the party requiring the financing (being the assignor of the receivables) either, unless otherwise agreed. So, even the US practice confirms that if there is no interest agreed, there is no loan agreement, and, if there is no loan agreement, there result difficulties with the security analogy if there was some kind of proprietary transfer. On the other hand, when there is an interest rate structure, it must be 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 here. 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

264  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.

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of proprietary rights in the assets of the party requiring funding. This is the situation in repos, finance leases and ‘limited recourse’ factoring, as we shall see. 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 hand or as a secured transaction on the other, is unlikely to reflect reality. What is more likely to follow is a conditional ownership with some split proprietary rights structure in the manner discussed below. 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 is 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. 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; 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 thin. One may note the proprietary element probably 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, therefore transferees 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, 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. In countries that do so, as may be the case particularly among some civil law countries as we have seen, investment security repos in particular may then become subject to the cherry-­picking option of the bankruptcy trustee of either party. This means that the bankruptcy

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t­ rustee of whatever party it concerns may have the right to reject the contract if that is advantageous to the bankrupt estate. The 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. Netting of the contractual position has proven to be the answer between parties who regularly engage in this business between each other as already mentioned 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. 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 master agreements, see ­section 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 2, chapter 2, sections 3.1.3 and 3.2.4 and s­ ection 4.1.5 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 claims to assets can be converted into money, 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 also be reduced to money. That tends to be the aim of netting agreements that introduce by contract formulae under which all rights can be reduced to money if an event of default (as defined) occurs. See for the repos and swap netting or master agreements, sections 4.2.4ff and 3.2.5 below.

2.1.2  The Practical Differences Between Security and Ownership-based Funding. The Re-characterisation 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

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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,265 following German law,266 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 accessory security interest, confuses everything. The sales 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 always 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 he is not doing so. The buyer would not want to hear of any other proposition and would rather go elsewhere. If, on the other hand, there is room for manoeuvre as regards the price to be charged, the seller will normally charge the best price he can get so that any mark-up is unlikely to be related to an interest rate for any credit extended either. Again, there is a cost, but that is something quite different. 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 he wants to resell the securities to third parties). At the end of the agreed period, 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

265  266 

Art 3.92 CC. See also text at n 71 above. S 449 BGB.

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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. On the other hand, the repo buyer or financier is protected in the case of the repo seller defaulting in his 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 for him the trade-off. The situation may be different in practice when the proprietary nature of repos remains in doubt or even where it is 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 would appear a grave mistake to see all funding as loan financing and all credit as a loan, a mistake nevertheless very common among lawyers. It confuses different risks. 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 extra cost, and for the lessor his extra profit, in providing this kind of service rather than a secured loan. 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 ownershipbased 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,267 as there are in the Dutch reservation of title, but in Germany, since its Civil Code of 1900 (BGB), this perception has receded into

267  See for English law, n 211 above and accompanying text. Note for France the concern, however, about scam secured transactions by using conditional sales: see text at n 112 above and Cour de Cass, 21 March 1938, D 2.57 (1938) and earlier 11 March 1879, D 1.401 (1879).

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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 the rest of the European Continent. That is also borne out in the DCFR, which declared the reservation of title a special proprietary interest following German case law and no longer a conditional one, while in the US the UCC has also tried to ignore the difference, as we have seen,268 thus introducing a serious element of confusion and deleting a true asset-backed funding alternative. It is 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 chapter and even in the US required important later exceptions, especially for equipment leases and repos as we have seen. 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 some serious attention, especially in the older French and Dutch legal literature, but it is not now much pursued, although new case law in the Netherlands since 2016 has reopened the discussion.269 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,270

268 

See also nn 196, 212, 104, 71, 157 and 243 above and accompanying text. See Scheltema, n 163 above, 203. 270  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 meant room for some kind of reservation of title. However, in many States a filing requirement was introduced, which 269 

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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,271 the qualification of the interests and the accessory right

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). 271  See for details in particular the text at nn 205 and 206 above, and for the appropriation right giving way to the bankruptcy trustee’s option under executory contracts, the text at n 258 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 tender and its effect were obvious issues, especially in an intervening bankruptcy of the seller who still had conditional title, although 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). 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.

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issues,272 and the continuing protection of any security supporting a receivable in the case of ­factoring.273 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

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). 272  See more particularly the discussion at nn 24, 75, 125, 160 and 230 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 right to the purchase price therefore did not automatically include an assignment of his 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 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 192 and 234 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 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).

Part II  Financial Products and Funding Techniques 159

they could cause to o ­thers.274 The entirely different situation under conditional sales (as compared to secured transactions) was particularly illustrated in the proprietary protections of each party’s ­interest:275 in the disposition rights in the goods 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 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 252 above. Most importantly, a non-possessory 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). 273  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 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 24 above. 274  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. 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

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and of their interests in them, including the protection of bona fide buyers;276 the possibility and right to (subsequently) encumber the various interests in the asset;277 and in the inclusion of future assets and the shifting of the interest into replacement

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 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 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 an 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 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. 275  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. 276  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 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 proprietary interest will be completed through the physical delivery of the asset or constituto possessorio if the asset remains in his 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

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goods.278 Then there was the difference in the entitlement to the asset in 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

title (either as successor of the legal owner or upon repudiation of all unknown equitable interests in the property), 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 action to recover the purchase price but rather on his 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 he could nevertheless sell. Also the buyer had some interest in the property. When in possession, some saw him 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 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 himself of his interest, either through agreement with the seller or through surrender, merely in order to defraud his creditors: Horn v Georgia Fertilizer & Oil Co 18 Ga App 35 (1916). A simple return of the property to relieve him 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 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 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 262 above. An assignment of the conditional interest itself divested the seller of all his rights in the assets. A subsequent second sale of his 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 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 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 successor in interest.

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could conceivably give proprietary protection and reclamation rights. Any pledge of a bankrupt financier would, on the other hand, certainly disappear upon repayment of the loan by the debtor, which gave him a reclaiming right in the asset.

It was thus sometimes held that delivery of physical possession to the buyer in a conditional sale gave him 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 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 predecessor if 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 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 he acquired his own interest. As in the case of the seller, the buyer could also sub-encumber his interest either by granting his bank a security interest in his conditional title or by selling on the interest in a further conditional sale of his 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 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 business, the purchaser acquired full title even if 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. 277  A pledgee normally has no right to repledge his 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 212 above. See in the US before the UCC, n 273 above. An interesting complication is whether an encumbrance of his 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, 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. 278  See for common law in England, nn 231 and 232 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 270 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 (even calf in

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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,279 or the inclusion of either party’s interest in a bankruptcy of the other and his bankrupt estate.280 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). 279  Only German law has a 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 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 271 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 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 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. 280  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 260 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 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 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 165 above. It is in fact an in rem option. 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

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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 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 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.281

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.

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 he had failed to record his 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 276 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 right was also likely to pass to his 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. 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. 281  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 277 above in fine—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 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 2, ch 2, 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.

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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. 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, he would want to resell the asset whenever a good opportunity arose and preserve his store of value until such time. He would also want to avoid the extra risk of the delays necessarily attached to an execution sale. Even if technically 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 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, which is targeted at potentially higher-inflation countries, the re-characterisation of the reservation of title into a security interest is 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, 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. 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

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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).282 The concerns are likely to be about proportionality of reward in the sense that the non-defaulting party gets more than 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. 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 he did not object if only because 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.283 In Germany, the common Sicherungsübereignung started as a conditional transfer, as we

282  283 

See s 1.1.8 above. See n 112 above and accompanying text.

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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).284 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.285 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, but has failed to define what such substitutes are. It did not introduce either 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 nonloan situations, although the precise consequences for both parties remain profoundly unclear.286

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.287 This results in a delayed transfer and is often considered the essence

284 

See n 172 above and accompanying text. See n 170 above. 286  See respectively text at nn 176, 112 and 83ff above. See for the latest case law, n 72 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. 287  Duality of ownership in conditional transfers is often supported in civil law countries, at least in principle: see nn 113 and 78 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 163 above. This may be in the realm of semantics, but cf more recently Scheltema (n 163) 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 285 

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of the reservation of title. Title may also be considered transferred immediately, but made subject to a resolutive condition, such as non-payment. 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, later again weakened in civil law 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.288 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, 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 or obligations 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 necessarily 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. condition was, however, sometimes construed as a suspensive condition for the counterparty of which 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 Historisch Vooruitzicht, BW-krant Jaarboek (Arnhem, 1994) 19; see also n 75 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 and 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 163 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 163, 46, 54, 71, 124ff. 288 

See for the situation in the Netherlands the text at n 78 above and in France the text at n 108 above.

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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. Again, 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. Thus 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 (for movable assets in equity). To repeat, such a framework is largely missing in civil law. As we have seen in ­Volume 2, chapter 2, s­ection 1.2.2, the civil law of property thinks of each of the ­proprietary 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

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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. This concerns the ownership of the underlying conditional ownership rights and the connected concepts of legal or constructive possession, and perhaps even of holdership of the asset. 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, even in civil law, 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 he or she may hold for him or herself 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 possessor of the suspensive title. It might thus be said that the physical holder has either a suspensive and resolutive holdership, depending on whether he or she 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 he pays, the holdership disappears; he will then hold for himself as legal possessor. If he does not pay, his 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. 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),

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and (c) ­equitable interests such as beneficial, future or conditional ownership rights: see in more detail Volume 2, chapter 2, s­ ection 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 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), but 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 may 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 2, chapter 2, ­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.289 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 2, chapter 2, ­section  1.3.8.290 In common law, this openness exists in equity (subject always to the protection of the bona fide transferee/assignee for value). 289 

See nn 232 and 268 above for the tenuous position of the bailor in a bankruptcy of the bailee. 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 290 

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In civil law, the key question thus remains whether the duality in ownership and therefore the proprietary interest of either party is accepted. In common law, there was never much of a conceptual approach in these matters. In civil law this is different, 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, 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). This seems to be happening in civil law, at least in the traditional reservation of title as a sales-price protection tool. 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.291 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 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 also s­ ection 1.4.1 above and Volume 2, chapter 2, s­ ection 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. 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.

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 n 274 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 good faith, see also Vol 2, ch 2, s 1.5.3. 291 

See n 160 above.

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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 thus cut short an interest, which does not thereby become temporary but is merely 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 in this manner.292 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).293 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.

292  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 72, 122, 154, and 224 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. 293  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.

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In French law, there may be another need for 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.294 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) the creation of the interest; (b) the qualification of the arrangement as dual ownership, bailment, or executory contract; (c) the comparison between the position of the seller and buyer; (d) the shifting of the interests into replacement goods; (e) the rights to physical possession, capital gains and the liability for loss; (f) the transfer of the interests of each party and the possibility of sub-encumbrances in each party’s interest; (g) the protection of bona fide purchasers from either party; (h) the consequences of default of either party, the execution duty or appropriation right and the entitlement to overvalue; (i) the position of the creditors of each party; (j) the effect of attachment of each party’s interest; and (k) the position and characterisation or ranking of each party’s interest in the other party’s bankruptcy. As we have seen in s­ ection 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 new 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; 294 

See n 122 above.

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(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),295 and (d) the conversion of foreign interests, here conditional ownership rights used in asset-backed funding, into a comparable or nearest domestic interest (if any) especially in local bankruptcies. Any flexibility at the transnational level in this regard, ie 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 and bankruptcies. In fact, allowing the new 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, ownershipbased 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 re-characterisation risks for the financier. The danger for the financier 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. In the case of default it allows 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 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

295  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.

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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. As has already been noted, in such cases the arrangement may 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 though 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 to the asset, thus being deprived of any proprietary protection in a bankruptcy of the lessor.296 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, although in repos of investment securities, it 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. Therefore in modern financings, unless there is re-characterisation 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 this 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 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. It 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, 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

296 

See for the situation in the Netherlands text at n 85 above.

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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 2, chapter 2, 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. 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 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, it 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 section, there is significant case law from pre-UCC practice in the US, especially in connection with the reservation of title.297 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 distinctions such 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 below in ­section 4.2.2, a particular problem arises here in the case of repos when fungible assets are involved, especially important

297  See for some early attention to the subject in Germany, n 158 above and in Roman law and later France n 105 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 270–79 above.

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in the case of investment securities repos and is a seriously disturbing element in that the underlying assets need not be physically returned. In the minds of many, this may affect the proprietary status of the repurchaser in a bankruptcy of the financier. 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. As a consequence, it is often 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. As a consequence, netting the relative values has become a more 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 is submitted, however, that in an advanced legal system proprietary rights in prospective assets or replacement assets which can be sufficiently identified is a necessary concept, and should not be frustrated by physical notions of assets, which then must exist and be set aside, where in fact only (intangible) rights in or to these assets are the issue. In this newer approach proprietary rights in fungible assets are entirely feasible as long as these assets can be adequately described or identified as a class. Nevertheless, where there are sufficient reciprocal transactions, netting is likely to be the easier remedy, but it should not deflect from the underlying legal characterisation.

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, stakeholding 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,298 the essence being that the element of profit and loss sharing in respect of any money given to a 298  See S Archer and RA Abdel Karim, ‘The Structure, Regulation and Supervision of Islamic Banks’ (2012) 13 Journal of Banking Regulation 228.

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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 if banks themselves participate as principals (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 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.299

299  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.

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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 a conditional sale and as such 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,

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’ (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.

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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 bankrupty scheme will want to rely on some proprietary rights in the underlying assets in the sense of an assetbacked 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 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 re-characterised 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 liquidity-providing 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 known, 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

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and other non-Islamic countries are increasingly considering issuing in this market through their banks or agencies, however. Tax treatment of these products is 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, chapter 1, ­section 3.2.2 and Volume 2, chapter 2 s­ ection 1.10. In Volume 2, chapter 2, 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,300 a choice needs to be made between the laws of the 300 The lex situs notion finds general acceptance in proprietary matters, see also Vol 2, ch 2, 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 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 2, ch 2, 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 2, ch 2, 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 2, ch 2, s 3.2.3.

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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 2, chapter 2, ­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 may even 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 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 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. Also 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 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, in enforcement, the nature of the legal structures concerned may also be tested in preliminary, ­provisional

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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. 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. It 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. 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. Under the prevailing private international law view, there is therefore a two-step approach and it is no longer 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,

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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 the 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 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 may depend on whether foreign bankruptcy jurisdiction will be accepted at the situs, but then 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, prejudgment 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 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.

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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. 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

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s­ ection 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 2, chapter 2, sections 1.9.1 and 1.9.2. They involve tripartite structures, always of particular difficulty in private international law, hence the 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 also 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. Yet is was argued before and will be below that legal transnationalisation is the answer in these areas although it may not come through treaty law but rather through a more 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, chapter 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 yet 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 here 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 2, chapter 2, ­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.301 In the absence of

301  Moreover these treaties are seldom comprehensive and commonly still rely on traditional private international law for aspects outside their scope, see also Vol. I, ch.1, s 1.4.14. They do so even for those aspects within their scope if not specifically covered by the relevant Conventions, in which connection a difference between

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uniform treaty law, private international law approaches may thus still 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, chapter 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

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 2, ch 1, 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. 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. Yet 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, ch 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 conflicts 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, ch 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 2, ch 2, s 1.9.3. A 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 law proved incomplete: see s 2.3.8 below.

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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, chapter 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. The 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 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 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 are that it applies only to the business sphere (Article 2) and does not attempt to cover conditional or finance sales (Comment, Article 1.2). It does not, however, maintain a functional approach and parties are free to organise their funding activities in the way they deem fit, which, at least in the professional sphere, appears to be the correct approach. Nevertheless, the reservation of title is covered and characterised as a secured transaction (see Article 9) and requires an execution sale upon default, returning any overvalue to the buyer. Whether this is suitable in high-inflation countries or whether this restriction is necessary in the professional sphere was already doubted, as the overvalue will go to the defaulting debtor. It should also be realised that this approach applies here 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

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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 somewhat 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 chattels. Here the Model Law follows the example of Article 9 UCC in the US, 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 2, chapter 2, ­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).

Part II  Financial Products and Funding Techniques 191

2.1.10  International Aspects: The 2001 UNIDROIT Convention on International Interests in Mobile Equipment UNIDROIT has produced a Convention aiming at the creation of an international interest in mobile equipment.302 Especially its Aircraft Protocol is of interest and so far successful. As such it stands out amongst the other projects mentioned in the previous section. The background is that the need for internationally supported security 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 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). Realistically, the US functional approach is abandoned, and the re-characterisation of conditional sales 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), such as aircraft, aircraft engines, helicopters, ships, oil rigs, containers, railway rolling stock, satellites or other space property and other categories of uniquely identifiable 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. Yet 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 2, chapter 1, s­ ection 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 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

302  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).

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filing system that does not require documents to be deposited. UNIDROIT designates the registry or registers.303 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 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 57 ratifying states. There are at present three Protocols to the Convention: for Aircraft Equipment (2001, ratified by 59 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. The reason is that it is well drafted, relatively simple, and pragmatic, mindful in particular of the differences between secured interests and finance sales.

303  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.

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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. Also they may 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. In this area, public policy concerns, if any, 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. 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 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 2, chapter 2, ­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 first normally conform to the pattern of conditional sales of assets, the latter to the traditional secured loan, while sale credit

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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 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 are still 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 re-characterisation. This conclusion is all the more unexpected as it concerns here two common law countries, while academic opinion, shared by many in England,304 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 in the unitary functional approach to finance sales.305 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 does not consider the concept of finance sales either—see Volume 2, chapter 2, ­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 several countries there remains a substantial re-characterisation 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

304  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. 305  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 Art 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.

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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 2, chapter 2, s­ection 1.10.306 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, chapter 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, chapter 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 2, chapter 2, s­ ection 1.5.7). Transnationally, the eurobond is the most important modern example (see also note 7 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, chapter 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), 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

306  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 2, ch 2, s 1.6.7), will provide its own stimulus in this approximation process.

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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, but no more. 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.307 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 2, chapter 2, ­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

307 

See for a summary also Dalhuisen (n 263).

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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 and efficient support for modern financing (in equity, see also Volume 2, chapter 2, 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 in the right direction.308

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 book-entry 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 most 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

308  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 socalled 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.

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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 connected 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 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, finally into receivables and bank balances. Because of this transformation by the manufacturer/borrower, no physical possession can be given to the lender either. Even the manufacturer/seller/borrower cannot be required to hold onto them. Worse for the lender, upon a sale, the assets must be released from the charge in order to be sellable; 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. 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, particularly in civil law, which created considerable problems for bulk transfers/assignments and the inclusion of future (even replacement) assets at the same rank, problems that remain vivid in civil law today. These problems need to be overcome for floating charges to be effective. They are security interests in 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 in this manner, they may be collected by the lender while the outstanding amount of the loan is reduced accordingly. Indeed, 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

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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 of its own funds, the business will be forced to borrow and that is the more normal situation. Lenders will ask for security. As just mentioned, the only security on offer will normally be inventory of materials, semi-finished or end-products, and the receivables and cash proceeds, perhaps also equipment. Especially the former but also the latter are part of the ongoing business of the borrower and cannot therefore be handed over as possessory security to a lender. Moreover, also inventory is meant to be sold free and clear of any charge to third parties. Hence the shift into replacement assets, including receivables and proceeds. Returning to the type of loans floating charges may secure, the lender may indeed be involved in the collections and that may reduce the outstanding debt. These loans may 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 proceeds309 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 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 here is with the cycle of production and collection. If less is produced and more collected, the collateral shrinks and the loan will be reduced out of cash proceeds. This is likely to be different in 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 possibility of 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

309  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.

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question. Naturally, all kinds of permutations are possible. In all situations, any security that the borrower under these loans 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? (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?

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(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 s­ ection 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: see ­section 9-204 UCC. Description depends on the loan agreement and need only be reasonably clear. A security transfer has no further formal requirements except that filing is required 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.310

310 See

KMC v Irving Trust Co 757 F2d 752 (1985).

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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 search duty) may ignore the interests of others of which 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. 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 s­ ection 9-108 UCC, which requires a reasonable description (note again that s­ ection 2-105 UCC in respect of the sale of goods is much 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 most effective. 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. On the other hand, in civil law, modern non-possessory security interests must habitually still 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 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

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of tracing, constructive trusts or otherwise, even if in the case of commingling a form of pooling may result; see also Volume 2, chapter 2, ­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, is 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,311 in which connection the need to notify all receivable assignments to individual account debtors was a serious further (new) impediment, relieved in 2004, but such assignments still require a 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 can be identified with regard to certain future debtors).312 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).313 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 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 also ­section 1.5.2 above for the English variant of floating charges. The traditional equitable facilities of tracing of the interest in replacement goods, 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

311  Under the new Netherlands Civil Code of 1992, a floating charge is not foreseen, and must similarly 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 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. 312  See s 1.3.1 above. 313  See for the Loi Dailly, s 1.3.5 above.

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(Sale of Goods Act 1979, s­ ection 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 default314 or sooner if control is acquired. In England, it is therefore still essential to distinguish clearly between fixed and floating charges, the former having a higher status (and often included in charges over a whole business, eg mortgages in real estate). In respect of 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.315 It is important to make some distinction here. In England the floating charge is not compatible 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.316 As for the inclusion of future receivables in ­England, they must come into existence before they can be included (see more particularly ­Volume 2, chapter 2, ­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 but 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 court 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 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.317 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

314  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 200 above. 315  See n 200 above. 316  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. 317  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.

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other hand, as was observed in ­section 1.1.9 above, the repossession itself remains the clearest expression of private control and separation. It continues unabated and private control is now much 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. German law 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 s­ ection 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 from lowly ranked 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 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 2, chapter 2, s­ ection 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

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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 2, chapter 2, ­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; 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 bulks, (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 non-possessory 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 2, chapter 2, ­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 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

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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 also 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.318 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 2, chapter 2, s­ ection 1.11) but bona fide purchasers and even assignees may be protected regardless. It may help creditors to see where they are. In an international context more than lip service is often paid to filing notions, as we have seen. Publicity is often thought to be the cornerstone of proprietary rights. That is in itself untrue—see also Volume 2, chapter 2, ­section 1.1—as is clear from the

318 

See G Gilmore, Security Interests in Personal Property (London, 1965) s 15.1.

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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. Yet 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 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. Again, it makes 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 them and 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 purchasers or buyers in the ordinary course of business, and therefore the commercial flows, are always protected. 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. Again, it is not immediately apparent what filing systems add here to justify their cost and expense, even if access were easy and there were 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 s­ ection 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 relationback system of priority, lastly in a Law Commission consultation paper of 2002.319

319 

See n 200 above.

Part II  Financial Products and Funding Techniques 209

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.

2.2.4  Special Problems of the Assignment 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 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.320 At the heart of all these structures is therefore a bulk assignment of present and future claims: see also Volume 2, chapter 2, ­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

320  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.

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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, this means foremost that individualisation should be avoided, in the case of receivables 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 1988,321 and altogether in Belgium (as far as third parties are concerned). 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,322 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 law323 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

321  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 136 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). 322  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 91 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 61 above. 323  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).

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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 a mess for no obvious practical reason, only because the basic issues were never properly considered.324 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. Only ­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 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 2, chapter 2, ­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

324 

See ss 1.2.1 and 1.2.2 above.

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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 s­ ection 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 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,

Part II  Financial Products and Funding Techniques 213

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. 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. Again, party autonomy is not traditionally decisive in this area of proprietary rights where the objectively applicable law is likely to prevail also at the expense of party autonomy, 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

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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 which then apply.325 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 may be 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 2, chapter 2, ­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.326 This is a utilitarian 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), even though 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, 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 2, chapter 2, ­section 1.9.2 and ­section 2.3.5 below.327 This party autonomy in the choice of the applicable law may then also lead to the transnationalisation of the law in this area and could then also 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, proposes 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 s­ ection and has not received sufficient support to become effective. 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 2, chapter 2, s­ ection 3.2.4 and s­ ection 1.1.9 above. In the EU, in the DCFR, the floating

325  326  327 

See the Scottish case of Zahnrad Fabrik Passau GmbH v Terex Ltd (1986) SLT 84. See n 340 below and accompanying text. See in particular n 340 below.

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charge is not given a special place and whatever there is, it is regressive even compared to the present German situation: see Volume 2, chapter 2, ­section 1.11.4. An international project in this field setting out basic principles would 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. 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, but in many other countries they remain legally problematic. There is, however, 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. It is in fact 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 and has most recently also been done for floating charges in France: see ­section 1.3.1 above. It shows that there are no real public policy constraints. Rather 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. ­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

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note became as a negotiable instrument, at least in respect of receivables resulting in the ordinary course of business from 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 as 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 also a matter of finality. But even if we allow the domestic law of the owner to determine these issues, there would still be differences aggravated considerably in local bankruptcies or other enforcement proceedings elsewhere in which these assets and priorities figure. Here unity must come from treaty law or otherwise in practice foremost from transnational custom. 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, 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, as we have seen, it having left these matters ultimately to domestic laws, as it left also 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 presents the best analogy, as further elaborated in Article 9 UCC in the US (or otherwise for receivables the promissory note). Indeed, equitable proprietary interests

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(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, chapter 1, sections 1.4.6 and 3.2.2 and Volume 2, chapter 2, s­ ection 1.10.2 (and for the hierarchy of norms in this connection, Volume 1, chapter 1, s­ ection 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 2, chapter 2, ­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 is regressive in respect of floating charges, even in terms of German law. It is unlikely therefore to receive much support, particularly in England. 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.

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 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 also depend on a bulk assignment of present and future receivables (see s­ ection 2.2.4 above), and are as such important 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

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or in bulk), these assignments present a number of traditional problems which may be grouped in clusters more fully discussed in Volume 2, chapter 2, ­section 1.5.328 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 or documentation which may again impair bulk assignments, which 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, for example, amply showed.329 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. In bulk assignments, these distinctions may acquire a further importance, particularly the assignability of 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

328  The major problems of assignments discussed in Vol 2 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 facility to make a liberating payment whilst maintaining his 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 default, especially if the assignment was less than a full assignment. 329  See n 339 below.

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a­ ssignment possibility and overly protective defences of debtors under the assigned claims against payment requests of assignees are not favoured in this approach. Another 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.330 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 he must pay as long as 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 for all 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. Is it automatic? Does the assignor remain responsible for their implementation, or can the debtor object to the assignment on the basis that he has not consented to the transfer of these related duties? If 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, chapter 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 330 

See also Vol 2, ch 2, s 1.5.12.

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imposition of extra burdens or risk (eg 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 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 if this consent is forthcoming. In the US, on the other hand, ­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. A more 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 2, chapter 2, ­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 he knew or could have known of the restriction or problems. He should not even be dependent for the validity of the transfer on his bona fides (which in the case of assignments, at least in civil law, is in any event 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

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this rule was also maintained for the transfer of intangible assets, but most laws remain resistant: see more particularly Volume 2, chapter 2, s­ ection 1.5.5. It means that they do not understand the meaning of liquidity in this context. However, the liquidity of claims, especially trade receivables but also service invoices (like those of law firms) is becoming greatly important. 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 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. In countries like Germany, 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.331 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 2, chapter 2, s­ ection 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

331  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.

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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 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 to a collection guarantee for the seller).332 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.333 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).

332  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. 333  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 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.

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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, as we shall see. 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. 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 (see ­section 2.2 above), except that the latter usually also includes 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 bookkeeping, 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

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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 2, chapter 2, 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, 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 (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 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

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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 2, chapter 2, ­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 at least 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, as will be attempted below. The terms are in any event 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 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 notification, publication and documentation), the right of the assignee to collect and retain the proceeds, the liquidity of the claims, and the liberating payment of the debtor, who may be very differently protected against assignees’ claims under his own law, and the priority between various assignees of the same pools of assets inter se.

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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.334 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, perhaps even less so here, 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 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 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

334  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.

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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. 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),335 here more properly a bulk assignment, therefore a

335 

See n 136 above.

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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, as in general is still the case in the Netherlands and France, 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.336 As was suggested earlier, rather 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 he will transfer his 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

336  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.

Part II  Financial Products and Funding Techniques 229

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 2, chapter 2, ­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.337 It is a mere Forderungskauf. This is in line with German thinking about receivables being mere obligatory rights but does not conform to international practice. Yet also in the US and even in E ­ ngland, 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 retransfer. These transfers would not then be bankruptcy resistant. As mentioned before, a conditional transfer structure may 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. It may 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.

337  See for a brief discussion Bülow (n 331). 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.

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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, excess collections above the principal and interest and extra receivables will then 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 lifts 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 of course 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 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

Part II  Financial Products and Funding Techniques 231

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 registration system in respect of them and remains more generally hostile to bulk transfers and the conditional sale for financing purposes. It seems an unnecessary complication.338

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 bulk assignments, especially those in bulk, the key question becomes when an assignment is international and what the concerns are. What uniform or other law should or does apply?339 An assignment imposes a new contractual layer of interests and also

338 

See for this latest Dutch departure, nn 61 and 64 above. 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 2, ch 2, 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 KokkiniIatridou (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 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 assignments 339 

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raises, as we saw in s­ ection 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.

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 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 applies 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.

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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, he becomes unavoidably involved, even though in principle as passive spectator: when is the assignment valid as regards him? Whom does he need to pay? How does payment to the assignee discharge him? Under his own law he might be very differently protected. Does it apply as to him? 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 (ie, 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, which deals

See for a more commercially oriented view in England, Goode (n 323) 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 2, ch 2, 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)?

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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 2, chapter 2, ­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. 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 (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 transnational 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. ­

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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.340 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, he must be located in a Contracting State or the law governing the receivable should be the law of a Contracting 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.

340  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.

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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 more patchy 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 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. Whatever the merits of these rules in contractual matters (and even there they can be much criticised, see Volume 2, chapter 1, sections 2.3.6–2.3.7 and Volume 1, ­chapter 1, s­ ection 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 conflicts 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

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definitions of their main concepts, it deprives them of substantially all 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 here that could be explained and supplemented through analysis of the Convention from within, supplemented by international practices.341 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 chapter 1, ­section 1.5.4. 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 also followed, which looks at custom essentially in terms of implied conditions of the contract. This is also much 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 2, chapter 1, ­section  2.3.6. In its uniform conflicts 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 the relations between various assignees (Article 30).342 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

341  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. 342  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.

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bulk assignments. The particular aspect is here of course the protection of the debtor and the question whom he should pay and what his defences and set-off 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 2, chapter 2, ­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 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.343

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 receivables344 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. 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

343 

See n 340 above. 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. 344 

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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 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

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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 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 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 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 also does not determine the proper situs of the claim for proprietary or enforcement issues. 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

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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 provides a much more comprehensive uniform regime. The Convention is not limited to bulk assignments of trade receivables,345 and has or should have particular relevance in the context of 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 funding objectives became irrelevant and a decision was therefore taken not to limit the ambit to receivable financing 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. It might have been better not to have gone beyond it. 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 and security transfer, their different structures and possibly formalities. In later drafts, it became unclear, however, 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

345  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.

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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 the 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 represents 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 are two important achievements. 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 these 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 section, 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 regimes (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

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filing system,346 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 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 aspect 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 also important for the operation of floating charges, in which the substitution of assets, especially inventory and receivables, is a

346 

See for a critique s 2.2.3 above.

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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 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. 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. This was indeed the original programme of the UNCITRAL Convention, and it follows 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 and interpretation. The Convention should notably have been more careful with any reference to good faith in its interpretation, which, as the Convention 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

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would have been a clear reference to international 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, chapter 1, s­ ection 1.4.14 and Volume 2, chapter 1, sections 2.3.7 and 2.3.8. That being said, 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 found no 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

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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 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 re-characterisation. 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 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

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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 he might have had to pay if he had borrowed the money (assuming 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.

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

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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.347 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). 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 2, chapter 2, ­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 2, chapter 1, ­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 347  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.

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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 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

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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 conditions 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 recharacterisation 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

Part II  Financial Products and Funding Techniques 251

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. 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 German348 and French law349 seem largely uninterested in the proprietary and collateral aspects of finance leases, while Dutch law, if not now outlawing the finance 348  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 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

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lease in its proprietary aspects as a pseudo-secured transaction, tends to characterise the finance lease as a purely contractual arrangement, as we have seen.350 In Germany, the focus of the discussion 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 at least the position in real estate: see s­ ection 566 BGB. It may also be the Dutch approach after case law validating finance leases if 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,351 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

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. 349  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 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 ‘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. 350  See n 86 above and accompanying text. 351  See WM Kleyn, Leasing, Paper, Netherlands Association ‘Handelsrecht’ (1989).

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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,352 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 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 s­ ection 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

352 

Goode (n 323) 709, 721; see also n 234 above and accompanying text.

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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.353 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 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 faraway 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, he may be declared bankrupt in that country when the whole characterisation issue may be

353 

See also n 259 above for the bailment aspect.

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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 2, chapter 2,­ 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 2, chapter 2, s­ ection 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 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.

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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 2, chapter 2, ­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

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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 its 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 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.354 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

354  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’ (Kluwer, 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).

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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 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 2, chapter 1, 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, chapter 1, s­ ection 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

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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 (eg 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 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 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

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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.355 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.356 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.357 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 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,358 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).

355 

See also Explanatory Report (n 354) 40 (no 70). ibid 61 (no 114). 357  ibid 32 (no 52). 358  This follows from the text of Art 1(1)(a), which refers to equipment; see also Explanatory Report (n 354) 36 (no 63). 356 

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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).359 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.

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

359 

See s 1.6.3 above.

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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,360 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

360 

Explanatory Report (n 354) 51 (no 93).

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publication set out in Article 7 of the Convention in any event does not appear indicative of any general principles on which the 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 third-party 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.361 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 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, 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.

361 

ibid 78 (no 149).

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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 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.362 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 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.363 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

362  363 

See further s 2.4.10 below. See comment by E Gewirtz and J Pote [1998] International Financial Law Review 24, 25.

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of possession—and may in any event do neither before 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 he is not supposed to have signed it.364 He may still have substantially relied on the guidance of the lessor, and is 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 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 s­ ection 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 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.

364 

Explanatory Report (n 354) 62 (no 116).

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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.365 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 he terminates the agreement and claims damages, he has the right to reclaim any payments less any benefits derived from the equipment. 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, 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 (eg 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.366 365  366 

Dageförde (n 354) 153. Explanatory Report (n 354) 109.

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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 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.367 The Convention, moreover, contemplates only a

367  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

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partial codification.368 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.369 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,370 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.371 Also in this area, progress may now only be expected from further­ 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. 368  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. 369  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. 370  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. 371  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 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.

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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 s­ ection on leasing: see Volume 2, ­chapter 2, s­ ection 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 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.372 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

372  See also SL Schwarcz, ‘The Universal Language of Cross-border Finance’ (1998) 8 Duke Journal of Comparative & International Law 235.

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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 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 securities 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 2, chapter 2, ­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 (eg 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, eg under revolving loan agreements, to provide more credit (eg 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

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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. 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

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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 2, chapter 2, ­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 2, chapter 2, s­ ection 1.9.2, and a practical argument can be made that it should be the law of the assignor—see s­ ection 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. All these facilities depend 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 risks 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

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(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.373 A first step in this credit enhancement process may be collateralisation. The bonds so issued may then be 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

373  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 e.g. 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. 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 over-transparent 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.

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s­ pecially 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. 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, eg 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,

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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 two 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

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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 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. See for false liquidity or the appearance of it also chapter 2, note 17 below. 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.

2.5.2  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 sub-participation 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.

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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 is 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. Thus, 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 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 even 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 still 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 market place but misselling 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

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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 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 five per cent and that is also the idea in the US Dodd-Frank Act of 2010.374 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

374 

See ch 2, n 25 and s 3.1 below.

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(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,375 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 2.5.4 below as will regulatory issues and action in ­section 2.5.10 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 subprime pool.

2.5.3  Synthetic Securitisation. 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 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.

375 

See for operation at that time of these funds in narrow banking, ch 2, s 1.2.6 below.

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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.376 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 s­ ection 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 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 376  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.

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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 the CDS are the best known, there are other types of protection imaginable. They are 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, s­ ection 2.6.7 below) may be used in this connection to define the events of default.377 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

377  See PC Hardin, ‘A Practical Guide to the 2003 ISDA Credit Derivatives Definitions’ (2004) Euromoney Institutional Investor Plc 134.

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be the result of the intervention of a central counterparty (CCP): see s­ection 2.6.4 below.378 The term is also used in the case of early termination or when there is bilateral novation netting (or compression, see s­ ection 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.379 This still leaves the problem whether the protection giver will be able 378  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. 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. 379  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 sellers 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.

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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, 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 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 five 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

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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 (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 pass-through 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 decade. 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.380 In this connection, compression is a technique through which two or more counterparties replace existing contracts with new ones. It is often considered important that the netted face value is in the order of 10 per cent of the unnetted face value.381 Their impact on the investors was more fully tested in the 2007–09

380  I Aldasoro and T Ehlers, ‘The Credit Default Swap Market: what a difference a decade makes’ (June 2018) BIS Quarterly Review. 381  See IOSCO Report FR05/12, The Credit Default Swap, 5 (June 2012).

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financial crisis: see ­section 2.5.4 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).

2.5.4  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 subparticipations at the level of the originator, which would fund its loans in this manner through investor participation, 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.382 382  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.

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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 shortterm 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. 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.

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 sub-prime 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.

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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 chapter 2, ­section 1.3.4 below. In such a highly leveraged environment, the early crisis in the interbank market had an instant ripple effect on all lending activities.383 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 highyielding 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

383  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.

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can hardly cure but for which under Basel II since 2008384 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 chapter 2, ­section 2.5 below. 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,385 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 chapter 2, ­section 1.1.7 below. 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

384  385 

See ch 2, s 2.5.10 below. See ch 2, n 163 below.

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and work to 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 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 chapter 2, ­section 1.3 below.

2.5.5  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.386 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 whistle-blowers 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.387 386  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. 387  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.

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In the case of Enron some successful prosecutions followed, but they were not unaffected by later Supreme Court review.388 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

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 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 had no cash) to pay for these shares through a promissory note (this might have been an illegal margin transaction which requires a 50% 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. 388  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.

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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 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.

2.5.6  Covered Bonds In the meantime, covered bonds have appeared as some alternative or variant of ­securitisation.389 They have 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 principle 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 ring-fenced 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

389  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).

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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.390 In 2010 alone, banks were estimated to have issued and sold around 350 billion US$ 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.

2.5.7  The Re-characterisation Risk in Securitisations In ­section 2.1 above, the distinction between secured transactions and finance sales was discussed, and the dangers of re-characterisation 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 (­section 9-607 UCC). The use of SPVs or similar entities (with or without securitisation) to move assets off-balance-sheet could be seen as another exception. Indeed, there could be a funding

390 

In the US, this is also considered: see HR Bill 5823 (2010).

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element, for example where protection providers also provide a loan or in securitisation the originator becomes a loan creditor of the SPV, in the latter case the proceeds of a bond issue are in any event unlikely to be on-lent to the originator/protection buyer, but 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. Re-­characterisation 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 unusual in the context of a securitisation of risk assets. The mere transfer of a class of assets to an SPV, which acquires them outright and pays for them, should therefore never be re-characterised as a secured transaction in which the purchase price could be recast as a loan secured on the assets transferred to the SPV.391 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.392 Altogether, it would make these structures unsafe for them. This whole re-characterisation debate is thus highly damaging and mis-focused. Yet 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 initiative).393 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 at all but payment for assets irrevocably transferred. 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.394 In fact, some States of the US, such as Delaware

391  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. 392  This in itself could raise disposition questions and might prevent mere collection by the bond holders. 393  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 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 PostEnron’ (2005) 25 Cardozo Law Review 1539. 394  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

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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 SPV, 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 re-characterisation risks depending on the nature of the scheme, which always has some funding elements, but if the re-characterisation 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.395 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.396

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. 395  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. 396  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 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’.

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2.5.8  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 market place. 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 re-characterisation 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.397 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 this 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

397  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.

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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.398 The argument here is that the payment obligation is not 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.399 There is also a feeling that this activity needs special regulation,400 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.

2.5.9  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

398  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. 399  See in the US Circular Letter No 19 Best Practices for Financial Guarantee Insurers from Eric Dinallo Superintendent NY Ins Dept (22 Sept 2008). 400  See BB Saunders, ‘Should Credit Default Swap Issuers be Subject to Prudential Regulation’ (2010) 10(2) Journal of Corporate Law Studies 428.

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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 s­ ection 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 2, chapter 2, ­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 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 2, chapter 2, ­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.

2.5.10  Domestic and International Regulatory Aspects Apart from the legislative attempt discussed in ­section 2.5.8 above, in the US, the ­Sarbanes-Oxley Act of 2002 already concerned itself in s­ ection 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.401 401  See also n 393 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

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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.402 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 of these newer products, their proper documentation and assessment of the risk.403 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

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 the 2007–09 crisis, in which they were much criticised, was therefore not a new issue and had been considered earlier. 402 

See also Saunders, n 400, 428. 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 B ­ enefit?’ 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. 403 

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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 chapter 2, s­ection 1.3.7 below. 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 five per cent stake in these products.404 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. All the same, new regulation would likely affect the market activity and gearing in securitised instruments. In CDS, the concern is rather standardisation405 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.406 It should be understood in this connection, however, that centralised clearing does not necessarily mean a CCP acting as sole counterparty. There are

404 

See ch 2, n 25 and s 3.7.3 below. See also n 378 above. 406  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. 405 

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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 who 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 s­ ection 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 s­ ection 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.407 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 chapter 2, sections 1.3.9, 3.7.6 and 3.7.9 below. 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

407  TV Koeppl, ‘Time for Stability in Derivative Markets—A New Look at Central Counterparty Clearing for Securities Markets’ in CD Howe Institute Commentary (2011).

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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 eight 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 chapter 2, sections 1.1.14 and 1.3.7 below. 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 chapter 2, ­sections 1.3 below. 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 chapter 2, ­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 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 to become effective in 2017, effective January 2019, see chapter 2 ­section 3.7.18 below. It demonstrated to some extent a change in sentiment in favour of the practice assuming it was 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 securitied and any originator or sponsor who buys such exposures for securitisation purposes must verify that the original lender also met such requirements. Notably the five per cent retention or skin in the game is maintained, but the disclosure requirements are relaxed, although there are 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.

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2.5.11  Concluding Remarks. Transnationalisation The modern possibility of removing whole classes of risk assets from balance sheets to SPVs and now even specific risks, qua risk, in credit derivatives or in risk layering and the facility (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, precisely because these structures are contractual rather than 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

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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, chapter 1, ­section 1.4.13. In such a more advanced approach, domestic law remains only the default rule. As far as regulation is concerned, it presents special problems of application in international cases, as we have seen in Volume 1, chapter 1, 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 ­chapter 2, part III below.

2.5.12  Impact of Fintec on Securitisation Securitisation is an area that could potentially benefit from the widespread utilisation of blockchain408 or a similar facility and smart contract technology.409 Firm answers on likely use are not yet available. However, it can be envisaged that blockchain or similar technology may have a transformative effect on a securitisation’s entire lifecycle.410 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. 408  The following text is substantially taken from the King’s College Executive LLM organised by JH ­Dalhuisen, C Kletzer and M Schillig. 409  See for smart contracts s 2.6.12 below. 410  SFIG and Chamber of Digital Commerce, Applying blockchain in securitization: opportunities for reinvention (2017).

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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 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 has 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

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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 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; a consortium led by JP Morgan, Barclays, Credit Suisse and Citi have tested equity swaps post-trade 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 foolproof level of reliability. The interlinkages between blockchain and off-blockchain assets and systems remain a source of risk. Standardisation and

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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 not least 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, credit derivatives 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. He immediately receives a price or premium for his willingness to accept that risk. That is his 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 he may also use the option as a speculative instrument and in covered calls as a way to create extra income. The futures contract411 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

411  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.

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may thus mean selling the asset forward at current prices. 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 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, notably central counterparties (CCPs) as we shall see, may further 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, which transaction is netted out with the original one. This taking of opposite positions can of course also be done offexchange, 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. Party substitution in principle requires consent of the other party who therefore has a veto (see also the discussion in s­ ection 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 central counterparties or CCPs with whom all participants deal, allowing in particular for a netting out of these opposite transactions, now between the same parties. A future may provide the most ready 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 future 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 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 regular exchanges mostly act as CCPs in standardised transactions of this nature in the manner explained below in s­ection 2.6.4. The end

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result is that the owner still has the underlying asset and has realised a profit in it in the meantime. 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 he would benefit if in floating. The other fears a decrease against which 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 wanting to enter into one 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 swap. Market makers of this type could also provide swaps which would not then exactly match size and maturities. 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.412

412  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

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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 floating for the period. After two years the interest rate is 10 per cent. Now a fall in interest rate is expected and the party concerned may swap back into fixed 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 two per cent increase for three years while having had the benefit of the rising interest rate during 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.413 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, 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 may now be used, as we have seen. They are in fact a type of third-party guarantee of performance, 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 an SPV: see ­section 2.5.1 above.

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. 413  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.

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2.6.2  The Use of Derivatives. Hedging Thus 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. 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 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

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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. The option gives more flexibility than a future (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 he will end up with the securities as if 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. 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 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 c­ urrency swaps,

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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 (for them) 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 risks 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 in volatile currency and interest rate environments. 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 in the bond or loan markets, in practice, the swap parties are unlikely effectively to exchange the amounts or flows involved. In asset swaps—eg 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 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.

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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, swapoptions 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 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 he guarantees a minimum. Swaptions allow the other party, for a fee to be paid immediately, to enter into a pre-agreed 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 putable 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. As we shall see in s­ ection 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

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c­ ertain 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 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.

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 the same way as the underlying assets. Price fluctuations in the underlying asset will nevertheless have an 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) are not part of the

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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. By the end of 2014 the total was about $600 trillion, a decline of nine 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. The value of these swaps is the difference from time to time between the value of exchanged cash flows as they develop. 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. 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, and also in those cases only the differences in values will normally be settled.

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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 there is regulatory pressure for this to change for swaps that can be standardised. It raises the important issue what standardisation means in this connection, see ­section 2.6.5 below. 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 that a group of market makers in a pit shout prices to floor brokers who communicate with them through a set of hand signs. 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 (six seconds) but it became doubtful whether this was really so while the communication facilities on the floor remained unavoidably cumbersome. The US exchanges held out the longest but have now also abandoned the open outcry. These future and option exchanges each have their own clearing and settlement systems or may use outside organisations (as LIFFE in London does by using the London Clearing House (LCH)). These are likely to be quite different from the ones in the securities markets, where the emphasis in clearing is on 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 each transaction immediate and final. 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, just mentioned, but also for the publication of quotes and done prices. This is now common in all exchanges, whether formal or informal, as we have seen. If some or all of these functions are left to outside

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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 preand 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 is here done in house, informally. New regulation in the US (Dodd-Frank Act) and in Europe (the EMIR)—see chapter 2, ­section 3.7.4—meant to change this at least for standardised products. It is felt that this makes this business safer as it will be better and more professionally administered. It may also be better monitored. It has already been said that by the end of 2014 almost 30 per cent of this trading was considered by the BIS to take place through central clearing. While discussing the ‘trading’ of derivatives, even on regular derivatives markets, again it should s 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 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, is only effective, however, 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 the transfer. This could amount to novation as a tripartite agreement under which the old contract disappears and is replaced by a new one.414 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

414  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, but the truth is rather, at least in Europe, that the contracts are entered into immediately with the CCP and that there are no others; see also n 394 below.

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(b)

(c)

(d)

(e)

(f)

(g)

(h)

(i)

d­ ocumentation 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). 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. 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 as we shall see. 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. 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 as we shall see. 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. 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. This is often explained as a novation but, as we shall see, it may be that through an agency construction the exchange was always directly engaged through its clearing members. The interposition of CCPs in this manner makes an instant or immediate closeout 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. 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.415

415  See for CCPs and their functioning in particular, J Huang, The Law and Regulation of Central Counterparties (Oxford, 2010) and further C Chamorro-Courtland, ‘Counterparty Substitution in Central Counterparty (CCP) Systems’ (2012) 26 Banking & Finance Law Review 519.

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(j) 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. (k) 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. (l) 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 need. (m) 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 the future 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 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 closeout, 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

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s­ ystem 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.416 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 L ­ ondon). This role is becoming the essence of all modern clearing systems.417 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

416 

See for the particulars and conditions for novation netting, s 3.2 below. 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. 417 

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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 floorbroker does so not in its own name but in the name of the clearing member supporting this broker, which 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.418 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 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.

418  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.

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It may be asked in this connection who is the agent for whom or what? Who is principal and who is 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 endusers (the ‘seller’ and ‘buyer’) may differ between futures markets and option markets and between futures 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, he activates at the same time an agency relationship between his 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,419 or at least there need not be. It was already mentioned that novation terminology is often used in this connection but it may be better argued that because of the general power to commit the clearing members, there was never any other contract. 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 winning party the difference on a daily basis through this mechanism.

419  Especially in England, one often sees here a reference to novation, as if an original agreement between the end-seller or buyer were novated into new agreements with the exchange (CCP) through the clearing members. This is confusing. Although it could be arranged otherwise, the normal situation, at least in Europe, is that there is no agreement between end-users and therefore no novation at all. Rather, what happens is that through agency constructions in the manner here described (even though the ordinary rules of agency may not apply in all aspects) clearing members are irrevocably activated by their floor brokers and market makers (at the instigation of end-users who are unlikely to be known to each other) to engage the exchange (CCP) as principal, always for their own risk but ultimately to the benefit of the end-investors. From this, the end-sellers or -buyers derive rights and obligations vis-à-vis the clearing members but not vis-à-vis the exchange (CCP) directly; see also Huang (n 415) 82ff.

Part II  Financial Products and Funding Techniques 323

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.420 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 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 clearing organisation or 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. Thus on a closeout there is usually nothing to pay either way. 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. Bankruptcy of a clearing member would still be a serious matter but they are carefully selected. In fact, this method of clearing and settlement is also increasingly adopted in ordinary stock exchanges, to minimise the risk to the system through the operation of well-capitalised clearing members who take over the liabilities of individual investors. This system lends itself also to clearing or transfers of foreign exchange transactions and even payment instructions and OTC 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 recently421 an informal OTC market in which there were no general rules for clearing and settlement, set-off or margin (and other collateral) requirements or calls.422 There is then

420  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. 421  See in the EU for the EMIR Regulation favouring central clearing, ch 2, s 3.7 below. 422  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.

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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. See for further details sections 2.6.8 and 3.2.5 below. 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 interpose423 themselves between the counterparties.424 This is promoted by modern regulation and would logically entail (some) supervision of documentation, enforcement of margin requirements, verification of trades, and price reporting. This means 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,425 although such a regular close-out may not be the prime purpose here, and may be less opportune where the exposures are tailor made although market makers might still be willing to create opposite positions.426 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

423  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 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). 424  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 ch 2, s 3.7.4 below. Art 2(1). 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’. 425  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. 426  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.

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horizons (see ­section 2.6.1 above)427 there may be problems, although again under the ISDA Master they can and are dealt with, more in particular in situations of default, as we have seen. In regular derivative 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 2010,428 explained that standardisation of this type is not 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.429 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) put emphasis also 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 easy transferability and replacement was here also identified as an important issue, which suggests that the derivative can then also 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.430 Margin and proper 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.431 Again, that also leads into 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

427  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. 428  The Future Regulation of Derivatives Market, HL Paper 93, 42 (2010). 429  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 counterposition or hedge. 430  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. 431  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.

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operational standardisation. The EU financial stability board (called the European Systemic Risk Board or ESRB, see chapter 2, s­ ection 1.1.14 note 79 and s­ ection 3.7.2 below)432 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 being 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 standardised products can still not be cleared because they are not liquid, showing that at least for swaps, formal standardisation may 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 (which may also suggest that interposition of CCPs is not always necessary in central clearing; it could be Clearnet) although achieving it is normally a major aim in standardisation and may be a powerful risk management tool by itself. Operational standardisation remains therefore 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.433 These products may range from very simple products to products that are highly complex. Customised features of bespoke products may include, among other things special consideration of: (a) underlying assets; (b) strike

432  433 

See its 2010 paper Implementing OTC Derivatives Market Reforms, 13. EU Financial Stability Board, Implementing OTC Derivatives Market Reforms (October 2010).

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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 a crucial issue.434 Again, 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 they may be too risky for them because they may not be liquid enough and are not in line for close-out netting either. 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 chapter 2, ­section 3.7.4 below), much of this 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 derivatives 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 in any event 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 (CDR).435 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

434  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. 435  See s 2.5.3 and n 362 above.

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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-regular 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 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, who acts as counterparty to both 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. 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 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, who 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, who 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 with whom the CCP will deal. 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

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and their systems expertise. From a legal point of view, there is also the standardisation of documentation and there are further substantial benefits from operational standardisation, which allows what amounts in effect to a transfer of positions which, at least for derivatives as contracts (and notably not negotiable instruments), could not otherwise be easily achieved. The CCP facility shows a close modern connection between clearing, settlement and securities markets, it remaining always understood that clearing is market specific and for derivatives it is foremost connected with counterparty risk when (often repeated) payments under longer-term contracts must be made. In fact, that does not in itself require a CCP taking over the transactions although it greatly improves the netting facilities and close-out possibilities when these positions are also ‘traded’, but clearing is not then primarily an issue of settlement risk upon a transfer of positions as it is in the securities markets. 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 counterpositions. 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 closeout agreed. That may be done under bilateral netting agreements, as under the ISDA Master Agreements, but is facilitated through CCPs. They reduce settlement risk which is mitigated also because of the strong financial backing of CCPs and their margin requirements Again, the close-out is not then the sole or even 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. All derivative markets could ultimately dissolve in this kind of central clearing and settlement systems, with or without CCPs. They would compete for the business and could operate across different businesses for multiple markets (including securities, derivatives and commodity trading), acquiring in that case the substantial benefit of scale, but also ever broader netting facilities through the further interposition of CCPs and therefore risk mitigating tools in terms of liquidity and settlement risk. Counterparty risk is thus concentrated but also eased, and the stability of the financial markets may be enhanced. Transaction costs may be reduced, at least that is the idea. It may be the way of the future, even for investment securities trading and commodities436 and could even mean the end of official stock and commodities exchanges as we know them today. Cross-border transactions may also be facilitated, especially if there are clearing members in different countries, further promoted by the easier dealing facilities that emerge from paperless investment securities entitlements systems in custodial holdings. 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

436  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.

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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 chapter 2, ­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 most 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 compete. That makes them vulnerable and they perform a balancing act. Forcing the pace through regulatory intervention could easily destroy their credibility. In other words, if politicians/regulators want more, they may have to organise and guarantee them. 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.

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, see further also the discussion in s­ection 2.6.3 above. They may carry substantial risk, especially the naked options and uncovered future sales. In swaps, if principal and/or cash flows are exchanged, 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

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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 may be simpler to refer here to a contract for differences, and the term ‘novation netting’ may not add much (see for this concept s­ ection 3.2.3 below). 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. If cash flows are exchanged, or in currency swaps even the underlying principal 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 principle 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 crossborrowings, 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 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

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defaults or cross-defaults or goes bankrupt, or when other 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 draftsmanship an attempt is often made at a form of contractual novation netting, see, for the complications, ­section 3.2.3 below. 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. Swaps netting makes an enormous difference (just as CCPs make an enormous difference in regular markets in terms of total exposures). The total netted swap exposure is seldom considered to be more than three per cent of the total swap amounts. This means a total exposure for the market as a whole of less than US$1.35 trillion on a total of US$45 trillion being (nominally) swapped, which was probably of the order of the total swap market in 1999. By 2006, the total swap market was estimated to be US$ (equivalent) 285 trillion (nominal); by the end of 2009 it was well over US$500 t­ rillion (equivalent) with the real exposure believed not to exceed US$7 ­trillion, most of it between financial institutions. By the end of 2014, it was more than US$600 ­trillion, the replacement values after full bilateral netting not deemed by the BIS to be much more than US$21 trillion (even though a sharp increase on the previous year when it was US$17 trillion). Still it is in the 3 per cent region. By 2017 according to the BIS, the total outstanding amount was deemed to be US$542 trillion, and the netted out amount US$13 trillion. The centrally cleared portion was thought to be over 50 per cent.

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. 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

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to a void agreement. 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 as we have seen. Whether by contract such a protection can indeed be effectively achieved 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 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: see also ­section 3.2 below. Outside bankruptcy, connexity between the obligations being set off may in some countries (especially of the common law) still be a prerequisite for any set-off, therefore within one swap or rather among several swaps with the same counterparty. As a consequence in full bilateral netting there may be a need to bring (as a minimum) all swaps between the same parties within one (master) framework showing dependency or mutuality.437 Again, the drafting was much helped by ISDA, which first produced a swap master agreement in 1985. 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. The idea is then first (a) 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 could easily be calculated upon default. But second (b) all mutually outstanding swaps would also be integrated into one single balance payable at all times to the net gaining party (at that moment). 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) closeout (settlement) netting if envisaged in the swap agreement. It assumes a continuous

437  There may be reason to distinguish between connexity and mutuality, the former referring 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.

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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 nonbankrupt 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 close-out 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 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 the frame contract, 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 closeout 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 depends 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.438 This necessitated amendments to save bilateral netting for swaps (and repos). They also recognised the close-out netting.439 438  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. 439  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).

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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. 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 s­ ection 2.6.1: if through an offsetting swap at 10 per cent, a spread of two per cent for three years was locked in, which lock-in is now endangered, a new offsetting swap at nine per cent with two years left would present a loss of one 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. As regards the close-out bilateral netting itself, there is a further issue whether the non-bankrupt 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: see s­ection 4.2.6 below and for the law applicable to set-off and netting, also in the context of swaps, ­section 3.2.6 below. There are here many problems

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and great differences in view as we shall see, reason why a transnational legal approach increasingly imposes itself, centring on customary law, 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.440 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 very much a regulatory objective, as we have seen in s­ection 2.6.5 above. Better documentation, 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 chapter 2, sections 1.3.7 and 3.7.4. One way of promoting central clearing through official facilities is to impose greater capital requirements on nonclearing 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 credit risk as we have seen above in s­ ection 2.5.3. Asset securitisations aim at removing assets completely from the balance sheet and thus all risk connected with the holding of them. 440  The ‘value at risk’ or VaR approach may lead to further refinement: see for this approach ch 2, ss 2.5.5 and 2.5.13 below.

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In practice, financial derivatives are often considered investment securities, at least for regulatory purposes, but legally they are mere contractual facilities and certainly 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. An assignment (with its formalities), only transfers rights. Thus the writer of a call option is essentially stuck with its position until the end of the option period; 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 winning or losing. Taking an opposite position will protect them if they wish to limit their risk in the meantime. That is hedging of or reducing position risk. It means that they have 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, backed by similar contracts with other end-users (who are often market makers). It makes possible close-out netting, in which counterpositions once entered into may be immediately netted off with the exchange (CCP) giving rise to an immediate payment. In the swap market 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, used to acting as such for regular option and futures exchanges, are also starting to act as CCPs for swaps. This is the regulatory preference at the moment, 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 and 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 may thus also become possible. Central to the system is then the margin requirement 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 still the 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).

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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 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 endusers’ account) and especially the notion of margin are 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. 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).441 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 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 custom and practice thus become dominant as part of the modern lex mercatoria. This will probably first be tested in international arbitrations, where, within the EU, the 2008 Regulation (Rome I) does not hold sway and there may therefore be greater room for the transnational approach even in Europe. 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 trans- national practices in this regard will be more readily accepted even in local bankruptcies.

441  See Vol 2, ch 2, 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.

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2.6.12  Impact of Fintec. Smart Contracts and the Potential Operation of a Permissioned Distributed Ledger Network Many commentators believe that the impact of distributed ledger technology is likely to be greatest in the context of derivative transactions.442 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.443 The new system may be of special significance for OTC derivatives, especially swaps. CCPs may no longer be necessary and especially promoted. 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 computer although some parts may still require human input and control. Enforceable means execution either by legal enforcement of rights and obligations or via tamper-proof execution of computer code.444 Thus, smart contracts allow for the transposing of the contractual obligations imposed on users into the digital 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 blockchain or within—triggers the application of these terms. In this way, smart contracts can provide for automatic transactions to take place in the ledger in response to specific corporate or market events: crediting a dividend or coupon payment, issuing and reacting to margin calls, optimising the use of collateral.445 A smart contract can also 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

442  The following text is substantially taken from the King’s College Executive LLM organised by JH ­Dalhuisen, C Kletzer and M Schillig. 443  C De Meijer, Blockchain and derivatives: reimagining the industry (06 February 2017). 444  ISDA and Linklaters, Whitepaper: Smart Contracts and Distributed Ledger—A Legal Perspective (August 2017) 5. 445  A Pinna, and W Ruttenberg, ‘Distributed ledger technologies in securities post-trading’, ECB Occasional Paper Series No 172/April 2016, 18.

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payment instruction automatically generated in the cash ledger, effectuating regular payments or closing out the deal.446 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 blockchainbased framework could operate.447 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 oracles lack in resilience. 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. Seller and buyer 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 by providing it with the address of the seller’s or buyer’s trading account, the underlying asset, the strike price, notional and date of maturity. Initialisation automatically authorises the contract 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.

446 

Euroclear and Oliver Wyman, Blockchain in Capital Markets (February 2016) 10.

447 https://medium.com/@vishakh/a-deeper-look-into-a-financial-derivative-on-the-ethereum-blockchain-

47497bd64744.

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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 insure 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, 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-topeer networks that secure digital assets would allow parties to identify, transact and settle with each other in expedited workflows. Currently the system entails a three to five day process involving many third parties, which represents a significant opportunity cost that parties could recapture with a blockchain-based system allowing for real time settlement. 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.448

448 

C De Meijer, ‘Blockchain and derivatives: reimagining the industry’ (06 February 2017).

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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, smart contract technology 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 risk of centralisation and vulnerabilities. The latter issues may be more easily resolved in private or permissioned blockchains. The DTCC supported platform was meant to go live in 2018. In a phased approach it will run alongside traditional settlement systems. Time will tell whether blockchain technology will be able to meet the high expectations.

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 2, chapter 2, s­ ection 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 chapter 2, ­section 1.5.9 below. 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) 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

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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.449 They result from the manager accessing the market place for its clients. This raises questions of agency law in its proprietary and contractual aspects: see further chapter 2, ­section 1.5.9 below. 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.450 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 who relies on this advice, there are

449 

See L van Setten, The Law of Institutional Investment Management (Oxford, 2009). 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. 450 

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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, 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 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. As just mentioned, 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

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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 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 s­ ection 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.451 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).

451  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.

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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 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 chapter 2, sections 3.2.5 and 3.5.14 below and further also s­ ection 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 chapter 2, ­section 3.3 below. 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.

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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. These distributors may act in turn as market makers for smaller investors using their ability to buy or redeem underlying shares and 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.

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 preset 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

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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 their collapse 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 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 1998.452 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 452  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.

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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 chapter 2, s­ ection 1.3.10 n 191 below. 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 should more regulation 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 sufficiently confidentiality in the rating exercise itself, it could at least counter the problem with disclosure 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

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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), 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 into trouble, especially banks. 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 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

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e­ xample 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 during 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, but how? Protection of retail 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 retailers 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 on these products, smaller investors not then being allowed directly to participate. 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 duties, 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 also for diversification reasons and would from that point of view need lesser restrictions too. Another matter is the fee structure itself453 and 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

453  The so-called 2–20 rule gives managers two 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.

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hedge funds. Yet again this is hardly a matter that can 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. 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 open-ended 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 the Far East on the strength of it. UCITS being a liberalisation measure would, however, hardly appear to be the proper framework for hedge fund regulation, although in implementation legislation in some EU countries some special attention was given to these funds. ­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 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 principle. 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 damage claims of

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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 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 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. 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 or into the clouds altogether, 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 routine inspections and examinations. That was the Hedge Fund Rule of 2004. A federal appeals court threw this out in 2006 on technical grounds.454 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.

454  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.

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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 chapter 2, ­section 3.7.7 below) amending also the Pension Directive of 2003.455 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 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.

2.7.5  Prime Brokerage Since shorting is a normal activity of hedge funds, they need securities lending. It is an activity that will be further discussed in ­section 4.2 below where the close connection with and differences from the 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, a risk that

455  Directive 2003/41/EC [2003] OJ L235/10, on the Activities and Supervision of Institutions for Occupational Retirement Provision, see ch 2, s 3.6.4.

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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 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 he has sold but does not have. The prime broker may also provide credit, foreign exchange and custody facilities in this 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. 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 funds assets, may engage in margin financing and stock-lending services, provide risk management, clearance and settlement services and all kind of back-office or administrative support, and may also handle subscriptions and redemptions. 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 also 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

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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. Regulation is thus demanded, but again it is less clear on what it should focus unless killing off the activity itself. Again 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, and 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 instead of shareholders—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.

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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 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 chapter 2, ­section 3.5.14 below. 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 chapter 2, ­section 3.7.7 below) and looking for a comprehensive set of rules covering all funds operating transborder, 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 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

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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. 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 of money 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.456 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);457 456 

See also van Setten (n 449) ch 5, 179ff. 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. 457 

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(b) through a bank transfer 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 transferred458—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 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 mature) against its creditor; (d) 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 (e) 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. 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 his 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

458  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 ch 2, s 1.4.9 below.

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s­ ufficient 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; so may be the issuance of a promissory note of a bank to the creditor (or the latter’s order). 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, 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. 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 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 setoff 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 and 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 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 means 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.

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See for the ­difference more particularly Volume 2, chapter 2, ­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 2, chapter 1, s­ ection 1.2.2) is a problem in either, 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.459 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. 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.460 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

459  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). 460  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.

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units of payment are they joined by the requirement of actual delivery, at least in countries that require it for the transfer of title in chattels461 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. The value of money is no longer supported by gold 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.

3.1.3  Legal Aspects of Payment. 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,

461  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.

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(b) when it does not give the creditor/payee full disposal rights of the money (therefore an unconditional credit in his own account), (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, although 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 or delivery or acceptance (assuming always that the money was owed and indeed received). That is 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 are 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, although 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

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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).462 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 notes. 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: too much was transferred, errors were made, there may have been no intent or sufficient capacity (eg when minors make payments), or proper disposition rights; 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.463 So it goes down the chain464 until the payment reaches the creditor who may

462  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 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. 463  In the US, ss 4A-209 and 211 UCC set a standard by dealing with this point in electronic payments. 464  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 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

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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. 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 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 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.

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).

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(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 2, chapter 2, s­ ection 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 need 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 s­ ection 4A-303). The Germans may rely more on (b). In many countries, statutory law may still 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 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, 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 in the operation of payment systems. Another one

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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. To repeat, it is the issue of finality of the transfer or payment.

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 credit card imprints or even the use of a debit card 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, a credit card imprint, 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, credit card imprint 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 (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 in 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 a credit card imprint 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

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i­ nstruction to the banking system will be given by the payee/creditor, who will normally send the cheque 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 imprints, 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. 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. 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.

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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 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 2, chapter 2, s­ ection 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.

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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 parties so choose, but again this appears exceptional and is normally avoided.465 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 s­ ection 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

465  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.

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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 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.466 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 (eg 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.

466  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 18th 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) pt I prefers 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.

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To repeat, we are concerned here with finality of the payment, in which connection the key concepts are: (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 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, 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

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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).467 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 s­ ection 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, however, 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 payor, payee or any intermediary bank becomes insolvent, and the question becomes: who has got what?.

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

467  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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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. 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 instructions 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 realtime basis through the Bank of England (provided it is put in funds) to limit day-time exposure. 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

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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), chapter 2, ­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 retrievable from the defaulting member, the participants may operate a pre-agreed cost-sharing formula system.

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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 c­ hapter 2, 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. 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: 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 clearing and settlement risk. They only act as agents for the system to make or receive each participant’s settlement balance. Settlement means here 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

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called the central counterparty but that is strictly speaking confusing as the common agent does not act as central assignee. A simpler example may demonstrate the 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.468

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.469 This problem also arises when foreign money judgments are recognised in another country and there may be redenomination of the payment obligation.470

468  See for CHAPS also Goode (n 198) 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. 469  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). 470  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.

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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 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.471 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. The fact is, however, that 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.

471  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), see further also ch 2, s 1.4.4, n 237.

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In 2007, the EU issued a Directive in this area: see also chapter 2, s­ection 3.6.12 for the Single Euro Payments Area (SEPA). It is concerned 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 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. 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 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 default rule: see Volume 1, chapter 1, ­section 1.4.13 for the hierarchy of rules within this modern lex mercatoria.

3.1.10  The Impact of Fintec. Permission-less and Permissioned Blockchain Payment Systems with or without the Use of Crypto Currencies. 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 crypto-currencies. 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

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­ romises and challenges that blockchain technology may hold in store in this context p we may resume the above model of a fairly typical international payment by way of an inter-bank funds transfer across borders.472 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. 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 e­ nvisaged. 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.

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

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Perhaps the most radical innovation would be a permission-less distributed ledger system in combination with a crypto-currency, say Bitcoin. 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 B ­ itcoin. 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 his wallet the destination address generated by C’s wallet as an input together with the amount of Bitcoin to be sent. Upon pressing the send button on his wallet, D broadcasts the transaction message to the peer-to-peer network. Within seconds the message will have been picked up by most well-connected nodes within the network. The nodes 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. If valid, any node will immediately forward the transaction to any other nodes to which it is connected. Within seconds, C’s wallet will identify the transaction as an incoming payment. However, at this stage, the transaction has not been verified and is not yet part of the blockchain. Full nodes collect unverified transactions, bundle them into blocks of transactions and compete to solve the proof-of work algorithm. If successful, the respective block—perhaps containing D’s transaction—will be added to the blockchain. The transaction has now been verified.473 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 peerto-peer system as such and can be picked up by any node. The transaction message becomes irreversible as soon as D 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 D’s obligation 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 transaction, 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.

473  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.

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However, currently crypto-currencies are neither a medium of exchange (they are not widely accepted) nor a store of value (too volatile). Their value is quoted in traditional fiat currencies (no 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 permission-less system with fiat rather than crypto currencies. To understand this better, we can modify our example somewhat. Now D owes payment in the currency of Country B, a normal fiat currency. 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 bitcoin 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 currency to D’s bank account with DB (using the status quo domestic payment process). Thereafter, D can pay C using the 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 amount 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 crypto-currency that has state backing (fiat crypto-currency) 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

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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 off 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 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; by for example 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 crypto-currency, 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. 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 cryptotokens 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.474 What are the promises and perils? Blockchain technology might be able to realise its greatest potential in a permission-less network that relies on a universally accepted crypto-currency. 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 permission-less system has

474  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 2, ch 1., s 1.1.10. It could be followed by a transfer and storage of assets.

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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. 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 permission-less 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 but at least there are 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 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 crypto currency), the system gains in strength in terms of autonomy. Lacking so far sufficient support as a payment system, it has rather become a speculative tool, therefore an investors attribute which distorts its meaning. Although all payment systems have a store of value aspect, when it becomes dominant, they are likely to become distorted and their meaning as 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 another piece of paper. 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. They were never good as investment vehicles and may as such better be avoided. Or to put it differently, if they become so, they are useless as 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. 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. In this later respect, a permissioned network may be even more vulnerable than a permission-less

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system such as Bitcoin,475 and a permissioned blockchain has no less to erect external barriers in order to prevent attacks on the system. Once an attacker has broken these barriers it may be easier to manipulate the distributed ledger from inside in a permissioned system. By posing as a legitimate participant an attacker can potentially alter the ledger on the basis of a proof of identity system, without having to obtain significant computing power. A proof of identity system presumably should therefore be backed up by some proof or stake mechanism that makes it more difficult for an attacker to validate transactions. Overall, whether these operational risks are greater than even under the current system is so far also hard to say. In conclusion it might be said that blockchain has the potential of significantly enhancing current payment systems, in particular 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 system do on a daily basis. 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.

3.2  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 risk management tool, as we shall see, it may acquire other features, especially in novation netting.476 All the same, 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. 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 to offset mutual monetary claims and settle them in this manner. The facility is particularly important in the bankruptcy of one of the parties as the setoff 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).

475  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. 476  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).

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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, is as such generally accepted. Why should the creditor pay anything as long as the bankrupt is not paying. This is a key feature and also promotes the set-off as the main risk management tool, especially between banks, as will be extensively discussed below. In bankruptcy, commonly payment through set-off is considered not only a right of a creditor, who is at the same time a debtor of the estate, but also 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. The reason is that 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 in doubt. That would also affect any set-off notices— hence the (often) statutory automaticity of the set-off in such cases to retain its full effect. One of the traditional issues in the set-off is therefore 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 indeed the case in England, Germany and the Netherlands, although even then in quite different ways. In England outside ­bankruptcy,477 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 CC accepts the automaticity of the set-off also outside bankruptcy (Articles 1289ff CC). That is also still the situation in Italy but now less common elsewhere. The new Dutch Civil Code deviates in this respect from French law, which it used to follow (see Article 6.127 CC) 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 mostly procedural, is that in countries like Germany and the Netherlands, upon notification, the set-off is retroactive to the time the set-off possibility arose. Payment is therefore made 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 importance of the election or notification requirement is further that at least in civil law 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

477 

See for a discussion Stein v Blake [1995] 2 WLR 710.

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become subject to party autonomy. It means that parties need not avail themselves of it and in their contracts they may make other arrangements imposing additional requirements or excluding the facility altogether. Most importantly, it also means that they could extend the facility, although under new Dutch law, this freedom may be limited in consumer contracts: see Articles 6.236(f) and 6.237(g) CC. It may also allow parties to choose the applicable law, but the effectiveness of such a choice will find its limits where a preference is invoked, which is likely to be subject to the mandatory rules of the applicable bankruptcy laws. As just mentioned, a limiting aspect may be 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. It must in this sense be legally valid and as a consequence becomes vulnerable not only in a bankruptcy of one of the parties, but even outside it also to defects in capacity and intent, which may affect the finality of the payment which the set-off implies. It is exactly 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, reference may be made to ­section 3.1.3 above. The automaticity of the set-off in bankruptcy may mean, on the other hand, that parties cannot rely on any contractual embellishments or expansions of the concept in such a bankruptcy. As we shall see, this has become an important issue, now mostly alleviated by amendments to the relevant bankruptcy acts. Set-off is a way of payment, but not all claims may be eligible for payment through a set-off. 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 was traditionally more particularly required in common law (outside bankruptcy or other litigation), except where there was a contractual provision doing away with the requirement, and in countries like Belgium and Luxembourg it is still necessary in a bankruptcy set-off. They still follow the French tradition in this respect, now abandoned in France itself in the case of contractual netting clauses, as we shall see below in ­section 3.2.2. Belgian and Luxembourg law may be relevant in this aspect, especially in repo dealings of investment securities held in Euroclear or Clearstream (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.478 It is not a question of the claims a­ rising 478  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.

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out of the same transaction or relationship. Problems with mutuality of this kind may arise particularly in connection with client accounts. 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 on 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). 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 investment securities trading and clearing. 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 notification countries). Another set-off issue is (d) whether both debts must be mature, also a traditional requirement of French law—see Article 1291 CC—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 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 follows from the principle that in bankruptcy all claims against the bankrupt mature immediately. It may still leave problems with contingent debt. In many common law countries, the set-off of contingent debts of the bankrupt, including damages, is also 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, 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 is still a problem in that rules 4.86 and 12.3(1) of the Bankruptcy Rules 1986 only assess 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, (e) the question of retroactivity arises. It is a more complicated aspect that has a meaning in several different ways. In the case of full retroactivity of the set-off, it could 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

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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 French system of an automatic set-off (even outside bankruptcy), the retroactivity would appear to be implicit. English law traditionally did not have it but it can be negotiated.

3.2.2  The Evolution of the Set-off Principle It may not truly be useful to start with history. The Roman law of set-off or the compensatio remained incidental.479 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). For it to be given, there was a need for connexity but it did not matter what type of performances 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.480 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 is generally speaking the German one, which is believed to have had its origins in the writings of Azo.481 The other approach roughly embodied in French law and in many bankruptcy statutes 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, s­ ection 388 BGB in Germany stands at the one end, Article 1289 CC in France at the other. Common law presents a mixed picture. With its rigid set of original actions, it could not easily accommodate the set-off.482 At first, it depended mostly on statutory law in set-off statutes. In Green v Farmer,483 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 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 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 (substantive) defence,

479 

See P Pichonnaz, La Compensation (Freiburg, 2001) 9ff. See also Inst 4.6.30 and R Zimmermann, The Law of Obligations (Cape Town, 1990) 760. 481  Summa Codicis, Lib IV, De Compensationibus Rubrica. 482  See ‘Comment, Automatic Extinction of Cross-Demands: Compensation from Rome to California’ (1965) 53 California Law Review 224. 483  Green v Farmer (1768) 98 ER 154 (KB). 480 

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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, however. Courts may overcome this and this is then often referred to as a particular form of equitable set-off. Otherwise the common law set-off is, barring contractual stipulation, considered a procedural device, 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— as already mentioned. 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 set-off 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.484 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 s­ ection 382 and rule 13.12), although they are very broad. Under them, it is for example immaterial whether the debts are present or future.485 Regardless of this basic attitude, it may still be questioned, however, whether contractual enhancements of the netting principle are effective in bankruptcy. At least an acceleration clause survives bankruptcy,486 and a bankruptcy trustee’s option to repudiate contracts under ­section 175(2) of the Insolvency Act 1986 does not appear to prevent contractually agreed acceleration in bankruptcy, but there may remain doubt about the validity of other contractual enhancements of the set-off principle.487 Thus further expansion of the set-off facility in bankruptcy could still be considered to violate the principle of equality of the unsecured creditors expressed in ­section 107 of the Insolvency Act 1986,488 which never excluded, however, ranking in respect of senior claims and the operation of other preferences. Documentation commonly tries to increase the chances of acceptance however. In close-out netting, it seeks to make it effective as at the date of the close-out event as defined, which may be well before the bankruptcy petition. As already mentioned, it

484  See for terminology and further comment the comparative study by PR Wood, English and International Set-off (London, 1989). 485 See Stein v Blake [1995] 2 WLR 710. 486  See Shipton, Anderson & Co (1927) Ltd v Micks Lambert & Co [1936] 2 All ER 1032. 487  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, cf Carreras Rothmans Ltd v Freeman Matthew Treasure Ltd [1985] 1 Ch 207 and also Derham, n 222, 463, 541 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). 488 See Carreras Rothmans Ltd v Freeman Mathews Treasure Ltd [1985] 1 Ch 207.

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may also introduce 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. Modern law also avoids penalties, like one-way or limited two-way payments to make this set-off more palatable. 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 Green v Darling,489 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.490 Case law confirms, however, that the claims must be mature491 if only upon acceleration under a contractual clause to the effect.492 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 against the set-off (­section 362(a)(7)) while s­ ection 365(e) renders contractual acceleration clauses ineffectual in bankruptcy, although importantly through amendments of the Bankruptcy Code relief against it was given in repo and swap situations (see ­section 559 for repos and ­section 560 for swaps, since the 2005 amendments for netting agreements further elaborated in sections 561 and 562).493 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.494 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.495

489 

Green v Darling 10 Fed Cas 1141 (DRI 1828). Otto v Lincoln Savings Bank 51 NYS 2nd 561 (1944). 491 See Jordan v National Shoe and Leather Bank 74 NY 467 (1878). 492  See also PM Mortimer, ‘The Law of Set-off in New York’, International Financial Law Review (24 May 1983). 493  In the US, netting is now allowed in the context of settlement payments, also accepted in the UK under the Companies Act 1989 but is limited to transactions executed on recognised exchanges, while a statutory amendment of 1990 in the US 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. 494  See BGH, 24 November 1954, [1955] NJW 339. 495  See E Jaeger, Kommentar zur Konkursordnung, 8th edn (Springer 1958) s 54. 490 See

Part III  Payments, Modern Payment Methods and Systems 393

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 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.496 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. In France, as we have seen, the system essentially remains one of ipso facto set-off, both inside and outside bankruptcy, with the narrowing concept of connexity in the latter case for debts that mature only after bankruptcy.497 Bank account set-offs are probably also allowed in a bankruptcy of the client. Under modern French bankruptcy law since 1985, there is also a stay of acceleration clauses, although since amending bankruptcy legislation by Law No 93-1444 of 31 December 1993, now replaced by ­Article L 431-7 of the Monetary and Financial Code of 2000, the situation has been clarified in the case of swap contracts. French law allows contractual netting in these cases, even in bankruptcy, provided it is covered by a master agreement or convention cadre using generally accepted principles, while one of the parties must be a bank or other financial, insurance or brokerage institution. Although integration and acceleration through master agreements have thus been accepted in the US and France even in bankruptcy by statutory amendment, they may still not be accepted in other countries.498 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.

496 

See BGH, 6 July 1978, [1981] NJW 2244. See G Ripert and R Roblot, 2 Droit Commercial, 16th edn (Paris, 2000) nos 2842, 3039 and 3217. 498  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 masters 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. 497 

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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 to a large degree of 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 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 traditional sense. Agreements expanding on the set-off facility in this manner are commonly called netting agreements and have become particularly important in financial derivatives (like swaps) and in repos: see sections 2.6.6 above and 4.2.4 below. As already mentioned, 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, different therefore in principle from countries where the set-off is always automatic, even outside bankruptcy. This issue is 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? In other words, can the contractual netting so introduced also benefit from the automaticity? If not, it may be vulnerable as notice would have to be given after the bankruptcy which may no longer have any legal effect on the bankrupt counterparty. 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.499

499  See Derham (n 222) 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

Part III  Payments, Modern Payment Methods and Systems 395

Settlement netting is in this connection 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, for example bonds and shares of the same type 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 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 in a bankruptcy before the physical netting and payment (sometimes through clearing agencies) there can still be an effective set-off will be a matter to be determined under the ordinarily applicable bankruptcy laws. Again, the notion of retroactivity of the set-off could then acquire a special meaning. 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. 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.500 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. Indeed, a special and obvious form of novation netting may be

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. 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. 500  When novation netting is combined with a clearing function, it is also referred to as ‘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.

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found in contracts for differences when, as in modern interest rate swaps,501 (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) would not then apply. Indeed, it could be said that, unlike when swaps were still back-to-back agreements, there is here only a contract for differences and not therefore a set-off in the more traditional sense. 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.502 If a novation netting can be construed, it is likely to be effective in a bankruptcy of the counterparty, as there are only net outstanding balances. In clearing systems without a CCP, there may still result a netting 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. Again, it is a form of settlement netting that is not complete before all have paid their net contribution at the end of the settlement cycle. Close-out netting is a netting that becomes operative only upon a default or other close-out event by a counterparty. It is sometimes also called default netting, open contract netting, or replacement contract netting. It nets bilaterally all outstanding positions between both parties as at the moment of default or upon another agreed close-out event and accelerates or matures all outstanding obligations. 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. It will be clear that whether there is novation netting or not may be a key issue in a bankruptcy of the counterparty, and is often a question of contract interpretation. It 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 set-off even if there is a resultant net obligation. That may be simply an accounting

501  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. 502  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.

Part III  Payments, Modern Payment Methods and Systems 397

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 should be continuously notified (although payment may still be postponed) and could still not be effective in such a bankruptcy unless it was also retroactive.503 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 validity, but not necessarily (or to the same extent) the set-off under it when it comes, which may stretch out into a bankruptcy of one of the parties, who may no longer have capacity. Capacity and intent are then issues of payment finality. 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 countries.504

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 them especially against systemic risk. It transcends 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 the bankrupt banks and would only get a small percentage back (the bankruptcy dividend) on all the bankrupt banks owes them. It is clear that the netting clauses acquire here a special significance. 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

503 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 moved on: 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. For Germany see CG Paulus, ‘Rechtspolitisches und Rechtspraktisches zur Insolvenzfestigkeit von Aufrechnungsvereinbarungen’ in CW Canaris et al (eds), 50 Jahre Bundesgerichtshof (Munich, 2000) 765. 504  For the 2005 US Bankruptcy Code amendments see S Vasser, ‘Derivatives in Bankruptcy’ (2006) 60 The Business Lawyer 1507.

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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 we have seen. 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. Here there is novation netting entered into at the beginning of the transaction. It is its essence so that most 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, novation may lead here 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 assets are still likely to be exchanged, at least in the case of liability swaps (although as we shall see 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 and acceleration, 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 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 another. 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 use a narrower set-off concept and at the same time avoid the impression of further legal acts having to be performed upon bankruptcy, which could no less interfere with the effectiveness of the set-off. Here we enter the area of risk management. There may be uncertainty also 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

Part III  Payments, Modern Payment Methods and Systems 399

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 admitted 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.505 In this connection, it may 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 itself 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 2, chapter 1, s­ ection 1.5.3.506 Parallel loan agreements and indeed 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 the 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 mutually connected. It is likely, however, that there must also be some more objective cause for the integration and interdependence in such cases, which may have to be found in economic realities. The importance of the integration, conditionality and acceleration language in modern swap agreements in the context of

505  In terms of bankruptcy law policies, the limit is usually that no extra preference is created for the nonbankrupt party at the expense of the other creditors. As suggested above, by introducing integration and conditionality 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 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 ch 2, s 2.5.5 below). Yet it remains true all the same that extra preferences are created which may offend applicable bankruptcy laws. That is the challenge. 506  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. Art 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 (Dissertation, Leuven, 1992) 177ff.

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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 then 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. The result is better risk management, as already mentioned now generally favoured by regulators in the financial services industry, see also the figures given in s­ ection 2.6.7 in fine. It is in this manner that modern contractual netting clauses are likely to attempt to tie all swap deals 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 s­ ection 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. 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 system. The intention is that aggregation, contractual close-out, or bilateral netting results in one amount either owed or owned. Such termination through acceleration is 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 close-out 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 all swaps 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 any defaulter or the bankrupt party anything 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 is often a termination option for parties in the case of new tax or regulatory burdens or in the case of

Part III  Payments, Modern Payment Methods and Systems 401

intervening illegality or impossibility, leading to a so-called ‘limited two-way payment’, which can also be incorporated into standard documentation. 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 are increasingly criticised and are now commonly deleted from standard swap 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 s­ ection 4.2.4 below). As mentioned above, ipso facto termination combined with a contractual acceleration and aggregation clause in close-out netting as foreseen in the modern swap documentation may not be acceptable under the set-off provisions of all bankruptcy laws. The 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 guards against this risk for payment and security transfer systems, as we have seen. Such an attitude may be all the more expected under modern French and US law, which, with their reorganisation-oriented insolvency laws, do not accept the acceleration and 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 1978.507

3.2.5  The ISDA Swap and Derivatives Master Agreements. The Notion of Conditionality and ‘Flawed Assets’ as an Alternative to the Set-off. The EU Collateral Directive 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 telex confirmations.508

507  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. 508  There are other important industry standard master agreements like the 2000 TBMA/ISMA Global M ­ aster Repurchase Agreement, the Overseas Securities Lenders Agreement, the International Currency Options Market Terms (ICOM) and the International Foreign Exchange Master Agreement (IEFMA).

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This integration is certainly the prime objective of the International Swap Dealers Association, which produced in this connection in 1987 an industry standard agreement, the ISDA Swap Master Agreement, in the latest version extended to all derivatives (see also ­section 2.6.7 above). There were always two such masters, the Rate Swap Master for interest rate swaps and the Rate and Currency Swap Master for both interest rate and currency swaps. The latter is the more common outside the US and 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. Force majeure and acts of state affecting payment or compliance with other material provisions are notably not to upset the close-out and its effectiveness and present a new termination event or event of default. In 2009 ISDA developed a new Master Confirmation Agreement, also called the Big Bang Protocol, which introduced two 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. 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 subject to New York law, although English law may alternatively be made applicable. It does not seem to 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 law. Both Swap Masters are very 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 attempts to expand the notion 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. 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 through the schedule specific swaps may be excepted from it. For close-outs, acceleration is provided in s­ection 6, which includes a reference to a

Part III  Payments, Modern Payment Methods and Systems 403

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 above, 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 then be found 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.509 The netting facility under repo agreements 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. Indeed, ­section 2(a)(iii) makes it clear that the Swap Master is based on conditionality and

509  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 ch 2, ss 2.5ff below. In this respect it is of the greatest 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. 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 ch 2, s 2.5.5 below) 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 500 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 and n 487 above.

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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, which is based on conditionality, 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. The EU Collateral Directive envisages here a special close-out netting facility that must be considered bankruptcy resistant in EU countries (see Volume 2, chapter 2, ­section 3.2.4). 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 security, title transfers or margin accounts. 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 of the non-defaulting party, and net out all delivery and payment obligations in a final closeout upon an event of default. Local bankruptcy laws that impede these facilities or require statutory delays are accordingly made ineffective for these types of financial transactions.

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 is also reduced. Private international law rules may revive, however, in connection with international bank transfers and this 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 such specific new facilities created at the transnational level except in terms of international master agreements under the ISDA Master Agreements, notably for swaps where the netting out trans-border and in 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 and the transnationalisation of the applicable legal regime an important issue. Again, in the end in the international flows

Part III  Payments, Modern Payment Methods and Systems 405

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.510 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 but then 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, although it will become apparent shortly 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, which 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 that 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 here is jurisdiction over the cross-claim or the absence of it.511 The 2010 UNCITRAL Arbitration Rules in Article 21(3) expressly allow counterclaims and setoff to be considered by arbitrators. If the set-off is considered procedural like (mostly) in England (outside bankruptcy), the jurisdictional issue is also important from that perspective as the lex fori then commonly decides these issues (short of a choice of law provision). 510 

See Pichonnaz (n 479) 979ff. 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. 511 

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It is 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 shall see, again 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 France generally and elsewhere in bankruptcy only. This approach is indeed imperative in bankruptcy as the set-off might otherwise not be effective as 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. 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 in principle in France. 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

Part III  Payments, Modern Payment Methods and Systems 407

sits has understandably found support in England512 and is (more surprisingly) sometimes also advocated in the Netherlands even outside bankruptcy.513 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 others creditors adversely. This nevertheless appears to be the French approach regardless of its ipso facto attitude,514 but it is sometimes also favoured in the Netherlands,515 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 2, chapter 1, 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.516 In a contract for differences depending on novation netting like the modern swap, it is even questionable whether the set-off is a method of payment of underlying claims at all. Rather, there is a new financial instrument as we have seen in s­ ection 3.2.3 above and 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. 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 setoff (therefore a counterclaim) in his defence can only do so under the law of the first 512  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. 513 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 N ­ etherlands before 1992 (in the French tradition). 514  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. 515  See Crt Arnhem, 19 December 1991, NIPR nr 107 (1992). 516  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 regards, 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.

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claim, therefore the claim against which the set-off is made. This is the German517 and Swiss518 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)). 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 it is a limited measure geared to a particular set of circumstances, in practice territorially confined (unless there is 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, the reason why modern bankruptcy Acts have been amended to allow for much greater party autonomy here. One could deduce from this also mandatory transnational minimum standards outside or even inside bankruptcy. Internationally, there are also jurisdiction 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?519 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.

517  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. 518  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). 519  See ECJ cited in n 511.

Part III  Payments, Modern Payment Methods and Systems 409

Novation netting producing the modern swap as a contract for differences has in fact resulted in a separate financial product in this manner.520 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 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, takes place ipso facto, and is not meant to be used as a defence or to create a preference. In fact, 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 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 setoff 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.

520  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.

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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 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 depend more directly on transnational custom and practice. The true issue is how far that also obtains in bankruptcy situations where the lex fori concursus may be considered ultimately to control the effect of the netting agreement. 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, chapter 1, ­section 3.2.5). It would concern mandatory practice or customary law binding also on local bankruptcy courts, an issue already introduced above. It is supported by important Australian case law521 and the other side of the globalisation coin: 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 take 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. It was noted in this connection that the BIS became involved early while allowing netting in banks for capital adequacy purposes (see chapter 2, s­ ection 2.5.5 below). 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.

521 

See n 503 above.

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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 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 parties522 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 market place that is likely to apply: see Article 4(1)(h). That would suggest room for transnational custom. 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.

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. 522 

See in the Netherlands, HR, 19 May 1989 [1990] NJ 745.

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From a broader regulatory perspective, the limitation of risk through set-off and netting is another 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 chapter 2, ­section 2.5.5 below. 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) but also here the true issue is whether transnational minimum standards are developing and how they are going to be enforced and support the setoff, especially in its 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. In the EU the Collateral Directive is here a policy example supporting a transnationalising underlying risk management trend.

3.2.9  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 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. 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 has shown some of the way. The UNIDROIT Principles of International Commercial Contracts in chapter 8 cover set-off in some of its aspects, as do the European Contract Principles (PECL) in chapter 13 and the DCFR in 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 in this connection the role of industry practices and custom, particularly in respect of the status and effect of the swap and repo master agreements transnationally, therefore the status of the ISDA and ISMA Master Agreements. They are key documents. Indeed, it is risk management in the international market place that is truly the issue and this requires transparency and finality cross-border and therefore increasingly a transnational legal framework to diminish legal risk and transaction costs in the international market place. 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

Part III  Payments, Modern Payment Methods and Systems 413

where available, general principle, and party autonomy that determine the legal environment in the international flows including the possibility to set off claims in that environment. 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. Local bankruptcy laws remain here particularly relevant but may adapt, as is clear especially with regard to the netting principle, but case law will further elaborate as the Australian Ansett case is showing.523 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 it will throw off the domestic shackles of the set-off to be transnationally effective as it did earlier in the Middle Ages, now not least to operate as an effective risk management tool in the international financial flows. Increasingly, international arbitrators will have to deal with these matters. Where the issue is considered mainly procedural they have great powers. When deemed substantive, it may not be much different since it is now generally accepted that international arbitrators may also apply the modern lex mercatoria in that case subject to a choice of a domestic law by the parties which, however, needs 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 such domestic law to make sense in that context. 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). It has already been said also that the applicable law here bears a close relationship to the powers of international arbitrators. The arbitral awards 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 policy, although one must still ask whether bankruptcy judges are here the proper judges under the New York Convention—it depends on local laws. In any event, also here we have seen progression and in a globalising world domestic public policy may be less of a bar (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 s­ ection 3.1.7 above.

523 

See n 503 above.

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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 also were used in this connection, are not now as important as they used to be. In all cases 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, part of the older law merchant, which still retain considerable relevance, also as examples of the force of the international market 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 will on the whole be in a poorer position than he would be locally to remain 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 his own currency or in any other, there are, if there is a restricted foreign exchange regime, 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 payment in 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. It is likely to be costly. To guard against risk to the convertibility and transferability of the payment proceeds, the seller

Part III  Payments, Modern Payment Methods and Systems 415

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 himself 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 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 2, chapter 1, s­ ection 2.1.2).

3.3.2  Paper Currencies, Modern Currency Election and Gold Clauses Before going any further, 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. Henceforth it became easy politically to adjust the value of the currency, which could practically also evaporate (through inflation). Modern paper 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 much 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

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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 other 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 (hard) currency was agreed as the unit of payment, it might not automatically be available to a payor either 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. 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 quota systems). 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 chapter 2, s­ ection 2.2 below). 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 strong currency on the due date. In that case, (b) foreign parties may agree instead 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

Part III  Payments, Modern Payment Methods and Systems 417

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 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.524 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 recharacterised 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 be made (in the country of the seller/payee) were issued, the buyer/payor would normally require its government’s or central bank’s 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 (harder) currency if required. But the payee needs also to be certain that the proceeds (even if freely convertible) may be transferred to wherever 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

524  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.

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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 he may indicate, assuming that the agreed currency is in principle available and as hard currency 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. 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, sterling, the US, Canadian, Australian and New Zealand dollar, 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. 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). C ­ onfirming 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. 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 connection 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

Part III  Payments, Modern Payment Methods and Systems 419

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, chapter 1, ­section  2.2.6). In this connection, the 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 farther-reaching 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 chapter 2, ­ section 2.4 below. 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 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.

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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. 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 of California. Weaker countries leaving rather than claiming long-term support may actually strengthen the euro. The idea that one country leaving is a disaster and breaks up the euro, is spurious: these issues are not directly related. Barring a collapse of the world economic order, the euro is likely to disintegrate only when France cannot keep up with Germany. This can be judged mainly in the longer term. On the other hand, Germany might 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. 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 true value if not the discipline that went with it. Or to put it differently: people liked the low interest rates and stability but not 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 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 by 2015 risking being undercut by the ECB and its devaluation policies, old-fashioned Southern Europe style. 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. So 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 never end or take care of itself—see further the discussion in chapter 2, sections 1.3.4 and 1.3.5 below. 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

Part III  Payments, Modern Payment Methods and Systems 421

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 led to sudden crises and huge hikes in interest rates for some 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 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 proved 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 in the US and more so in the UK where the sovereign right to debase the currency is highly valued, never mind the UK’s membership of the EU common market where such devaluations function as competitive advantages and cannot go on for ever without retaliation. 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 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

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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 are affected, especially relevant for foreign investors, banks or companies holding local deposits or 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 BITs might here 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 make a difference in respect of mandatory laws and public policy in the exiting country under its 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 eg 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 much 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

Part III  Payments, Modern Payment Methods and Systems 423

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),525 but the operation of the lex monetae is obscure in a currency zone. Such a 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. 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.526 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.527 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 arbitration;528 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,

525 

See Eurozone Bulletin Linklaters, 15 December 2011. 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). 527  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). 528  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. 526 

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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 in the EU would have to be considered. Equally any accompanying tariffs and other import 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. 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 the 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.

Part III  Payments, Modern Payment Methods and Systems 425

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 2, chapter 2, s­ ection 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, 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 damages 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 2, chapter 2, s­ection 2.1). That is understandable, but naturally the seller is equally 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 of 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 form 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

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this c­ onnection by 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, 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, 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 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 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 2, chapter 2, s­ection 2.2. Here the only issue is how they may

Part III  Payments, Modern Payment Methods and Systems 427

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 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 2, chapter 2, s­ ection 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.

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

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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.529 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

529 

See for the collecting bank, Art 3(a)(iii), and for the presenting bank, Art 3(a)(iv) URC.

Part III  Payments, Modern Payment Methods and Systems 429

(without recourse as a ‘forfait’)530 in which case the credit risk is transferred to the discounting bank. This will often be the presenting bank itself. (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 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, although he may still have to guarantee the forfaiting. D/P is the most risky 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

530  See, for more on ‘forfaiting’ CM Schmitthoff et al, Schmitthof ’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.

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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 (eg 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 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.

Part III  Payments, Modern Payment Methods and Systems 431

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 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.

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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 s­ ection 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.531 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 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

531 

Sound of Market Street, Inc v Continental Bank International 819 F 2d 384 (1987).

Part III  Payments, Modern Payment Methods and Systems 433

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 ignored532 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) UCP533—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 (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

532  533 

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

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on p ­ ayment 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,534 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.535

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

534 

See in England Bank of Baroda v Vysya Bank Ltd [1994] 2 Lloyd’s Rep 87. 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 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. 535 

Part III  Payments, Modern Payment Methods and Systems 435

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. 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 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.536 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, he will receive payment in this manner unconditionally (assuming he may do so without recourse), but under a negotiation credit, only conditionally, therefore depending upon reimbursement of the issuing bank.

536  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 he will do. In continental European countries, the drawer/beneficiary cannot exclude recourse against himself. This is different in England and the US.

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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. The UCP in Articles 23–38 distinguish four types of document: (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.

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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 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. This is so even in the case of a sea waybill (see for these various documents Volume 2, chapter 2, ­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,537 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 he receives upon the resale. These trust receipts have also become common

537  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.

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in the Netherlands and Germany (Treuhandschein). 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: Legal Nature of Letters of Credit. The ‘Pay First, Argue Later’ Notion The letter of credit is in fact neither a letter nor a credit,538 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). As we have already seen, the other aspect of the letter of credit is that it contains a so-called primary undertaking of the bank. 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 the security, 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

538  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.

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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 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 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

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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. 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. 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 buyer and 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 he takes delivery of the goods from the carrier, he will have to start an action against the seller for recovery in whole 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

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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 s­ ection 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 saw 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. Nonpayment 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 have seen, even though it is none

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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 should not be accepted. 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), which for him are not normally defined either, but frequently connected with known deficiencies in the assets as produced by him. 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

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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 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 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

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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 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 here, 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 nonpayment. 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.

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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. 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

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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 payment facilities discussed in this part of the book concern the operation of the older law merchant and were developed thereunder. As such, they were meant to operate primarily under a national law rather than under transnational custom as it developed. Even so, internationalising tendencies could not altogether be denied even here. The 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 2, chapter 2, sections 2.2.10, 2.2.11 and 2.2.12. The ICC has issued 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 undertaking in Article 15 UCP. As we also saw, the UCP particularly concern themselves 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. 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.

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In Volume 1, chapter 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. Even though both sets of rules 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. It is in fact best 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, chapter 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 important, within the EU they may 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 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 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

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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.

3.4  Money Laundering 3.4.1  Techniques and Remedies Ultimately, as far as payments are concerned, the question of laundering illicitly obtained proceeds (often cash) through the international banking system has created

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some considerable interest in view of the large amounts of 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 already in 2001 the IMF believed them to be in the region of $500 billion–$1.5 trillion equivalent per year or 1.5–4.5 per cent of gross world product. 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. 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, 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 littleknown 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.539 An obvious one is cash deposits being made with local banks in their local currencies. From there they may be moved to somewhat better banks in probably a better-known financial centre upon conversion of the money into the currency of that country. This is called soaking, smurfing or placing. 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 in its home market. Part of this process is always to confuse the trail by engaging in numerous interim transfers and transactions (so-called layering) and commingling dirty with clean money. Drying or integrating is subsequently achieved through entering into legitimate investments. 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

539 

See also P Alldridge, Money Laundering Law (Oxford, 2003).

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or the otherwise applicable laws. It is submitted that, at least in international arbitrations, arbitrators have these powers and probably duties: see Volume 1, chapter 2, ­section  1.2.5. The fight against money laundering has been greatly complicated by the large sums of US dollars cash floating around in Eastern Europe and other 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 shelf 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 first-class 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 banking system. Many countries maintain a simple rule to the effect that cash deposits above a certain amount must be reported per se. 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, therefore the use of money legally 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 eg 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 proper, and must be seen in the context of international crime prevention as such and the war against organised crime and international terrorism.

Part III  Payments, Modern Payment Methods and Systems 451

The definition of the relevant crimes is a key legal aspect of the fight against money laundering. Narcotics syndicates, later drug trafficking, illegal immigration rings, and prostitution and child abuse organisations, spring immediately to mind, but now also the parking of money by former dictators and terrorism more generally. 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. Thus reporting of suspicions in respect of much broader crime categories or even in respect of potential illegal activity not only puts a further major burden on banks in terms of attention and judgement, but also forces upon them a further breach of their fiduciary duties to their customers, especially their duty of secrecy, for ever less compelling or vaguer reasons. Whether this is wise is another matter. Broadening the scope of the offence of money laundering in this manner may unduly encumber and undermine the money laundering combating efforts and their obvious legitimacy.

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,540 but there can be little doubt that it is 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, although the

540  See for a critical review P van Duyne, ‘Money Laundering: Pavlov’s Dog and Beyond’ (1998) 37 Howard Journal of Criminal Justice 359.

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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 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 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. 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 ass 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 appears 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

Part III  Payments, Modern Payment Methods and Systems 453

of intervention that uses untraditional means. 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 of international bodies. The banking supervisory authorities of the G-10 (within the BIS) 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 Financial Action Task Force or 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 haven countries 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. On the other hand, many Eastern European countries 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

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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. Earlier the United Nations had adopted a (Vienna) Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances in 1988.541 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 European Community.542 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 intimately connected with the free flow of persons, goods, services and money). Secondly, it has among its members the Eastern European countries and former members of the Soviet Union, even in Asia, all countries which may be used for money laundering purposes. The importance of this Convention is further that it goes beyond drug trafficking.543 But it requires co-operation between the signatories in the investigation and confiscation of proceeds, for which there an active implementation programme and the Council of Europe regularly issues papers on best practices in the combating of fraud, drugs and organised crime.

3.4.4  The EU Finally, 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.544 541  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. 542  In 1993, the UN set up a model law facility on Money Laundering, Confiscation and International Cooperation 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. 543  A Council of Europe Criminal Law Convention on Corruption has additional money laundering provisions in this area. 544  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.

Part III  Payments, Modern Payment Methods and Systems 455

Although the EU has no general criminal jurisdiction, it is agreed that it may assume545 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 fist 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 yet 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 circuit more generally. As already observed, that may well undermine the credibility of the entire policy, which would thus become a prime tax collection tool. It is necessary in this connection to define the policy 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 545  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.

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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.546 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 2005.547 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—see chapter 2, ­section 3.6.10 below.

546  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. 547  Directive 2005/60/EC of 26 October 2005 of the European Parliament and of the Council [2005] OJ L309/12.

Part IV  Security Entitlements and Their Transfers through Securities Accounts. Securities 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 2, chapter 2, 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. 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 or not. 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. 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 outset, as they 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

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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.548 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 normal 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 legally the depositories hold the underlying securities as owners. They only issue entitlements to security brokers who in turn issue entitlements to their clients as end-investors: see for greater detail Volume 2, chapter 2, 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 the claims 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 and 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 u ­ nderlying

548  Publicly traded securities are issued in the primary market and traded in the secondary markets. How these markets operate is covered in ch 2, ss 1.5.2ff below. 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.

Part IV  Security Entitlements and Their Transfers 459

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 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 that loss of confidentiality which bearer holdings traditionally offered investors. 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 bankrupt estate. End-investors are often held to be together jointly entitled to all beneficial interests 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 investors’ 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 pass-through 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

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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. 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 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 bookentry 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. 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),

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who has a back-up entitlement against a Dutch broker (say ABN Amro), 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 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 2, chapter 2, s­ ection 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 Character 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

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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. 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.549 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).550 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.

549  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 asset-maintenance obligation. 550  Smaller brokers may act differently and still go through the chain until they find someone who deals from their own inventory or goes short.

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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 and could not be an ordinary checking account unless the broker is also a bank. 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

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and best execution. These may in turn raise important regulatory concerns to be discussed in chapter 2, s­ ection 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 asset-maintenance 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 s­ ection 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 asset-maintenance obligation. 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

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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 s­ ection 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, (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 (eg 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 they were in the plot—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.551 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

551  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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r­ easons. 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.

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 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 end-buyer, 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

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s­ ituations, 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 chapter 2, ­section 3.7.9 below. 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 setoff 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,552 see for this Directive ­section 1.1.9 above, MiFID (Article 13(7)),553 see for this Directive chapter 2, s­ ection 3.5.3 below, and the AIFMD (Article 4(1)), see for this Directive chapter 2, s­ ection 3.7.7 below, which all accept it explicitly. In practice, the situation is of particular 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

552  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. 553  See also Art 19 Commission Implementing Directive 2006/73/EC subject only to keep records of clients’ details.

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of the u ­ nderlying 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.554 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 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 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.555 The possibility of shortening securities and their back-up would thus appear enhanced and facilitated. The broker could simply credit the 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

554  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. 555  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.

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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.556 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

556  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.

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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 market where it came to be seen as a potential form of market manipulation—see again chapter 2, s­ ection 3.7.9 below. 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. 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 s­ ection 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.557 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). 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.

557  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 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).

Part IV  Security Entitlements and Their Transfers 471

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’.558 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.559 It follows that the position of the original investor is seriously weakened upon rehypothecation and she may no longer have a proper entry in the security account but at best some other indication of 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.560 In fact, there may also be serious re-­characterisation

558  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. 559  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 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. 560  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

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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

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 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).

Part IV  Security Entitlements and Their Transfers 473

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 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 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.561 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.

561  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.

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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 technique, as we have seen). Thus the buying of securities will result in the crediting of the securities account which 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 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, 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.562 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 assetmaintenance 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,

562 

See also HF Minnerop, ‘Clearing Arrangements’ (2003) 58 The Business Lawyer 917.

Part IV  Security Entitlements and Their Transfers 475

the settlement and clearing facilities between intermediaries have been fundamentally refined—see Volume 2, chapter 2, ­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.563 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.564 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.

563  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. 564  DVP is not without it 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).

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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 s­ ecurities

Part IV  Security Entitlements and Their Transfers 477

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 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 s­ ection 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. The CCP is in fact only administrator and 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 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.565

565  Not every intermediary can be a member of clearing systems, 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 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.

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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 above566 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 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 2, chapter 2, s­ ection 3.1.567 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) the asset-maintenance obligation affecting tiers in other countries; (b) the protection against insolvent brokers who have back-up entitlements in other countries; (c) a shortfall in such entitlements if there is insufficient back-up; (d) any remaining pass-through rights in other countries; (e) the prohibition on the pledging by intermediaries of back-up entitlements if elsewhere; (f) 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

566 

See Vol 2, ch 2, s 3.1.3. 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. 567 

Part IV  Security Entitlements and Their Transfers 479

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 the 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 (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 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), and 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 2, chapter 2, ­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 2, chapter 2, s­ ection 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

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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 coownership 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 of 1999 presents a form of mini transnationalisation, here through legislation limited to the EU area. It is still couched in terms of harmonisation of domestic laws.568 It seeks to deal especially with the 568  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.

Part IV  Security Entitlements and Their Transfers 481

­ ankruptcy problems under (b) and (c) above and provides for a harmonised regime b meant to protect the position of the European Central Bank (ECB) in its liquidityproviding 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 2, chapter 2, s­ ection 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 2, chapter 2, s­ ection 3.2.4.569 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 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 defined570 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.571 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,

569  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. 570  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. 571  This issue arose in the Lehman bankruptcy cases, where insufficient control defeated the arrangements which lost their protection, see Re Lehman Brothers International (Europe) [2012] EWHC 2997 (Ch) (also called ‘Extended Liens’ case).

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s­ ubject 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 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, and therefore for the law of the most immediately concerned intermediary with whom the account is held: see Volume 2, chapter 2, s­ ection 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

Part IV  Security Entitlements and Their Transfers 483

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 2, chapter 2, ­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 2, chapter 2, ­section 3.2.4. It presents a treaty effort which so far suffers from a lack of ratifications. The text is complex and would, in the approach of this book, still have to be considered within 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 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. Error 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 s­ ection 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

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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, chapter 2, ­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. 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 by the financial services industry itself. This was discussed earlier in Volume 2, chapter 2, ­section 3.2.3 and more generally within the context of the hierarchy of norms of the modern lex mercatoria in Volume 1, chapter 1, ­section  1.4.13.

4.1.8  Impact of Fintec. Permission-less 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.572 It is dematerialised

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

Part IV  Security Entitlements and Their Transfers 485

where no paper certificates are issued at all (registered securities), and it is immobilised where 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, their clients will maintain securities accounts with them. These clients may be a smaller bank or broker and may sell the securities on to their own clients, perhaps retail investors (seller and buyer). 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) As we have seen, 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 right sui generis. 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 contact is there only 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. The basic rights of investors cascade down this system: dividends, voting rights, corporate information, and liquidation proceeds but there are commonly no pass through 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. 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 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 as we have seen, 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 permission-less peer-to-peer framework could thus be e­nvisaged

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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, operating full nodes, and 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, seller and 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. Seller and 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 Seller and 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. This system would remove a number of functions that are essential for the current intermediated holding system. Securities depositories, custodians, central counterparties 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. 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

Part IV  Security Entitlements and Their Transfers 487

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 fiat crypto-currency system to effectuate the cash transfers efficiently unless all investors would stay in the crypto accounts for both their investments and cash balances, which as a start and for the time being would be unlikely. 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. Indeed, it is unlikely that the large number of traditional securities currently held through intermediaries can be converted into crypto-securities 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. 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 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. This is also referred to as permissioned blockchain off-ledger securities trading. 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. 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, which in this system continues to function. These off-ledger securities then have to be translated into tokens on the blockchain at the depository interface. The depository creates tokens that uniquely refer to the global note (or the Depository’s entry on the issuer’s register). Whereas the tokens created by the depository are native to the blockchain maintained by the participants (member banks, brokers and trading venue), the reference 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

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of securities to the account of Non-Member Bank (in exchange for cash), who may than credit its client’s securities account, eg a buyer’s. The buyer’s holding remains indirect and intermediated through its securities account with Non-Member Bank, the latter’s securities account with Member Bank, and member Bank’s account with the depository. As for secondary market transactions, seller and buyer would instruct their brokers 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 the means of payment. ­Broker 1 and Broker 2 would than sign the transaction message to the network; upon verification the respective number of tokens would be transferred from Broker 1 to ­Broker 2—automatically the broker’s securities accounts with the depository would be amended accordingly, as would Seller’s securities account with Broker 1 (by debiting it) and Buyer’s securities account with Broker 2 (by crediting it). There would be a direct token transfer between Broker 1 and Broker 2. In this system there would be no need for a CCP and for settlement agents; the number of intermediaries could thus be significantly reduced and the tasks they perform 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 demobilised indirect holding systems have 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 (eg more shares are being voted than are outstanding). The rights of end-investors vis-à-vis the issuer are reduced compared to holders of bearer securities. 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 involved, and can take up to a number of days, which limits the actions that investors can take in the interim. Counterparty risk is significant. Whereas the introduction of a fully operational direct holding system based on crypto-securities may not be viable for the foreseeable future, a more limited system

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based on a permissioned distributed ledger could reduce the number of intermediaries involved, speed up the process, 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. 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 asset573 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 mark-up as a reward for this service, is no proper indication of an

573  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).

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interest rate (unless there is a sham). 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, 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

Part IV  Security Entitlements and Their Transfers 491

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 s­ ection 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. 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,574 at least in the case of the investment securities repo.575 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 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

574  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. 575  The term ‘repo’ is usually considered to refer to repurchase agreements in respect of investment securities of the fungible type.

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r­ etaining 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.576 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. 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.577 The consequence is that in a

576  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. 577  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).

Part IV  Security Entitlements and Their Transfers 493

­ ankruptcy the bankruptcy trustee is given the choice to disown the contract (subject to b 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 the repurchase price which 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

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 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 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 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 reclaiming rights against the trustee.

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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.578 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 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 by the TMBA/ISMA in their Global Master Repurchase Agreement (GMRA): see s­ ection 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.

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.579 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,

578  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 on the register. In other words, his 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 practise 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. 579  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.

Part IV  Security Entitlements and Their Transfers 495

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 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 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.580 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. Naturally the repo buyer needs to be rewarded for the service and funding he ­provides; 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

580  See C Brown, ‘How to Spot the Difference between Repos and Stock Loans’ [1996] International Financial Law Review 51.

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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.581 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. So 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 would be possible

581  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).

Part IV  Security Entitlements and Their Transfers 497

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 he relies here on possession and ownership rights as basic protection. Accordingly, he may request a special margin or haircut, that is to say that he may deduct a small percentage, often two per cent, of the sale price, and so of the cost at which 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.

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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 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 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 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.

Part IV  Security Entitlements and Their Transfers 499

As in swaps, where there is considered to be only one contract through the integration of all aspects of the deal (see chapter 2, 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 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 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 TBMA/ISMA Global Master Repurchase Agreement 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 TBMA/ISMA (formerly the PSA/ICMA)582 GMRA of 2000 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

582  ‘TBMA’ stands for The Bond Market Association in New York, the successor to the Public Securities Association (PSA), and ‘ISMA’ is 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 is the inclusion of conditions precedent allowing parties to withhold further payments or deliveries as soon as a potential event of default occurs.

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to the Master. Its main objective is the facilitation of margin payments and of closeout 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.583 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. 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.

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 583  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 117 above.

Part IV  Security Entitlements and Their Transfers 501

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 setoff 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,584 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 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.585 In this view, the TMBA/ISMA Master is a further expression of these practices.

584 

Directive 98/26 EC of 11 June 1998 [1998] OJ L166/45. It is true that adverse Belgian case law (see n 132 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: see also Vol 2, ch 2, pt III at n 498. 585 

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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.586 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 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.

586  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.

Part IV  Security Entitlements and Their Transfers 503

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 (TSFR).587 STFs are here all transactions in which investment securities are used to borrow money. Practically it concerns temporary transfers in repos, securities lending, and sell-buy-back transactions. CCPs would effect an even more robust reporting and also a clearing and settlement facility.588 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 2016589 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 closeout netting agreement. This will mostly bring relief against any cherry-picking which follows from the contract characterisation provided there are a sufficient ­number of

587 

(EU) 2015/2365 of the European Parliament and of the of the Council OJL 337 Dec 23 2015. 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. 589  ICMA Quarterly Report Issue 40 (First Quarter 2016), 26ff. 588 

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mutual positions between the parties and the close-out netting is 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 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 s­ ection 3.2.7 above for the international aspects of set-off and netting. In this connection, the EU Collateral Directive 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 still be seen as making a contribution to the modern lex mercatoria in this area. Although both remain territorial in nature, they may operate transnationally in terms of general principle, but then always within the hierarchy of the modern lex mercatoria where transnational custom and market practices are higher.

2 Financial Risk, Financial Stability and the Role of Financial Regulation Part I  Financial Services, Financial Service Providers, Financial Risk and Financial Regulation 1.1  Financial Services and Their Regulation 1.1.1  The Recycling of Money. Commercial Banking and Capital Markets In terms of financial services, products, risks and regulation, it is useful from the outset to distinguish clearly between the money-recycling function of (a) the (commercial) banks and (b) the capital markets. They together provide the main sources of funding (or liquidity in that sense) in society but give rise to different operations and different concerns. The so-called ‘shadow banking system’ (see section 1.1.17 below) and modern technologies often referred to as Fintech (see section 1.1.18 below) may provide others but we will concentrate on the two traditional recycling facilities which remain so far also the most important. Commercial banks typically take deposits from the public, become owners of these deposits, and issue loans in their own name and at their own risk—say, for house ­mortgages and business activities, or as overdrafts and credit card advances. ­Deposits of this nature function as a major funding vehicle for banks (others are interbank borrowings, bond issues, paid-in capital and retained earnings in the capital markets). Banks mediate in the liquidity-providing function by using these deposits to extend loans to the public.1 The consequence for depositors is that, while making deposits, 1  In this book it is this mediating function that is emphasised because it is the easier way to explain the operation of banks in providing new loans out of their cash reserves mainly accrued from their deposits or taken from their deposits with central or other banks or institutions. Economically, this view has long been challenged and the emphasis is then rather on money creation by banks, see more recently also the Bank of England paper by M McLeay, A Radia and R Thomas, ‘Money Creation in the Modern Economy’ (2014) 1(1) Quarterly Bulletin. It is indeed a fact that banks do not individually mark the funding for their new loans (or any other) and may create ‘phantom’ deposits or entering ‘accounts payable’ on the liability or funding side of their balance sheet when entering into new loan agreements. Accounting practices allow it: it appears to result from the nature of the deposittaking function itself, it may mean that in an insolvency, there may be fewer actual creditors than the deposit total would suggest. Another way of looking at this is that the borrower of the money lent is deemed simultaneously to have made a deposit for the same amount.

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they lose all ownership rights in ‘their’ money and become mere creditors of (or lenders to) the bank often at very low interest rates or no deposit interest at all. The main reason individuals do this is because they want to park their cash somewhere and get access to the payment system for their current income and expenditure. It is no place for keeping their longer-term savings, however, unless they can arrange time deposits at a better interest rate. Mostly the money depositors provide is short term (cash deposits or short-term time deposits) and banks normally lend longer. That is a key part of their business and recycling function.2 In other words, they repackage the short-term deposits they receive. This is also called maturity transformation and has an important economic function. It allows the public, for example, to get 10 to 20 year mortgages for house purchases. The significance for banks is that it allows them to earn an interest rate spread, short-term interest rates usually being lower than long-term interest rates and deposit money often coming for free. This recycling from short to long is the essence of commercial banking and is potentially very lucrative for the bank but they carry the credit risk of their borrowers, who might not repay these loans or pay the interest

This is then considered a form of money creation, repayment of these loans money destruction as is the making of payments to suppliers or paying off other debt out of these ‘deposits’. It is a facility notably not deemed available to the shadow banking system or capital markets where the intermediaries cannot take deposits and are for client funds subject to a segregation requirement. It follows that someone with a banking licence could start lending even without external deposits or other resources. As long as no cash is required, all is then a matter of book entries in a system of claims on others. That would be the clearest example of money creation in banks. If there was only one bank in the world and all payments a matter of debiting and crediting within that bank this could work at least as long as no one asked for cash. In its most extreme form, this money creating facility may induce a bank to lend money so created to investors who buy its new shares to shore up its own capital base, an activity mostly condoned in banks but usually prohibited in companies, cf s 678 UK Companies Act 2006. This money creation practice in ordinary commercial banks is limited, however, by capital adequacy requirements, but also by regulatory liquidity requirements and leverage ratios. As we shall see, in the approach of this book, see ss 1.1.13/14 below, macro-prudential supervision should be able to limit this facility further through variable capital adequacy, liquidity and leverage ratio requirements per banking activity. The result is that this type of money creation is limited and now by itself seldom identified as a source of instability in the banking system. However, especially in the 1930s, this money creation aspect of banking was much highlighted by Irving Fisher and others who sought to limit it and these ideas are regularly revisited, see eg J Benes and M Kumhof, ‘The Chicago Plan revisited’, IMF Working Paper August 2012. It should be realised that there is another use of the terminology of money creation and destruction. In this perception, banks may ‘destroy’ money by taking it out of circulation whilst not lending or not investing the money they receive as deposits or out of other funding, especially whilst parking this money at central banks. It means that by re-activating these reserves they may be deemed to ‘create’ money. This is the model that is used by economists interested in monetary policy and monetary equilibria in the context of the money supply and measuring and dealing with inflation or deflation. Although activating or de-activating money may here still be couched in the language of creating and destroying money, it is then quite distinct and a monetary issue, not directly relevant for the present discussion either, which is mainly concerned with the recycling of money and the stability of the financial system and risk management in that context. For the purposes of the following discussions, these are considered details, although they are not unimportant in understanding what banks do and how they operate. 2  This banking model has not remained unchallenged and was questioned by Milton Friedman following Irving Fisher, see also the reference in the previous note, who thought that for depositors to invest in this way in unsafe assets was of dubious merit. Narrow banking is motivated by similar concerns, see s 1.4.6 below. But investing in other products might not be much safer whilst the rationale for many depositors is access to the payment system as we shall see, not investing. Giving depositors a direct interest in banking assets is another approach, and may be approximated in Sharia financing, see also s 1.4.6 below and ch 1, s 2.1.7 above, but it may also be inefficient and of dubious value.

PART I  Financial Services, Service Providers, Risk and Regulation 507

on time. Being funded by short-term money also creates maturity mismatches and as a consequence liquidity risk in banks, which, as we shall see, constitutes a constant and innate threat to the stability of the banking system. This is one way of recycling money. In the capital market, on the other hand, persons or entities with excess savings meet those who need capital more directly. Instead of depositing these excess funds for little reward with commercial banks, investors buy shares or bonds (which are the typical capital market instruments, also called investment securities) issued in that market by issuers who could be banks, governments or their agencies, or commercial companies. This leads to (banking) disintermediation. Investors thus become exposed directly to those who need the money rather than to their banks through their deposits. Also here they become mere creditors when buying bonds, but these are no deposits, the investors own their investments, and there is also likely to be a higher return: the interest rate banks would otherwise have received on their loans to these issuers. Capital market activity of this nature assumes (a) an issuer in (b) the new issues market or primary market and (c) some type of investment security as a proprietary instrument. It then usually also assumes (d) a trading facility in these instruments in the so-called secondary market, which provides liquidity, that is (in this context)3 the facility to sell the investment securities and reduce them to money when needed at the then prevailing market price. The securities themselves are then issued in transferable or tradable form to facilitate their easy transfer.4 Both the primary and secondary markets are segments of the capital market in operation, and may be concentrated in (i) regular stock exchanges, or in (ii) over-the-counter or ‘OTC’ or informal (or telephone) markets as we shall see in section 1.1.18 below. The activities of issuers and investors in the primary and secondary markets (within the capital market) assume intermediaries of their own. They operate as advisers to issuers, as underwriters, as market-makers, as brokers or as investment advisers, or as service providers in exchanges, clearing, settlement and custody functions as will be discussed later in ­1.5.7, 3.5.8, 3.6.14 and 3.7.6 below. We are here concerned

3  The term ‘liquidity’ is used in at least two different ways: (a) in the present context it is market liquidity, the facility to (easily) sell investments and reduce them to money without affecting the market price adversely, but (b) there is also funding liquidity, which is the just-mentioned liquidity provided by banks and the capital markets to the public through their money-recycling function. See MK Brunnemeier and LH Pederson, ‘Market Liquidity and Funding Liquidity’ (2009) 16 Econ Pol Rev 29. See further also the comment n 16 below. Within banks, on the other hand, liquidity may refer more broadly to asset and liability management, meaning the maturity mismatch between short term-funding, mainly through deposits, and long-term assets, mainly outstanding loans. Here we see a connection between market and funding liquidity in so far that when market liquidity dries up, banks are likely to be affected in their investment portfolio and liquidity management with the result that they will be limited in their ability to provide more funding or liquidity to society. There is then a close relationship between this funding liquidity and societal leverage, see VV Acharya and S Viswanathan, ‘Leverage, Moral Hazard and Liquidity’ NBER Working Papers Series (2010). 4  Traditionally, we are here concerned with negotiable instruments (bearer or order paper, see Vol 2, ch 2, s 3.1), in modern times replaced by security entitlements, see also the discussion in ch 1, s 4.1 above. As we shall see, new issues may not always take the form of marketable or tradable securities and they may remain then wholly illiquid, often in so-called private placements. In that case, the investments, although they may still be represented by some paper, resemble ordinary loans and are normally held by investors until their redemption or maturity dates and may then be considered part of the loan book rather than of the investment book when held by banks. This may have capital adequacy consequences as we shall see.

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with intermediation of a different kind than that of commercial banks; these are activities in which investment banks or securities houses/investment firms or broker/dealers are likely to become involved (who may still be part of a commercial bank in what is then called universal banking, see section 1.1.16 below). Reference may here also be made to investment services, a term now more commonly used in Europe, where intermediaries like underwriters and brokers are often called investment firms. In these activities, these intermediaries operate for others (their clients) mainly on a service basis (except in the case of underwriting or market-making as we shall see when they take risk) for which they receive a fee, especially as brokers or investment managers or while advising on and organising primary issues for their clients. It follows that moneys or cash, shares or bonds that they hold for clients do not become their own as do deposits in commercial banks. In fact, they do not normally share in the risk of the recycling of money in this manner (as commercial banks do) while organising new issues or buying and selling securities for their clients (except again when underwriting or market-making). It explains the basic difference in the position of commercial banks on the one hand and investment firms, investment banks, or broker/dealers on the other. It follows that even when brokers are dealing in the markets for their clients in their own name, which is normal, the securities they so obtain and the moneys they so handle for their clients do not become their own, although there may still be serious legal problems in terms of title to the securities shooting through to their clients, and in the segregation especially of fungible securities and client moneys, in particular in civil law countries, all especially relevant in a bankruptcy of the intermediary, but for the moment this may remain a detail except to say that legal systems may leave here a lot of legal risk on the table, see further section 1.5.10 below. However, the principle of segregation should be clear and is tantamount in capital market activity, however protected and implemented. A key difference with commercial banking is therefore that investment banks (or securities houses, investment services providers or broker-dealers) do not take client assets as their own and as a matter of principle the notion of segregation operates. It would be a very grave matter indeed if these capital market intermediaries did appropriate these assets, which would legally amount to theft. Instead, investment banking clients will (in principle) hold property rights (rather than contractual or creditors’ rights) in respect of these moneys and securities against their brokers or custodians even if, as just mentioned, the adequate protection of these proprietary rights may still be a major legal issue in investment services and their regulation. It follows, nevertheless, that at least in principle, the fate of these intermediaries including their bankruptcy should not affect their clients. Again, this is very different in commercial banks, but in respect of deposits only. If these banks operate at the same time as security brokers and custodians, only the money deposited to that effect will be theirs as deposit takers, not the securities they so buy or hold, and they must segregate them.5

5  It should also be understood that if segregation is achieved by a broker putting its clients’ moneys in a client-account which the broker opens with a bank, the clients’ ownership is expressed by them having direct

PART I  Financial Services, Service Providers, Risk and Regulation 509

As just mentioned, investment banks normally provide services, but, as already noted also, they may sometimes take positions in the securities so issued, especially as underwriters in the primary market or market-makers in securities in the primary and secondary markets. In these cases, they take market risk (something that will also be explained more fully below) in securities of which they are or become owners at their own expense. Again, in these or other activities they will never be able or be allowed to deal with clients’ assets as their own, notably when acting as custodians of the investment securities of their clients. They should in that capacity, for example, never be legally able to use client funds for their underwriting or market-making activity nor ever lend the investment securities they hold for clients to others (without their clients’ consent, see for securities lending c­ hapter 1, s­ ection 4.1.3 above), let alone use them as security for their own debt.

1.1.2  Financial Services and Financial Risks. Systemic Risk and Financial Stability It may be clear from the foregoing that the financial services sector comprises on the one hand commercial banking services and on the other capital market or securities and investment services (it also comprises insurance and pension services which are not considered further here and there is also the shadow banking system and perhaps fintech financing to consider as already mentioned earlier). In most countries, commercial banking has long been regulated and supervised because of its importance and the need for its proper functioning for customers, at first particularly to protect depositors in the deposit-taking function but now more particularly the public at large in the lending or liquidity-providing function of the banking sector, particularly to guard against sudden shocks and interruptions. This is the issue of systemic risk often also expressed as the issue of financial stability. What this means and whether they should be distinguished needs to be considered foremost in terms of the risks banks take, the way they manage them and what other, mostly more external factors there may be which may further affect the stability of the financial system. One major aim of financial regulation6 is in this connection to avoid, contain or minimise some of the considerable risks inherent in banking, foremost the insolvency risk of banks, the issue of insolvency and its different manifestations being discussed further in the next section. Bank insolvency is obviously dangerous for depositors, who may lose all rights to repayment, but in a modern economy it will also affect the lending function and therefore be an impediment to the recycling of money on which society has come to depend. Although bankruptcy does not shorten the maturities of outstanding loans so that present borrowers are safe from that perspective (unless there is

access to this account, especially important in a bankruptcy of the broker. They thus escape the credit risk of the broker, but they still incur the credit risk of the bank where the broker has put their money. 6  See also P Wood, Regulation of International Finance (London, 2007); see further for the regulatory ­objectives s 1.1.7 below.

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a covenant in the loan documentation to the effect that the loan matures upon insolvency or other events of default of the bank, which is unusual), no new credit will be extended and any roll-over clauses or standby credits may become ineffective. Most important in such situations, problems in one bank may affect other banks as they are all closely connected in the interbank credit or wholesale markets and through the payment system. They may be connected in many others ways, for example as each other’s clients in in the repo and swap markets or by having guaranteed each ­other’s risks in the credit derivative markets (through credit default swaps or CDSs, see ­chapter 1, ­section 2.5.3 above). This raises more in particular the issue of systemic risk,7 an important aspect of financial stability, although it is submitted that

7  There is no commonly accepted definition. The Vice-Chair of the European Systemic Risk Board (ESRB) observed that ‘systemic risk can mean almost anything (or nothing), depending on whom you ask’, cf SG Cechetti, ‘Measuring Systemic Risk’ in E Gnan and J Ulbricht (eds), The ESBR at 1 (The European Money and Finance Forum, Vienna, Dec 2012) 25. The EU itself defined it as ‘A risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and real economy’, see Art 2(c) ESBR Regulation (EU) No 1092/2010 of Nov 24 2010, OJL 331/1 (2010), which does not explain much either. In its simple form, systemic risk is the risk that the toppling of one bank affects others, notably through their connection in the interbank and payment system. This is the question of the domino effect. Another instance may be in situations where all participants move in the same direction so that no good two-way activity develops. This is of importance especially in market related activities but may also affect banking behaviour more generally eg in making provisions for dubious loans or declaring them non-performing. Importantly, systemic risk may also be considered to arise externally, notably the whole economy weakening or entering extreme leverage putting the whole banking system at risk. Here macro-economic features dominate. It is a matter of judgement how serious any domino effect may be or become at any moment in time and not all bank insolvencies need to be fatal for the system. Moreover, since many borrowers now have access directly to capital markets, it is often assumed that systemic risk in banks is not as important as it used to be in terms of a threat to funding generally, but it may become more costly. Through margin requirements, see ch 1, s 2.6.4 above and the extensive use of set-off facilities, see ch 1, s 3.2.3 above, risk in banking proper (especially credit risk) may be reduced. Whether systemic risk in terms of interconnectedness is in itself a significant source of financial instability may be contested. It is more likely that it is a contributing factor to greater instability but not the cause of it itself. In this connection it may be realised that in many industries there is considerably interconnectedness but it is no problem when the industry itself is stable. This suggests indeed that systemic risk (when tied to interconnectedness) and financial instability should be well distinguished, the latter having many causes, the former contributing to it but not being at its origin. As for interconnectedness itself, a distinction may be made between asset interconnectedness and liability interconnectedness, the one focusing on credit exposure to other financial institutions, the other on short-term funding that may easily be withdrawn or terminated by other banks. Contagion refers in this connection to the ripple effect, which may become irrational, fed by a lack of information. Perhaps more importantly, the 2008–09 crisis highlighted the possibility of systemic risk originating not only in one or more banks but elsewhere in the financial system, especially after the bankruptcy of Lehman Brothers (and much earlier, in 1998, the failure of LTCM), which was not a commercial bank but had borrowed large amounts of money from them. It caused (or earlier in the case of LTCM threatened to cause) failed margin calls, immediate close-out, and a serious liquidity crisis, again with the attendant likelihood of an increase in the cost of funding and access thereto by all. In the event, the systemic risk presented by the Lehman bankruptcy proved less pervasive than feared at the moment of crisis. This is often the case. It may still be less important in investment banking activity. Access to and cost of funding are now sometimes seen as the essence of systemic risk, not the result, cf eg SL Schwarcz, ‘Systemic Risk’ (2008) 97 Georgetown Law Journal 193, which thereby becomes primarily a liquidity issue but it may not cover the full picture. In any event, competitive pressures may keep interest rates down and allow the truth to be revealed much later. See further also SL Schwarcz, ‘Controlling Financial Chaos: The Power and Limits of Law’ (2012) 3 Wisconsin Law Review 816; and I Anabtawi and SL Schwarcz, ‘Regulating Systemic Risk: An Analytical Framework’ (2011) 86 Notre Dame Law Review 1349. In the already mentioned Regulation (EU) No 1092/2010 on the European Macro Prudential Oversight establishing the European Systemic Risk Board (ESRB), see s 3.7.2 below, in Preamble no 9, three criteria are given

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­ nancial instability may have many other more authentic causes that affect banks more fi directly, like liquidity, societal leverage, the pro-cyclicity of banks, the economic cycle, bubbles especially in real estate where most banking crises originate, innovation, or complacency.8 In respect of innovation, eg, the redistribution of financial risk through securitisation amongst banks and insurance companies rather than investors in the capital markets, proved a major issue in 2008. As for complacency, it may lead to overleverage in good times and this may become a permanent condition and result in a different more instable credit culture, see further the discussion in ­section 1.3.4 below. Macro-economic shocks affect the stability of the financial system as a whole, obviously a macro-economic downturn when even good borrowers weaken, likely exacerbated in the case of overleverage: a bank is never stronger than its clients. There may also be political shocks that destabilise the financial system; they might even lead to misdirected government action and regulation effectively destabilising the system further. Indeed, in s­ ection 1.3.5 below it will be argued that government policy itself is likely to be a great if not the greatest destabiliser. Systemic risk is commonly thought not to be diversifiable as other risks may be.9 Translating into regulation, it appears to remain concerned mainly with insolvency of individual banks and the diversifiable risks that lead up to it especially (in this approach) credit and market risk, traditionally less liquidity risk, as will be discussed in the next section.10 The essence is that there are many sources of financial instability which may not all occur at the same time, and may not all lead in the same direction.11 to help identify the systemic importance of markets and institutions. They are considered to be (a) size (the volume of financial services provided by the individual component of the financial system), substitutionability (the extent to which other components of the system can provide the same services in the event of failure) and interconnectedness (linkage with other components of the system), (b) substitutability (the extent to which other components of the system can provide the same services in the event of failure), and (c) interconnectedness (linkages with other components of the system). This is supplemented by a reference to ‘financial vulnerabilities and the capacity of the institutional framework to deal with financial failures [which] should consider a wide range of additional factors such as, inter alia, the complexity of specific structures and business models, the degree of financial autonomy, intensity and scope of supervision, transparency of financial arrangements and linkages that may affect the overall risk of institutions’. Especially this last addition continues to make for a judgemental approach and does not provide a legal criterion. This may be an issue when macro-prudential supervision steps in, further regulates banks, and the question of recourse must be posed, see ss 1.1.13 and 4.1.5 below. 8  See also L Summers FT Blog, 2 May 2017. The latter two sources of instability were much in the mind of Minsky, who otherwise thought that financial instability was part of the normal economic cycle (and the 2008 crisis seemed to be no other, unemployment not reaching levels beyond the late 1970s after the two oil shocks and nothing like the levels of the 1930s), see HP Minsky, ‘The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to “Standard” Theory’ (1977) 20 Challenge 20. Innovation was deemed a lesser concern in the Summers FT Blog. 9  See R Prasch and T Warin, ‘Systemic Risk and Financial Regulation: Theoretical Perspective’ (2016) 17 JBR 189. They argue that diversification of risk in deeper markets, even where possible, does not bring greater stability. They relate interconnectedness to complexity and opacity, which in this view contribute to instability and need a specific regulatory response, going beyond the traditional micro-prudential supervision. It is a variation on ­Minsky’s theory that innovation promotes financial instability, see Minsky, n 8. 10  Although it is not immediately clear whether we mean balance sheet or cash flow insolvency, see s 1.1.3 below, the regulatory bias in this regard still appears to be towards the former. 11  Again, the 2008–09 crisis highlighted the possibility of systemic risk originating not only in one or more banks but elsewhere in the financial system, especially after the bankruptcy of Lehman Brothers, see n 7 above and n 28 below for investment banks in the US then asking for banking licences to obtain access to greater liquidity from the Fed.

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Naturally banks are foremost in charge of their own fate. Financial regulation is supposed to help and provide a better framework, presumably also to deal with external risks. How this is done and whether it is effective will be a main issue in the following discussion. The essence is that financial regulation as we know it has repeatedly been shown not to prevent crises and there is no guarantee whatever that it will do better in the future. Much of it remains experimentation, or simply a response to past crises which in that form are not likely to recur. To put it differently, especially in Europe banks remain fragile even 10 years after the last crisis notwithstanding a considerable revamp of the regulatory system. The reason may be that there is insufficient insight into what is truly going on in society and what causes these sudden crises, especially the timing. If we knew more, they would not occur or if they still did we would better know what to do. It is even conceivable that the main cause of it all has not been identified and remains to be discovered. It will be argued later that there may be a new paradigm in modern banking, which remains poorly understood. Indeed, what is then left is experimentation and the need to save banks in trouble as we cannot be without. In practice, much may depend on where banks are in the economic cycle, which is a matter of judgement, see further the discussion in ­1.1.13/14 below. This also goes into modern bank resolution facilities, meaning what to do with them if in crisis, also an area of experimentation after 2008, see ­section 4.1 below, when regulation had failed once more. It is now often considered a sequel to micro-prudential regulation as we now know it. It is clear that the aim of government action cannot be to save them all, it would be the ultimate in moral hazard, see ­section 1.1.12 below; the concern is rather the whole system but it remains a fine judgement in each situation to determine which banks can or must go and under what conditions or safeguards. The new idea is to separate the fate of banks from that of governments, but if it is true that government policy is at least in part at the heart of financial instability, then this will prove to be a phantasy solution.

1.1.3  The Issues of Banking Illiquidity and Insolvency. Types of Banking Risk To understand these issues better, and to consider the internal and external factors of instability, it must be realised especially in respect of the former that bank insolvency or the threat of it is a major first issue and needs further exploring. Legally, insolvency or bankruptcy commonly takes two different forms. It may mean that total liabilities exceed total assets. This is balance-sheet insolvency, in England and the US also called legal insolvency, and poses the important and difficult question of asset valuation. This is a type of insolvency risk that derives from other more specific risks such as in commercial banking credit or counterparty risk, which is the degree of risk in the loans a bank has given to its customers who may not repay them, or position or market risk, which is the risk in investments a bank has made and which may go down in value for other than counterparty reasons, eg in the case of fixed interest rate securities because interests rates go up. This can also be expressed as the difference between the risk inherent in entering contractual relationships and in holding property or investment assets.

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Thus buying a bond exposes the buyer to the risk of non-payment by the issuer and the value of the bond declines when the risk of non-payment increases. That is credit risk. On the other hand, fixed-interest-rate bonds also decline in value when market interests rates increase for similar maturities. That is market risk. In the case of noninterest bearing instruments like shares or land, a decline in market values of these assets produces similarly market risk, which is in such cases more direct and perhaps easier to understand. Then there is operational risk to consider as cause of balance sheet insolvency: it is the risk that management is bad and systems do not work properly and identify correctly and promptly consolidated risk. Insolvency may also take the form of inability to pay the debts as they mature. That is called cash flow insolvency or in England and the US also equitable insolvency. In banks, it is common to call the threat of this type of insolvency liquidity risk.12 Cash flow insolvency or illiquidity in this sense is easier to determine than balance sheet insolvency because it does not involve valuations and is generally the more likely form of insolvency to lead to formal bankruptcy proceedings. It could mean, however, that there is no balance-sheet insolvency at all and that as a consequence at the end of the proceedings, there may be a net positive balance in the accounts. It would follow that all is paid but the bankrupt institution will still be liquidated and its activities terminated unless some kind of reorganisation under more modern proceedings takes place instead. Liquidity risk is innate in all banking activity, which is, as we have seen, characterised by the recycling of short-term money, basically deposits from the public, into longerterm loans for those who need them, such as house buyers in mortgages, and companies in corporate debt. This is maturity transformation. The essence of commercial banking may indeed be seen as the maturity mismatch between assets and liabilities. It means that there are potentially more depositors able to claim their money back than there are borrowers repaying their loans. This may happen daily for no particular reason at all. Some depositors may have large withdrawal or payment needs and may come back with their money the next day. Nevertheless, when there is a rumour that a bank may be less solid than it appears to be because, for example, it has lent to the wrong people who may not return the money, then depositors may start to withdraw their money for fear that they may not be repaid. This may create the conditions for a bank run, especially when large losses in banks are expected. That is the connection between balance-sheet and cash flow insolvency. In other words, the fear of balance-sheet insolvency, which means that not all might be repaid, may create the conditions for a bank run and cash flow insolvency. The maturity mismatch that typifies banking activity means that banks are constantly at risk that shortterm funding supporting longer-term lending activities is withdrawn although it is more typical for situations of financial stress. The result is that banks may have no money to continue to fund their lending activities, refund deposits, or pay their bills or employees. This makes banking intrinsically an unstable and dangerous business as banks are dependent for their survival on the continuing indulgence of their depositors who hold

12 

See for the notion of liquidity n 3 above.

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mature claims against them and thus have the fate of the bank in their hands at all times. However, they may be sweetened and have in more normal times their own reasons to support the banks: holding large amounts of cash at home is unsafe; deposits may accrue some interest; and holding some money in banks enables depositors to take part in the payment facilities through the banking system, which is for many people a most important aspect of their banking relationship. Yet (unless they have made time deposits) depositors may reclaim their money at any time of their choosing, while the bank cannot reclaim this money from its borrowers before maturity. It could be said in this connection that cash flow insolvency is the normal state of affairs in banking and is structural in commercial banks, therefore not dependent on any particular mishap as it may be in other businesses. Hence the fragile state of banking and the great importance of liquidity management in banks. Indeed, it is not lack of capital but illiquidity that is the true or immediate killer of banks.13 This is easily forgotten in good times but it is a major contributor to systemic risk and also translates into economic (and social) consequences as a bank getting into liquidity problems is likely immediately to limit its liquidity-providing function to the public. A final observation may be in order. Known sources of the instability of banks were identified in ­section 1.1.2 above in the management of credit, market, operational and liquidity risk. These are internal to each bank. Bank management can do something about this and it is its main task aided by regulation. Systemic risk is different in that it is often said not to be diversifiable—it was already mentioned in the previous section. So are others like the leverage in society, assets liquidity, the economic cycle, pro-cyclicity, bubbles especially in real estate, government intervention through regulation or otherwise. These are then external factors of banking instability. Again, the concept of systemic risk remains here contentious and may have different meanings, even whether this risk is really all that great in commercial banks and the true cause of its instability. It was long assumed to be even smaller in investment banks. Whatever it is and however it contributes to financial instability, it was already said that it is considered not diversifiable, meaning that individual banks cannot do much about it, although they might conceivably reduce their interconnectedness. Rather, the fear of systemic risk has often been used by regulators to amass more power. As far as the issue of financial stability more generally is concerned, and which may well go beyond systemic risk proper, as we have seen, banks may individually not be able to do a great deal about any external factors either and this would then be more a regulatory issue also. It can hardly be part of their internal risk management, but its business strategy will have to consider the environment and develop some response against such events. Clearly, some do better than others: in the 2008 crisis and its aftermath, JP Morgan did well whilst Citibank collapsed. In terms of regulation, it was the same for both. It suggests, as we shall see in s­ ection 1.1.14 below, a macro- or policy-based rather than a micro- or rule-based approach, which has failed us and does not seem to be able to prevent crises or lift us out of them. 13  See also J Larosiere, ‘Remaining European and Global Challenges’, Regulatory Reforms and Remaining Challenges Occasion Paper No 81, www.group30.org/images/PDF/ReportPDF/OP81.pdf, 30 (2009).

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An important feature in this connection is to determine at what level of economic activity financial stability is to be achieved and what it truly means in terms of the liquidity-providing function of banks and the size of their operations in each phase in the economic cycle. It would appear that financial stability, although very desirable in the abstract, is not in itself an objective criterion or can be a self-standing objective. It may even be asked whether it is truly wanted because it may suggest economic activity at a lower level, which may not be politically or economically acceptable: fewer house loans, consumer or student loans, and credit cards. It may mean less leverage for all. Clearly, some balance must be struck and the trade-off becomes public policy. This being the case, in modern economies, innate instability of banks is often tolerated or even enhanced. Again, that is policy, and it must indeed be asked why in such situations depositors or senior bondholders should be in line for making a contribution or bail-in in any subsequent banking resolution or otherwise. It may make things worse. It follows that it is essentially for governments to act and save the banks when banking regulation and supervision has failed once more, see again the discussion in ­sections 1.1.13/14 below.

1.1.4  Liquidity Management and Management of Balance-sheet Risk In all of this, modern liquidity management or management of liquidity risk must prevent cash flow insolvency and bank runs, while modern risk management in terms of counterparty risk, market risk and operational risk is the key factor to limit the threat of balance-sheet insolvency.14 This is then also a prime focus of banking regulation, as it has developed which seeks here a legal framework and level playing field for banks, at least in micro-prudential regulation as we shall see. It has already been said that, although distinct, these two forms of insolvency are connected: bank runs or illiquidity of that nature usually start when balance-sheet insolvency is feared, therefore a situation in which not all creditors would be repaid. To protect against liquidity risk in terms of the management of this risk,15 some of the moneys banks gather will come from longer-term loans they organise in the capital

14  See D Murphy, Understanding Risk: The Theory and Practice of Financial Risk Management (London, 2008) and K Alexander, R Dhumale and J Eatwell, Global Governance of Financial Systems: The International Regulation of Systemic Risk (Oxford, 2006). There may also be an operational risk component as we shall see, very much more difficult to assess and hedge. 15  See the BIS Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision (June 2008). It set out a number of principles which focussed on the importance of establishing a liquidity risk tolerance, maintaining a liquidity cushion, allocating the cost of liquidity per activity, covering contingent liquidity risks (in off-balance-sheet and future cash flow exposures), use of stress tests, access to contingency funding, management of intra-day liquidity, and public disclosure so as to allow the informed judgement of the markets. See further also the EU March 2010 Commission Services Staff Working Document on Possible Further Changes to the Capital Requirements Directive. In the UK in October 2009, the then financial regulator, the SFA, proposed a far-reaching new regime that would dramatically increase a bank’s need to invest in government securities and limit severely its funding short term. It was thought that as a start, banks’ short-term funding should be reduced by 20 per cent from present-day levels, ultimately rising to 80 per cent (from present-day levels). It would fundamentally change the nature of banking,

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markets by issuing bonds of varying rank and maturities. They may also issue certificates of deposits which denote maturities of at least some months. That is the issue of liquidity on the funding side. On the asset side, banks may invest in liquid assets,16 normally government bonds or securities, to provide a liquidity buffer as these assets can be sold off immediately when needed,17 but even this became less certain during the government funding crisis in 2011 in Europe. In any event, most bank funding remains through short-term deposits that go into longer-term loans to client/borrowers. Again, this is the normal activity of banks and their most important economic and social function. It is usual for banks to strive for up to 90 per cent of their loans to be funded by deposits. That is for them the most profitable.

which has always been to recycle short money and to convert it into long-term loans, the attendant liquidity management being banking’s major skill. As always, the true issue is how far these newer ideas curtail the recycling function of banks and reduce banking activities, including the liquidity-providing function to the public at large, therefore the effect on the real economy. Proposals of this nature may mean a substantial contraction of the liquidity-providing function through banks, which may be socially unacceptable. It would also raise the question what banks should do with their excess deposits, which then only could be lent short term, probably mainly to governments, which lending in many countries has also become unsafe. 16  Again, this is market liquidity more directly connected with whether investments can trade, see n 3 above. It is particularly significant in connection with a bank’s liquidity management, as a bank is likely to hold a large portfolio of investment securities to help it manage its liquidity exposure in respect of depositors. The liquidity of such investment securities is commonly demonstrated by the price discount that must be offered if larger volumes are sold. It is also said that a liquid asset in this sense is ‘one which can be converted rapidly into cash with little or no loss of value’, see European Banking Authority (EBA), Discussion Paper on Defining Liquid Assets, 21 February 2013; see further Andrew Crocket, ‘Market Liquidity and Financial Stability’, Banque de France, Financial Stability Review—Special Issue on Liquidity (2008) 14. It follows that the greater the price discount the less liquid the security is considered to be. This can to some extent be measured, more so if there is full transparency on size and price of done deals. See for the danger of an illusion of liquidity in banks, A Nesvetailova, ‘The Crisis of Invented Money: Liquidity Illusion and the Global Credit Meltdown’ (2010) 11(1) Theoretical Inquiries in Law. As liquidity in banks is often equated with and deemed completed by the tradability of its assets, advanced forms of innovation/securitisation become favoured if the underlying loans or investments are not themselves liquid. Through securitisation, they seem to become so, but tradability in this sense still depends on confidence of the market, in good times much helped by proprietary trading of these instruments in banks. This type of liquidity pretends to be a substitute for ready conversion of loan assets into cash. It was traditionally associated with government bonds, which, if issued in its own (paper) currency, can always be redeemed by the country printing money, but the expansion of the notion of liquidity into other assets may suggest here a two-tier notion of liquidity. Indeed, it may assume a more advanced state of market vitality, in which liquidity of this (government bond) quality is ‘privatised’ by market forces, but it may have contributed to the ‘originate and distribute’ model in securitisations by banks before the crisis of 2008: see for the issue of excess ch 1, s 2.5.4 above, in which the ensuing securitised products proved subject to mispricing and to turning toxic in financial crises. In fact, when the market in these instruments did hot up, there was a tendency for them to seize up at the same time. Continued funding of these products, often by SUVs, which was usually short term, is then likely to become another major problem. As these products may still be held within the financial system (with other banks or insurance companies), they may destabilise the system further, the risk not therefore being sufficiently widely spread among end-investors to reduce systemic risk. The problem of these newer products becoming illiquid while tradability vanishes is not new and had been spotted before, see BIS paper No 2 (2001): Structural Aspects of Market Liquidity from a Financial Stability Perspective, but is soon forgotten in times of euphoria. 17  Banks may enter into liquidity swaps with insurance companies or pension or other funds that hold large portfolios of highly liquid assets, and exchange them for a number of years against their more illiquid assets such as mortgages. By 2011 this had incurred unfavourable comment from regulators in the UK who became concerned about the liquidity position of these insurance companies and funds.

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Clearly, liquidity should become a regulatory concern here although often still eclipsed by capital adequacy considerations, which are more an aspect of risk management that primarily addresses balance-sheet insolvency as we have seen. The relative lack of regulatory concern for liquidity risk may well have contributed to the 2008–09 financial crisis, although it should be appreciated that the maturity mismatch between assets and liabilities is the essence of all banking, which regulation cannot remove without destroying this business and the recycling of money facility it represents.18 Banks must be given substantial leeway to manage this risk themselves; it is their business. As for capital requirements, this is not to suggest that they are unimportant in terms of liquidity risk management. Holding adequate capital against risk assets may steady the nerves of depositors in terms of balance-sheet insolvency and then also guard against a bank run or cash flow insolvency—the connection was already mentioned in the previous section—but it is true that in the past 20 years, first through the Basel I and subsequently Basel II Accords as international capital adequacy standards (see further the discussion in s­ ection 2.5 below), the main emphasis was on standards for capital adequacy (which, in the event, proved too low) in terms of balance-sheet insolvency,19 not on cash flow insolvency or liquidity, lack of which was already identified above as the more immediate killer of banks. As we shall see in s­ection 2.5.12 below, the Basel III guidelines now not only seek to reassess the balance-sheet risks and increase capital from that perspective, but is also concerned with liquidity risk. It must then define what is liquid, not at all an easy task, especially in terms of assets in times of distress. Again, in doing so, these measures are likely to affect the liquidity-providing function of banks, reduce their recycling activity and then potentially also economic growth. There is a balance that must be struck. It is unlikely that in our type of society, which thrives on leverage, we can go back to old-fashioned ‘safe’ banking;20 see also the discussion in s­ ection 1.3.8 below.

18  Other mismatches between assets and liabilities that need also be managed (in an active asset/liability management) are currency mismatches and interest rate mismatches (between fixed and floating). 19  Interestingly, the weakness of banks during the 2008/09 crisis was not due, at least not initially, to excessively low capital levels within the existing framework of Basel I and II but it is arguable that they became so only after a number of black swans (see n 157 below) had arrived in the US in the form of the plights of Fannie Mae and Freddie Mac and then AIG, which in the event were all nationalised (but soon denationalised with a substantial profit for the US government). Even the lack of a bailout of Lehman Brothers, the bankruptcy of which caused mayhem, was, when the accounts were ultimately settled, in reality not the drama that had been anticipated. This is only to show that wrong perceptions aggravate financial crises, the cause and especially the timing of which may remain largely obscure and are usually only retroactively established as matters of opinion, see s 1.1.2 above and also s 1.3.4 below. It was already said that if it were otherwise these events would be foreseeable and would not occur, or if they occurred regardless, there would be some clear cure. 20  In ‘old-fashioned’ banking, one was likely to find that banks would lend to customers one-third of their money or deposits (if longer, often secured by mortgages), lend another one-third to other banks (shorter), and put the last one-third in (liquid) government bonds. To complete the picture: they would hold capital up to one-third of their risk assets, however defined. This was considered ‘safe’ banking but was also likely to be unprofitable. However, any less may become ‘unsafe’. Even at the time of the US banking crisis of 1907, it was thought that banks still held about 20 per cent capital against their risk assets, which proved not to be enough. Modern banking is, as we shall see, far removed from this more classical ‘safe’ model. Under Basel I, eight per cent capital became the norm, half of which could be held in so-called Tier II capital. This allowed for and accommodated a high degree of gearing, see further s 2.5.4 below. To give an example: if we allow in this manner a gearing of 12.5 times qualifying capital, institutions needed only lose eight per cent of their asset values to be bankrupt, meaning insolvent in a balance-sheet sense. Through all kind of exceptions to the eight per cent capital

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1.1.5  Risk Management, Hedging and the Commoditisation of Risk Through proper liquidity management on the asset and liability side of the balance sheet as mentioned in the previous section, it ought to be possible for banks, internally at least, to better manage liquidity risk and guard better against illiquidity and cash flow insolvency. Proper risk management in terms of balance-sheet insolvency on the other hand means in modern times extensive hedging or similar activity for credit and market risk and to determine the proper level of capital in respect of the remaining exposures. To this effect, credit risk may be limited or spread through collateralisation, diversity in loan portfolios, avoiding large exposures to one counterparty or through obtaining forms of guarantees, including the use of credit default swaps or CDSs as we have seen in c­ hapter 1, ­section 2.5.3.21 Market risk is commonly hedged through the use of derivatives: options, futures and swaps (see ­chapter 1, ­section 2.6.1 above).22 Securitisation now also fulfils an important function in the management of both risks and is a powerful risk-management tool in either case, as it may remove these risks entirely from the balance sheet (see ­chapter 1, ­section 2.5.1 above). Thus the issuance of collateral debt obligations (CDOs) by special purpose vehicles (SPVs) as part of a securitisation and the protection against credit risk through credit derivatives, especially CDSs, is now commonly used and has become another essential part of modern risk management in banks. This type of risk management is necessary but costly and not a perfect art as we have seen in the previous chapter. Besides liquidity and balance sheet risk, operational risk was also mentioned, meaning concern with systems and proper management. It is a much more contentious concept because it is barely quantifiable and capable of management through the addition of more capital, see s­ ection 2.5 below. There may also be legal problems (and therefore legal risk), often not considered or sufficiently understood (and sometimes deemed part of operational risk, although commonly still not rising to the level of regulatory concern), more in particular clear in respect of the status internationally of collateral (such as floating charges), repos, receivable financing and securitisation

r­ equirement, a gearing of 20 or more was not uncommon in banks, which meant that a loss of only five per cent of its assets would bankrupt the bank in terms of balance-sheet insolvency. It is clear that high gearing is here to stay even after Basel III. It will be argued later that a new paradigm appears to be operating in banking, see s 1.3.5 below. 21  Credit derivatives were much criticised in 2007–08 and were requested to be regulated but present a most effective tool to hedge credit risk and are as such of fundamental importance. It is a market that (like the repos and interest rate swap markets) did not seize up in 2008 even though an important protection provider (AIG) had to be saved in the US. One aspect was that this protection had become too easily available (and therefore too cheap) whilst concern for the risk in the underlying portfolio diminished. In fact, this criticism concerned all securitisations. See for the excess in financial engineering, ch 1, s 2.5.4 above. 22  Interest rate swap markets were valued in 2008 at around US$ (equivalent) 400 trillion, about 8 times world GDP. By 2014, the total was around US$ (equivalent) 600 trillion outstanding. They remained largely OTC products provided by banks and were major sources of profit for them. A greater degree of standardisation through CCPs (see ch 1, s 2.6.5 above and n 180 below) might also regularise this market and this is being implemented even though again the cause of the financial crisis was not here either; it was more part of a general mopping up round that may or may not have been beneficial. In the EU, a Regulation on the European Market Infrastructure (EMIR), was introduced in this connection as of 2011 and became effective at the end of 2012; see also ch 1, s 2.5.10 above and s 3.7.6 below.

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tranches, as we have seen in the previous chapter. Modern assignment, segregation and set-off statutes or facilities complete the system, but it was argued before and also demonstrated in the previous c­ hapter that there may remain substantial legal exposure also in these areas, applicable laws being seldom sufficiently up to date even if it were clear which law it is in international transactions. In fact, it was argued before that one major problem is that the written law often does not help but is a hindrance to better risk ­management for no obvious reasons. Perhaps more importantly, these facilities often remain too localised under national laws to serve their proper international function, eg in asset-backed funding based on assets or cash flows and production and sales facilities or chains dispersed or arising in different countries.23 Transnational floating charges still do not exist and they are impossible to organise on the basis of an amalgam of national laws. In terms of risk management, the spreading of risk through securitisation, which allows for the removal of banking assets and/or their risks from a bank’s balance sheet to investors, is here more directly of importance. It also provides the crucial connection between banking and capital markets, necessary as banks can no longer take all lending requirements of the public on their own books. This is financial engineering, which can become excessive as the 2008 financial crisis showed and may lead to all kind of risk layering that may not be fully understood or, while being sold on, be incorrectly priced, and in any event too readily retained or bought with an insufficient concern for risk, even by professionals such as banks,24 either as originators, financial engineers, ­traders or investors.25 Moreover, these longer-term, potentially illiquid assets were

23  Much of Vol 2, ch 2 and of Vol 3, ch 1 was devoted to this subject. The conclusion was that minimising legal risk requires a greater degree of transnationalisation of the law and the full recognition in particular of transnational industry custom and practices, especially in the areas of set-off and netting and in asset-backed funding using assets in different countries, to be recognised in domestic bankruptcy regimes. Fundamentally we need to put ourselves legally in these international flows rather than trying to chop them up into domestic parts in the hope that the total of the legal regimes that become so applicable to these flows still adds up. It is unlikely. As was argued in the referenced parts and s­ ections of this book, inefficiency, uncertainty, and extra cost result for no obvious reasons except mere legal nationalism for its own sake. 24  See for excess and abuse more particularly ch 1, s 2.5.4 above. The EU in an amendment to the relevant EU Directives in September 2009 (see Art 1(30) and Art 122(a) Directive 2009/111/EC of the European Parliament and of the Council (CRD 2) [2009] OJ L302/97, and also s 3.7.3 below) demanded from the end of 2010 that originators retain five per cent in their securitised products so as to prevent them losing all interest in the underlying loans or credits they granted but (through securitisation) removed immediately from their balance sheet (including the connected credit risk). Guidelines were published in 2010 which assumed consolidated supervision at the level of the home regulator of the authorised institution. It is a complex issue as the retention must be met by one of four risk retention mechanisms: (a) the vertical slice retention, (b) the originator interest retention, (c) the on-balance-sheet retention, or (d) the first loss retention. In the US, this originally G-20 idea was further diluted to alleviate ‘additional constraints on mortgage credit availability’. An original industry proposal had wanted to exempt mortgages with a 20 per cent minimum deposit and monthly repayments of no more than 35 per cent of the borrower’s income. Ultimately, the loan-to-income ratio was lifted to 43 per cent and the minimum deposit was dropped entirely, see The Economist, 25 October 2014, 68. See further for the role of and comment on the status of Fanny Mae and Freddy Mac in the US, n 144 below. 25  Before the 2008–09 financial crisis, prevailing euphoria in the financial markets created many products of more dubious value, such as: (a) contingent value rights or CVRs, in which buyers do not pay for an asset but instead give sellers an option to future returns (often leading to large payments, although often made subject to many conditions), which may easily stifle a business when they become due; (b) cash-settled options, which allow corporate raiders to top up the purchase price by later cash payments, which could cripple them; (c) accumulators,

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often financed short term, thus contributing to and aggravating liquidity risk, while their proper valuation (for capital adequacy purposes in terms of credit and market risk) proved difficult and uncertain when markets seized up. All the same, it is mostly understood that the commoditisation and tradability of risk that has been achieved notably through securitisation and credit default swaps is of great importance and may allow better access to funding by the public on a much larger scale. In the face of growing criticism, in 2009 the International Monetary Fund (IMF) was ultimately forced to underline and support the crucial role of especially the securitisation facility. However, it was already said that if not sufficiently diversified in placement, securitisation has the effect of merely spreading the risk to others in the financial industry, therefore other banks and insurance companies, who may be seriously weakened thereby. In 2008, this required the (temporary) nationalisation of the largest insurance company in the world (AIG) which concerned mainly the back-up of credit derivatives.26 The 2008 events further showed that lack of transparency where the risk subsequently resided could itself destabilise the financial system and reduce confidence. Especially for swaps, approximation to tradability of these contracts through CCP’s aims at being an important risk management reinforcement in the future, see ­chapter 1, ­section 2.6.5 above and may be seen as a further expansion of the commoditisation of risk. Indeed, more up to date regulation seeks to address these concerns and to promote a legal framework that is meant to stabilise finance along better lines although it does not go as far as to promote legal transnationalisation. However, even this type of regulation may not prevent major shocks and may even exacerbate the situation by limiting the diversification facility. As has already been noted, investment banking activity is traditionally different in that investment banks do not take deposits and issue loans but are intermediaries as advisers, underwriters and market-makers in the recycling of money through the capital markets where investors meet issuers of financial securities more directly. Segregation of client assets follows. As a consequence, they do not carry the same type of systemic and client risks and are therefore traditionally more lightly regulated. But the 2008–09 crisis also showed that they may be so intrinsically part of the system that their demise may still carry great risk for commercial banking, if only because they ­borrow large amounts from commercial banks and are themselves highly geared, often

which hedge cross-currency exposure while limiting the profits that can be made but not the losses, suggesting improper risk distribution; (d) debt accordions, allowing issuers to issue senior debt to new investors potentially forcing existing ones to trade up at large discounts; (e) payment in kind or PIK toggles, which allowed debt issuers to issue more bonds as substitutes for coupons, especially likely in financial crises when bonds may become worth a great deal less and coupons payments valuable; and (f) minibonds, which are not bonds proper but merely contractual rights, often in small nominal amounts to appeal to retail, to a slice of ordinary bonds held in portfolio by the organisers who so reduce their own risk, mostly at some higher yield. 26  One problem is that these protection providers may not hold enough capital against these products when they themselves are downgraded and margin calls are being made on them by the protection buyers—see for these calls, ch 1, s 2.6.4 above. Another issue in this connection was that these products appeared mostly not to be properly defined and made subject to regular capital adequacy standards, either as guarantees or in particular as insurance policies (which they are not truly). See for the Basel III capital adequacy amendments in this connection, s 2.5.12 below.

PART I  Financial Services, Service Providers, Risk and Regulation 521

for their (proprietary) trading activity.27 Through prime brokerage, they also habitually lend to often highly leveraged hedge funds, which may thus also become part of the financial system and affect its stability.28 This is now often referred to as the ‘shadow’ banking system, which is large, in the US in 2010 estimated to be a business of about US$13 trillion, almost as much as the national GDP. By the end of 2013 it was estimated at around US$ equivalent of 75 trillion worldwide by the Financial Stability Board, an increase of five trillion over the previous year. To what extent it should become regulated has itself become a matter of debate—see s­ ection 1.1.17 below.

1.1.6  The Role of Central Banks as Lenders of Last Resort. Government Support Systems As far as liquidity is concerned, it has already been said that it may be quite normal for banks to find themselves short of funds at the end of the day when more depositors withdraw money than make deposits. To ease short-term liquidity problems of this nature, banks will then normally borrow short term from other banks in the opposite position. They do this in the interbank markets. As some banks may be short of funds and others may be long in this manner, it is only natural that they should do so and that is what the interbank market does for them. In such situations alternatively, central banks may also come to the rescue as banks of last resort and lend banks the short-term money they need in these circumstances.29 27  Proprietary trading is the trading of banks for their own account in any product where a trading profit may result. Banks may be stimulated into doing this as they are likely to see the trading flows. It may result in a form of insider dealing that reduces their risk but is not commonly found offensive as it does not concern corporate information. This trading should be distinguished in principle from the trading in areas where banks make markets for their clients as commonly in foreign exchange, swaps and repos, shares and bonds and now also in CDOs and CDS. This trading is normally short term, geared to managing open positions and requires a very different trading talent; see also the discussion below in s 1.3.9 at n 173 below on curtailing these various activities, see also nn 151 and 157 below on theVolcker rule. It will be argued later that the line between proprietary trading and managing trading books is often difficult to draw, see s 3.7.11 below. 28  See for prime brokerage, ch 1, s 2.7.5 above. When, in 2008, US investment banks could no longer fund themselves short term in the market conditions of those days, this also affected the hedge funds, which investment banks often funded through their prime brokerage arm. In these circumstances, investment banks had to obtain funding from the bank of last resort (the Fed), which, although legally not obliged to do so, was forced to provide it for systemic reasons. It made these investment banks subject to greater supervision, which then induced the largest of them, Goldman Sachs and Morgan Stanley, to apply for ordinary banking status to gain access to deposit-taking, especially from their corporate clients, as a cheaper way of funding. It was the end for the time being of independent investment banking (except for smaller institutions) in the US. The separation of commercial banking and investment banking had been demanded earlier, under the banking reforms in the US in the 1930s (Glass-Steagall Act), only lifted in 1999, see s 1.1.9 below. An added problem proved to be that, to the extent some or all of these functions were conducted within banks or bank holding companies, no special bankruptcy regime existed for connected financial institutions, even in a country like the US, which has special bankruptcy rules for banks. Ad hoc intervention thus became necessary but was dependent on sufficient political support, which could not always be immediately activated or, as in the case of Lehman’s, was immediately forthcoming. 29  In times of financial stress, the liquidity in the interbank market is likely to dry up as banks do not dare to lend to each other. This was poignantly demonstrated in the banking crisis in 2008, it being uncommon for

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It should be clearly understood that this lender-of-last-resort function is not a question of regulation proper but is an extra facility in banking that is necessary to protect the system. In other words, all banking systems require some lender of last resort as a special facility to iron out short-term liquidity needs in banks. This facility acquires great importance, size and momentum, however, when meant also to alleviate financial stress and may then well be used to avoid systemic risk and achieve financial stability more directly. Nevertheless, this is often considered an improper use of this facility30

security or collateral to be sought as protection in this market. The lender of last resort is then the only port of call, but this lender is likely to want security, ie the banks’ investments taken as collateral, usually as repos, see ch 1, s 4.2.1 above. The function of lender of last resort is complicated in the eurozone, where the ECB is in charge but in emergencies there is supplementation by the Emergency Liquidity Assistance Facility, which is an acknowledged deviation from the normal role of lenders of last resort. It may be provided by national central banks at their risk if banks have no more eligible collateral available for repos with the ECB (although the latter does relax its rules at times). This support remains subject to ECB approval (by two thirds of its Council renewable every two weeks, where in emergencies local collateral definitions may also be further relaxed). Since November 2014, the ECB directly oversees the major eurozone banks, see s.4.1 below, and it may be wondered whether this support should still be given by local central banks at their risk. It became an issue in 2015 when Greece wanted to restart the discussion on its debt, which immediately excluded its banks from repos financing via the ECB. 30  Some central banks, such as traditionally the German Bundesbank, do or did not accept the role of lender of last resort in these circumstances as a matter of principle. The disinclination for the central bank to become involved in this manner did not prevent the German government from organising bank bailouts when needed but it did so in another manner. In fact, in Germany there was created a Liquidity Consortium Bank, which could do so, and in which the Bundesbank takes part. Since 1974 it has been able to grant short-term assistance to banks with temporary problems (it is sometimes described as the lender of next-to-last resort) and might as such also become a model for the eurozone, which so far has no such facility. This strict view of the function of lender of last resort may also have been the original position of the ECB, but it still had to provide liquidity to the whole system in 2008–09 when the interbank market dried up because banking trouble was expected but could not be pinpointed in any one particular bank. The ECB was forced to continue this role when many banks in southern Europe and Ireland remained weak and could not find alternative funding, while their own governments were hardly in a position to recapitalise them either, a facility in any event superseded by the resolution regime agreed for the eurozone after 2014, see s 4.1 below. This forced the ECB to accept virtually any type of investment of these banks (including their own government’s low-rated debt and toxic assets) as collateral in the repo. One trillion euros were printed at the time for this (short-term) programme. In fact, the ECB became seriously extended in the process and through these banks in the periphery countries of the EU was also funding their governments who depended on banks for the sale of government securities. Later in 2012, under the European Stability Mechanism or ESM, see also n 603 below, in the guise of enforcing its monetary or interest rate policy, the ECB offered to enter the market in these bonds of up to three years directly throughout the eurozone, albeit only at the request of individual countries and subject to conditions. This was on top of the Securities Market Programme of €223 billion provided to ailing governments through national central banks as members of the system and meant to provide depth especially in government securities markets. Confusion between monetary and fiscal policy ensued and gave rise to litigation before the ECJ, see n 613 below, which supported, however, the scheme as being within the monetary authority of the ECB. The ECB in fact risked becoming a bank of last resort for government debt thus involving itself indirectly in fiscal policy. Its German and Dutch directors objected and the measures were not intended to be more than temporary. In 2014, ahead of the ECB becoming the bank supervisor in the eurozone, it offered a further programme for bank support by relieving banks of toxic assets through a securitisation programme of two years supported by the ECB buying the better tranches, the junk to be bought by the European Investment Bank (EIB), at least that was the idea. The ECB set aside another one trillion euros for this programme, adopting indirectly the stature of bad bank. The argument in favour was that it staved off looming deflation, which was not, however, apparent overall and, where identifiable as in southern Europe, was probably necessary for these countries to regain competitiveness. The real issue was that the ECB tried to stimulate growth by monetary means, balancing fiscal restraints without restructuring conditions. Further steps in this direction were taken in early 2015, when the ECB started a full quantitative easing (QE) programme over German and Dutch objections. Under it, the ECB started to buy up government and some other bonds to provide more liquidity to the markets and reduce longer term interest rates and

PART I  Financial Services, Service Providers, Risk and Regulation 523

and the prospect of banks being saved in this manner may create even more irresponsibility or moral hazard in them as we shall see below in ­section 1.1.11. In any event, if the problems in banks run deeper, (central) banks of last resort may not have the means or could be bankrupted themselves or be forced simply to print more money if they have that power, which, except for the European Central Bank (ECB), they no longer have within the eurozone. Governments may then have to step in to save the banking system. This will be the case especially if there is a danger of balance-sheet insolvency, therefore of big losses in banks, which usually sets off liquidity crises as we have seen. In fact, in EU terms, this could still result in improper and therefore distorting government aid. Conditions will therefore normally be imposed. As already mentioned, in the eurozone, this is now very much connected with the resolution regime or the Single Resolution Mechanism (SRM) as we shall see in ­section 4.1.4 below, but everywhere the question of the safety net especially for large international banks in distress is becoming a key issue: see further ­section 1.3.11 below. State intervention of this nature denotes in truth the inadequacy or failure of financial regulation to offer sufficient protection or stability. The 2008 financial crisis and the governmental and central bank support for banking it engendered demonstrated once again the weakness of banking regulation in terms of guarding the health of the financial system as a whole. The subsequent idea that in the government debt crisis which followed in southern Europe, the ECB indirectly should act as lender of last resort even to euro countries themselves31 denotes an extreme use of the facility of lender of last resort, which may then come down simply to printing money to finance indebted states, including their banks, and goes far beyond liquidity support proper. Although in grave financial crises, there may be reasons to do so (open the liquidity tap and forget all discipline), little suggested that that stage of despair was reached in the southern European government debt crises after 2010, long-term interest rates for Italy and Spain hardly moving beyond 6 per cent. Even in the 1990s, these countries had seen much higher interest rates and similar unemployment levels. Yet in the minds of many, printing money is a cure for most economic ailments. Its ultimate effect is inflation, at first demonstrated in asset bubbles, and if that is not happening immediately, eg because open markets favour cheaper products and labour costs, this type of funding will at least postpone the necessary structural adjustments but cannot avoid the day of reckoning for ever. Such an approach usually denotes a long era of decline. See for a discussion of the 2008 crisis and its aftermath more in particular ­section 1.3 below.

deflationary tendencies. The philosophy was that regardless of printing money, there was no increase in the money supply as other financial instruments (bonds etc) were withdrawn from the market at the same time. Hence no excessive inflation danger, it was assumed, but this increased liquidity created all the same bubbles, notably in stock markets and real estate, although this was denied by the ECB. The greater problem may be that the ECB is getting involved in too many potentially conflicting functions: (a) monetary policy, (b) protection of the euro, (c) bank of last resort, (d) micro-prudential supervision of banks, (e) macro-prudential supervision of the financial system, and (f) banking resolution, besides (g) its involvement indirectly in fiscal policy and economic stimulation. 31 

See also the comment in n 30 above.

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1.1.7  The Role of Regulation and the Major Regulatory Concerns: Financial Stability, Depositors and Investor Protection, Market Integrity In the previous section, central bank and government support were presented as non-regulatory issues, at least if one considers financial regulation to be rule-based. Rather, regulation is meant to prevent the need for such support beyond the mere activity of lender of last resort to smooth out banking’s daily liquidity requirements. In its modern form, regulation became primarily focussed on (a) financial stability, although other important features of financial regulation remain, (b) the conduct of business, meaning the protection of depositors, investors and even borrowers in respect of unsuitable financial products, and (c) market integrity as we shall see. These are the three pillars or prongs of a modern financial (micro-prudential) regulatory system, that is rule-based and enforceable through regulatory action under court supervision (judicial review) aiming at the behaviour of banks and protection of the system or more directly through civil court proceedings and damage actions aiming at the protection of clients. It has already been said that the concern for financial stability in terms of solvency and proper liquidity has now come to dominate regulatory thinking. That is solvency affecting the whole system and financial regulation then figures as an important support. This raises the issue not only of micro-financial supervision, but more recently also that of macro-financial supervision, which distinction will be discussed more extensively in ­sections 1.1.13/14 below. The essence of micro-financial supervision is in this connection that it represents indeed a pre-existing legal frame work of risk management and capital adequacy and potentially also of liquidity management that aims at stabilising the system through legally enforceable rules and a level playing field for all. Again, this micro-financial supervision and the formulation and operation of its rules has been much of the governmental concern in the last generation in the context of the promotion of financial stability. The narrower issue of the immediate effect of insolvency on depositors or investors, should it still happen, is in this approach more specifically alleviated by the organisation of (a) deposit guarantee schemes for bank depositors and (b) investor protection schemes for investors in securities.32 Macro-prudential supervision on the other hand is the result of scepticism of the micro-prudential approach from a financial stability point of view and puts the micro-prudential regulatory approach in this aspect in the balance, especially its capital adequacy and liquidity regime, also the one in Basel III as we shall see in ­sections 1.1.13/14 below. Legal predictability considerations are then abandoned in favour of pure ­policy

32  It should be noted that these protection schemes do not by themselves reduce the insolvency risk or eliminate the systemic risk connected in particular with major commercial banking crises, but it allows the regulator to take broader policy considerations into account when deciding on the suitability of action where it is still given some discretion in a rule based system (eg to close a bank) in the knowledge that at least the smaller depositors or investors are protected. This is important as systemic considerations have often come to prevail over the immediate protection of depositors, although in the end in the 2008 financial crisis, when the system had to be saved, all came together, leading in several countries to a complete government guarantee of all deposits and in others to a considerable increase in the amounts deposit schemes would reimburse.

PART I  Financial Services, Service Providers, Risk and Regulation 525

initiatives to prevent or resolve financial crises. It suggests (a) a form of regulatory discretion as to the capital and liquidity requirements depending on the situation and product, (b) supervision or at least guidance of micro-financial regulation, and (c) crisis management or resolution supervision if all goes wrong. It will be argued later in ­section 1.1.13/14, that this puts pressure on financial regulation as a legal framework and on the idea of a level playing field for all. It also affects the judiciability of regulatory action so taken which tends towards pure policy. Indeed, although traditionally, commercial banking regulation was more concerned with what banks did with depositors’ money after it had become their own, and subsequently focussed more in particular on balance sheet insolvency and more recently also on cash flow insolvency and liquidity issues, as we have seen, this concern is now eclipsed by concerns for financial stability and systemic risk more generally, hence also the experimentation with a macro-prudential approach. However that may be or evolve, for the moment the more traditional concerns and tools of micro-prudential supervision need to be more directly explored, especially for commercial banks, therefore primarily the rules of regulatory capital and liquidity. It also concerns the role and impact of risk management and particular of risk spreading and hedging facilities, including set-off and netting. In the securities industry or capital markets, the prime micro-prudential concern, on the other hand, was not stability but more the proper segregation of clients’ assets. Beyond this, regulatory concern in the securities industry was and still is very much about the advice that is being given and prices obtained for clients,33 therefore conduct of business issues. In respect of clearing and settlement systems, there is further the risk that trades are not, or wrongly, executed, or that there is insufficient cash or that there are insufficient back-up securities in modern bookentry entitlement systems, see ­chapter 1, ­section 4.1.1 above. It is important in this connection to recall the different functions of commercial and investment banks, their different roles in the recycling of money, and the variations in the traditional regulatory concerns and tools depending on the structure, function and risks of their various activities and products. In ­section 1.1.5 above, it was already said that these risks and concerns may extend to the types of financial products on offer, such as, for instance, complicated derivatives structures, and in the way they are sold to unsuspecting investors, therefore to the intermediaries’ conduct of business. We may here also be concerned with the legal risk in financial products, and therefore with the question whether these products are sufficiently embedded and protected by modern legal systems and function properly.34 These conduct of business and product issues may also increasingly arise in commercial banking in respect of more specialised banking products and services (where they were traditionally less acute as banking products used to be fairly simple), for example

33  Traditionally, systemic risk was thought to be less important in this area of investment services, but as already pointed out in n 7 above, the 2007–09 financial crisis and especially the demise of Lehman Brothers highlighted the systemic risk originating in the investment service industry as well, enhanced by its increasing dependence on short-term funding from ordinary banks and its large exposure to hedge funds through prime brokerage activity. 34  See also R McCormick, Legal Risk in the Financial Market (Oxford, 2006).

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when mortgage products become more complicated or the deposit interest structure and banking charges become un-transparent or too one-sided. The offering of consumer loans and the distribution and charging of credit cards may here be other areas of legitimate concern. It raises conduct-of-business and product issues also for commercial banks, even if, as was said before, the emphasis in commercial banking regulation is now on stability. It may also be considered in this connection that, although the crisis of 2008 was often attributed primarily to the irresponsibility of banks in terms of their liquidity and risk management, the fact that there was no public sympathy when banks had to be saved at considerable cost was due in large part to conduct-of-business shortcomings and client irritation when it came to their personal protection over time, never mind the almost unlimited access to liquidity and leverage banks had provided. Perhaps conduct of business and product supervision are areas where micro-prudential regulation is better able to achieve something, at least a great deal more than it does at the moment. Hence under Dodd-Frank in the US the special attention to consumer protection in banking as we shall see. Here the issue is that because of more protection of this nature, these services will become more expensive or even largely unavailable for them. Undoubtedly banking clients, especially the smaller ones, are at risk of a mentality in banks that means to grab as much as possible. This became a more important issue after the crisis faded and the attitude of banks was more independently probed. At least in respect of their smaller customers, banks are in a dominant position. This could correctly create regulatory concern, but regulation often fails also in this area. It may be more successful in the securities or investment business. In banking, far too much may still be left to the unilateral decision making of banks, if only in terms of interest rates and charges, but it goes much further. The banking contract itself (see ­section 1.4.9 below) is very one-sided and commonly allows a bank to fill in many conditions unilaterally. Competition between banks is mostly quoted as protection for the banking public, but it is often insufficiently understood that changing banks is not easy and that all banks tend to behave alike. It is therefore not surprising that in the latest US legislation (Dodd-Frank) there was created a regulator especially for consumer clients. As for these conduct of business concerns, in the investment area proper, as early as the 1930s in the US regulation of conduct of business became important (the issuing of investment securities, securities underwriting, brokerage and advice— activities now often concentrated in so-called investment banks) with particular emphasis on (a) investors’ protection, (b) transparency in public offerings and trading, and (c) ultimately fair dealing. Again, this concerned especially the operations and investment risks in the capital markets. This early US regulatory example in the area of investors’ protection has now been followed elsewhere, and the securities industry has as a consequence become substantially regulated also, indeed originally especially from this investor-protection perspective, although still with very different levels of sophistication from one country to another and from one investment function to another (for example, it is very different for underwriters and brokers). There is here even less of a consensus transnationally about the risks that need regulatory attention and on the objectives of such regulation. Even in the US, the broker was not subject to the same fiduciary duties in this regard as is the investment manager, a difference

PART I  Financial Services, Service Providers, Risk and Regulation 527

meant to be cured by the Dodd-Frank Act. These concerns have acquired added poignancy in connection with the increasing need to create a sound climate for investments to cover the financial needs of an ever-ageing population. Investments must be carried and be made safe, or safer, for very long periods. In this vein, regulation of this type is now becoming important also for the pension industry, which is closely connected with the life insurance industry. As already mentioned, besides financial stability and conduct of business, a third overriding regulatory concern in this area is market integrity, which goes back to the issue of the protection of the public at large and of confidence, at first particularly in issuing and trading investment securities. It is connected with fair dealing, but goes beyond it and is also different from the issue of stability. It concerns the prevention of market abuse, anti-competitive behaviour, insider dealing, money laundering and other forms of corruption (see further the discussion in ­section 1.1.18 below) and is not a supervision issue proper but rather one of civil and criminal penalties or sanctions, including the disgorging of any benefits so obtained. There is an obvious public concern with markets being clean and operating properly, which is also in the interest of these markets themselves, their legitimacy, and the confidence in them. Modern securities regulation will also remain concerned with market integrity from other perspectives and may as a consequence continue to cover certain specific market aspects, especially pre- and post-trade price transparency and proper settlement of transactions and this is likely to be reflected in regulation. However, in other respects, markets must be free, especially in price formation, and not be interfered with by regulators so that false markets result. This also affects the issue of short selling, as to which see further ­section 3.7.9 below.

1.1.8  The Basic Structure of Modern Financial Regulation. The Type of Recourse In the previous s­ection it has already been said that micro-prudential financial regulation proper implies some prescribing and supervisory function or authority while aiming in a rule-based system at (a) greater financial stability, (b) better protection of depositors, investors and sometimes also bank borrowers, and (c) a better functioning of the financial markets (including the payment and settlement systems) especially avoiding abuse and promoting integrity. It has also been said in this connection that at least in commercial banking, the search for greater stability and minimising systemic risk has taken over from other concerns while depositors and investment protection schemes guard against the more immediate effects of insolvency on clients. It left other aspects of regulation, especially conduct of business issues, often undervalued. Conflicting policy objectives and concerns in micro-prudential supervision of this nature will be discussed further in ­section 1.1.10 below. Financial regulation, at its best, should be seen as reinforcing internal procedures and practices which banks and other financial intermediaries already have in place to adequately manage their risks and conduct. That is their prime responsibility, but they

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may weaken in the pursuit of other objectives, mainly volume and profits, especially in good times. Here regulation becomes a warning and a bottom line, more than necessary in practice but still notoriously ineffective in preventing financial crises, some of the reasons for which will be further explored later in ­section 1.3 below. One is the outside risks which banks themselves can hardly control or diversify, see section 1.1.2 above. To repeat, the present type of (micro-prudential) financial regulation is rule, or at least legal principle, based, which means that, although regulators will apply the rules to individual banks (which is what micro-supervision means), they will not enter into the business of a particular bank or other financial intermediary itself beyond enforcing these rules. It has already been said that they are not equipped to do so or educated to that effect, and it could make them liable for the consequences, which regulators would want to avoid at all costs. Yet financial crises commonly lead to calls for more ad hoc intervention and a so-called judgement-based approach to (micro-prudential) supervision may support it as we shall see: it has led to increasing emphasis on a macroprudential approach, as we have noted, see further ­1.1.13/14 below. However, for micro-prudential regulators it is a mistake to interfere autonomously, unless perhaps in emergencies when this power goes well beyond the ordinary regulatory role while one may still ask whether it might make things even worse. There is no guarantee of any better insight of such regulators in what needs to be done in extremis. Rather, the more normal objective is to provide a legal framework within which financial business must be conducted and can be supervised. This then requires clear rules to be enforced rather than a daily (ad hoc) involvement of regulators. At least in micro-prudential financial supervision, the key is therefore a legal regime of checks and balances, not of discretionary intervention, although, again, if there are specific and serious reasons, that is not to be ruled out entirely but it should remain exceptional even if there may be some room under the regulatory rules to do so. This being said, regulators will still tailor the rules to individual institutions to the extent these rules allow and require it. Again, that is micro-prudential supervision as distinguished from macro-prudential supervision, which is not regulation in this more traditional sense (see again ­1.1.13/14 below) and is geared in particular to a more anti-cyclical policy attitude towards capital and liquidity requirements, therefore to the intensity of banking activity and its size in every phase of the economic cycle, which puts this function, it will be argued later, at the level of monetary and fiscal policy, although well separated from them (especially monetary policy even if macro-prudential supervision and monetary policy may both operate at the level of central banks). A micro-prudential regulatory framework of this nature, although rule-based even though allowing for some variations in its application to individual banks, will still be diverse and varied also because of the different financial functions exercised by financial intermediaries, be they banks in commercial banking activity or investment banks in the capital markets. But there may also be different perceptions and evaluation of risk per country, and different objectives or traditions and ways of doing business. This is likely to result from the size of the industry or financial market in a given country and the differences in the level of regulatory sophistication. In connection with the details of financial regulation of this nature, there is, however, a general pattern or model and it is useful to (a) focus first on the type of service rendered, such as commercial banking,

PART I  Financial Services, Service Providers, Risk and Regulation 529

securities or insurance services, which may be broken down further into specialised functions such as deposit and payment services for commercial banks, and underwriting, trading or brokerage, clearing and settlement or investment advice in investment banking. Subsequently it is useful to (b) distinguish between the service provider and the service itself. In respect of both, the regulatory issues can be broken down further. In the case of the service provider (per industry or function), there is commonly concern with (a) authorisation and (b) prudential supervision. Thus, commercial banks as institutions and investment banks per function are likely to need some form of authorisation or some governmental licence. The authorisation itself will depend on (i) ­reputation (the fit and proper test),35 (ii) capital, (iii) adequate infrastructure and systems, and (iv) the business plan or profile of the financial service provider. It will be followed by (micro) prudential supervision, which is based on the ongoing requirement that the basic authorisation requirements remain fulfilled, for commercial banks especially in the aspect of adequate capital (and potentially also liquidity) and its management to prevent insolvency. Ultimately there will also be concern with enforcement and the consequences of failure. Important as they are, these are aspects of regulation that concern the aftermath and will not here be the main focus of the discussion, although, as we shall see, it becomes an important issue in banking resolution regimes and macro-prudential supervision of that nature. See for the EU s­ ection 4.1 below. It has already been said that in commercial banking regulation remains largely confined to the supervision of the service provider, therefore to the two regulatory aspects of authorisation and prudential supervision. It is the issue of financial stability. For commercial banks, the activities of deposit-taking, providing loans and organising payments are usually secondary conduct of business issues. In the securities industries, on the other hand, there is traditionally more emphasis on the regulation and supervision of the services or conduct of business concerning these activities of the intermediaries themselves, while issues of authorisation and prudential supervision were often more secondary, therefore in fact the reverse of the situation in commercial banks. It has already been noted that concern about the services may become increasingly relevant for the more sophisticated banking services as well, for example in the areas of

35  Senior management is often made directly subject to the fit and proper test even though it applies foremost to their institutions, and they are then brought into the supervision personally through a system of examinations and supervision of minimum qualifications. What is fit and proper remains, however, a difficult issue in practice and has two features: ability and moral standing. As to these requirements, which tend to be quite basic in the way they are expressed, the first is usually left to management and shareholders, the latter may attract more regulatory attention. They may also be seen as matters of corporate governance, although, again, regulators may be careful not to get involved in the running of financial institutions more than absolutely necessary. In the EU, the Commission Green Paper of 2 June 2010 on corporate governance in financial institutions and remuneration policies identified a series of failures in corporate governance in credit institutions and investment firms that should be addressed. Among the solutions identified, the Commission referred to the need to strengthen significantly requirements relating to persons who effectively direct the business of the credit institution. They should be of sufficiently good repute and have appropriate experience and also be assessed as to their suitability to perform their professional activities. The Green Paper also underlined the need to improve shareholders’ involvement in approving remuneration policies. The European Parliament and the Council noted the Commission’s intention, as a follow-up, to make legislative proposals, where appropriate, on those issues. Some action came in the Capital Requirements Directive (CDR3), Directive 2010/76/EC of the European Parliament and of the Council of 24 November 2010 [2010] OJ L329/3, but it did not truly clarify the criteria, see also s 3.7.3 below.

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derivatives and insured mortgage credit when offered to the public. There is further to go here but it means that also for banks, conduct of business and product supervision may increasingly become a regulatory issue. In this connection, it was also mentioned that the way they unilaterally charge customers for their services may become relevant as well, especially in respect of the smaller banking clients. Credit cards may be another area of concern and other consumer loan incentives. On the other hand, it may also be repeated that licence conditions and stability issues are now also becoming more relevant for investment banks which have become more systematically integrated in the financial system. As regards these financial services, from a regulatory perspective, a further distinction was already made between (a) the conduct of business and (b) the type of products offered (per function). This focuses on what is sold and how, and the safeguards in these respects for investors (or, in the case of banks, borrowers), traditionally especially important in respect of the smaller or retail investor and the way they are serviced or protected by their service provider, who may have some innate duties of care here. When it comes to types of products, it is also an issue of legal risk: do these products work and are they sufficiently transparent. In the area of issuing new securities (or primary market), there are likely to be ­further regulatory requirements. These concern the issuer or fundraiser more directly, not the intermediaries, such as its registration with the Securities Exchange Commission (SEC) in the US (if the issue is targeted at US investors), which commonly leads to a prospectus requirement. Issuers are thus regulated and the need for them to produce at least a prospectus is now also an increasingly common requirement in Europe—see for the EU regime ­section 3.5.10 below. Here we are concerned with corporate transparency and identification of corporate risks.36 This transparency may be required all the more if the issue is at the same time listed and traded on an official stock exchange, therefore targeted at the public at large.37 To repeat, in the new issue or primary market, financial regulation will foremost affect the issuer, therefore the party that needs money and raises it publicly. So is the type of securities offered and their advertisement, now commonly subject to prudential regulation, here as part of the issuing process. The conduct of the financial service providers or intermediaries, largely underwriters and placement agents, activities mostly

36  Besides these special regulatory requirements in respect of issuers, there may also be company law issues for an issuer if it is a corporate entity (and not a government or governmental agency), for example the necessary corporate approvals or the nature of the securities that can be offered. In company law, one sees here an important shift in interest from typical organisational or company law matters to capital markets and regulatory concerns, most importantly also in connection with the financial information given and the accounting principles underlying this information. There may also be tax and stamp duty aspects of new issues and, in international offerings, there may be restrictions on issuers as to the markets in which they may issue or currency restrictions and money transfer problems. 37  In respect of the trading activity, a new area of law has in the meantime resulted from the emergence of new types of securities (shares or bonds) in terms of book-entry system entitlements. They are replacing the older negotiable instruments, the way investment securities are held and transferred, and bona fide purchasers of them are protected. This has been dealt with more particularly in Vol 2, ch 2, part III, summarised in ch 1, s 4.1 above. It is not a regulatory issue proper, rather a question of private law protection or legal risk that is nevertheless also of relevance to regulators where it affects investors’ rights and remedies. This therefore concerns the nature of the investment product and the investors’ protection from that point of view.

PART I  Financial Services, Service Providers, Risk and Regulation 531

concentrated in investment banks, is also important, but their regulation is quite different although they still take the model of bank regulation, as we have seen, but, again, the emphasis may be different: less on financial stability and more on conduct of business. So may be the involvement of financial service providers as advisers to the issuer in respect of the available funding alternatives and in arranging the documentation, including the prospectus. Again, this is the world of intermediaries, especially of investment banks, here in their corporate finance departments, which also involves lawyers, although this purely advisory work may not be regulated or require authorisation in the manner already discussed as long as it does not involve offering investment advice to the public (the same may go for merger and acquisition activity and advice). Rather, it may attract other forms of supervision for investment banks and will in any event not extend to the lawyers (although they may be liable for negligence). The latter tend to be supervised by their own professional bodies, such as the Bar of which they are members. In terms of legal protection and recourse for or against financial intermediaries, the regulatory concerns with proper authorisation and prudential supervision of commercial banks and securities intermediaries or investment banks, and with the supervision of the issuing activity itself, have in many countries resulted in new structures of administrative law and in the creation of new supervisory authorities that grant licences for or authorise the various financial functions and supervise the implementation of their conditions. Failure to comply may then lead to a loss or suspension of these licences or authorisations, subject to some forms of judicial review in the administrative courts. It means that private parties will not have standing to sue their banks or intermediaries under these rules, although some so-called horizontal effect is not always excluded, but it must still be considered rare. The only thing aggrieved parties can do is to write to regulators, who may or may not act.38 For banks, this supervisory function was in the first instance mostly exercised by central banks and often still is. For the securities industry, it had in the US already led in the 1930s to the creation of a specialised regulator, the SEC. The Financial Services Authority (FSA) in the UK was a much more recent creation (1997) and was until 2012 the sole (consolidated) regulator for all financial services in the UK. It thus also covered commercial banking supervision, which was earlier taken away from the Bank of England, but this division of labour is reversible and is often determined by political considerations. In fact, in 2012, in the area of financial stability, banking regulation reverted in the UK to (a subsidiary of) the Bank of England in a specialised separate function. This is the Prudential Regulation Authority (PRA), which decides on authorisation and prudential supervision of all financial activity. What was left of the FSA became the Financial Conduct Authority (FCA). It concerns itself primarily with conduct-of-business issues.39

38 

See n 40 below. See for the latest recast of the supervisory system in the UK, the Financial Services Act 2012, operative as of 1 April 2013. While more modern proposals increasingly seek to separate stability issues from client or investor protection as already noted and may lead to a regulatory split, like in the UK, many other countries still have specialised regulators for the various functions, although there continues some trend in the direction of regulatory 39 

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As just mentioned, client protection foremost concerns the services provided (rather than the service providers), and covers conduct of business and types of products. In terms of legal protection and recourse, this is likely to lead to concern with the reinforcement of private (rather than administrative) law, especially in the area of agency (and duties of care, loyalty and confidentiality), segregation of assets, and constructive trust. Here aggrieved parties can sue for damages or for the cancellation of improper transactions. These issues and protections will be discussed at greater length below in ­section 1.5.9 and concern in particular ‘know your customer’, ‘suitability of the investment’, and ‘best price or best execution’ issues. The difference with authorisation and prudential rules is thus that even when these protections are further elaborated and expanded in regulatory rule books, the remedies are likely to be in private law in terms of breach of contract, breach of fiduciary or statutory duties especially in situations of dependency, or tort liability, although special statutory (ombudsman) schemes may also be put in place instead to facilitate proceedings brought on these (reinforced) grounds, especially by small investors against their brokers. It has already been said that regulatory concern may then also cover the (proper) legal characterisation of modern financial products, such as security entitlements and custodial arrangements, clearing and settlement, collateralisations, securitisations, derivatives (including swaps), and repurchase agreements, set-off, and netting, here again primarily as matters of clarification, reinforcement or amplification of private law. These problems (and therefore the legal risks inherent in these financial products) were discussed in ­chapter 1 above. Again if improperly sold, the recourse would be in private law, resulting in damages or the undoing of the transaction at the intermediaries’ expense. For corporate issuers, modern issuer activity may result in amendments to corporate and commercial law in terms of disclosures, accounting principles, and types of securities on offer. In clearing and settlement, there may be particular concern with safety and proper functioning of these facilities, leading to regulatory supervision from that perspective (although less so in Europe), but also to the further development of private law, such as the evolution of the guarantees of clearing members and of the legal acceptability of close-out netting agreements. Such private law developments may make more direct regulation of these activities superfluous. Again, in all these instances, the balance between private or administrative law intervention is of considerable interest, the key always being that administrative law remedies do not automatically give rise to civil remedies.40 Of immediate importance is here to realise

consolidation in a single regulator (but most notably not in the US and no longer in the UK). Whether this is a good development may be reconsidered further in the wake of the 2008–09 crisis. 40  Indeed, the House of Lords in Three Rivers District Council and Others v Governor and Company of the Bank of England [2000] 2 WLR 1220, seemed less concerned with depositors but accepted—absent bad faith—the prevailing legal restrictions on civil liability for banking supervisors as an adequate defence. In the UK this defence is more extensively interpreted than elsewhere; in France, for instance, administrative courts now accept in this connection faute simple as sufficient ground for civil liability, therefore conceivably leaving more room for depositors’ protection; see Cour Administrative d’Appel de Paris, 30 March 1999. In Three Rivers, even reasonable policy objectives and considerations connected with systemic risk or the smooth operation of the financial system did not seem to figure large. They were in any event not weighed against

PART I  Financial Services, Service Providers, Risk and Regulation 533

that administrative law remedies do not give private investors’ protection, see however also the discussion in s­ ection 3.7.19 below. To reiterate, there is normally no horizontal effect in that sense and civil liability of regulators is also exceptional. Thus licences or authorisations and their repeal is a matter between an intermediary and its supervisor as an issue of administrative law. Neither bank clients nor investors can insist on it, nor does such a repeal give them any direct claims against the regulator or relevant intermediary/perpetrator. As noted, the emphasis of modern financial regulation in the area of commercial banking remains particularly on authorisation and prudential supervision and is less conduct of business and product oriented. Again, systemic risk or financial stability has become the main concern; administrative law rather than private law issues arise here. In the capital markets, the regulatory focus is instead on issuers in respect of transparency and securities offered and on intermediaries or service providers in respect of their services. That is private law, although even here there may also be authorisation and prudential supervision, at least for the underwriting, trading, brokerage and advisory activity, and sometimes also for support functions such as clearing, settlement and custody, but the emphasis is still more likely to be on conduct of business and products, therefore on private law protection rather than on administrative law remedies, especially in respect of retail investors. However, it was already mentioned that during the crisis of 2008–09 it became clear how interdependent and closely connected the larger of these institutions became with commercial banks. This heightened the interest in their authorisation and prudential supervision and that is the present trend.

1.1.9  Deregulation and Re-regulation of Modern Financial Activity. The Institutional and Functional Approach to Financial Regulation. Monetary, Liquidity and Foreign Exchange Policies Distinguished It is important to repeat that not all financial services are directly related to deposittaking or the selling of banking products and investments to the public. In commercial banking there is eg the payment function. In investment services, there are u ­ nderwriting, market-making or order matching, brokerage, investment management, information supply, clearing, settlement and custody functions. These are foremost market functions traditionally grouped around the formal or official markets or stock exchanges but now often split out and spread over different entities, which have no official status and may compete. This is clear where unofficial or OTC markets started to operate and compete with the more traditional stock exchanges (see for these markets and their operation s­ ection 1.1.18 below). They are often markets created by investment banks

the statutory requirements of depositors’ protection as laid down in s 3 of the UK Banking Act 1987. It was assumed that the EU First Banking Directive of 1977 (77/780/EEC), now largely superseded by the Credit Institution Directives of 2000 and 2006, even though clearly concerned with depositors, did not give depositors extra rights in this connection. No guidance from the European Court of Justice was sought; see further M Andenas, ‘Liability for Supervision’ [2000] Euredia 379.

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for their own clients or each other. Electronic trading platforms have facilitated this development (see also ­section 1.5.6 below). It is also clear in the information supply and clearing and settlement functions, where other private organisations increasingly compete with the official exchanges for this business, notably central counterparties (CCPs): see ­chapter 1, ­section 2.6.5 above. As already mentioned, many of these market functions may also be taken over by different departments of investment banks. As a consequence, modern financial regulatory objectives and requirements in terms of authorisation, supervision, conduct of business, and product control may be different in respect of each type of financial service or service provider. Regulation by function rather than by institution like a bank or exchange, has thus become more normal in these areas, and may be done through different regulators. This is the approach in the US, although it may also be done by a single (consolidated) regulator, as did the FSA in the UK until 2012, but in that case still differently according to function. It is also possible to split regulation and have one regulator in respect of the authorisation and prudential supervision (of commercial banking, investment banking and insurance) and another in respect of conduct of business and product supervision, therefore one for stability issuers and another for client protection as we have already seen. This may be a regulatory improvement, and is probably the latest trend, as borne out in the UK where we now have the PRA and the FCA (see the previous section). So, in the structure of financial regulation, we have gone from an institutional to a functional approach and now to a sharper distinction between stability and client protection. These trends are not necessarily complete, but it is apparent that there was in modern financial regulation a fundamental shift away from the regulation of institutions, like again the traditional commercial banks and stock exchanges as such, to the regulation of intermediaries according to their different functions, particularly relevant in investment banking. As a consequence, one service provider may be subject to different regulatory regimes. Again, this is clearer for investment banks, but it may also increasingly affect commercial banks. The emergence of bank holding companies where different activities are relegated to different subsidiaries reinforces this functional approach also, therefore even in commercial banking, but if this is still less obvious for commercial banks. This has largely to do with the overriding aim to avoid commercial bank insolvencies, insolvency being an institutional phenomenon which engenders systemic risk and issues of financial instability, traditionally less of an issue for investment banking, as we have seen, although perhaps becoming more so now because of their size and their increasing interconnectedness with commercial banks. On the other hand, as we have also seen already, even within commercial banking proper, there is now greater concern about conduct of business, therefore about protection especially in respect of borrowers and the financial products on offer, less for depositors. Although other regulators may thus come on board, especially in so-called universal banks which also conduct investment business—see s­ ection 1.1.16 below— the institutional approach is not fully abandoned and the supervision for commercial banks remains largely subservient to this aim of preventing insolvency, relevant especially in the determination of sufficient capital for the entire entity, the ultimate aim being to reinforce financial stability and reduce systemic risk. For this reason also, there still remains more of an emphasis on authorisation and prudential supervision

PART I  Financial Services, Service Providers, Risk and Regulation 535

in ­commercial banks, indeed with a predominant concern for capital adequacy and increasingly also liquidity for the whole institution (or even group). It is tin any event likely that there will be only one lead regulator for capital adequacy (and liquidity) in respect of all activities. That is normally the banking supervisor. Again, at least in commercial banking, it highlights institutional concerns at the expense of conduct of business and product supervision, which automatically lead to a more functional supervisory approach. It follows that the functional approach itself is more evident in the securities b ­ usiness when operating on a stand-alone basis. Regulation along functional lines is sometimes also referred to as objective-based regulation and may thus differ for underwriting and trading, for brokerage, clearing, settlement and custody functions, and for investment advice and fund management. The shift in regulatory approach in the capital markets from institution to function in the above sense was, for the securities business, already achieved in the US under the 1933 Securities and 1934 Securities Exchange Acts, which, in the Glass-Steagall Act (as part of the Securities Exchange Act) separated the banking and underwriting businesses. They could no longer be combined in one institution. This separation legally endured until 1999 but became uncommon, especially after the financial crisis in 2008, when the main investment banks in the US applied for a banking licence. Separation directed against proprietary trading is among the newer regulatory proposals since 2010 in this regard: see the discussion in ­1.3.10 and 3.7.11below (the Volcker rule). In a country like the UK, after the so-called ‘Big Bang’ in 1986, the functional approach also became clearer and part of the breaking up of the club atmosphere and monopolising tendencies in the stock exchange in London, official markets having traditionally been institutionally self-regulated. A sequel to this was that, in the UK, market, settlement and custodian facilities could henceforth be freely created, as had already happened in the offshore euromarkets (see for these markets s­ ection 2.1.2 below) even to the extent operating from London. These services are (unlike in the US) no longer subject to regulation per se, although transparency (and price reporting) was imposed by law on all market participants operating from the UK, while there is a system of official recognition possible, which gives such recognised markets (which must be well distinguished from official markets), or settlement and custody entities that want to operate within them some advantages in their reporting duties and then often also more credibility. It also protects them against any charges of engaging (inadvertently) in regulated activities without a proper licence. The charge is often heard, especially during the financial crisis of 2008–09, that there has been aggressive financial deregulation during the last generation, see also ­section 1.3.2 below. Beyond the lifting of Glass-Steagall in the US in 1999, this is hardly the case for financial intermediaries and services, as may be seen from the mushrooming of compliance departments, long before 2008. If there was a regulatory shift from institutions to functions and therefore a form of deregulation of the former, it was accompanied by re-regulation, now often along functional lines. It was more that in good times enforcement of regulation became lax and liquidity management was neglected by regulators altogether. At the formal level it is also true that capital requirements had been ever further reduced, which was certainly confirmed by Basel II.

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So one could say that there was a government inspired deregulation of the capital requirements further demonstrated by the self-assessment possibilities of Basel II. More particularly, newer financial products were not normally considered for regulation, which applied, for example, to securitisations, hedge funds, and credit derivatives, although they were gradually brought within the reach of the capital adequacy rules, especially under Basel II. This being said, it is also clear that an ex ante approach is here hardly possible and it is only logical that regulation is always behind: it is often hard to see at first where the problems with these newer products are. They are likely to be only truly tested in financial crises when regulation comes (by definition) too late. So we may have a lack of regulation by default, but this is not deregulation. Licensing of all innovation would be the answer but is not realistic where the risks change all the time. This should not be confused with another fundamental element of de- and re-­regulation in finance. We are then concerned with the deregulation of the flows of financial services and products, therefore of markets (except to protect their integrity), and the re-regulation of participants therein. In this approach, flows or markets are free in concept and not to be manipulated or distorted by regulation or otherwise, especially in their price formation aspects. This deregulation of the flows acquired an international dimension and concerns the free flow of financial services and products internationally. Again, there should not be interference with the price formation function in respect of these services and products. Participants are different and may still be regulated locally and per type of activity. In the capital markets, they may be issuers and intermediaries as we have seen or even investors, who may thus all be regulated in some form or another (the latter, for example, in the case of pension funds to redirect their investments). The deregulation of the flows of financial services and financial products in this manner should in turn be distinguished from the regulation and subsequent deregulation of the capital flows, although it is true that the increasing liberalisation of these flows internationally has given an enormous impetus to the financial services industry worldwide, while greatly encouraging the cross-border delivery of financial services and products. In the EU, as we shall see in ­section 2.4.1 below, the liberalisation of the capital flows after 1988 was indeed the catalyst for the further liberalisation and therefore deregulation of cross-border financial service flows and products as such, even though in principle already freed under the original Treaty of Rome of 1958, which created the original EEC. Again, it left the question of the regulation of issuers and intermediaries as market participants. In practice, the free flow of these services and products was delayed in the EU because of the regulatory complication and the lack of clarity, especially in terms of host regulator competencies to regulate incoming service providers from other EU countries. Only in the so-called Third Generation of EU Directives in this field, issued in the context of the Single European Act 1992, was a division of labour achieved between home and host regulator of financial services in this respect (with the emphasis on the former, as we shall see), which made the flow of these services to, and the right of establishment of the service provider in other EU countries practicable, while at the same time achieving harmonisation of the regulatory aims and regimes: see ­1.2.1, 2.3.4 and 3.1.1 below.

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Unlike in the liberalisation of financial services and products providers, which was meant no longer to inhibit the financial flows or markets except to promote proper conduct in intermediaries and the integrity of the marketplace, in the liberalisation of capital flows themselves we do not primarily think of depositors or investors and their regulatory protection or of borrowers or issuers and the financial services provided to them by financial intermediaries. There are here domestic and international aspects. Domestically, we rather think of monetary and liquidity policies (in terms of the economy at large and not individual banks), including issues of money supply, exchange rates, and (short-term) interest rates, inflation control, and the allocation of credit to various economic sectors, the first two (monetary and liquidity policy) being traditionally conducted by central banks and of particular concern for commercial banks. In England, these matters come under the Bank of England Act 1998 (while the deposit-taking function of commercial banks is now regulated under the Financial Services and Markets Act 2000 as amended). Internationally, in terms of capital flows, we think foremost of the free movement of investments and payments, including the export and import of the related currency and its convertibility. Deregulation concerns here domestically the freeing of exchange rates and of interest rates (at least the longer ones), henceforth to be set by market forces, and internationally the freedom and ability to borrow or raise and invest capital wherever one wants and in whatever currency. Another aspect is the freedom to make and accept payments in any currency one wants. The deregulation of capital flows at the international level and their possible re-­ regulation to prevent financial upheaval or to deal with the international investment and taxation consequences—matters which the 1944 Bretton Woods Agreements essentially left to national governments—raise very different issues from the regulation of the financial services industry, its structure and organisation. Unlike the regulation of financial services, this can hardly be left to (domestic) home/host regulation alone. They must be dealt with internationally, partly within the IMF, and in Europe also at the EU level. In other words, this is not merely a matter of the division of labour or recognition thereof between (regulators from) Member States. This issue will not be considered here in greater depth. As just mentioned, in the EU after 1988, capital flows were fully liberated (see s­ection 2.4.1 below) while the re-regulation possibilities in respect of them are now limited in the EU. This left a number of investment and taxation issues, which will be discussed in greater detail in ­section 2.4.2 below. If, as suggested in ­section 1.1.8 above and below in ­sections 1.1.10 and 1.4.7, the essence of modern banking regulation in a narrower sense is now financial stability, it may become increasingly directed towards macro-prudential supervision. This may mean curtailing banks at the top of the cycle for them to build capital at that time. This suggests another facility besides micro-managing banks through regulation in the manner so far discussed. This is indeed policy, a facility closer related to monetary policy than financial regulation as we know it and is, as will be argued later—see ­1.1.13/14—below, another typical central bank function, which like monetary policy may or may not be conducted independent from government. The true issue is here the determination of the banks’ size in each stage of the economic cycle. Operating besides monetary policy, such a macro-economic banking policy must then also

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be ­distinguished from fiscal policies, which concern budgets and taxation and are the preserve of government. Indeed, these three policy vehicles are the preserves of governments or their central banks, although this banking policy in particular may have to be internationalised through international agencies determining the top of the cycle as a signal for stricter capital requirements, if only to maintain a level playing field between the larger banks in their global operations. It may have to be backed up by a stability fund to be created in good times cross-border so as to provide an international safety net for larger banks: see further the discussion in ­section 1.3.8 below. It is submitted that this is likely to stabilise the banking industry much more than present microprudential supervision can do.

1.1.10  The Different Aims of Modern Financial Regulation Altogether the conclusion so far is that (apart from issuers and, sometimes, investors), the emphasis of modern regulation of the financial services industry at the microprudential supervision level is on the service providers, therefore (a) on the intermediaries in the banking and securities business, their function, their proper authorisation and supervision, where financial stability is increasingly the issue, (b) on the way they provide their services and on the products they offer, where the protection of depositors and investors is the issue where the conduct of business is the major issue, and (c) on the proper functioning of financial markets, hence the interest in pre and posttrading price disclosures and transparency in that regard, but not or no longer in the flows or markets and price formation processes themselves, except for the important issues of market abuse, insider dealing, anti-competitive behaviour, money laundering, and corruption. It follows that, depending on these services or functions and the way they are provided, the main aims or concerns of modern financial regulation may be quite diverse, although likely to be concurrent, but they may also conflict as we shall see in the next section. Even if generally the objectives crystallise in the three categories mentioned—stability of the financial system, conduct of business, and the protection of the integrity of the markets and the prevention of market abuse—to be effective, the regulatory aims should be oriented towards some more clearly defined risk per function. Yet clarity of purpose remains a major problem in financial regulation, and regulatory objectives often remain clouded in vague ideas and sentiment or cloaked in unspecific, even though highly desirable policy aims, such as indeed the stability of the financial system, protection of depositors and investors, and the promotion of market integrity. The question is how? Can these aims be achieved effectively and efficiently, and at what cost? What is the model or method? This is foremost a question of properly defining the sub-objectives in terms of regulation, which is often lacking, so that the discussion tends to become confused. Financial stability, for example, it will be argued later may be achieved at too low a level of banking activity which may become destructive. More precisely and by way of summary of what has mostly already been said,

PART I  Financial Services, Service Providers, Risk and Regulation 539

the main objectives are the following (although, again, their intensity is likely to vary according to function and type of institution or product or even from country to country): (a) The minimalisation of contagion or systemic risk, meaning the prevention of the collapse of one financial firm affecting others. This is the issue of financial stability, although interconnectedness may not be the only cause of instability, see ­section 1.1.2 above.41 It concerns primarily insolvency risk, which risk has important contagion aspects. It is especially considered in commercial banking, where, through the interbank market, trading accounts and settlement, swaps and repo exposure, CDS guarantees, and payment systems, all banks are closely connected and the failure of one may seriously affect others. It could thus endanger the entire liquidity-providing function of banks and also the payment system, especially the off-line clearing systems (see ­chapter 1, s­ ection 3.1.6). Systemic risk was found to be traditionally less relevant in respect of investment services providers unless they become very large (as the major US investment banks were found to be in the crisis of 2008, while being at the same time important borrowers from commercial banks). Concerns of this nature may now conceivably also extend to other large financial entities or non-banks in the so-called shadow banking system (see s­ ection 1.1.15 below) but the more proper question is, as we shall see, which ones and in what way. To address these concerns, an authorisation and prudential supervision regime is commonly used42 and the remedy here is administrative action in terms of loss of licence and/or fines. Bank bankruptcies occur, however, unabated, including even bank runs, while it has also become clear that through regulation, especially of the capital adequacy requirements and limitation on large exposures, systemic risk is hardly reduced. In consequence, so far, modern (micro-prudential) regulation has been proven to be largely irrelevant to redress systemic risk or to increase financial stability. Proper insulation of problems and greater discipline in banks may require more radical action, perhaps even leading to some form of narrow banking, as will be discussed more extensively in s­ ection 1.3.6 below.43 It could, however, dramatically shrink the banking business, which is likely to have serious social consequences in terms of growth and employment. It may therefore in truth no longer be a realistic option. It was already argued and will be expanded later that much stricter regulation of banks at the top of the economic cycle as a matter of macro-prudential supervision, may be more effective and efficient, 41  See for a discussion of systemic risk also n 7 above and the tendency to overrate this risk by regulators. It gives them more power, but the question is how they are exercising this power, see for macro- and micro-prudential supervision, ss 1.1.13/14 below. 42  As has already been observed in the previous section, for commercial banks this leads to a more institutional approach. In a more functional approach, conduct of business and product concern, on the other hand, is mainly associated with securities activities, therefore with the operations of investment banks and securities houses or independent brokers. 43  It is also of interest that limiting systemic risk as a regulatory objective became implied in older regulatory systems that never meant to combat it. That was so, eg, in the UK, where under the Banking Act 1987 the objective of banking regulation remained depositors’ protection. Systemic risk was not mentioned and only appeared subsequently in the Bank of England’s three-monthly reports.

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see ­section 1.1.14 below. It goes well beyond the established regulatory model and is in fact policy much as monetary and fiscal policy is: see also the discussion at the end of the previous section. (b) The protection of clients or customers, such as bank depositors and securities investors, against: (i) bankruptcy of the service provider; (ii) bad selling or advisory practices and uncompetitive prices often caused by a conflict of interests between service provider and client; or (iii) risky products.44 The impact of insolvency of the institution on its depositors and customers is now commonly covered by deposit and investors’ protection schemes; see also ­section 1.1.12 below.45 On the other hand, the modern concerns about financial products and the way they are treated or sold, are not or no longer primarily ­limited to investment securities as transferable instruments, such as negotiable shares and bonds. They may also relate to derivatives and deposits or other structured banking products. Even in commercial banking activities, credit card business or specialised mortgages may increasingly become a proper modern regulatory concern. It is appropriate in this connection to distinguish between the needs of the professional clients and others that have less experience. In general, only the latter need special protections. The result is often an increased possibility for private action against brokers and other intermediaries through private law remedies, as we have seen, especially damages or the avoidance of the transaction, often as the result of reinforced fiduciary duties, but it may also extend to the reinforcement of segregation of client assets in a broker’s bankruptcy. (c) The creation of a proper legal framework for financial products and services generally. This is legal risk and its minimisation. Regulatory concern in this aspect may and should increasingly extend to the legal characterisation and structure of newer financial products and services, especially obvious in the case of derivatives (and the ways in which they are cleared and settled) and other modern types of investments such as book-entry entitlements and custodial services and their operation transnationally. It may also concern modern set-off and netting ­facilities, and the functioning of exchange and payment systems, including CCPs. In banking proper, it may cover insurance-related loan or mortgage products. These raise mostly issues of private law and its reinforcement which were the subject of c­ hapter 1 above. It is an important (but often ignored) area of modern regulatory concern, which may also go to the transferability or proper unwinding of investments, as in the case of the more sophisticated derivatives. 44  In the area of investors’ protection, the regulator is often enabled to react through setting further rules (for the future) under delegated rule-making powers (in a private law manner) and may in this way also be able better to tailor these rules to the different functions of intermediaries and different products and selling techniques as they develop. The remedy is not here normally the termination of authorisation as an administrative measure but rather (reinforced) private law remedies leading to claims for damages. 45  See for these schemes also n 32 above. Note that the need for segregation of client assets in non-bank intermediaries, may provide additional protection, notably of investors’ money.

PART I  Financial Services, Service Providers, Risk and Regulation 541

As we have seen, civil law in particular is too consumer law focused and tends to be formalistic in its system approach which is not geared to professional dealings and a dynamic legal environment that can easily deal with financial innovation. Again, regulation would not be along the traditional lines of authorisation and prudential supervision, but may acquire the form of more specific facilitation and intervention in private law, which is then likely to become mandatory in these areas. (d) The creation of a simplified enforcement system is another important, closely related, client-protection aspect of financial regulation that may introduce a quick and cheap complaint procedure for the smaller customers or investors, either through ombudsmen or compulsory arbitration schemes in their recourse against financial intermediaries. This may also be extended to commercial bank customers, taking into account, however, the differences between various types of customers: borrowers have protection needs different from those of depositors and the latter have a different legal status vis-à-vis their bank. (e) The protection of the payment system. This concerns the continued unhindered operation of the payment system regardless of insolvency of banking participants and the proper and efficient operation of the clearing system between banks, see the discussion in ­chapter 1, s­ ection 3.1. (f) The integrity and smooth operation of markets. This is of importance foremost in the investment services industry. In terms of public policy, it could be seen as the investment services’ equivalent of systemic risk. This is not a question of regulating markets as such, whose flows and price formation process should not or no longer be hindered, but regulation is here first of a facilitating nature.46 It is likely to concern adequate information on issuers (through prospectuses and regular information supply) and adequate price transparency, therefore proper pre- and post-trading price information supply in these markets, as well as proper clearing and settlement and custody facilities. But regulation in the broader sense here also means the absence of market abuse or manipulation, including insider dealing (although the latter may be more an issue of corporate integrity and credibility, see also ­section 1.1.19 below). In terms of market abuse and manipulation, there can hardly be a regulatory oversight system but civil and criminal sanctions will be the normal remedies. Regulatory concern in this connection may be limited to these aspects while other market operations and activity may be self-regulated OTC or telephone trading or may remain unregulated like mostly information supply, clearing and custody. The eurobond markets showed early that full-scale regulation of major financial services and activities is not unavoidable, especially in professional dealings by experienced participants.47 46  Of course, formal markets, such as stock exchanges, will be subject to clear operating rules. Even informal or OTC markets will have to enforce some order as do the euromarkets in the International Capital Market Association (ICMA), and therefore through self-regulation. These rules are internal and mean to promote the functioning of the market but do not mean to protect the investors in those markets. 47  See for these markets and their operation s 2.1.2 below, with Euroclear and Clearstream (formerly Cedel) as clearers and custodians. In these markets, until the EU Prospectus Directive of 2004, even a prospectus was not

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Even in traditionally more heavily regulated domestic markets, a form of deregulation soon followed for information supply, clearing, settlement, and custody activities. Indeed, competition may create the better environment for protection here in the sense that the better capitalised and better managed institutions are likely to attract the most business in these areas. This may also hold true for modern derivatives markets with their own counterparty and clearing functions (see for the EU regulatory efforts in this connection (EMIR) ­3.6.14 and 3.7.6 below and built-in protections (along the lines of CCPs): see in particular ­chapter 1, ­section 2.6.5). As the euromarkets also showed, competition may even deal with issuers in the sense that in the absence of prospectus requirements, the market will decide the fate of issues that lack sufficient issuer transparency.48 (g) The prevention of monopolies among intermediaries in financial services. This is a subject closely related to market integrity. The risk of monopolisation has always been considerable in financial markets, especially in the securities business, but now also affects banking where, not least because of regulation, new entry is very difficult and there is to be further consolidation. At least the club atmosphere in stock exchanges, which were often given statutory monopoly status, is now mostly found objectionable and informal markets as competitors are often encouraged. Again, related services such as price and other information supply, clearing and settlement and custody may now mostly be offered in competition. Importantly, modern competition agencies may also force settlement and clearing systems of established exchanges to open to off-exchange dealings by non-members. The hold of (universal) banks over their smaller customers and the payment system, including the credit card business, may also be a particular matter of competitive concern. On the other hand, another issue in commercial banking is precisely the access of smaller companies to affordable banking services. It is the opposite problem, which touches on the public service function of commercial banks, see ­section 1.4.10 below. That may also relate to the ability of relatively small account holders to hold on to their accounts and in this way to their access to the payment system. These concerns suggest better access and competition

compulsory (which appears not to have led to great problems in a market that has become one largely for professionals) and is not even now necessary in many cases: see s 3.5.10 below. Except again for concern for proper price information and market abuse, key market functions, as well as the issuing activity itself, may thus remain entirely unregulated in a modern system. In fact the Euromarkets are the prime example of clean, self-regulated markets and became the largest capital market in the world. It demonstrates that there is no absolute need for regulation to make markets operate properly. 48  Particularly in professional markets, as the euromarkets have become, issuer transparency is often much less of a concern as the type of issuer that issues in these markets tends to be well known and is watched by credit agencies and analysts while their findings are immediately divulged and discounted in the price for their securities. Interesting in this connection is Jesse Fried, however: ‘Should Corporate Disclosure be Deregulated? Lessons from the US’, Law and Economics Workshop Paper 4 (UC Berkeley, 2007), who argues against the market function in this area on the basis of the American experience. In the meantime, much eurobond primary and secondary activity is regulated to the extent it is organised from a particular country, in the EU under the Prospectus Directive and MiFID with large private placement exceptions, see s 3.5.10 below.

PART I  Financial Services, Service Providers, Risk and Regulation 543

rules, not financial regulation in the traditional sense (of authorisation and prudential supervision, conduct of business or product control).49 (h) The concern with asymmetric markets.50 This is a particular academic concern with the functioning of the markets and with market transparency. The idea is that goods that cannot be properly inspected and valued sell at an average price which may be so low that it induces the sellers of the better goods to withdraw from the market altogether, which becomes low quality as a result. Thus an un-transparent market may become ever more inferior in the quality of goods (or services) offered. It also means that, if the better quality of certain goods can be demonstrated, their market price rises. Transposed to securities trading, it suggests that in the offering of investment securities, enforced disclosure requirements might lead to a better-quality market and higher prices. It supports centralisation of markets and their regulation to provide transparency, which in turn creates liquidity. In commercial banking, asymmetry in this sense also arises in and may result from customers (including other banks) not knowing how strong a particular bank’s position is in terms of liquidity, maturity of its assets and liabilities, counterparty, position or operational risk, and its asset and liability management. This could in this view lower the quality of the entire banking system, while leading to an unease or even unwillingness to fund banks. The same could happen in the insurance and investment brokerage industries. Regulation enforcing proper disclosure or suggesting adequate financial supervision would then be the answer and (at least in theory) be likely to upgrade the whole system. This could, however, also derive from the guidance given by rating agencies, which (whatever the criticisms of these agencies) might be much more effective and incisive. Banks on the other hand have always been successful in arguing that confidentiality requirements prevent them from much disclosure,

49  It is tempting to think that regulation is ultimately inspired by efficiency considerations, and that therefore a number of the above-detailed objectives can be grouped together under that heading. This is misleading if only because the demands of efficiency may not be clear or may be different, eg in terms of internal risk factors (such as counterparty or market risk) or be external ones such as the system’s stability, but there are also distribution considerations that may enter the equation or notions of economic health and social consequences that transcend efficiency requirements. In terms of stability, one concern is likely to be the externality or lack of incentives for firms to limit their internal risk, thus their unwillingness to internalise the cost of stability, which would translate into higher capital, therefore less gearing, and stricter liquidity requirements. This is a legitimate regulatory concern, the cost of which could be calculated and shown to be either higher or lower than the benefit in terms of stability. 50  This resulted particularly from the researches of Professor George Akerlof at UC Berkeley. See his seminal paper, ‘The Market for Lemons’ (1970) 84 Quarterly Journal of Economics 488–500. A similar situation was identified in respect of a bank’s creditors by J Stiglitz and A Weis, ‘Credit Rationing in Markets with Imperfect Information’ (1981) 71 American Economic Review 393–410, as a bank cannot know whether its borrowers are serious entrepreneurs or gamblers. The idea is that in the case of increases in interest rates to cover the risk, the category of serious entrepreneurs borrowing money becomes smaller so that (in view of the increased risk) a bank’s profit may even decrease. Asking for security (rather than regulatory disclosure) may overcome this problem and seek out the better credits. In this view, applicants for credit may order themselves into different classes according to their willingness to give security. To the extent these borrowers are rated, other sources of information will also be available.

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but this has to be weighed against public policy, which may require much more transparency for proper evaluation by analysts and academics alike.51 The asymmetric markets theory also implies that in the investment industry, through proper disclosure (forced by regulation), brokers with better or superior knowledge of the markets could be identified. Whether or not this is a realistic regulatory expectation is a different matter entirely. Regulatory emphasis on proper disclosures and on transparency nevertheless finds extra justification here, but asymmetry considerations were not the original motivation for them and have not so far inspired specific new regulatory measures either.52 The problem of asymmetrical information is much raised in respect of retail investors who obviously have less information than the professionals. But they have a professional broker to help them.53 (i) The creation of a level playing field, especially between commercial banks. The idea is that the more prudent bank should not in the short term be punished for its financial prudence and affected in its competition with other banks. In particular, imposition of similar capital adequacy and infrastructure standards on all is in this connection considered an important regulatory leveller, even if a somewhat odd objective of financial regulation as it does not then seek to protect customers or the system as a whole, but rather financial institutions against each other. In that sense, it is regulation to protect fair competition.54 (j) Concern for the reputation and soundness of the financial services industry and financial sectors and markets in the centre(s) from which they operate. This goes beyond systemic concerns and market integrity and is more properly the issue of confidence. Yet the regulator needs to strike a balance between regulation that supports the reputation of its financial community and centre thereby attracting business, and regulation that is so unfocused or severe as to drive business away.

51 

See n 138 below. As for financial markets themselves, there seems to be little proof that, left to their own devises, they incline towards lower-quality trading. They have their own decentralised ways of information gathering at least amongst professionals and it is not at all certain whether regulatory insistence on transparency (unlike in banks) can add a great deal in this connection. Asymmetric information concerns would in any event not appear to justify or provide a proper argument for the centralisation and regulation of the market function as such (in official exchanges), which is sometimes suggested as an additional remedy. 53  Probably much more important is that retail investors only deal in the market occasionally, guided in such cases by the prices set by the professional dealers who discount their own superior information. That is the true retail protection and explains why financial markets evolved with strong retail support even in the absence of much regulation of intermediaries and notwithstanding substantial insider dealing and serious conflicts of interests between brokers and their clients, of which churning and front-running are the most obvious examples. 54  Fair as the level-playing-field requirements might be, in the financial sector they may impose extra costs on non-banking business even if operating on a stand-alone basis, eg the broker-dealer business. Although the capital required for such security business is likely to be small unless large market positions are taken, it makes a difference for universal banks, which combine commercial banking, non-bank securities business, and even insurance activity, and need capital for all of them. To level the playing field, this may lead to similar requirements for non-bank securities intermediaries which engage in investment activities independently even though, as mentioned before, concern for insolvency and therefore capital adequacy may be less strong in relation to them, first because these intermediaries should segregate client assets and moneys and second because their insolvency is less likely to entail systemic risk, even though in the 2008 financial crisis this became less clear, see also the discussion in s 1.1.2 above. Nevertheless, the imposition of an authorisation requirement with the related capital requirement on this separate business may well have been hastened by level-playing-field considerations for universal banks. 52 

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The details may be less important than the general drift and the perceived credibility of the regulator becomes here a major issue and was badly shaken in 2008. On the other hand, the survival of national financial centres cannot be the endobjective. If other centres can provide the better facilities (in terms of efficiency, reliability and cost), they must prevail. Especially in Europe where irrationally each country still aspires to have its own stock exchange (like its own airline), this remains often a delicate issue. After Brexit it will be of interest to see how the cards may be reshuffled.

1.1.11  Conflicting Regulatory Objectives. Lack of Clarity in Statutory Regulatory Aims Although the true end-objective of financial regulation may now well be the promotion of financial stability, it was already submitted that it is unlikely to be achieved through financial regulation of the present micro-prudential type to which regular financial crises testify. Indeed in the UK, the Parliamentary Ombudsman showed as early as June 2003 the fallibility of regulators (the FSA of those days) in this regard and the limited preventive effect this type of regulation can have, at least in terms of financial stability. As will be submitted throughout (see more particularly s­ection 1.1.14 below), the issue of stability cannot be satisfactorily covered by the present microprudential financial supervision and requires a macro-prudential component with a very different (anti-cyclical) policy approach that is not rule-based or judicial. After the issue of financial stability, the next objective as we have seen may be the protection of the deposit and investment climate especially for an ageing population that will be increasingly dependent on their savings and investments. It may truly be the key concern in all of this and the longer term objective. It shows that conduct of business is ultimately a much greater concern than it is usually perceived to be, stability concerns having taken over. But it is then an expanded concept where the safety of savings in terms of deposits and government bonds may come first, although it also touches on the hardness of the currency and a fair return on investments not unduly hindered by a manipulation of interest rates in monetary policies. Importantly, even stability is a major issue in this context and confidence an important factor, which also touches on market integrity. It may indeed be enhanced by regulators who might still be perceived as helping, at least in these areas, whatever their failings. It was already said that especially in the narrower issue of client protection against financial intermediaries (conduct of business), regulators could be more effective even if the depositor or investor must in the end retain the ultimate responsibility for the choices made in terms of bank, intermediary and product. Caveat emptor remains a key issue, although now subject to deposit and investor protection schemes, see ­section 1.1.11 below and a great deal of conduct of business protection. There are here also justified concerns about the reliability of payment systems, which may also more properly and effectively depend on regulatory acumen and expertise: see ­chapter 1, ­section 3.1.8 above.

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At the more theoretical level, regulation has often been defined as governmental intervention through mandatory law in the pursuit of the public interest, more particularly in the pursuit of some social or economic goal. Here it is or has become foremost financial stability, as we have seen, at least on the surface, and confidence.55 In its pursuit, administrative agencies (or regulators) will take the decisions in terms of authorisation and prudential supervision. To protect the affected intermediary or issuer against an improper refusal or withdrawal of authorisation, it was shown that there is likely to exist an appeal possibility to the courts (in administrative review proceedings). In respect of the rule books that these agencies may impose, there may also be a review procedure to determine whether they acted intra vires. On the other hand, (reinforced) rules of private law, notably to guard against abuse by intermediaries, was shown normally to lead to damages or rescinded transactions to be obtainable through the ordinary civil courts or in special complaint procedures (of private law-like arbitration or ombudsman schemes). The latter may still allow the customer or investor an appeal to the ordinary courts (which facility may not be given to the intermediary). Market integrity in terms of avoiding manipulation, insider dealing, money laundering, corruption and monopolisation, will be countered by criminal and civil sanctions. It was already mentioned that this is not regulation in the more traditional sense but nevertheless an important public policy concern, see ­section 1.1.8 above. These objectives and the way they are pursued in financial regulation may prove, however, to be quite contradictory and there may be no clarity in the priorities, quite apart from the problems with the details and the implementation. Providing liquidity to the public, as against stability of the financial system, were mentioned in this connection earlier. There are other potential conflicts: the proper protection of depositors could require an early closure of a bank, which for the functioning of the payment system or for other systemic reasons might not be opportune. Some of this we have seen in the BCCI case in London in the 1990s.56 In a regulatory shift in commercial banking away from depositors’ concerns (which are now often thought to be better covered by deposit insurance) to systemic risk and stability or concerns for the payment system, supervisors may be perfectly entitled to let the latter concerns prevail as English case law has shown,57 even if banking law may put the main emphasis on the former as was still the case in the UK Banking Act 1987, now superseded by the Financial Services and Markets Act 2000 (FSMA as amended several times), which also deals with deposittaking, while the other functions (such as liquidity, monetary policy and function as bank of last resort) of the Bank of England are now covered by the Bank of England Act 1998 as amended.

55  In all this, it should be remembered that there are different ways to achieve public policy objectives. Discarding nationalisation, it could be done: (a) through new governmental agencies, which normally supervise under administrative law; (b) through self-regulating industry organisations (SROs), which often operate on the basis of contract law vis-à-vis their members over whom as a consequence they acquire some power by contract or through membership; (c) through a strengthening of private law in a mandatory fashion, especially to protect depositors and investors vis-à-vis their banks or brokers; or more likely (d) through a combination of all three. 56  See also TC Baxter and JJ de Saram, ‘BCCI: The Lessons for Banking Supervision’ in RC Effors (ed), (1997) 4 Current Legal Issues Affecting Central Banks 371. 57  See n 40 above.

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Because of these various complications, the approach to financial regulation has in more recent times become more pragmatic, at least until the 2008 financial crisis. It is largely accepted that no one single theory of financial regulation is able to adequately underpin and explain the needs and evolution of modern financial regulatory systems. To repeat, perhaps the true function and impact of regulation, whatever its real effect, is simply to create greater confidence, not mainly stability,58 but much of this was seen to fail in 2008–09. Poor liquidity management, the lack of sufficient regulatory capital, and the vagaries of an internationally effective safety net may be seen as the more direct causes of this crisis, the deeper problem probably being in our credit culture; see also the discussion in ­section 1.3.6 below. It suggests that the bite and sophistication of the regulator is itself the major point and that the rules may even become secondary. The downside of this emphasis on the bite and sophistication of the traditional regulator is that rule books may become ever larger but also more unfocused/uncoordinated and guided by the ideas of those who happen to write them and their personal perspectives and changing views, subject to public pressures. Given the very different objectives and levels of regulation and possible contradictions in purpose, and the differences in sophistication of regulators, this is hardly surprising, yet unsatisfactory. Even among those who favour the present trends in financial regulation, there is a recognition that this unavoidably leads to uncertainty and a lack of balance in its core. It has already been said repeatedly that, as for financial stability, the effectiveness of managing banks through micro-prudential regulation must be mistrusted. After Basel III, this kind of regulation now seems to be focused on making banks smaller and again more domestic, but it will be argued throughout that it is hardly an answer to the liquidity needs that are prevailing in a globalising environment from which the little growth that may be expected may have to come. In all financial regulation, it would seem only normal for the legislator to ask itself at least what the precise concerns are, which financial service functions it wants to regulate, what risks it wants to or can protect against, therefore what the true objectives of such regulation are in each instance, and how they can most effectively be achieved. What is needed therefore is a more extensive risk analysis of the modern financial services activities and the need for them in order to develop a clearer view of (a) what risks must be handled by the industry internally, (b) how its risk management can be enhanced through regulation, and (c) in what manner. This is mostly not forthcoming except in a haphazard way, and modern legislation shows this in a lack of clear direction. In this book, one important reason is perceived to be that a full discussion of the future worldwide liquidity requirements and of the realistic capital needs of a banking

58  See also C Goodhart et al, Financial Regulation: Why, How and Where Now? (London, 1998), C Ford and J Kay, ‘Why Regulate Financial Markets’ in F Oditah (ed), The Future for the Global Securities Market (Oxford, 1996), EP Davis, Debt, Financial Fragility, and Systemic Risk (Oxford, 1995), J Norton, Devising International Bank Supervisory Standards (London, 1995), S Valdez, Introduction to Global Financial Markets, 2nd edn (Basingstoke, 1997). See also, C Goodhart and D Schoenmaker, ‘Should the Functions of Monetary Policy and Banking Supervision Be Separated?’ (1995) 47 Oxford Economic Papers 539, D Llewellyn, The Economic Rationale for Financial Regulation, FSA Occasional Paper no 1 (April 1999), M Taylor, Twin Peaks: A Regulatory Structure for the New Century (London, 1995).

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system operating in that environment is avoided: see the discussion in ­1.3.6 and 1.3.7 below. Haphazard micro-management through regulation is then preferred. If this leads to smaller and national banks, the negative effect on growth is commonly ignored, at least for the time being. In the EU in the meantime, the original banking and investment services Directives, which will be discussed later in s­ ection 3.5 below, did not give any unequivocal answer to the objectives of financial regulation. Nor do their successors, respectively the Credit Institutions Directives 2000, 2006 and the 2013 SSM Regulation or the Markets in Financial Instruments Directive (MiFID) 2004 and its 2014 successor (MiFID II) or the 2003 Prospectus and 2004 Transparency Directives. That is more understandable, as these instruments are primarily concerned with the division of regulatory powers between home and host states, although the original Investment Services Directive (ISD) in Recitals 2 and 42 of the Preamble stated investor protection and the stability of the financial system as the aims of the authorisation requirement. Especially in Article 11 it was also concerned with markets and their smooth operation and integrity. The 2004 updating of the ISD in MiFID refered more extensively to market integrity, in this book considered the third prong of financial regulation besides financial stability and customer protection—see ­section 1.1.6 above. In the UK, the Banking Act 1987 referred especially to the protection of depositors and hence devoted much attention to the deposit protection scheme. Perhaps surprisingly, it did not refer to systemic risk concerns in the context of banking supervision at all, although the Bank of England in its regular reports started to do so, suggesting an informal shift in regulatory emphasis.59 The earlier Financial Services Act 1986 did not make any general statement about its objectives either, except to say that it meant (amongst other things) to regulate the carrying on of investment business and to make provisions with respect to the listing of securities, insider dealing and fair trading. Why it did and what the true aims were remained unspecific, even if it was clear that it was for the most part investor protection against intermediaries in terms of conflicts of interests, bankruptcy and market manipulation. The UK FSMA 2000, which also covers the commercial banking activity (in which connection ‘deposits’ are defined and treated as investments), was more specific and refers in ­section 2(2) to: (a) maintaining market confidence which is further defined as confidence in the financial system; (b) promoting public awareness which is further defined as promoting public understanding of the financial system particularly in assessing benefits and risks of investments through appropriate information supply and advice; 59  Even without a statutory change, the refocusing of the banking supervision objectives in this direction became clear from the annual reports of the Bank of England on banking supervision before this activity was handed over to the FSA as from 1997. If managing systemic risk becomes a valid regulatory objective, it may easily be at the expense of depositors’ protection as we have seen in BCCI. It is in any event clear that this protection objective is less overriding than it once was. It seems that in a modern banking regulation system, they are primarily left to whatever protection depositor guarantee schemes may give them and whatever protection capital adequacy requirements may yield them in a macro sense. See for the concept of systemic risk also, R Cranston, Principles of Banking Law, 2nd edn (Oxford, 2002) 66 and Schwarcz (n 7).

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(c) protecting consumers to secure an appropriate degree of consumer protection taking into account different degrees of risk, different degrees of experience, the need for advice and accurate information but also their responsibility for their own decisions; and (d) reducing financial crime by reducing the likelihood that authorised intermediaries become involved in it or are used by criminals. Interestingly, financial stability was not expressly mentioned. In any event. it is not made clear what the status of these principles is and whether they are meant to be overriding and therefore have a force of their own. That would not be in the nature of the traditional English approach to legislation, which avoids purposive interpretation of this sort—see Volume 1, ­chapter 1, ­section 1.3.3. The list might be no more than a summary of concerns of the legislator without further relevance for the application of the statute. According to its title, the Act also covers markets (­section 3(2)(a)), not in the sense of regulating them but rather to promote confidence in them. They may apply for recognition (­section 286), which makes them more official and exempts them from the general prohibition to engage in any regulated activity. This activity is defined in ­section 22 and schedule 2 mainly as dealing in investments, managing investments and giving investment advice. Making or organising markets itself is not a regulated activity per se and does not therefore need to be authorised in the UK. As for these markets, in the UK the supervisory interest is primarily on the distribution of price information, transparency of corporate information, and proper settlement. In the meantime the International Organization of Securities Commissions (IOSCO, see ­section 2.5.1 below), in its 1998 Principles and Objectives of Securities Regulation states as principal objectives: (a) the protection of investors; (b) ensuring that markets are fair and transparent; and (c) the reduction of systemic risk. As already noted above, this last objective would be a less obvious regulatory objective in the securities intermediaries business, which is the proper concern of IOSCO. It became an issue only after the Lehman crisis in 2008.

1.1.12  Financial Regulation and the Issue of Moral Hazard. The Operation and Effects of Deposit and Investor Guarantee Schemes As we have seen, in commercial banking, regulation became universal early on, but the true objectives were never fully clear and shifted over time. It has been mentioned before that first there was the concern with depositors, although it became clear that in practice banking survival could not be achieved by merely requiring authorisation and the supervision of a minimum capital under an established regulatory framework. In times of crises, ad hoc interventions could often not be avoided and there was little proof that modern financial regulation led to fewer such emergencies. The fear

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of insolvency was more likely to provide banks with extra liquidity through central banks operating as banks of last resort in the hope that the relevant financial institution would ride out the storm in this manner. If they themselves were banking regulators, it could even be a way for them to avoid admitting past regulatory shortcomings or failures. The existence of this type of informal safety net for banks or even the mere existence of depositor guarantee schemes could, however, lead to adverse effects in terms of the behaviour of bank management.60 It could make it less responsible as it comes to rely on public bail-outs of the bank or at least of its depositors, either through deposit guarantee schemes or otherwise. This is the issue of moral hazard, much highlighted by the Chicago school of economics.61 It indicates a situation in which the rescuer or even the fact of its existence itself creates the need for rescues. Regulators are aware of this and like to keep the banks guessing and even let them go under. A last stand in this regard was not saving Lehman Brothers (considered only an investment bank, therefore less connected) in 2008, which backfired badly, although it can be maintained that the deleveraging through market forces that had already been in motion and much accelerated as a consequence would have taken place anyway, but probably not to the same extent so soon. AIG was nationalised on the rebound. Indeed, in future crises, insurance firms and even hedge funds may well have to be offered similar support, again for stability reasons. The unavoidable result is more moral hazard in good times and therefore greater instability in bad. The continuing need for liquidity in the system may itself add to this moral hazard. But even the existence of regulation may create it: all that is still allowed can then be exploited to the full. Excess becomes the regulators’ fault! More modern thinking is indeed conscious of the fact that regulators and supervisors may be captured by the market in these situations, which may force their hands in terms of rescue, making the industry itself less careful. Regulation may thus suggest an implied guarantee to depositors or investors in a regulatory environment in which the notion of caveat emptor is superseded or suspended—see for the role of bank regulators as lenders of last resort in this connection also ­section 1.1.6 above. At the operational

60  J Friedman and W Kraus, Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation (U Penn Press, 2011) question whether this is a conscious process in bank management. It may easily be fired, so it cannot be sure to benefit. 61  See for example K Dowd, ‘Moral Hazard and the Financial Crisis’ (2009) Winter Cato Journal 142, 160. The term derives from the insurance industry where insurance, eg of one’s house against fire, was thought to increase the fire risk. People become less careful. It truly means that benefits are privatised and risks are socialised, see also A Buckley, Financial Crisis, Causes, Context and Consequences (FT Prentice Hall 2011) and R Meyerson, ‘A Model of Moral Hazard Credit Cycles’, U Chicago Working Paper, 25 (2010). It separates control from risk, which is laid somewhere else and in particular assumes for banks that insolvency will be prevented by outside action or is irrelevant because of some future discharge from debt. It is one idea behind the need for capital adequacy but there is still the danger of these requirements becoming nominal under pressure of the banking lobby. It is also said that moral hazard may arise from asymmetric information: issuers have it and investors not, so they are likely to be abused. Deposit guarantee and bailout schemes may have a similar effect. Securitisation also showed moral hazard aspects where originators were not required to retain some skin in the game, see also n 24 above. Remuneration schemes can be similar: bonuses are collected up front, regardless of future risks in the transactions. The same applies in investment management, where up-front gains may be generated to increase fee income leaving a long risk tail, which may well lead to insolvency of the scheme at the end.

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level the lack of care on the part of bankers may manifest itself in more risk taking, supported by the innate profitability of banking business, which easily leads to assuming all kinds of additional exposure for more instant profits, especially in good times when banking becomes very profitable and there seems no direct need for restraint. Again, it is the pro-cyclical nature of all banking, see further the discussion in s­ ection 1.1.13 below. To counter moral hazard, lesser or at least better focussed regulation could be suggested, including a limitation of pay-outs by deposit guarantee schemes. In modern resolution regimes for banks, the emphasis is at least on depositors and lenders to take a cut before regulators or governments can give financial aid, see s­ection 4.1 below, which may make bankers mildly more prudent. Yet in practice, the regulatory regime and therefore the regulatory protection ethos (and responsibility) has mostly been strengthened over time, not only in respect of commercial banks. We see it in ever larger rule books even if its effectiveness may not have been enhanced. But there were also lapses. Note the lack of interest in liquidity management. The lack of enforcement of regulation in good times has also already been mentioned. It does not diminish the need for governments and their regulators still to guarantee deposits in bad times and it may be asked whether modern resolution regimes for banks will change this, especially in respect of depositors. One way to protect them is to split a bank in trouble in a good and bad bank and transfer all ordinary deposits to the former. It means that only a selected class of depositors suffers, so far often with little due process in the selection process, however, see also ­section 4.1.5 below. Even bond holders may be saved in this manner in order to avoid universal panic. Both in the US and EU, much regulatory attention became focused on this resolution regime for banks, including the creation of a common safety net, which assumes a measure of mutualisation of their obligations (up to the value of the fund so created)—see also s­ ections 1.3.8, 3.7.16 and 4.1.3 below. However, it remains to be seen whether it will make an appreciable difference in future financial crises. It will be shown later that this system may be very arbitrary and the separation of banks from government a pipedream, especially because banking activity is very much a part of government policy and much used by it to activate the economy. Hence also the virtual elimination of the capital requirement in Basel I and II and the absence of liquidity requirements. Even a leverage ratio was rejected by the EU at the time. That is policy, no matter how easy it is to blame banks afterwards for the consequences.

1.1.13  The Pro-cyclical Nature of Banking and Banking Regulation It has long been acknowledged that banking is highly pro-cyclical. It means that in a situation in which the whole banking industry suffers, it becomes restrained in its appetite and ability to continue its money recycling or liquidity-providing function, and this may last for years. Loans may thus be hard to come by at the moment they are most needed. It potentially makes the crisis worse. Regulatory sentiment may at the same time shift to financial stability, reinforcing the regulators’ powers but the need for

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liquidity is then likely to become an opposing force. This became clearer in the EU after 2010 when a strong regulation drive ended in banks increasingly providing insufficient liquidity to the public, thus undermining further the growth prospects which were needed and desired but failing. The regulatory idea apparently was that growth can be had without risk, or that somehow the banking system can be exempted and made ‘safe’ without consequences. It was already noted that it raises other issues, notably whether a special bankruptcy or resolution regime must be devised for such situations and could be effective in making banking activity better survive when major insolvencies loom.62 Again, the prime issue in such situations should be the continuing facility of banks to recycle money; nobody is interested in lame banks. This may even require the abandonment of considerations of stability and of capital and liquidity requirements for the time being, that is what is perceived in this book as the essence of macro-prudential supervision, see the next section. That is less odd where governments have already been forced to guarantee all bank deposits anyway. At the other end of the spectrum, banks suffer from extreme hubris in good times when everyone thinks the sky is the limit and loans are extended freely; there is no restraint. This is the other side of pro-cyclicity. It results in excessive leverage and aggravates the situation, likely to result in monetary booms and asset bubbles which invariably turn into bust, thus endangering the banks when these loans cannot be repaid. It means that banks should be submitted to higher capital requirements in good times to avoid irresponsible behaviour. The same counter-cyclical attitude might then prevail in the area of liquidity supervision. Leverage ratios should be increased, which can be done differently per activity or asset class. Again, it is the view of this book that except for matters of conduct of business and market abuse, we should deregulate in bad times and re-regulate in good times, see further the next section. The true risk of banks appears in good times, at the top of the cycle. They should be severely restrained in their moments of hubris and be required to build up their capital, watch liquidity, and limit dividends and bonuses, whilst the largest must create an international safety net. In bad times, on the other hand, banks should be encouraged in their liquidityproviding function and that may mean reducing capital for new business to zero and lift liquidity requirements and also leverage ratios.

62  As already mentioned in the previous section, a related feature is that the traditional and very necessary governmental support for banks in crisis is becoming problematic for modern states, which are now also largely bankrupt. The 2008 banking crisis thus soon became an aspect of the government debt crisis. In this atmosphere, decoupling banks from government in times of financial crisis became a political priority, much promoted by G-20, but it may be asked how realistic this truly is. Banks are becoming ever more government tools, encouraged (if not forced) to provide the financial support to the public at large that governments are unable to give, not least to consumers. It was very much behind the extreme reductions in capital requirements under Basel I and II, which exacerbated the pro-cyclical nature of banking. This was thought to promote growth but it was always questionable whether this money-driven type of growth could ever be more than a temporary fix, mere monetary fluff, see also s 1.3.8 below. With higher capital adequacy and liquidity requirements for banks and a desire for smaller banking after 2010, governments may have to find other ways to make our type of society work beyond suggesting that central banks keep the liquidity tap open. To find that alternative may not be easy. Promoting access for everyone to the capital markets is a fancy idea but not realistic for smaller borrowers, see also s 3.7.15 below for the EU Common Market Union. It is too costly and would probably also mean a substantial dilution of the prospectus requirements. More likely is that, as in countries like China, the shadow banking system is seriously activated.

PART I  Financial Services, Service Providers, Risk and Regulation 553

Thus, where the liquidity-providing function must be a major concern in bad times, the stability of the system should be the main consideration in good times. In fact, whatever lip service is paid to the idea of stability, it was already said that we may not truly want it,63 especially not in good times when there appears to be no problem. Even governments may join the spending spree: see the discussion in ­section 1.3.6 below. However that may be, financial stability cannot be the main consideration in bad times, nor indeed the rebuilding of capital at the worst moment. In any event, and never mind the existence of some bank resolution regime (see Title II Dodd-Frank Wall Street Reform Act 2010 and for the eurozone ­3.7.16 and 4.1.3 below), if the bottom line is no longer government help, all else will prove counter-productive in such periods and further regulation or more capital will only add to financial stress. The true problem, it is submitted, is that our society in order to progress must take considerable and probably ever increasing risks, also in banking.64 We can manage it to some extent and may be able better to avoid excess both in bad and good times, in bad times indeed through forceful deregulation especially of the capital adequacy and liquidity requirements and in good times through forceful re-regulation in these areas. In fact, there may be no advance without it and no growth either, especially now that populations are becoming smaller and older in many parts of the developed world and the needs much larger in others. Banks are in the forefront of these developments and finance was substantially recast in the 1980s to deal with providing the attendant liquidity to government, business, and consumers alike, on a scale never seen before, whilst operating also at the transnational level. It is this liquidity-providing function65 which is the oil in the machine of the entire modern society, but it requires risk management on a similarly increased scale. It may have been thought that we had the means and Basel I and especially Basel II reflected greater sophistication, see s­ ection 2.5.10 below, but the latter flopped immediately, and the financial crisis after 2008 made clear that our means properly to manage financial risk on this scale remain limited. At least the traditional microprudential supervision and its models were not sufficient. Although substantially reinforced after 2008, it must be asked whether this model can ever save banks or hold out the prospect of doing so, see also the next section.66 Macro-prudential supervision is meant to fill that void and, if properly understood, should become another policy tool besides monetary and fiscal policy, which are all to be counter-cyclical, see the discussion in ­section 1.1.9 in fine. However, the ­introduction of yet another committee in this connection, as has now happened in many countries in terms of stability boards (see the next section) does not by itself clarify anything

63  It may indeed be questioned whether we want stability at all if it means no more consumer and student loans, see also the discussion in s 1.1.2 above and s 1.3.5 below. 64  It will be submitted throughout that stability may be more difficult to achieve in an over-leveraged society which is naturally more sensitive to shocks, notably the sudden drying up of liquidity. In modern times, this may be the truer cause of financial instability or at least greatly contributes to it, see further the discussion in ­1.1.2 above and 1.3.1ff below. 65  Cf also the discussion on liquidity in s 1.1.3 above. 66  See also N Sarin and LH Summers, ‘Have Big Banks Gotten Safer’, Brookings Papers (Sept 2016), who warn against complacency.

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and there is considerable confusion about their tasks as we shall see. The failure of the earlier Financial Stability Forum at G-7 level was a case in point—see ­section 1.2.5 below. At best, the introduction of macro-prudential supervision committees creates the impression that something is done but without a clearer view of what is needed, it still leaves society exposed to the same, very considerable risks. So far, it would appear, science has proved to be unable to provide better risk management models or better ways to spot financial shocks and similar upheavals in good times. Moreover, the quality of financial data is often weak and the data themselves incomplete, so the financial landscape is often poorly mapped out or understood (except with the benefit of hindsight) and a macro-prudential committee is not going to change this. In practice, the answer has not been more sophistication, which is very much needed, but limiting financial activity altogether, indeed in many countries by making banks smaller or limiting their activities through more stringent capital and liquidity requirements at the bottom of the economic cycle. As liquidity or the lack thereof is the true killer of banks (see ­section 1.1.3 above), not therefore its balance sheet, the renewed emphasis on capital was probably always misguided. Adequacy of this nature in any event depends much on valuations and a lot of it is opinion. It was already said that at the beginning of 2008, many banks had more capital than was required and still proved unsafe. Later on it appeared that stress tests meant very little for similar valuation reasons. In a crisis, the best answer remains for authorities simply to open the liquidity tap, and not to require banks to re-build capital or wanting smaller banks as a result. Again, it is conceivably the worst of all worlds in those circumstances and resolves nothing. First, smaller banks increase banking instability as they can diversify less. They are more risky—stress tests show this all the time67—even if, of course, a bigger bank in trouble creates bigger problems. Second, the idea that smaller banks can provide the liquidity for big business on the scale now necessary in the international flows is a ­fallacy. Virtually all larger borrowing would have to be syndicated, which is costly and time consuming. There is also an adverse effect of smaller banking on profitability, therefore on the ability for banks promptly to recover. Heavy regulation and supervision has a similarly negative effect and prevent banks to grow out of their problems. As a consequence, especially in Europe, banks have had considerable difficulty to recover and resume their function after 2010. This contributes to a structurally low growth rate, which is in turn creating ever greater problems in financing the social welfare state (and its governments). It is submitted that banking is a highly dangerous activity at the top of the economic cycle. In good times, there is no end to the euphoria and the public attitude and government indulgence may make things a great deal worse.68 Banking activity needs to

67  It is well known that the multitude of smaller banks were the major problem in the US during the 1930s financial crisis. 68  There is strong empirical evidence supporting this. N Kiyotali and J Moore, ‘Credit Cycles’ (1997) 105 Journal of Political Economy 211 demonstrate this in the housing markets when in good times collateral values increase supporting further borrowing while in bad times decreases lead to crises. K Brunnermeier and Y Sannikov, ‘A Macro-economic Model with a Financial Sector’ (2014) 104 American Economic Review 379 amplify

PART I  Financial Services, Service Providers, Risk and Regulation 555

be heavily supervised in such situations; perhaps capital adequacy then needs to be put at 30 per cent for new business while profits should be retained, bonuses capped, and financial buffers (and resolution funds) built for the bad times which invariably follow. From a liquidity management point of view, funding should match new lending in terms of maturity. Financial buffers should be built in this manner in good times, not in bad. That is what macro-prudential supervision should be all about. It determines in fact the size of banks in each phase of the economic cycle. It was already said at the end of s­ ection 1.1.9 above, that it is not regulation proper but policy and must operate besides monetary and fiscal policy as a separate function in the management of the economy. Notably, macro-prudential supervision should be able to suspend the capital requirements in times of crisis when it would also be normal for banks to be nationalised and the liquidity tap to be opened widely. A resolution regime asking bond holders and depositors to contribute in such times, now often believed also to be part of the answer (and of macro-prudential supervision), would only hasten bank runs and undermine stability further. Rather, a substantial safety net should have been built in the good times as a buffer and then be activated. Probably the key is that the regulatory aim of financial stability is meaningless as long as it is not clear at what level of activity this is going to be reached. It was already argued in ­section 1.1.2 above that we may not truly want it because it may come at too low a level economic activity. Financial stability is not an objective criterion or an aim that can be objectively achieved or a result which automatically derives from a given micro-prudential approach. It was shown that such a rule-based system is itself likely to be pro-cyclical and may promote instability. Other contributing factors were pointed out also, notably financial innovation and even prolonged financial stability itself, especially noted by Minsky,69 which may suggest less risk than there is, or when extrapolation is used, like in value at risk (VaR) approaches, an ever smaller market risk in good times. To repeat, in the society we have and have chosen to live in, a substantial amount of risk must be taken to progress, not least in banking. There is a downside but it should not be exaggerated. The 2008 banking crisis was the first sign of a bigger economic crisis which all the same never went beyond a normal cyclical event in its size and impact. It was nothing compared to what happened in the 1930s when GDP shrank by 25 per cent in many countries. Unemployment did not go beyond what had been seen in the early 1980s after the two oil shocks, even if there were higher pockets and youth unemployment became a problem more generally, a product of a lack of structural reform in labour markets. Unpleasant as it was and still is, a crisis of this nature can be overcome and has been in the US sooner than in Europe, probably because of a better understanding of the situation and a less defensive and more imaginative approach to banking and its supervision after the initial Dodd-Frank regulation fervour. Banks must be given room to get themselves back on track and no amount of regulation can substitute. What macro-supervision can and must do is to call the moment

this with respect to increased capital levels in banks in good times allowing further lending. It lowers volatility in asset prices, which allows banks to increase leverage, etc. 69 

See n 8 above.

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when the screws must be tightened, capital buffers built, leverage ratios increased, and liquidity ratios strengthened to activate counter-cyclical forces and create capital, of which Basel III now also speaks but it leaves it at the margin; it should be put at the centre. Resolution funds should also be strengthened in these situations. To call that moment is an issue of policy not regulation. The various stability committees (rather than central banks) could be put in charge, assuming they can acquire the expertise.70 Again in times of crisis or distress, they should be able to reduce the capital requirements to zero and also decide on resolution including nationalisation, and the opening of the liquidity tap, and manage this involvement and unwind it as soon as possible. In the longer term, they might even redirect micro-prudential policies if indeed they can show better risk management tools, but these are different functions. To repeat, micro-prudential supervision depends on a legal framework, which may vary for the different types of involvement but in essence means the same jacket for all. That is the level playing field; it is not wrong but as we have seen it does not save banks. Again, the issue of calling for counter-cyclical measures is one of pure policy, only concerned with the jurisdiction issue (who can call). Resolution on the other hand needs a legal form—a liquidation or reorganisation regime without rules is a bad idea—as does the involvement of macro-prudential authorities in micro-prudential supervision, although it may be quite differently expressed.

1.1.14  Principle-based Regulation and Judgement-based Supervision in the UK. Micro- and Macro-prudential Supervision Unease with the existing micro-supervisory regulatory models is not new. In 2005 emphasis emerged, especially in the UK, on principle-based rather than rule-based regulation with full implementation foreseen by 2010. The first question was to what extent the Financial Services and Markets Act (FSMA 2000) allowed for this new approach. As it left much to the FSA, the UK regulator of those days, and its rule-making authority through its rule books, especially in retail protection and in financial crime and prudential supervision, this was not considered a substantial hindrance. It is a natural response to the impossibility of regulators to adapt to new protection needs in a pre-ordained legal framework and an acceptance of a more dynamic marketdriven approach where rules should not be a bar to legitimate innovation nor to new protections. It is an admission that rule-based regulation of this nature cannot fully be conceived ex ante but needs regular and speedy adjustments ex post. Still there is a need for a legal framework if there is to be a level playing field and regulatory issues are meant to be judiciable. A similar approach more principle-driven attitude could subsequently also be detected in the EU: see s­ ection 3.4 below. Hence a reduced emphasis

70  The IMF found mixed results in the use of macro-prudential tools in reducing systemic risk in 49 ­countries, see C Lim, F Columba et al, ‘Macro-prudential Policy: What Instruments and How to Use Them? Lessons from Country Experiences’, IMF Working Paper WP/11/238 (Oct 2011), but these measures where incidental and did not amount to a more strategic counter-cyclical policy here advocated.

PART I  Financial Services, Service Providers, Risk and Regulation 557

on prescriptive rules and the rejection of a regulatory mentality of box ticking. Lesser concern results here with an abstract notion of certainty than with guidance and the search is on for an interpretive community among regulators, industry associations and especially retail. In the UK, much earlier a predecessor of the FSA (the Securities and Investments Board) had initiated a similar approach but it was soon forgotten. It is important in this connection to understand that this concern turned out primarily to affect the protection of investors and depositors, perhaps also borrowers of banks, therefore substantially with conduct of business and products, not with the issue of financial stability, and therefore foremost with private law protection against intermediaries, not even their insolvency as depositors; depositors and investors were at the time considered to be sufficiently protected in this regard through depositors’ and investors’ compensation funds. Contrary to what was meant, it remained true, however, that the move to principle in this manner could inhibit rather than favour private law sanctions in courts of law for lack of clarity as there might not be a sufficiently precise cause of action, especially an issue in common law countries. On the other hand, a principle-based approach of this nature could more readily be used against intermediaries in enforcement actions before regulatory tribunals and affect their licence and its conditions if clients had allegedly been abused from a conduct of business perspective. The result could be that regulators in their eagerness more readily found some breach of principle. It followed that there still had to be some reasonableness test and some reliance on reasonable predictability in outcome. In any event, the FSA (and now its successor, the FCA) was to have the burden of proof of any wrongdoing under these principles if they were used by the regulator against intermediaries rather than in private actions by investors or depositors, but even for the latter there was a need for some precision. In this connection, the following basic principles or rather areas of principal concern were identified in the UK: integrity, due skill and care, adequate financial resources, proper market conduct, treating customers fairly (now commonly referred to as TCF, it often being perceived as the key principle), proper use of financial promotions, avoidance of conflicts, suitability of advice, protection (segregation) of client assets, and active interacting with regulators. In several succeeding FSA reports, the notion of TCF indeed became the central theme while the whole concept of conduct of business was in the process of being recast. Again, it is clear that financial stability was not the main concern here, important as it remains in other contexts, and this regardless of the reference to adequate financial resources. The emphasis thus shifts in terms of principle to the protection of depositors and more especially of investors and ultimately perhaps also borrowers from commercial banks. The idea is that consumers must be comfortable with the culture of their financial intermediaries, that the products and services on offer are designed to meet their requirements, that advice is suitable, that they get what they have been led to expect, are kept properly informed before, during and after a sale or purchase, and do not face unreasonable post-transaction barriers and costs. Intermediaries should continually reconsider their procedures and practices in the light of these issues. Regulators should reflect them in their rule books concerning client protections. There is also the idea that they should look at the various stages of a relationship from product design, through

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promotion, quality of research and advertising, transaction including suitability and best execution, after-transaction care including complaints, and systems and controls including paper trails and internal sales incentives. In this approach, wholesale is basically left to its own devices. This newer policy, especially in respect of smaller investors, seemed undisturbed by the crisis of 2008 and may particularly be used to challenge intermediaries more intensely on the decisions they are making in respect of their clients, how they ensure continuing compliance with the principles, whether they regularly review the consequences of their decisions, and whether they adequately consider the potential for risk crystallisation and new risks when moving their business forward. This may go beyond the mere protection of depositors and investors and principle-based regulation may then even enter the world of financial stability. If it is true that conduct of business concerns have suffered from excessive regulatory attention for stability, this principlebased approach was at least one way to redress some of the balance. After the financial crisis, a new idea took hold in the UK when banking supervision was re-transferred to the Bank of England (in a separate subsidiary: the PRA to be distinguished from the FCA, which became the successor to the FSA and concerns itself with conduct of business in particular as already mentioned). The idea of judgement-based supervision was then presented as a key new feature,71 although it was never made fully clear what it meant. At first introduced further to counter a box-ticking mentality in the regulator, it appears to stand for a degree of regulatory discretion that focuses on the activities of the supervisor in terms of a challenge to business models, risk identification, and proper action to be taken by banks, in this case more in particular to promote financial stability. It denoted an intensifying preoccupation with financial stability as main regulatory objective and concern. It was, however, still considered micro-prudential supervision, therefore directed to individual financial institutions within a legal framework for all, and must then still be distinguished from so-called macro-prudential supervision72 in terms of systemic risk and stability as a matter of policy.73 Micro-prudential supervision remains here essentially a tool to maximise economic efficiency in order to correct banking failures, which may ultimately trigger systemic risk. It is therefore concerned with financial stability (besides conduct of business), but only indirectly at the level of individual institutions within a rule-based system.

71  It is one of the innovations brought about by the Financial Services Act 2012, which introduced a new supervisory structure in the UK, operative as of 1 April 2013. Promoting confidence and transparency in financial services is a main aim. The new structure is also given a strong mandate in promoting competition. This is all very laudable, but it may be politics devoid of a compass, see further also RM Lastra, ‘Defining Forward Looking, Judgement-based Supervision’ (2013) 14 Journal of Banking Regulation 221 and JH Dalhuisen, ‘The Management of Systemic Risk from a Legal Perspective’, in M Andenas and G Deipenbrock (eds), Regulating and Supervising European Financial Markets (Springer, 2016) 365 SSRN under Search Jan Dalhuisen. 72  It is sometimes believed that macro-prudential supervision, which deals primarily with systemic risk and financial stability, is there not only to guard against banking failure, but to protect the system as ‘system’, see S Schwarcz, ‘Systemic Risk and The Financial Crisis: Protecting the Financial System as a “System”’ (2014) 97 Georgetown LJ 193. 73  See for the undesirable commingling of these functions at the level of the ECB in the eurozone and the dangers for regulation as a predictable legal framework, n 30 above and s 4.1.5 below.

PART I  Financial Services, Service Providers, Risk and Regulation 559

Newer regulatory proposals and objectives discussed in s­ection 1.3.8 below remain also foremost in this category. Again, the emphasis is on credit and market risk, operational risk, and increasingly also on liquidity risk (since Basel III). The concern may be summarised as foremost concentrating on systems and information failure in this context, including the models used to monitor and manage these risks, but they may also cover principal–agent failure, earnings retention, share buy-backs, and bonus problems. However, since the models used are unlikely to be comprehensive and up to date, there continue to be serious problems with micro-prudential regulation. Even with a judgement approach, it is unlikely to eliminate market risk and could still promote it, misjudge system failure, and thus create more systemic risk at the same time. There are other unresolved problems: unreliability of (ever more) information may lead directly to bank runs. Mark to market may defeat rationality in depressed markets. They may themselves be subjected to worn models that make things worse.74 We may also have the secondary or shadow banking industry to think of, see s­ ection 1.1.17 below. Macro-prudential supervision is considered to be different, the concept was already introduced in the previous section. It may have mainly three prongs: (a) to guide micro-prudential supervision from the macro level, (b) to put safeguards in place and manage them like leverage ratios, capital adequacy and liquidity requirements, resolution and ring-fencing regimes, or CoCo bonds and stabilisation funds,75 and finally (c) to try to stabilise the system when micro-prudential supervision has failed, macro-prudential supervision has not helped and a crisis is started. This can be done by providing liquidity (indiscriminately), nationalising affected banks and/or starting resolution, or calling in CoCO bonds or any stabilisation fund assuming its investments can be quickly liquidated. Macro-prudential supervision in the UK is now the preserve of the Financial Policy Committee (FPC)76 created at the Bank of England, comparable to the European Systemic Risk Board (ESBR) in the EU,77 which monitors the risk build-up in the

74  See also B Eichengreen, ‘Euro Area Risk (Mis)management’ in E Balleisen et al (eds), Recalibrating Risk: Crises, Perceptions and Regulatory Change (2014). 75  See JN Gordon and C Muller, ‘Confronting Financial Crisis: Dodd-Frank’s Dangers and the Case for a Systemic Emergency Insurance Fund’ (2011) 28 Yale Journal on Regulation 151, 156. 76  A Part 1A was added to the Bank of England Act 1998 on the Financial Stability Strategy of the Bank and a new Exhibit 2A was added concerning the appointment and removal of members of the Financial Policy Committee, but the precise remit was not made clear and it could be argued that the policy aspects should have been left to the Treasury. The Committee can only give recommendations to the Bank of England, which must consult the Treasury before it can act. In the absence of clear guidelines, the approach became ad hoc. It became clear, eg from a letter of the Governor of the Bank of England to the Chairman of the Treasury Committee of the House of Commons of 22 Nov 2013, that at first identifying bubbles in the housing market was a concern. According to the record of the FPC Committee meeting held on 17 and 25 June 2014, it concerned itself also with countercyclical capital buffers for mortgage lenders, which was recommended to be set at zero, but it also issued recommendations requiring a stress test of borrowers assuming rates would rise by three per cent and limiting mortgage lending to new mortgagors with a loan-to-income ratio of more than 4.5. 77  See Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on the European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (ESBR). The Regulation did not manage to create a clearer legal framework either and it is not obvious what the Board should do. According to Preamble 11, the previously existing arrangements in the EU placed too little emphasis on macro-prudential oversight and on inter-linkages between developments in the broader

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EU financial system as a whole. Both may only issue recommendations, however, especially when they detect risk concentrations and bubbles, as is also the case with the Financial Stability Oversight Council (FSOC) in the US.78 But even in the UK, the task of the FPC, is hardly clear and there appears insufficient statutory guidance. It will be argued that the three functions are quite different. The second is the true core and pure policy: see the previous section. To repeat, judgement-based supervision itself remains concerned with microprudential supervision, although now conceivably also to implement macro-prudential objectives at the level of specific institutions. It is related to principle-based regulation insofar that it looks at the spirit of the regulation rather than at the rules, but is more concerned with stability than client protection, therefore the other prong of the regulatory objectives. It suggests a proactive stance and sets great store by the credibility of the regulator and its ability to identify risk and how it should be managed but still per institution within an established legal framework. This newer approach is meant to cope better and more promptly with unknown future developments at that level. The idea appears to be that there is a clear societal goal for finance that financial regulators of this type align and for which they are the proper spokespersons. It is therefore supposed to better contribute to financial stability but again there is no clear concept of this objective, what it means, and requires. At the beginning of s­ection 1.1.8 above, it was shown that regulation of this nature operates a legal framework within which the financial business must be conducted. Although this book is sceptical of all micro-management through financial regulation beyond the area of conduct of business, product supervision and market

economic environment and the financial system. The ESRB is supposed to remedy this. As such, it became part of the new EU committee structure for banking, investment services, and insurance services (see s 3.7.9 below) and may exert considerable power without officially having it—it only gives advice and warnings not addressed to individual service providers but to the EU as a whole or to one or more Member States, or to one or more of the other Committees, or to one or more of the national supervisory authorities always with a specified timeline for the relevant policy response (Preamble 17). One reason is that macro-prudential supervision remains a Member State competency (as all financial regulation is) unless and until especially assumed by the EU as indeed the ECB was given limited macro-prudential authority under the SSM Regulation of 2013 (Art 5) concerning the banking union in the eurozone, see s 4.1.2. It then also received specific power to act, notably to impose counter-cyclical capital buffers. This is no longer advice or a recommendation. 78  In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (s 112) in Title 1A provides the legal basis following the G-20 lead. The FSOC has three primary purposes and must (a) identify risks to financial stability that could arise from material financial distress or failure, or ongoing activities of large interconnected bank holding companies or non-bank financial companies or that could arise outside the financial services marketplace; (b) promote market discipline by eliminating expectations that the US will shield these entities from losses in the event of failure; and (c) respond to emerging threats to the stability of the US financial system. Its 2014 Annual Report lauds the finalisation of the Volcker Rule (see also nn 27 above and 157 and ss 1.3.9 and 3.7.11 below), of the bank capital rules, of the supplementary leverage ratio for the largest banks, and the advent of clearing for swap markets. It highlights continuing concerns about money market funds, new financial products, complex connected financial institutions, reference rates (Libor etc), the prospective impact of greater interest rate volatility, operational risks, the impact of financial developments abroad, data gaps and data quality, and housing finance, all important subjects and some inventory of prospective trouble but no answer as to how to deal with them, probably because it is unclear how and in what circumstances they will arise. The 2017 Report is not different and concentrates on cybersecurity, asset management products and activity, but also contains broader observations on rising interest rates, changes to financial market structure, and global economic and financial developments.

PART I  Financial Services, Service Providers, Risk and Regulation 561

integrity, it has been pointed out repeatedly that whatever its merits, it cannot be based on discretion leading to a direct involvement of regulators in the running of financial ­institutions. This type of regulator is not equipped for it and, except perhaps in emergencies, regulators should not do so: it is not their task. They are not bankers; it would lead to a financial system being operated by complete amateurs. It is therefore a bad idea and may well be the worst of all worlds. Ideas of legality, proportionality79 and non-discrimination also falter in such an environment, especially tricky if there is subsequently also a macro-prudential overlay that is legally indeterminate. Hobbyism and vindictive attitudes in regulators, desires to impose large fines and create an income of this nature may get free space. In such an environment, as far as these regulators are concerned, as a minimum they and their organisations should be held accountable for the consequences of their interference in terms of civil liability. Macro-prudential supervision, on the other hand, when properly understood, is policy driven, does not depend on and may lack a clear legal framework, especially when it concerns itself with counter-cyclical capital adequacy and liquidity requirements, and is in this book seen as an essential policy tool, which is then outside the regulatory framework proper—much as monetary and fiscal policy also is,80 as already mentioned and distinguished at the end of s­ ection 1.1.9 above. To repeat, it is primarily concerned with the size of banking in each phase of the economic cycle. It may thus make much sense or it may even be necessary to sharply separate macroand micro-financial prudential supervision—also from the point of view of legal protection of and recourse to financial intermediaries. It may be noted that within the eurozone as part of its banking union (see ­section 4.1 below), the ECB according to

79 

See for the notion of proportionality further the discussion in s 4.1.6 below. The President of the ECB on 17 November 2014 made an Introductory Statement in a Hearing before the Committee on Economic and Monetary Affairs of the European Parliament, discussing also macro-prudential instruments. This was done with reference to Basel III as incorporated in the EU Capital Requirements Directive (CRD 4) and related Regulation (CRR), see s 3.7.4 below, not with reference to the SSM Regulation, see s 4.1.2 below. Reference was made in this connection to a June 2014 ESRB recommendation that uses a credit-to-GDP ratio to signal increased lending activity while seeking a common framework for all Member States in which connection it spotted around 30 national macro-prudential measures. They were broken down into two, addressing either (a) excessive credit growth and leverage or (b) systemic risk arising from the operation of large and complex banking groups, usually considered too large to fail. The counter-cyclical capital buffers belong to the first category but may still be considered less suited or sufficient to address credit developments in specific sectors, such as real estate, where limits on loan-to-value, loan-to-income and debt service-to-income may be preferred either alone or in addition. The ‘too large to fail’ problem, on the other hand, was thought to be better addressed by imposing extra capital as a permanent requirement. At virtually the same time, the President of the Cleveland Fed, Loretta Mester, ‘The Nexus of Macroprudential Supervision, Monetary Policy, and Financial Stability’ 5 December 2014, www.clevelandfed.org, laid heavier emphasis on macro-prudential instruments and identified structural and cyclical macro-prudential tools. The former are meant to build the resilience of the financial system throughout the business cycle. They were believed to include Basel III capital and liquidity requirements, central clearing of derivatives, and living will resolution plans. The cyclical tools are meant to mitigate the systemic risk that could build up over the cycle. That concerns the imposition of counter-cyclical capital buffers and stress tests scenarios. This tool is sometimes thought to be directed to the prevention of or otherwise the cleaning up of bubbles but the better view is probably that it should affect the liquidity-providing function of banks more generally at the top of the economic cycle. This comes close to monetary policy, which should still be used as an additional instrument, but since it has only one tool— short-term interest rates—it may be less effective and too broad. It would also not serve as a means to make banks stronger in the face of future crises. 80 

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Article 5 of the 2013 Regulation setting up the Single Supervisory Mechanism (SSM) (see ­section 4.1.2 below) exerts both functions and notably decides on when and how banks may be made subject to extra counter-cyclical capital buffers. Again, this is a different function, as such clearly to be set apart although it still raises issues of level playing field between banks. It does so even between countries if these buffers are still nationally set by the ECB as seems to be the structure under the relevant Regulation. Under Article 5, the ECB may do much more in the name of financial stability (even if this remains in principle also the area of national competencies), and may then even incorporate it into its micro-prudential supervision role in the eurozone, when these policies are applied to individual firms. This is joined by further ECB powers under the Single Resolution Mechanism agreed in 2014, especially in terms of initiative— see again ­section 4.1.3 below.81 To conclude, in the area of financial instability, there is no definition and its causes are unclear, see section 1.1.2 above. There may be many and which ones become­ relevant at any particular time is unpredictable. But all may be agreed that we have come to live in a highly leveraged society where much increased banking has become the spider in the web on which society totally depends and we do not want it to be different because it would deprive us from much liquidity which has become vital to the way we want to live. So, we may not want stability which may only be achieved at a level of activity which does not suit us. Banking as we have it is a reflection of ourselves. These modern demands are recognised in policy: it was government, not the banks, that reduced capital to virtually zero after Basel I and II, same for interest rates. It was government that did away with Glass-Steagall and promoted affordable housing. Bankers took advantage no doubt, but they are never stronger than the policies and clients they are meant to promote and support. Add to this the notorious pro-cyclicity of banks, see section 1.1.13 above, and there is a deadly mix which modern regulation has never sought to break. Rather, it adds to this pro-cyclicity by asking banks to build capital at the bottom of the cycle or in crises when their liquidity-providing function is most needed and it promotes their activity at the top when banks are at their most dangerous and irresponsible and should be severally curtailed in their new activities. We need a macro-prudential regulator

81  It also raises legal issues and questions of adequate protection for intermediaries in the case of principleor judgement-based micro-supervision and in macro-financial supervision. As to recourse, Art 22 of the 2013 SSM Regulation requires due process, especially a hearing for aggrieved persons (Art 22) taking into account also the EU Charter of Fundamental Rights (Preamble 63) but not in the case of emergency or for macro-prudential measures. The ECB’s acts more generally are subject to review by the ECJ but without prejudice to the ‘margin of discretion left to the ECB to decide on the opportunity to take these decisions’ (Recitals 60 and 64 of the Preamble). However, the ECB must make good any damage caused by it under ‘the general principles common to the laws of Member States’ (Preamble 62). Preamble 30 at the end further refers to the ‘principles of equality and non-discrimination’ (legality and proportionality are not mentioned) but it is preceded by a long policy declaration emphasising first the safety and soundness of credit institutions, the stability of the financial system and the unity and integrity of the internal market. The protection of depositors comes later and there may of course be considerable conflicts of interest, see also the discussion in s 1.1.11 above. All in all, the legal framework and recourse possibilities for financial intermediaries appear weak. In the present anti-banking environment, they clearly had little priority.

PART I  Financial Services, Service Providers, Risk and Regulation 563

which determines the size of banking in each phase of the economic cycle and operates besides fiscal and monetary policy. Hence variable capital adequacy and liquidity requirements and leverage ratios far beyond what Basel III has in mind. This is pure policy, well away therefore from a rule-based micro-prudential system as we now have it and which helps lawyers and compliance people a lot but probably never saved a bank and never will. In this world, regulation becomes a matter of managing instability and high leverage short of an inflationary blow-out. This returns the responsibility for the banking system to policy-makers where it belongs. The separation between banking and government is a chimera and the banking resolution regime as we now have it in Europe and the USA, which is based on it, see s­ ection 4.1.3 below, is a fantasy. We already see it in how it is applied. The next banking crisis will undoubtedly tell us more. The financial crisis starting in 2008 was probably not deep enough to produce new thinking as there had been in the USA in the 1930 motivated by a much deeper emergency. There was no sufficient consensus as to what was to be achieved and the way we operate with finance. Hence the continuation of the past micro-prudential system as the only framework about which there had been some consensus and it became polishing up at the edges. Whether Brexit may induce the UK to find a better model is of considerable interest. The fervour with which the UK regulators (the PRA and FCA) are implementing the present EU system in which they had much of a hand may suggest otherwise. There are also G-20 and the Basel Committee to reckon with and the reciprocity and equivalence issues in any mutual access between the EU and London markets, see s­ ection 3.7.17 below, but some renewed regulatory experimentation and competition might not be remiss and could do away with a host of rules, at least in the stability area. Elsewhere, in conduct of business and market integrity, we may need quite a few more.

1.1.15  The ‘Too Big to Fail’ Issue In respect of banks and their regulation and the need for public support if regulation once more fails to save them, we also have to consider the ‘too big to fail’ issue, meaning that major banks should not be allowed to fail because of the detrimental effect on society as a whole and must therefore be saved. On the other hand, there is the fact that they may be too big even for governments to help them; in the 2008 crisis, it was a predicament for the Swiss government in respect of its two largest banks but also in larger countries there has been a policy better to separate banks from government and this became G-20 policy as we have seen. In the European Union, it led to the Bank Recovery and Resolution Directive (BRRD), further implemented by the SRM in the eurozone for its banks (see s­ ections 3.7.16 and 4.1.3 below, and in the US Title II of the Dodd-Frank Act). The immediate answer of Basel III was more capital for these large banks (see ­section 2.5.12 below) even though it affects the liquidity-providing function. As a consequence, the excess capital requirement is relatively modest and unlikely to make

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much difference in a crisis. It may give smaller banks some advantage and may make them somewhat stronger at the expense of the larger ones, although it was already doubted whether they can easily function as replacement. It has been said also that they are in fact more risky, being less able to spread their risks and it therefore never made much real sense to let them operate with less capital. For larger banks another important complication is in practice that they normally operate internationally so that it becomes an issue who should save them when in trouble. It was submitted that the more apt requirement is to let these banks build an international safety net in good times rather than ask for more capital in a crisis, thus generally curtailing their lending activity, see ­section 1.3.7 below. Another important issue is how these banks are to be defined. For Basel III, the concept of systemically important financial institutions is dependent on size, complexity, interconnectedness, and substitutionability (of the financial infrastructure it provides) and its global activity. In practice, countries may use a list approach, identifying these banks by name. In Regulation (EU) No 1092/2010 on the European Macro Prudential Oversight establishing the European Systemic Risk Board (ESRB), the issue is of importance for the Board to determine the ambit of its policy proposals and in Recital 9 of the Preamble some key criteria are given to help identify the systemic importance of markets and institutions. It also attempts to indicate which institutions should be watched although it says nothing about when such risks are triggered. The criteria were considered to be (a) size (the volume of financial services provided by the individual component of the financial system), (b) substitutionability (the extent to which other components of the system can provide the same services in the event of failure), and (c) interconnectedness (linkage with other components of the system). These criteria were supplemented by a reference to (d) financial vulnerabilities and the capacity of the institutional framework to deal with financial failures, which should consider a wide range of additional factors such as, inter alia, the complexity of specific structures and business models, the degree of financial autonomy, intensity and scope of supervision, transparency of financial arrangements, and linkages that may affect the overall risk of institutions. Especially this last addition makes for a judgemental approach and does not provide sufficient legal criteria that can be objectively applied. In the US the Dodd-Frank Wall Street Reform Act defines the powers of the FSOC and refers in ­section 112 to identifying systemic risk arising from the activities of large interconnected bank holding companies but does not define them either; the definition of significant bank holding companies is left to the Fed Board under ­section 102(a)(7). About 30 banks with more than $50 billion in assets have been designated in a list approach. As already mentioned, the issue of ‘too big to fail’ also arises in the resolution regime established in the EU BRRD (see ­section 3.7.16 below), for the eurozone further implemented in the SRM Regulation (see s­ection 4.1.3 below), and under Title II of the Dodd-Frank Act dealing with resolution issues and the powers of intervention. Here again, there is a substantial measure of discretion to determine which bank is in this category and there is no definitional framework. In fact, it has been observed by many that the issue is not truly ‘too big to fail’ but ‘too big to manage’.

PART I  Financial Services, Service Providers, Risk and Regulation 565

1.1.16  Universal Banks, Conglomerate Risks and the Effect on Regulatory Supervision The universal banking structure has already been mentioned before and has long been common on the European continent, where commercial banks engage in many other financial services, especially capital market activities such as (typically) investment securities underwriting, trading and brokerage, and fund management. They may also engage in corporate finance activities, including mergers and acquisitions. In more recent times, insurance has frequently become a normal activity in banks as well, in which connection the term banc assurance is used. The result is financial conglomeralisation. In 2008 this universal banking concept triumphed worldwide after the US investment banks asked for banking licences. The consequence is that the largest banks in the world now all have an investment bank embedded and those that remain separate, like Goldman Sachs and Morgan Stanley, are now also ordinary banks. As we have seen in ­section 1.1.9 above, in the functional or objective-based approach to regulation, regulators are in principle sector or function specific while concentrating on the traditional model of authorisation, prudential supervision, conduct of business and product control, be it in different ways for different sectors or functions. The result is that several regulators are likely to be supervising parts of universal banks and the danger then is that coordination is lacking. The risks that are associated with the individual functions, such as credit-, market-, settlement-, operational-, legal-, mismatch-, liquidity- and systemic risk for ­commercial banks, and especially market-, settlement-, operational and legal risk for investment services, are the same in financial conglomerates. There may, however, be special complications in universal banks. First, there might be a lack of adequate centralised management, corporate and risk control, so that there is an insufficient overview, also from a management perspective. It is a special aspect of so-called operational risk. For conglomerates of this nature, there may also be extra solvency risk in mutual loans and guarantees between the different parts (or subsidiaries) and in cross-subsidies of the various business activities (even if organised through a holding company structure) which no longer operate on a stand-alone basis. In the US, the law guards against this in asking for a holding structure where these different activities must be conducted in different subsidiaries which are not to cross subsidise each other whilst bank deposits in the banking subsidiary are not to be used for funding activities in the other subsidiaries. There is no common pool. This is less common in Europe. Indeed, a particular concern in this connection is that in times of financial stress, the commercial banking activity in a conglomerate may through its access to deposits and the interbank market avail itself of short-term liquidity for the whole group, making that bank extra vulnerable through internal contagion. It may thus become a greater danger in terms of systemic risk, and this may cast a shadow on the entire interbank market. It also adds to the burden of banks of last resort (usually central banks) or governments in terms of any bailout of such a bank, which may not then be easy to separate from the rest of the group. Moral hazard itself might also increase as implied

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guarantees for the banking system may (have to) be extended to the entire group in an institutional sense. Again, one answer to this problem is to organise universal banking within bank holding companies, dividing the various businesses among subsidiaries and separating them. In matters of conduct of business, there may arise greater conflicts of interests and greater need for internal information separation through so-called Chinese walls, but it remains a problem and it has been said that a grapevine invariably grows over these walls. From the perspective of the regulators, in sector-specific regulation with functional supervision, there is in the case of financial conglomerates also the problem of regulators receiving insufficient information concerning the whole entity. There is further the important question which regulator takes the initiative and bears the direct and indirect costs when something goes wrong. Should there be some form of lead regulator for the entire entity especially to monitor the capital and enforce compliance at least in this aspect? It was already said that in practice, that lead regulator is always the bank regulator, as the insolvency risk and its systematic consequences are now the prime concern of regulators as we have seen and the most obvious concern in the banking activity, see also the discussion in ­section 1.1.9 above. As we have already seen also, this situation led in some countries, notably the UK (at one stage) and Japan, to combining the regulatory functions,82 especially supervision, into one single conglomerate supervisor or super-regulator: this was the FSA in the UK and still is the Financial Services Agency (FSA) in Japan, therefore to the creation of large supervisory agencies,83 but it has also been mentioned that as of 2012 UK financial supervision was returned to the Bank of England mainly because of financial stability considerations. It created the PRA to be separate from the FCA, which is the successor of the FSA and deals more specifically with conduct of business issues, which were more clearly separated out. At the organisational levels, even in the conglomerate regulators, the various financial service functions still tend to be separated. This could still lead to less clarity as to who is primarily responsible. So the problem shifts to the regulator, but co-ordination and the effectiveness of the regulatory supervision and response is in this way often deemed improved (at least on paper) in respect of conglomerate financial institutions. Regulatory competition (which the Americans still favour) is eliminated. Close relationships with the industry may, however, be lost in such supervision, and respect for the regulator may be lower because of the unavoidable increase in size and bureaucracy of a single regulator. It may also become more arrogant and overbearing. On the other hand, there may be savings, but large organisations can also be less efficient and more costly. In fact, the rapidly increasing overall cost of regulation has become an important issue everywhere. For depositors and especially investors there may be a considerable

82 

C Briault, The Rationale for a Single Financial Services Regulator, FSA Occasional Paper No 1 (May 1999). France followed in the French Financial Securities Act of August 2003, which created the French Financial Markets Authority (or Autorité des Marches Financiers (AMF), replacing the earlier Conseil des Marches Financiers (CMF) and Commission des Operations de Bourse (COB)). In France, commercial banking is not included. 83 

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advantage in centralisation of this nature, however, by promoting access to a unified complaint and appeal structure which is likely to be also more transparent.84 In the UK, this was provided under a special Memorandum of Understanding to the effect, but one of the lessons of the financial crisis of 2008 was that the co-operation was not working well, the Treasury also being involved. There was a feeling that the conglomerate FSA had failed to spot problems and that the Bank of England lacked the power and now also the knowledge to initiate action. Hence the review of the regulatory situation in the UK after the 2010 election and the return of banking authorisation and supervision to the Bank of England (now through a subsidiary). It may prove not to be ideal either and an aspect of endless improvisation in the UK regulatory system. It excluded the Treasury from policy-making which may make things easier but it may be questionable at the same time as much regulatory action is policy-driven, especially as we are moving into macro-prudential supervision. Even the independence of the Bank of England and, in the eurozone, of the ECB, could be seriously challenged in such an environment, which is not to say that political meddling should be encouraged.

1.1.17  The Shadow Banking System In the wake of the drive to re-regulate banking after the 2008 crisis, concern also emerged about the so-called shadow banking system, motivated especially by the fear that heavier banking regulation, not only in terms of capital adequacy and liquidity under Basel III, would move what was essentially a banking activity into other business shapes or areas not so regulated. This would be quite different from (some of) these activities simply moving offshore, although that was another prospect, especially in fund management. What should be regulated is therefore the issue, in which connection it should be realised that on the asset side of this activity, lending is not a regulated activity, everyone does do it on occasion, inter-group lending is normal, even lending to the public is not as such regulated. It is not easy to define this shadow banking system because of its multiple ­activities.85 It could be said that all money pools could operate like shadow banks, therefore all moneys in insurance companies, investment funds, large international holdings and 84  The corollary is that the banking supervision and monetary policy in central banks, where they were often combined, are separated in countries that have a single conglomerate regulator which is no longer the central bank. Thus in England, in 1997, banking supervision was withdrawn from the Bank of England at virtually the same time as it achieved independence in the determination of monetary policy. From a regulatory point of view, this separation makes sense, as the functions of liquidity provider and of lender of last resort may well be distorted by regulatory failures in the same central bank. There is here in any event room for a conflict of interests at that level as the central bank may provide liquidity more easily in circumstances of its own regulatory failure. On the other hand, for the implementation of their liquidity-providing function, central banks still need some insight into the soundness of the banks to which the liquidity is given. To obtain this information, there is a need for an information exchange between single conglomerate regulators and central banks where central banks lost their supervisory role vis-à-vis banks. 85  Financial Stability Board (FSB), Shadow Banking: Scoping the Issues, A Background Note (April 2011), talks about ‘credit intermediation involving entities and activities outside the regular banking system’. This is not saying a great deal. See for relevant literature: T Adrian and AB Ashcraft, ‘Shadow Banking: A Review of the Literature’ Federal Reserve Bank of NY Staff Reports Oct 2012.

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so on. It could even concern moneys borrowed from the regular banking system. In reality, the shadow banking system mostly funds itself through capital and retained earnings, bank loans, loans from investors directly, or through bond issues or commercial paper in the capital markets. Investment funds, although funded by participating investors (see also ­chapter 1, ­section 2.7 above), may also fund themselves additionally in these ways and may in that case become highly leveraged. That is a common approach in hedge funds, which may even start funding all kinds of other activities and then may more properly be considered part of the shadow banking system also. Negatively it may be said that the shadow banking industry recycles money without using deposits. That is approaching the subject from the liability or funding side. Institutions doing so are also called non-banks; they are not deposit-taking, the reason why historically they remained unsupervised. One way to get a better grip is to call all activity a form of banking where shortterm money is collected in order to lend or invest longer. That is the issue of maturity transformation and straddles both the asset and liability side of this activity. If that approach were taken, fund activity based merely on participants’ contributions might even become banking in this sense. In fact, everyone using short-term money to acquire longer-term assets might find themselves in a similar position. Many investors in securities of all kinds could thus also qualify. Whether that makes sense is another matter. Where short-term money might be acquired from money market funds or indeed from ordinary banks, interconnectedness between the banking and shadow banking system may become another distinguishing feature.86 Prime brokers already provide a similar facility to hedge funds where they may also maintain a maturity mismatch normally using short-term money borrowed from the banking system or raised in the money markets through commercial paper (CPs). In the view of others,87 shadow banking comprises a chain of intermediaries that are engaged in the transfer of funds channelled upstream in exchange for securities and loan documents that are moving downstream, therefore towards retail. Here non-banking activities typically include repo transactions, stock lending activities and re-hypothecation activity, see for these activities also ­chapter 1, ­section 4.1.3 above. By 2012, it was thought that the total of the shadow banking activity, however defined, was in the area of $50 trillion equivalent, although it was unclear what was included, by 2017 it was considered by the Financial Stability Board (FSB) to have about doubled, increasing by around 10 per cent per year. As shadow banking has become an important segment of the liquidity-providing function, a key issue thus becomes whether it presents or increases systemic risk and undermines financial stability. Indeed, before the 2008 financial crisis, some of these shadow banks had been large buyers of securitised products as well as major providers of short-term funding to SIVs (special investment vehicles or SPVs in that context) in securitisations: see ­chapter 1, ­section 2.5.4 above. One reason was that large pools of funds had formed outside the 86  The maturity mismatch and interconnectedness are indeed sometimes deemed the two major issues, see S Luck and P Schempp, ‘Banks, Shadow Banking and Fragility’, ECB Working Paper no 1726 (August 2014) http:// ssrn.com/abstract=2479948. 87  BJ Noeth and R Sengupta, ‘Is Shadow Banking Really Banking’, Regional Economist Oct 2011.

PART I  Financial Services, Service Providers, Risk and Regulation 569

banking system. To find a use for them, structured products were sought out, mostly funded short term (through CP), often in SPVs. Even money market funds had started to engage in this activity, which extended to loans given to private equity and hedge funds, financed further by private and institutional investors. A true shadow banking system thus emerged and this may become an important issue, although the truly cumulative effect on financial stability was never clearly established in the financial crisis. It was considered, however, that shadow banking is likely to be as pro-cyclical as banks or even more so. It showed when liquidity became limited in the banking crisis of 2008–09. This was not simply because the banks did not lend as usual, but equally because the shadow system was paralysed partly because of the losses its members had suffered. It squeezed the SIVs and hedge funds especially, whilst banks could no longer fully substitute for these sources of liquidity and in any event became themselves constrained. So it would appear established that the existence of the shadow banking system compounded the problems at the worst time and credibly contributed to financial instability and the pro-cyclical effect of all banking, see ­section 1.1.13 above. But if this is the issue, it suggests a macro- prudential supervision rather than a microprudential or some similar approach is necessary. As the liquidity-providing function in this sector is substantial, a key practical issue is in how far this is wanted or has become even indispensable. Again, if regulation was a perfect art, there would be nothing against regulating these activities, but it is far from being so. The negative and unpredictable effects of micro-managing financial services through micro-prudential regulation were highlighted above. It needs in any event to be critically reviewed and the beneficial effect of its extension into other areas of finance should not be automatically assumed.88 Yet it was already mentioned that with banks becoming more regulated, financial risk could move to this unregulated sector, which would thereby itself become more risky. That is indeed the danger of the restrictions on ordinary banking emerging from Basel III,89 but it may then be a problem of

88  Indeed, hedge funds have often served as an example. See for their basic features and operation ch 1, s 2.7.3 above. The systemic risk derives foremost from their borrowing of large amounts from the regular banking system, often through their prime brokers. The LTCM debacle in the 1990s showed this, requiring the Fed in the US to organise a lifeboat among the funding banks. Capital adequacy requirements in hedge funds could balance the risk. The buffer so far is the contribution of investors to these funds. What is adequate in this regard is a matter of opinion but hedge funds are seldom undercapitalised by Basel III standards. Their risk structure might require more and even that is normally forthcoming. In fact, hedge funds, regardless of initial fears, did not substantially contribute to the 2008 banking crisis, see also N Boyson, C Stahel and R Stulz, ‘Hedge Fund Contagion and Liquidity’, Dice Center Working Paper 2008.8 (2008). This study was inconclusive in respect of systemic risk resulting from shadow banking for the financial system as a whole; it was not obvious. 89  See for this danger, E Lee, ‘The Shadow Banking System—Why It Will Hamper the Effectiveness of Basel III’ (2015) March, Journal of International Banking Law and Regulation; A Kashyap et al, An Analysis of the Impact of ‘Substantially Heightened’ Capital Requirements on Large Financial Institutions (May 2010). It is altogether less clear why and how ordinary banks could shift to this kind of activity, as it is sometimes suggested they will, assuming it is beneficial to them, except by providing short-term funding to longer-term investors, raising the issue of connectedness, which would be countered by the large-exposure rule. Indeed, banks often support this activity by extending loans to non-banks (or indeed any other bank in or outside the interbank market) or to more speculative institutions such as hedge funds or real estate investment companies, or prime brokers. They may try to limit the credit risk by spreading it among many borrowers of this type and by avoiding large concentrated positions. There are other ways to cover this risk, eg through credit

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the established regulatory framework for which extension to other sectors is hardly a convincing cure. More to the point, is this sector perhaps more efficient? What are in fact the true risks and benefits? Although some argument may still be made for regulating shadow banking as if they were commercial banks (assuming this activity can be sufficiently identified), it could not be the objective to shackle and virtually eliminate it without good reason and proper insight.90 The negative growth effect of doing so may simply be unacceptable. In a crisis, the only help available must then come from capital markets through new capital injections in these shadow banks or, often, in more expensive long-term funding for end customers. Even for ordinary banks, the result may be a large measure of securitisation of their loan assets or covered bonds (see ­chapter 1, ­section 2.5). But these activities might prove difficult to restart once the products have disappointed or become capital market suspect. Banks of last resort and finally taxpayers’ money may have to be engaged to help, but that help is in principle only available for ordinary banks although it has already been said that the use of the lender of last resort to provide liquidity even for banks in trouble may be considered an improper use of that facility. However, it is common and then seen as a simple extension of a central bank’s concern with liquidity at large, but it does not directly help the shadow banking system. It may be repeated in this connection that at least this facility was extended in 2008 in the US to investment banks (but no further) who thereupon chose to become ordinary banks to retain this facility which allowed them to obtain deposits from their corporate clients at the same time. Full banking regulation and supervision was the price. Again, since they are not allowed to take deposits from the public and must keep all client funds segregated, shadow banks remained substantially unregulated except to the extent that they solicit public participation in their capital or fund-raising activity. Because of their connection with the financial system and its continued integrity and stability, as of 2018 it remains to be seen whether this situation can continue, quite apart from the question of how regulation should be structured and whether it could work.

default swaps, as we have seen in ch 1, s 2.5.2 above, or asking for security (collateral), as in mortgage lending or under floating charges: see ch 1, s 2.2 and s 1.4.3 below, or through repo financing with proper set-off and netting language, see ch 1, s 4.2 above. Under applicable secured transactions laws, many other types of collateral lending may be possible. Another way of containing the credit risk is commonly through entering covenants in the loan documentation under which these loans may be called in under certain circumstances, for example in the case of some act of default in other relationships of the borrower. This is cross-default. Even now, banking regulators will particularly watch this credit risk exposure of commercial banks to the shadow banking system and banking regulation may set limits or more likely may require specific capital against this lending activity depending on the perceived credit risk of such lending. Risk management is a central issue here and directly connected with the capital adequacy regulation for banks, see ss 2.5.2ff below. In this manner, lending to speculative institutions such as hedge funds or other shadow banking activity may be indirectly curtailed. In the aftermath of the 2008–09 crisis, the regulatory capital adequacy requirements were being further reviewed especially in respect of the risk in more specialised activities and products. This led to Basel III as we shall see in s 2.5.12 below, with, among other things, more product-specific rules, particularly for derivatives, but so far it has no coherent answer to the challenge of the shadow banking system. 90  See for a resulting sceptical approach to financial regulation, T Rixen, ‘Why Reregulation after the Crisis is Feeble: Shadow Banking, Offshore Financial Centers and Jurisdictional Competition’ (2013) 7(4) Regulation and Governance 435.

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For funds, there emerged in the EU in the meantime the Alternative Investment Fund Management Directive (see ­section 3.7.7 below) which confirmed the inclination towards a product or entities approach. Trying to regulate the shadow banking system as a whole, if considered feasible and desirable, would probably only lead to many of the institutions moving further offshore and may not help a great deal. Of course, commercial and investment banks can also move if they do not like their regulatory environment, but since they must serve a larger public and depend on much more infrastructure and proper manning levels, they are much less movable.91 China may prove to be in the forefront. By 2016 it appeared that the shadow banking industry in that country had bulged and could become troublesome, but this happened in an altogether more easily controllable legal and political environment.

1.1.18  Other Ways to Recycle Money. Fintech, Virtual Payment and Lending Systems: Bitcoin and Crowdfunding. The Potential Effect on Commercial Banking Technical progress does not keep banking unaffected and especially in the payment and lending function new possibilities are emerging and potentially disintermediate banks further, which for the better and larger credits had already happened by their moving into the capital markets for their borrowing requirements.92 The essence is the immediate finality of transactions and payments and the removal of intermediaries from the process. Even banks may come to use some of these newer facilities themselves to reduce their back-office cost. The possible impact in the area of securitisation, derivatives, custodial holdings of investment securities, and payments was discussed in ­chapter 1, ­sections 2.6.12, 2.5.12, 4.1.8 and 3.1.10. Much of this remains speculative but the direction cannot be ignored. As to the more immediate manifestations, on the one hand, we have seen the emergence of virtual currencies, of which Bitcoin so far is the most important example and it may potentially affect profoundly the payment system in banks. This may then also likely have an effect on their deposit-taking activity, most people keeping deposits in banks mainly to have access to the payment system. On the other hand, platforms on the net now enable forms of communication and may connect erstwhile depositors in banks more directly with borrowers. That may be a further disincentive to keep deposits in banks. The best known example so far may be in crowdfunding. It is clear that both these fintech facilities potentially create pressure on the banking system as we now know it today.

91  Nevertheless, because of Glass-Steagall, it was not unknown for American commercial banks unable to engage in investment banking in the US to incorporate investment subsidiaries elsewhere (notably in London). It is the normal consequence of differences in regulation and means regulatory arbitrage. 92  See P Black, L Collins, B Zhang, Understanding Alternative Finance (Nesta and Cambridge, 2014), PricewatershouseCoopers, Blurred Lines: How Fintec is Shaping Financial Services (2016); A Tapscott and P Tapscott, “How Blockchain is Changing Finance”, Harvard Bus. Rev. (March 1 2017).

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In ­chapter 1, ­section 3.1.10 it was discussed how a virtual currency like Bitcoin, without a central organiser, might work93 and how it may be kept operative and clean (principally through the function of miners), and whether it indeed can be considered a currency (or store of value) at all or is rather merely a commodity used for exchange or payment. Normally we think of money as a means of exchange or payment, a unit of account, less so now as a store of value in respect of paper currencies. Especially in the latter aspect, Bitcoin may fail if only because of its high volatility outside its own framework. In fact, it does not truly exist at all except at the moment of the exchange, but in this exchange function it is succeeding, allowing for an instant (telephonic) transfer substituting in part for credit cards and other bank payment facilities. Its success ultimately depends on a sufficient number of suppliers accepting this payment facility and that number is increasing. It is cheaper (the payor pays for the cost) and if broadly succeeding it could indeed affect banks in their deposit-gathering activity. From a legal point of view, it is important that whatever is transferred in this manner, is hard to locate in any place and therefore also in some existing legal system. The ledger is vital but it is comprised of thousands of computers located everywhere and transfers take place all around the world. This also impacts on regulation, which remains an important issue, quite apart from how to keep the criminals and money launderers out.94 More in particular, how are users protected against unauthorised spending, double payments, lack of return of value? What about the issue of payment finality? The key is that here the efficiency and safety of the system itself must be the safeguard in the absence of anybody in particular being responsible for its operation and there being no obvious competent regulator or legislative authority. The Bitcoin vision and that of the blockchain creators, which underlies it, was globalisation and transnationalisation expressly to avoid state authority. This is not unlike the original view of the internet, although in the latter case states were able to re-establish substantially their authority in the international flow of information and technology.95 This may facilitate privacy and proprietary protection, but also control and censure of information. Public policy is renationalised in this manner also and a search for international minimum standards abandoned, or reliance on the system itself and its competitiveness.

93  See ch 1, s 3.1.10 above. Dong He et al, ‘Virtual Currencies and Beyond: Initial Considerations’, SDN/16/03 (2016). Such a facility should be distinguished from much simpler telephonic payment systems such as Mpesa that have become popular especially in countries like Kenya. This allows for loading up one’s system for relatively low amounts with a further limit on the amount per payment that can be made. There is a central organiser, in this case Mpesa, which can be regulated. See for crowdfunding, the 2014 IOSCO Working Paper: Crowd-funding: An Infant Industry Growing Fast, followed in March 2016 by a warning in its Securities Markets Risk Outlook 2016. 94  D Arner, J Barberis and J Buckley, ‘Fintech, Reg Tech and the Reconceptualisation of Financial Regulation’ (2016), http://papers. ssrn.com; see also A Tapscott and P Tapscot, n 92 above. See for equity and loan based funding activity, R Ryan and M Donohue, “Securities on Blockchain”, 73 The Business Lawyer, 85 (2018), using the early example of Overstock and noting that Artcile 8 UCC under its notion of “uncertified securities” can accommodate blockchain investment securities and no statutory changes are needed in Sec. 8-102(a)(15) UCC, see further also JL Schroder, “Bitcoin and the UCC”, 24 U Miami, Bus. L. Rev 1, 66–78 (2016) and s. 1.5.15 below. See for payments in particular; J Cheng and B Gera, “Understanding Blockchain and Distributed Financial Technology, New Rules for Payments and an Analysis of Art. 4A UCC, Business Law Today (March 2016). 95  J Goldsmith and T WU, Who Controls the Internet (Oxford, 2006).

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It remains to be seen whether in Fintech a similar trend will become discernible. Where electronic platforms are still used, notably in crowdfunding or in Linq,96 they can be more easily located and this may remain an important contact point for regulation, but where the issue is merely the use of the blockchain, like in payment and trading, things may be very different in what are peer to peer dealings with a registry that is not kept centrally but by all members of the network simultaneously. For security trading and holding, at least in execution only arrangements, it might at the same time dispense with the tiered dematerialised present system, see ­chapter 1, ­section 4.1.8 above, which has still difficulty in determining the proprietary nature of each holding and the applicable legal system, see further Volume 2, c­ hapter 2, Part III. Thus endinvestors may again become direct ‘owners’ (or at least get more ready access to depositories) even if that concept may still need some redefining also in a blockchain, as must be the notion of finality. Security hypothecation, short selling and security lending would be issues that also may be practically facilitated and legally more easily settled. Obviously, there should be some legal regime, but it would be transnationalised in the way advocated in this book but much may be replaced by technology and filled in by smart contracts that are self-governing. That would also go to the issue of enforcement. Of course local authority remains here the ultimate authority, states having monopolised for very good reason the enforcement function in their territories, but much may become self executing and it is the thesis of this book that enforcing states should act on the basis of transnational law in appropriate cases if they take the rule of law seriously and want to be part of globalisation. They could still use their own public policy bar at that stage if they think that things have gotten out of hand to the extent international dealings come demonstrably onshore in conduct and effect and use this bar as some substitute for regulation, notably to protect own citizens in this manner against any adverse effects. However, it may well be that efficiency of fintech may start trumping here enforcement concerns especially between professionals. That is to say that if the facility is trustworthy and generally accepted in the marketplace, enforcement issues will be very rare. The system will determine how it is and legally produced certainty may be less relevant, indeed the law itself may be substantially disintermediated. Even in the transnational eurobond markets litigation is virtually unknown. Enforcement issues concerning the eurobond as a transnationalised document (see Volume 1, c­ hapter 1, s­ ection 3.2.3) are hardly ever an issue and market practices guard against uncertainty amongst professional participants. In this connection crowdfunding, also called peer to peer lending or marketplace lending, is another important modern development, no less a threat to traditional banking, now in the lending activity, and even to investment banking in their advisory, underwriting and trading functions. It raises in particular the issue of minimum 96  ‘Linq’ was developed by NASDAQ, which uses the blockchain for trading and for the issuing of shares to private investors. It has a location through NASDAQ which means that for regulatory reasons it cannot engage in public activity, but it purports to allow the online issuance and trading of dematerialised digitally represented shares, while reducing the clearing and settlement to just a few minutes, ‘thus reducing dramatically settlement and systemic risk’. Especially the reduction of settlement time and therefore its risk, is beneficial to all investors and may reduce the need for regulation from that point of view, even for the smaller investor.

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protection of investors, here through proper disclosure and through minimum supervision of trading activity. As just mentioned, the essence is direct access of lenders to borrowers, much as the capital markets had done earlier in respect of large creditworthy borrowers, but it dispenses notably with the traditional investment banking intermediaries and other inbuilt protections as notably the regulatory prospectus requirements.97 Fiduciary duties of intermediaries and their shortcomings may then also become less important. The advantage is that this type of funding may reach a much broader public. It had its origin in Asia and was originally a banking facility under which small amounts were advanced to small home-grown businesses, initially manufacturers of bamboo furniture. The Nobel prize-winning Grameen Bank specialised in this, but this micro-lending or micro-financing took off also in developed countries when connected with an electronic platform, which happened first in the USA in 2005.98 The main question is how reliable borrowers can be found. Again, there may be no prospectus as there is in the capital markets.99 The common answer and protection is here also primarily in the nature of the system itself. A prospective lender takes part in a pool of lenders to one particular borrower, which could be a start-up or any other. The basic protection is then found in numbers, more sophisticatedly expressed as the wisdom of the crowd.100 The idea is that a sufficiently diverse pool of independent actors with diverse sources of information and ranging across hierarchies come to common understandings of risk that are reliable. The platform provides no more than the mechanism for collective decision-taking of this nature and its expression. This is meant to dispense with regulation seeking to narrow the risks in other ways (eg through prospectus liability in the capital markets). As for crowdfunding, at least in the UK and the US, regulators have stepped in to avoid regulatory arbitrage (schemes being carried out by asset management companies), monopolistic practices, possibly systemic risk (when there arises interconnectedness with the banking system), but also to protect participants more directly. In the UK, the FCA has formulated a number of rules in this connection, especially to protect UK investors in investment-based crowd funding. There are three aspects: licensing, conduct of business, and investors’ protection, the latter two closely connected. Like all financial activity relating to investments, there is in principle a need for authorisation unless it is part of investment activity already authorised under MiFID II, see ­section 3.5.7 below. Since the investment-based crowd funding results in unlisted investments, several investor protections connected with such investments also

97  See EU Commission Paper, Peer to Peer Lending (August 2 2016) and OICV-IOSCO, Crowdfunding Responses Report, FR29/2015 2 (2015). European Banking Authority (EBA), Opinion of the European Banking Authority on Lending-based Crowdfunding, EBA/OP/2015/03 See also Ting XU, Financial Disintermediation and Entrepreneurial Learning: Evidence from the Crowdfunding Market (U Br Columbia, 2015). 98  The creation of Kiva.org. allowed potential lenders to identify potential borrowers. Posper.com as of 2006 launched a new start-up to fund entrepreneurs in this way and in 2009 Kickstarter supported creativity of all kind and made the term ‘crowdfunding’ popular. It was donation-based and the reward was not interest and repayment of principle, but a range of video games or apps or other products of the start-up. 99  The EBA in its report see n 97 above identified fraud risk due to the anonymity of the system, liquidity risk because of a less active secondary market, information asymmetry risk due to lack of disclosure, and possibly systemic risk. 100  The leading text is James Surowiecki, The Wisdom of the Crowds (London, 2004).

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­ perate, the first one limiting the promotion per class of investors where a basic o distinction is being made between professional and retail investors and in the latter case between those who are advised or not. The second protection is disclosure: the EU Prospectus Directive, since 2018 the Prospectus Regulation, is considered to apply and its exemption below Euro 5,000,000. Appropriate risk warnings must be given. For loan-based crowd funding there is also a need for authorisation. In terms of protection, there is special concern with money handling, business continuity and risk disclosure, the form of the latter being left largely to the platforms as the requirements may vary widely per market and type of funding. There are notably no minimum due diligence requirements so far for these platforms.101 Other fintech developments were already discussed in ­chapter 1 above, for payments in s­ection 3.1.10, for securitisations in s­ ection 2.5.12, for derivatives in s­ ection 2.6.12, and for custodial holdings of investment securities ­section 4.1.8. See for security markets operations further also ­section 1.5.15 below.

1.1.19  Official and Unofficial Financial Markets. Regulatory Issues In all of this, financial markets continue to play a crucial role, as places where supply meets demand, obvious in terms of investments, but it also goes for financial services. Markets are, as we have already seen, less and less regulated as institutions except to create transparency and avoid manipulation. Flows are free in principle, only participants are or should be subject to regulation. Financial markets in this sense, as places where supply meets demand, do not denote any specialised facility or institutionalised activity per se (although they may function in different ways) but cover all financial products and services on offer and include then even commercial banking activity, but financial markets proper are commonly subdivided into essentially five types: (a) the equity or (corporate) share markets; (b) the bond or fixed-income markets; (c) the money markets (short-term deposits or similar instruments, including interbank operations); (d) the foreign currency markets; and (e) the derivative and repo markets (see for the organisation of these markets especially ­chapter 1, ­section 2.6 above). The markets mentioned under (a) and (b) form the capital market of which the derivative and repo markets are sometimes also considered a part. The instruments of this capital market are called securities and the services therein investment or securities services. 101  The issue is an important one and came to the fore when Rebus, which had earlier sought restructuring advice, filed for administration in the UK in 2016 resulting in a potential non-payment of its lenders, see A Palin and A Williams, ‘Rebus becomes the Largest Crowdfund Failure’ Financial Times (3 Feb 2016). It was argued that due diligence should have revealed the fact that restructuring had been considered earlier.

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These markets may be institutionalised in certain places, as for shares and bonds notably in the traditional stock exchanges, which used to be regulated (or at least self-regulated) as institutions. Especially in a global economy, these markets need not remain so institutionalised and they can easily be informal, compete as such or even move offshore. This is the province of the so-called over-the-counter or OTC markets. Because of modern communication facilities, markets are in any event becoming less physical and more virtual and may result in no more than informal telephone markets, as the eurobond market—now the largest capital market in the world—has long been. They may be mere electronic trading platforms, not much more than a computer that matches trades as we shall see. Technically, they can establish themselves everywhere if domestic regulation or other rules start substantially and detrimentally to impinge on them. As alternatives to formal markets, which remain largely domestic, these informal, often offshore markets, have become greatly more important and commonly operate under more flexible mostly self-imposed rules. As just mentioned, in the capital markets, the eurobond market is the traditional example, the in origin unregulated nature of which hardly caused offence and problems. Indeed, informal markets of this nature have often provided useful competition to the regular markets and increasing liquidity. From early on, helped by paperless trading on the basis of book-entry systems (for shares and bonds or securities—see Volume 2, ­chapter 2, part III, summarised in ­chapter 1, ­section 4.1 above) they forced substantial change even in the formal domestic markets, which had to abandon their monopolistic tendencies and practices. As just mentioned (at first in the US), the rise of (OTC) electronic communication networks has added to the variety; see also s­ ection 1.5.6 below. It has been estimated that, even on NASDAQ in the US, market-makers have now hardly 20 per cent of the share dealings in the quoted shares; much of the rest is traded in competition on these newer networks. On the other hand, official markets in Europe, through mergers, have reinforced to some extent their market power and may still flex their muscle, foremost in setting fees for issuers and investors alike, but conceivably also in access to clearing and settlement. Competition with more informal markets and trading facilities has, however, also become a major issue in Europe as these so-called Alternative Trading Systems (ATSs) are becoming increasingly common and are no longer discouraged. In the EU, the term multilateral trading facility (MTF) is now more commonly used in this connection: see ­1.5.6, 3.5.7 and 3.7.7 below. Originally, in the capital markets or investment services field, regulation being domestic, mostly concentrated on the domestic stock exchanges (for shares and bonds) and their rule books, which in origin were often the product of self-regulation and therefore meant to bring order among members and protect their interests (rather than those of investors). There were mostly no other regulators or there was only faint supervision by ministries of finance. These stock market organisations as (sole) regulators for all investment services, including the listing of investment securities, were therefore often less suited for investors’ protection or to safeguard the public interest more generally. In the securities business, the more recent move to informal markets required in any event a rethink, in which connection the emphasis shifted to investors’ protection more generally. The Big Bang in London in 1986 was an important pointer in that direction and revived London as an international financial centre.

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The result was that the bulk of domestic regulation of capital markets’ activity could be refocussed away from stock exchanges and concentrated in independent agencies as supervisors and it was increasingly no longer targeted at the official markets (or exchanges) themselves and their members (except in terms of transparency and integrity). Rather this type of regulation covered all service providers as intermediaries in the (official and unofficial) markets, according to: (a) what they do, therefore per function (in the security markets mainly as underwriters, specialists or market-makers, clearing and settlement entities, custodians, brokers and investment managers); or (b) whom they serve (in the securities business, for example end-investors or other intermediaries, professionals or consumers, who could also include foreign residents, especially important for brokers and investment managers who contacted them). As we have seen, authorisation and prudential supervision thus started to be applied per function (see ­section 1.1.9 above) and could also be required in respect of those who organised markets, although especially in London this did not automatically follow and markets could operate freely subject to minimum transparency and integrity requirements, which were separately imposed. In the US, as early as the 1930s it led to a fundamental review under the Federal Securities Act of 1933 and the Securities Exchange Act of 1934: see ­section 1.2.3 below. As has already been noted, in this approach issuers of securities are also regulated although separately in terms of prospectus requirements, either for accessing the public or more particularly for listing their issues on a particular exchange, or both. In the first case, they may be under the supervision of the regulatory body itself and in the latter case under the supervision of the relevant exchange. Again, the authorisation and supervision (to the extent required per function) are now mostly separated from the trading activity in these exchanges and given to independent regulators per activity or function. Modern exchanges then concentrate mainly on the organisation of their trading business, itself often subject to regulation from the outside, but this may vary depending on the various exchange functions. Again, it should not affect the flows and price formation in them. See for these modern markets also s­ections 1.5.2–1.5.7 below. It was already said that they may increasingly be taken over by different service ­providers, such as information supply, clearing and settlement or custody organisations. It may therefore be repeated that also in market functions we have deregulated institutionally (official markets) and re-regulated functionally in relation to participants or s­ ervice providers and their activity, some of which may remain substantially unregulated and left to competition to maintain standards, eg in clearing and settlement, the best becoming the most trusted. It is another form of disintermediation that may be very beneficial even if it disturbs established regulatory patterns. Again, the underlying idea is that flows should be free and therefore also the markets in these flows of financial products and services unless there is manipulation or any other type of abuse impacting on the markets’ integrity. For the regulation of electronic trading or MTFs in the EU, see ­3.5.7 below. The trend is therefore clear: formal markets and even financial institutions as such are no longer the prime focus of regulation, but participants are depending on their function or activities. As a minimum, it requires their effectiveness to be reconsidered.

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This was increasingly obvious for the financial service providers, and may also be so for issuers to the public, especially where they must register with regulators. This means that the issuing of and trading in financial products itself may also be increasingly freed from distorting imposts in terms of withholding taxes, foreign exchange restrictions and other limitations, except again for transparency in price reporting and information supply and the avoidance of market manipulation. To repeat, in a modern financial environment, the issuing burdens and limitations are increasingly shifted from the issue to the issuer and the investment burdens (such as taxation and investment or foreign exchange restrictions) from the investments to the end-investors. This was always the objective of the eurobond market: see ­section 2.1.2 below. It was largely achieved in that market through careful selection of the place of the issuer (often a tax haven finance subsidiary), the choice of instrument (usually an anonymous bearer certificate), the type of underwriting and placement syndicate (usually formed by banks from different countries), and the place of payment of principal and interest (where a choice of paying agents in different countries is normally given). National connections with the issue were in this manner minimised and foreign exchange, investment limitations and tax burdens became a matter for the issuer and investor rather than a restraint on the issuing and trading of eurobonds themselves. That set a trend long before the globalisation of the capital markets became a fact, but this globalisation has reinforced the already existing tendency to shift regulation from markets and flows or even institutions as such to participants depending on their functions, position and location.

1.1.20  Market Abuse, Insider Dealing and Misleading Financial Structures. The Regulatory Response It has already been said that the incidences of market abuse, such as market manipulation, insider dealing or the use of markets to launder money, are the third prong of the public interest in finance after the stability and client-protection or conduct of business issues. They are also of concern to the markets themselves, their credibility and the confidence in them. This presents a number of externalities, which cannot be fought by the traditional tools of financial regulation in terms of authorisation, prudential supervision, conduct of business or product control, but must be countered by other means, usually civil and criminal penalties. The first ones mostly aim at illicit profits being disgorged, possibly accompanied by civil fines paid to injured parties or, if they cannot be identified, to regulators or other public authorities. Criminal penalties present the problem whether organisations can be made so liable, how that affects their directors and officers personally, and whether the amounts so collected can be distributed to the victims. The concept of market abuse, especially insider dealing, is itself not without its complications and controversies, nor is the question how it is best addressed. The term is pejorative by definition, but should not bar research into the nature and significance of the offence. Many believe, for example, that insider dealing is not wrong per se, and

PART I  Financial Services, Service Providers, Risk and Regulation 579

might even be an efficient and therefore beneficial way of distributing information. It should also be appreciated that even now only some forms are outlawed, often quite recently, especially where some insiders might otherwise be able to make large profits, likely in respect of the use of privileged corporate information. Another interesting aspect is that except in the case of takeovers, insider information regarding corporate information is not always a reliable guide to future price movements. In other words, markets may react differently from the way in which insiders would. In this connection, it has also been pointed out that the advantage for corporate insiders is truly a matter between the managers (insiders) and shareholders of a company, and may be entirely justified if shareholders agree to it as extra or substitute compensation for these insiders. It is then no more than distributing by contract the property rights to corporate information between managers and shareholders.102 More to the point than the reward and its size (although related to it), insider dealing based on privileged corporate information is often said to undermine the confidence in the whole system, thereby destabilising it, but there was little evidence of this when insider dealing of this nature was more rampant. There is here an obvious battle between greed and envy, but less proof of truly harmful effect. Most importantly, some forms of insider dealing remain perfectly accepted. As already mentioned, the use of trade-related information by intermediaries is not commonly deemed improper (unless derived from a pooling of information). Indeed, market-makers operate primarily on the basis of the flows they see and the information about sales and purchases they get. As a consequence, they are better informed about price formation than others and allowed to trade on it. That is also very much behind proprietary trading in banks and does not appear to be reprehensive. In fact, only the abuse of corporate (not market) information by insiders is the major focus of insider dealing at present and has made the use of it universally illegal.103 As far as market manipulation is concerned, there also seems to be an obvious prima facie case against it, but on a more proper analysis it may prove to be a largely indefinable concept. Short of fictitious trading (such as acting as buyer and seller at the same time) and fraud (usually making false statements), which can both be easily identified,104 a market squeeze like ramping, for example, (the creation of artificial shortages in supply in such a way that the short sellers cannot meet their delivery obligations except at exorbitant prices exacted by those who hold the securities as part of their scheme) may be an obvious other example of abuse, but is quite difficult to distinguish from running large positions in the hope that the short sellers will eventually have to unwind their short positions, while a bear squeeze as a defence of a lead

102  This is another famous Coase insight: RH Coase, ‘The Problem of Social Cost’ (1960) 3 Journal of Law & Economics 1. 103  See DW Carlton and DR Fischel, ‘The Regulation of Insider Trading’ (1983) 35 Stanford Law Review 857. See for insider dealing in Europe, KJ Hopt, ‘The European Insider Dealing Directive’ (1990) 27 CMLR 51. 104  See DR Fischel and DJ Ross, ‘Should the Law Prohibit “Manipulation” in Financial Markets’ (1991) 105 Harvard Law Review 503. See for the EU Market Abuse Directive, which also replaces the earlier Insider ­Dealings Directive, s 3.5.7 below. See for the UK, GA Walker, ‘Penalties for Market Abuse’ in M Blair QC et al (eds), ­Blackstone’s Guide to the Financial Services and Markets Act 2000 (London, 2000) 113.

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underwriter against those in the syndicate or others who short a new issue may be a perfectly proper retaliatory tactic. Stabilisation of new issues, that is, managing the supply when a new issue creates a temporary excess, is another technique that is often condoned on the grounds that in this way a better market climate is created as excessive price swings are prevented. The buying-in of own shares is usually also believed acceptable. All would appear to depend on the nature of the intent to interfere with supply and demand, but this is a poor legal guide, as all market interventions, however intended, including ordinary purchases and sales, have a market effect. Ideally, more objective standards are needed to determine acceptable and unacceptable market behaviour. Except in cases of fictitious sales, misleading disclosures, or lack of disclosure, they are not easy to find. Abuse may also occur through the structuring of financial instruments. Enron was a case in point: see ­chapter 1, ­section 2.5.5 above. Its schemes were not unknown nor were they hidden from investors but the details that were given in the company’s accounts were not substantial and there was clearly the hope that no further questions would be asked. It could thus be argued that, together with its auditors, Enron sought to mislead the public through incomplete and therefore misleading information. There was further an obvious reliance on legal formalism in the sense that a scheme, if legally correct under the positive law, was thought automatically to pass muster at the same time under rules of proper corporate governance and ethics, so that also from that point of view no further questions were to be asked.105 Morality as such is then commonly believed to be sufficiently expressed in the texts and there is no other. This is a common problem in financial structuring or engineering, which is often reduced to finding new legal and tax structures in the light of a technical reading of the law in order to circumvent or alleviate the (for the relevant party) undesirable consequences of present legal structures and their objectives. Yet again, moral considerations make difficult legal guidelines unless clear excess becomes obvious, that means until there is a prima facie case, which in Enron there was considered to be. In the UK, market abuse received a statutory definition in the Financial Services and Markets Act 2000 (­section 118(1)). It is considered behaviour that is likely to be regarded by regular users of a market as a failure on the part of the participants concerned to observe standards of behaviour that may reasonably be expected from them (in that market). Three specific behavioural tests are introduced in this connection. The behaviour must: (a) be based on information not generally available to others using the same market and that would be regarded by them as relevant in their investment decisions; or (b) be likely to give the regular user of the market a false or misleading impression as to supply and demand; or (c) be regarded by regular market users as behaviour that may distort the market in a particular investment.

105  See WH Widen, ‘Enron at the Margin’ (2003) 58 The Business Lawyer 961, 963, and SL Schwarcz, ‘Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures’ (2002) 70 University of Cincinnati Law Review 1309; see further ch 1, s 2.5.5 above.

PART I  Financial Services, Service Providers, Risk and Regulation 581

The FSA, being the UK regulator at the time, developed these notions further in its Code of Market Conduct. It may impose financial penalties or publish a public censure. It may also apply to the courts for an injunction or restitution or initiate criminal sanctions. Note again the obvious difficulties in arriving at more objective standards. Corporate and trade-related insider information is here not clearly distinguished. The issue of its reprehensible use is left to the perceptions of participants and ultimately the judiciary. The EU Market Abuse Directive of 2002, which replaced the Insider Dealing Directive of 1989 and extended to newer types of markets under the Market Abuse Regulation in 2014 (see ­section 3.5.13 below), accompanied by a further Directive,106 defined in Article 1 both inside information and market manipulation. Inside information is information of a precise nature which has not been made public but relates to issuers of financial instruments and which would, if made public, have a significant effect on the prices of these instruments. This is largely corporate information. For derivatives, there is a further provision relating to information of a precise nature not made public but which users of these markets on which they are traded would expect to receive under accepted market practices. Market manipulation means here transacting in such a manner as to give false or misleading signals concerning the supply and demand for financial instruments or to secure these instruments at abnormal or artificial levels. Again, acceptable market practices are exempted. Transactions or orders using fictitious devices or any other form of deception or contrivance are caught. Dissemination of deceptive information is also covered with the proviso that financial journalists may depend on their professional protections unless they use the information to their own benefit (directly or indirectly). In all these areas—insider dealing, market manipulation and abuse of financial structuring—the limits lie in excess. There is reliance on an innate sense of balance on the part of the participants, which may not be there. The definitions may also not be precise enough for criminal cases and prosecutions. It was already said that structures and subterfuges are likely to develop to circumvent existing criminal or other definitions. Clear frauds or shams present areas where there may be sufficient legal clarity. Others are where there is a form of conspiracy between participants and their technical advisers. Yet not all can be anticipated, let alone be defined and much must therefore be left to the self-correcting forces within the markets, or to regulation after the fact. This may go as far as to accept that Enron situations or the excesses of financial engineering before the 2008 financial crisis are necessary occurrences to sanitise the markets (and the practices of participants). It is clear that with present insights it may not be possible to devise an adequate legal framework that prevents all excess, but improvements can be made.107 It was already said before that as far as the public interest is concerned

106  Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on Market Abuse [2014] OJ L173/1 and Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014 [2014] OJ L 173/179. 107  In the US, in response to the Enron crisis, the Sarbanes-Oxley Act of 2002 tried to tackle corporate frauds and accounting oversights more effectively. It created an independent regulatory board to supervise auditors,

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which now mainly concentrates on financial stability, much remains to be desired and more could be done both in the areas of conduct of business/investor protection and in the area of market integrity.

1.2  International Aspects of Financial Regulation 1.2.1  When are Financial Services International? EU Approach, Home or Host Country Rule between Member States It has already been said that financial regulation remains in essence domestic notwithstanding the increasing globalisation of the financial flows. This is largely a result of the mandatory or peremptory nature of the relevant legislation and the absence so far of clear transnational minimum standards. It unavoidably leads to impediments to the cross-border movement of financial services. Thus better regulated countries will be wary of allowing lesser regulated foreign service providers to operate on their territories and may bring them and their products under their own regulation and supervision. As a consequence, even in free trade areas or custom unions, such as the EU, and certainly also in respect of services freed in the WTO/General Agreement on Trade in Services (GATS which does not generally apply to finance, see ­section 2.2.3 below), regulation by the receiving or host country may result in a form of dual regulation (by both home and host country) and therefore in an important (non-tariff) impediment to the movement of financial services and products and to the right of establishment. In the EU, this impeded seriously on the internal market and its freedoms. It gave rise to important legislation (Directives) in the early 1990s to safeguard these freedoms in a system in which the regulatory tasks were eventually divided between the regulator of the service provider (home regulation) and the regulator of the service receiver or user (host regulation) subject to minimum harmonisation of the applicable regulatory standards (in terms of authorisation and prudential supervision, and conduct of business and product supervision) with emphasis firmly on home regulation of the service provider from wherever in the EU. This is also called the European passport. The idea thus became mutual recognition of home-country rule subject to minimum uniform standards, with some remaining but limited powers for the host regulator, mainly to

requiring them to report to corporate audit committees on crucial accounting policies and alternative treatments used in respect of the company in question, introduced new corporate crimes for anyone who uses ‘scheme and artifice’ to defraud investors (with prison terms of up to 25 years), mandated chief executive officers (CEOs) and chief financial officers (CFOs) to certify the company’s financial information (with criminal sanctions for knowing or wilful violations), broadened the definition of illegal destruction of corporate records, increased fines for obstruction of justice and mail and wire fraud, reduced the time period for insiders to report trading in the company’s shares to two days after the transaction, gave protection to so-called whistleblowers, instructed the SEC to issue new rules regarding disclosure of changes in the financial condition of a company, and prohibited issuers from extending loans to executives and directors that are not available to others.

PART I  Financial Services, Service Providers, Risk and Regulation 583

protect small investors in the area of conduct of business, also expressed as the generalgood exception, which had been developed in case law (but was in fact curtailed by later EU Directives, especially MiFID as we shall see). For the rest there would be regulatory competition. It will be discussed in much greater detail below in ­sections 2.3.3, 3.1.2, 3.3 and 3.5 and may eventually prove to be an important model also for WTO/GATS. This EU regulatory regime applies to all banks and investment service providers in the EU in the area of financial regulation regardless of cross-border contact. This would appear to suggest that the EU has full jurisdiction but that is not the case, Member State regulation and regulators remaining in essence in charge. EU competency in this area remains limited and only derived from Article 95 of the EC Treaty, now Article 114 of the Treaty on the Functioning of the European Union (TFEU 2009), thus from the completion of the single market and therefore from the perspective of the free movement of services and money. On a proper analysis, that also has a bearing on the interpretation of the EU Directives in this area. There are other issues. When it comes to the division of labour between home and host regulator, it must still be determined whether there is room for a host regulator and that is only the case when there is a trans-border service proper. Thus, to decide whether there is host-country involvement, it needs to be established when a service is cross-border, which in an age of telephone or modern electronic communication is not always easy. Generally, when a service impacts on a country other than that of the service provider, there is a cross-border link, but that may not in itself be sufficient to motivate host-country regulation in both authorisation (and prudential supervision) and conduct of business (and product control). As a preliminary issue, it is therefore necessary to determine when there is such a link in legal terms. There may be differences for banking and capital market services. This important issue, which for all services also received attention in Article 1 of the GATS Treaty and in earlier case law in the EU, will be discussed in greater detail in ­2.2.3 and 2.3.3 below. In summary, it is clear especially in respect of brokerage services for the purchases and sales of investment securities in the capital market that cross-border services may in principle be provided by a service provider in four ways: (a) directly but incidentally, usually by telephone or (e)mail; (b) through more regular contacts established on the telephone or by (e)mail, conceivably backed up by visits in the host country; and (c) through the creation of an establishment or branch there; or (d) through the incorporation of a subsidiary. Where the provider moves to the client and physically operates in a host country through a subsidiary, the host country is clearly in control, but there may be doubts when there is merely a branch. Where there is less than a branch, for example only some sales visits, cross-border contact is still obvious, but could merely be the supply of (some) services from abroad in which physical contact could be de minimis if staff are sent only occasionally or if there are very few clients and normal contact is by telephone. Yet it could still raise conduct-of-business concerns in the host country although perhaps less the question of authorisation, which may in such cases be more readily left to the home country of the service provider. Advertising abroad might in

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this connection be no more than an invitation to treat, therefore leaving the initiative issue to the investor. Indeed, where the client or recipient contacts or moves to the provider, there may not be host-country activity at all. This client-induced investment service supply is also called ‘reverse solicitation’. Thus, if a prospective investor contacts a broker in another country, there may not be a cross-border service, all the less so if subsequently the investor keeps an account with the broker in the latter’s country. More problematic remains, however, the situation where the service is rendered in the host country by telephone, or other modern communication methods are used on a more regular basis, but it remains true all the same that if the service provider initiates the informal contact, it is from this perspective host-country business, but, if the client does, it is not. Thus initiative is therefore a key issue, but also the place of account may be considered relevant, or even of the place where the characteristic obligation is performed as we shall see in s­ ection 2.3.3 below and they may constitute important factors to locate a service, particularly when neither the service provider nor the recipient moves or when the recipient goes to the country of the provider. There may be other foreign aspects to financial transactions, to be covered by the domestic law most directly concerned if it can be established. Thus, as far as the issue of new securities is concerned, the rules will primarily be determined by the place where they are issued and underwritten or by the stock exchanges on which they are listed or both, although, as since the 2003 EU Prospectus Directive, it may now also be the country of the issuer. As far as their placement and trading are concerned, the rules may be determined by the residence of the investor at whom they are targeted and in whose country there may be selling restrictions or special investor protections and prospectus requirements. These restrictions may be less relevant in secondary trading (sometimes after a certain so-called lock-up period). Even if investments are not meant to flow to certain countries (like the US) that require registration of the issuer for the securities to be sold in that country, investors from those countries may still acquire them in the off-shore markets. That would seem to be their choice and could not be held against foreign brokers or market-makers acting at the investors’ request. For banking, the situation may be somewhat different. Key features may then be location, residence and currency of the banking transaction, but again if an account is opened by a foreign resident upon the latter’s own initiative, the account is likely to be considered local at the place of the relevant branch. Within the EU, we must in this connection consider its 1998 call for one single European market for financial services. Behind it was the idea of the operation of one single European capital market, but the concept is broader and also included commercial banking and insurance activities. The idea was a sequel to the appearance of the euro and it would seem logical that in its wake a single capital market and market for financial services, at least for euro countries, should result. Benefits similar to those derived from the large internal market in the US were envisaged. The appropriate level and manner of regulation (of the participants) in that single market was then also (re)considered. Hence the subsequent review of all EU Directives in this area: see ­section 3.4 below. With the unregulated (in principle) euromarket on one side and

PART I  Financial Services, Service Providers, Risk and Regulation 585

the fundamental freedoms and deregulation ethos of the EU in respect of the basic EU flows on the other, the development of the single European market in financial services suggested a relatively narrow margin for regulation.108 In a rational EU approach, not only the supervisory structures of home/host regulation and issuer disclosure should be constantly reconsidered, but also the regulatory objectives themselves, the need for and form of centralised regulation at EU level, and the feasibility of a single EU regulator. Indeed, in the eurozone, in 2012, there emerged a demand for a single banking regulator, presumably operating on the basis of a single regulatory regime for banks, although important lip service was still paid to the idea that the authorisation remained a Member State prerogative. The idea was that this would be the counterpart of these banks being virtually guaranteed (and supervised) by the ECB. This may in fact amount to an institutionalisation of an abuse of the concept of lender of last resort (see for this facility s­ ection 1.1.6 above) which is not there to save banks in distress or to communalise their debts. Access to this facility thus became subject to enhanced supervision, but no one can be confident that this mixing of functions, now at the level of the ECB, will be manageable and ultimately beneficial. It was joined by a single resolution regime—see ­section 4.1.3 below.

1.2.2  The EU Approach to Third Country Activity, Access to the EU and Export from the EU The EU regime concerning third country financial activity has evolved from the early Second Banking Directive and Investment Securities Directive, into the 2013 Credit Institution direction (CRD 4) and the 2014 MiFID, see for these Directives ­sections 3.7.3/4 below. The older regime will be described in s­ ection 3.3.5 below and the newer regime in s­ ection 3.7.17 below. It concerns the access from third countries and the access to third country markets or the export function and extraterritorial effect of EU rules. It may probably be noted that this area of EU involvement is not necessarily concerned with the overriding issue of the promotion of the internal market and stability and conduct or business and market integrity issues may become secondary or may be lost in other priorities, although they will always remain relevant concerns. After Brexit the attitude may be considered primarily political, culminating in the meaning and implementation of the notion of equivalence, especially in the access of UK financial service providers to the EU, see again ­section 3.7.17 below. A piecemeal and incidental product and type of service approach is likely to follow. This is also the attitude to US, Japanese and other countries’ financial services short of special arrangement as exist in Europe for EFTA countries and Switzerland.

108  See JH Dalhuisen, ‘Towards a Single European Capital Market and a Workable System of Regulation’ in M Andenas and I Avgerinos (eds), Financial Markets in Europe (The Hague, 2003) 35ff.

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1.2.3  Regulation of the Activities of Foreign Banks in the US The situation in respect of foreign commercial banking activities in the US should also be briefly considered and is quite different from that for investment securities activities conducted in the US from abroad. Generally, in the US, commercial banks in order to operate need a licence or authorisation or, in American terminology, they need to be chartered, which may be done by state or federal authorities (in the latter case by the Office of the Comptroller of the Currency, or OCC) at the option of the bank. If federally chartered, they are called national banks. State banks are in principle supervised by states but also by the Federal Reserve to the extent they are members of the Federal Reserve System or otherwise by the Federal Deposit Insurance Corporation if their deposits are federally insured. This supervision will lead to the usual capital adequacy and other prudential measures, therefore also for state banks. Originally this system only applied to American (and not foreign) banks. The most important restriction on these banks (at first not applying to foreign banks either) was the Glass-Steagall Act requirement of separation between banking and securities activities, only eliminated in 1999 by the Gramm-Leach-Bliley Act of that year109—see ­section 1.1.9 above. Another feature of the US system was the limitation on interstate banking under the McFadden Act of 1927, which applied unless a state made an exception. These exceptions became more common and the McFadden Act was repealed in 1994. Since then, interstate banking has been free (except if a state decides otherwise, which has led to reciprocity arrangements between states) although still subject to state rules on competition and community reinvestments. The situation was originally different for foreign banks opening a branch in the US. They were chartered under state law only and had much greater operational flexibility as federal restrictions did not apply to them (not even the McFadden and Glass-Steagall Acts, unless these foreign banks acquired a controlling interest in a bank in the US). This flexibility was curtailed, however, by the International Banking Act 1978, amended in 1991 by the Foreign Bank Supervisory Enhancement Act (FBSEA) and further defined in Regulation K of the Federal Reserve Board. This was done foremost to create a better level playing field between foreign and US banks. The result was that foreign branches operating in the US are now authorised at their option by the OCC, the Treasury, or by states. Their activities are determined by the applicable federal or state laws and they are made subject to all restrictions on non-banking activities (even if chartered by a state, as the FBSEA clarified).110 109  Until that year, most American banks were subsidiaries of large bank holding companies that were supervised by the Federal Reserve and could do more than their banks could under s 4(c)(8) of the Bank Holding Companies Act 1956. Notably, they could also engage in activities closely related to banking, but generally still not in securities, insurance and commercial activities. They were supervised as main providers of capital to the bank in the holding. Since 1999, under the new s 4(k) of the Bank Holding Companies Act, bank holding companies (BHCs) are allowed to engage through different subsidiaries in the full range of financial activities when a BHC is called a financial holding company (FHC). All larger banking groups are now organised in this manner. Wellcapitalised banks may also engage in these activities through subsidiaries. 110  See also D Gail, J Norton and M O’Neal, ‘The Foreign Bank Supervision Enhancement Act of 1991’ (1992) 26 International Lawyer 993.

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Foreign bank subsidiaries are chartered by either the OCC or a state and operate as any other US bank. These subsidiaries are much less common as banks traditionally prefer to operate through branches. A third option is an agency of a foreign bank. They are often used and may make loans and attract foreign deposits but no deposits in the US. Again, they are chartered either by the OCC or by a state. Representative offices of foreign banks are another option. They neither make loans nor take deposits in the US but may solicit business for their foreign bank in the US. They are either federally or state chartered. In ­section 1.2.5 below, the Basel Concordat will be discussed and the amendments thereto especially in the light o f the BCCI case. It gave rise in the US to the Foreign Bank Supervision Enhancement Act 1991, which amended the International Banking Act 1978. Here again, a major concern was federal deposit insurance and the supply of liquidity if a US branch of a foreign bank runs into difficulties (even if this is in principle the business of the lender of last resort of the foreign bank). That may also have an effect on the interbank payment system if foreign branches are members. The US approach is to require membership by foreign branches of the deposit insurance scheme and to supervise the participation of foreign branches in the electronic payment system (CHIPS). The US regulator will defer to foreign regulators only if it is satisfied with their capability to do so effectively.

1.2.4  The US Regulatory Approach to Issuing Activity and to Investment Services Rendered in the US by Foreign Issuers and Intermediaries Generally in the US, investment securities regulation is now a federal matter (although state law also remains competent) and there are a number of federal statutes relevant to the issuance and distribution of investment securities in the US: the Securities Act 1933; the Securities Exchange Act 1934; the Public Utility Holding Company Act 1935; the Trust Indenture Act 1939; the Investment Advisers Act 1940; and the Investment Company Act, also of 1940. The SEC administers these Acts, which (with the exception of the Public Utility Holding Company Act) also apply to foreign securities distributed in the US or to US investors. The present legal framework (often amended) has become quite ancient, although subject to further review and amendment after the 2008–09 financial crisis (the Dodd-Frank Act and its implementation), but is well tested. In fact, the basic structure derives everywhere from this US example and experience in this area, often with similar ambiguities about regulatory objectives and similar doubts on the achievements. The most important innovation of 1933 was that under the Securities Act all securities being distributed in the US or to US investors (resulting in a public offering) must be registered with the SEC, which will decide within five days whether it will review the issue. Most first-time offerings are reviewed, which will take between four and six weeks, during which time the securities may be offered but not sold. A p ­ reliminary prospectus may even be issued. In the area of offering investment securities to the public, many of the subsequent developments in the US centred on this prospectus requirement and therefore on the regulation of issuers rather than intermediaries.

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It is of interest in this connection to consider what, according to US law, is a prospectus. Under ­section 2(a)(10) of the 1933 Act, it is any written offer, offer by radio or television, or confirmation of a sale. So the first task is to determine what is an ‘offer’ in these terms. There is no clear definition but it is a broad concept that covers any action that conditions the market for the sale of securities. It implies a measure of publicity. Offers (therefore prospectuses) of this nature require a registration statement in which, as just mentioned, the approval of the prospectus is sought from the SEC. A satisfactory review will depend on basic conditions of the prospectus rules having been met. It means that the registration becomes effective only upon such a satisfactory review, which operates as an authorisation of the sale of the relevant securities. All further distribution of materials must subsequently be accompanied by the registered or official prospectus. The 1934 Act requires in addition ongoing disclosure in respect of issues listed on the US stock exchanges and NASDAQ. Shelf registration is now another way of obtaining this authorisation. In a shelf registration, the authorisation is sought and obtained in advance by filing a registration and a prospectus. If the prospectus is satisfactory, the securities may be sold within a two-year period. The importance of this facility is that issuers may take better advantage of good issuing conditions during that period without incurring any registration delays. Any offer during that period must, however, be accompanied by a supplemental prospectus covering the specific terms of the offer and any recent developments in the issuer’s business or status. For non-public or private placements, there is a registration exception under ­section 4(2) of the 1933 Act, see further Regulation D. It may help foreign issuers desiring only a limited distribution in the US or to US investors and is an option much exploited. In 1998, the SEC reduced the restrictions on distribution in respect of large seasoned issuers in order not to force them unduly into this private placement exception. At the same time, the necessary information under shelf registrations was expanded. In the area of disclosure, in 2000, the SEC adopted a Regulation FD, tightening the rules for selective disclosure of material non-public information. This was meant to reinforce the insider dealing rules. Except for private placements, in the US in the securities business until 1988, the SEC attitude had always been that all public offerings of securities (foreign or US) using means or instruments of transportation or communication in interstate commerce or the mail would have to be registered with the SEC unless there was an exemption under s­ection 5 of the Securities Act 1933. See further also s­ection 1.5.6 below for the modern electronic platforms and their effect on regulation. There were two further facilitating developments at the same time: first the repeal of Rule 390, which deprived the formal exchanges of their monopoly in trading securities listed on them, while the 2007 Regulation National Market System (NMS) established the principle of best price, thus informally connecting all trading facilities, at least for retail investors. As for foreign issues, the issuers use Forms F-1, F-2 or F-3 for capital raising in the US and F-4 for business combinations. A first-time filer would use the well-known form F-1 (the form F-20 is used for ongoing disclosure in respect of listed foreign issues,). Yet it had long been accepted that (other than to prevent or prosecute fraud)

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this approach did not apply to foreign offerings with only incidental contact with the US. This conclusion was based on the 1964 Securities Act Release 4708 concerning distribution to foreign nationals resulting in securities coming to rest abroad. On the basis of this Release, practitioners (helped by interpretive letters from the SEC) developed a number of practices resulting in underwriters: (a) not being considered to place directly in the US; or (b) observing a so-called lock-up period from 90 days to one year, during which no secondary sales could be made into the US or to US persons. To this end, sales restriction statements were inserted into the offering documents and underwriters certified that they had complied with the requirement not to sell in the US or to US persons. A global note was often used by the issuer to enforce the restrictions on distribution during the lock-up period. There resulted a (narrow) private placement exception as these placements were not then considered sales to the public. In 1988, the SEC moved further on three fronts. In Regulation S, it abandoned (in principle) any claim to extraterritoriality of its rules over transactions which properly occurred outside the US even in US securities or with US persons (except in the case of fraud). This immediately raised the question what was ‘outside the USA’. No rule was introduced and the SEC determines this on an ad hoc basis, but to clarify the situation Regulation S in Rules 903 and 904 provided two non-exclusive safe harbours, one for issuers and one for resales. For either, the offer or sale must be made in an ‘offshore transaction’ and no direct placement or selling efforts may be made in the US. For the issuer, there are further requirements depending on the category of issue, which categorisation is based on the likelihood of the securities flowing back to the US. A non-reporting issuer of an issue for which no US marketing effort is being made attracts the least restrictions. If the issuer reports to the SEC and there is a substantial US market interest (SUSMI), there will be a lock-up period of 90 days (one year for shares) as from the end of the issuing period (lowered for eurobonds to 40 days). For non-reporting issuers of an issue for which there is SUSMI, the requirements are the most severe because of lack of information. These requirements impose on issuers a verification duty and certification requirement that none of the securities issued were purchased by US persons before individual certificates were issued. The idea behind the lock-up period (which in respect of bearer securities requires a global note for the period) is that in the absence of sufficient information the market will have time to discount all eventualities. The second SEC move was to broaden the private placement option to resales under the new Rule 144A. It introduced a further safe harbour for three types of resales of non-fungible securities, respectively of (a) any privately placed, (b) not listed, or (c) ­privately placed but listed securities. The first type could be resold to qualifying institutional buyers (QIBs), which were entities with assets of more than US$100 ­million, even if residing in the US; the latter two types could be sold to all US or non-US institutions provided that privately placed but listed securities did not filter back into the US. The aim was not only to attract foreign issuers to the US, but also to facilitate private placements to large US investors and increased liquidity for these investments.

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The third change was a new Rule 15a-6 under the Securities Exchange Act 1934. It elaborated on transactions (giving research and making deals) with US investors from abroad and set out the conditions under which non-US brokers could avoid SEC registration. Here two safe harbours were created for them to deal with US institutions from abroad, but if they had an active business in the US always through or together with a US-registered broker or with their foreign subsidiary or an international agency based in the US (generally US institutions may always be approached by foreign brokers if the execution is handled through US-registered brokers). Offshore activities, even if involving purchases for US citizens abroad or concerning US securities, would no longer require foreign broker registration. Foreign firms providing research reports to major US firms (US$100 million minimum assets) may also execute transactions based on such research, if unsolicited. US brokers as well as international agencies in the US may always be directly solicited by foreign unregistered firms. An example may be helpful. If the intention is to sell eurobonds in the US, the first question to ask is whether they are meant to be sold in unfungible form to QIBs in the US or not. In the first case there would be no problem. If this safe harbour does not obtain (eg, because the bonds are fungible), the next question is whether there is the more general private placement exception under ­section 4(2) of the 1933 Act. For foreign public issues, there is otherwise still the question whether there is, in respect of issues not directly placed or sold in the US, a SUSMI in which case there will be a 40-day lock-up, provided there is a global note during that period. If the intention is, however, also to target the issue at the US, an F-1 registration will become necessary. It should be noted in this connection that the tax aspects are treated quite separately. There are the so-called TEFRA (Tax Equity and Fiscal Responsibility Act) rules for bearer securities. They impose a tax penalty. Eurobonds are exempted (if subject to a global note held by a clearing system so that there is no bearer security proper) provided interest is paid outside the US, there is a legend on the bonds warning of US tax implications for US persons (broadly those subject to US taxation), and there must be reasonable assurances that bonds are not sold to other than US qualifying persons (such as financial institutions).

1.2.5  The Basel Concordat Concerning International Commercial Banking Regulation. Efforts to Achieve a Framework for International Financial Conglomerate Supervision. The Joint Forum Because it may serve as an important model in international financial transactions, EU liberalisation and re-regulation efforts in the financial services area will be further discussed in part III below, which will subsequently proceed to the details of the regulation as it evolved at EU level. The movement from host- to home-country rule already mentioned in ­section 1.2.1 above will be traced in that context while the remaining (varying) scope for host-government intervention under the EU Directives and the concept of the general good will be further explored. This presents a cluster of

PART I  Financial Services, Service Providers, Risk and Regulation 591

problems which will eventually have to be faced also within WTO/GATS. It therefore deserves more attention. This discussion within the WTO is delayed at least until the next negotiation round (Doha) originally foreseen in 2000 but not so far concluded —see also ­section 2.2.3 below. Double regulation remains here for the time being an important barrier to the free flow of these services, as it did within the EU and as it may again for the UK after Brexit, see also s­ ection 3.7.17 for the notion of equivalence in the EU. However, electronic communication may increasingly cut through this and force the pace further in the direction of home-country rule, often already accepted if the service provider is not the initiator of the transaction but is accessed by clients directly from abroad, as we have seen. This may become the pattern, especially in respect of major investors from less developed countries who may prefer brokers in the main international financial centres even in respect of securities investments made in companies and in government bonds of their own country.111 Until such time and except for this direct access, it should be clear, however, that cross-border services outside the EU area, for example between the US and the EU countries or between them and Japan, remain in essence covered by host-country regulation in all their aspects. It was already pointed out before that this leads to double regulation, originally also in the EU before its home/host country arrangements, see s­ection 1.2.1 above. Eventually, moves started in 2013 to reach a Transatlantic Trade and Investment Partnership (TTIP) between the US and the EU. It may provide the background for revisiting this aspect of financial regulation but is so far from finished and has been stalled since 2016, see Volume 1, c­ hapter 2, ­section 3.5. Under the so-called Basel Concordat reached within the Bank of International Settlement (BIS) in 1983 (earlier efforts went back to 1975 following the Herstatt bankruptcy in Germany), certain rules were developed, however, as a matter of guidance for the consolidated supervision of commercial banks (only), to the extent they were involved in cross-border banking activities through foreign establishments.112 Although the text also covers subsidiaries, the main issue was foreign branches and their operation and supervision. Subsidiaries and their supervision are ultimately always the responsibility of host countries and that was acknowledged (although under the Concordat parent banks were still to assess whether the solvency of subsidiaries was affecting the group as a whole). The branch network supervision, on the other hand, was in essence based

111 

See for the definition of cross-border services in GATS and under EU case law, ss 2.2.3 and 2.3.3 below. The first Concordat dates from 1975: see Basel Committee, Report to the Governors on the Supervision of Banks’ Foreign Establishments (September 1975). See for the revised 1983 Concordat (following an earlier paper of 1978), Basel Committee, Principles for the Supervision of Banks’ Foreign Establishments (May 1983). There was a mostly technical 1990 Supplement: see Basel Committee, Report on International Developments in Banking Supervision (September 1990) ch VI. There followed a restatement of minimum standards in 1992 following the BCCI collapse: see Basel Committee, Report on International Developments in Banking Supervision (1992) ch VI. In 1996, there was a report with 29 recommendations to improve the supervision of cross-border banking more generally: see Basel Committee, Report on International Developments in Banking Supervision (September 1996) ch VI. This was followed in 1997 by 25 Core Principles of banking supervision at national levels prepared with 15 emerging market countries: see Basel Committee, Core Principles for Effective Bank Supervision (September 1997). It was accompanied by a Compendium that restated all the main Basel policy recommendations since it began issuing them in 1975: see Basel Committee, Compendium of Documents Produced by the Basel Committee on Banking Supervision (April 1997). 112 

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in the home-country for the operations of the bank worldwide, especially in terms of capital adequacy. For liquidity a greater role for the host authority was assumed, but for foreign exchange for the home regulator. Following the BCCI case, the Concordat was amended in 1992; earlier there had been an amendment after the collapse of Banco Ambrosiano in 1982, especially to cover non-banking and offshore parents or Head Offices when their major banking business was elsewhere. Although in principle maintaining home-country rule if there was adequate home-country regulation and supervision of the banking network, foreign branching in particular became subject to the prior approval of both home and host regulator (a model not maintained within the EU under the Second Banking Directive for banks). Under the Concordat as amended, it was suggested that the home regulator shared information on the foreign operations of the bank in question. Host regulators could impose restrictive measures on such operations if basic standards were not maintained by the home regulator or enforced by it in branches of their supervised banks in foreign countries. However, the move was henceforth more away from coordinating national regimes to finding common regulatory frameworks, hence the Basel Accords for capital common capital adequacy standards. Although the Basel Concordat is not a binding document, it is, like all Basel Committee policy statements, highly authoritative and generally implemented by banking regulators worldwide.113 The issue of international conglomerate supervision114 (as distinguished from consolidated supervision of all commercial banking activity which was the remit of the Concordat) received separate attention from the Basel Committee in 1992, when IOSCO also produced a paper with principles. It is especially important for internationally active universal banks. At that level, there are special conglomerate dangers because of regulatory gaps and inconsistencies which may lead to regulatory arbitrage. There arise even more questions than domestically (see the discussion in ­section 1.1.16 above) concerning the most appropriate regulatory contact point, information exchange, co-operation in and responsibility for crisis management. It is again a matter of proper division of home and host regulation and supervision. The related issues are far away from a satisfactory solution and have been the subject of many studies and will undoubtedly continue to be so. In essence, it is a search for minimum international standards in terms of international public policy. An ad hoc Tripartite Group representing the three financial service industries represented by the BIS, IOSCO and IAIS (International Association of Insurance Supervisors) (see s­ ections 1.2.5 and 2.5.1 below

113  The EU incorporated the original and the amendments to the Concordat in the First Consolidated Banking Supervision Directive of 1983 superseded by the Second Directive of 1992 with further amendments in 1995. They are now part of the Credit Institution Directives of 2000 and 2006—see also s 3.6.6 below. In the US, legislation preceded the revision of the Concordat in the FBSEA 1991, which made the establishment of all foreign bank branches, agencies and representative offices in the US subject to federal approval and insists that the host-country regulators must be confident that the home-country regulator is capable of adequate consolidated supervision before they can defer to its supervision. 114  GA Walker, Conglomerate Law and International Financial Market Control in International Banking Regulation: Law, Policy and Practice (The Hague, 2000) 165.

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for these organisations) reported in 1995. In 1999 there was a further report of the ad hoc Joint Forum, more formally set up in 1996, considering a regulatory framework for supervising international financial conglomerates. Major issues were identified, such as: (a) a common measurement technique for regulatory capital; (b) a common fit and proper test for managers; (c) a common exchange of information regime; and (d) the concept of the lead regulator. This issue of lead regulator, information co-ordinator or lead co-ordinator and its role present the most problems. Is it a mere co-ordinator or would it also be the proper authority to determine the acceptable level of risk on the basis of its own assessment and (pre-)crisis management? This could also affect the position of any lenders of last resort. In these aspects the BIS, IOSCO, Tripartite Group, and Joint Forum have so far failed to give decisive guidance.115 The Bank of England is traditionally in favour of an international lead regulator or some similar authority to supervise the activities of (conglomerate) international financial institutions. It is an ambitious position. The US (and within it more particularly the Fed) is traditionally resisting while other countries have also expressed concern as to the effect on national regulatory regimes. Pending agreement on these essential points, the international effort so far is largely relegated to the collection and dissemination of information. There is an EU Directive in the area of prudential supervision of financial conglomerates operating within the EU, which aims at appropriate capital measures (avoiding any multiple gearing), overall solvency rules, risk exposure rules, intra-group transaction rules and rules concerning the professionalism of management. It followed the Joint Forum Recommendations and will be discussed in ­section 3.6.5 below.

1.2.6  The Modern International Financial Architecture. The Advent of Macro-prudential Supervision, the Financial Stability Board (FSB) and its Significance In the foregoing, organisations such as the Bank of International Settlement (BIS), which is the bank of the central banks located in Basel, and IOSCO, located in Montreal, were mentioned. The BIS was meant to be dismantled under the Bretton Woods Agreements of 1944 but managed to continue. It is, through its Banking Supervision Committee (the Basel Committee), also a think-tank for banking regulation, now especially for the G-20, a role IOSCO fulfils for securities regulation. Neither has regulatory powers of its own. In the field of insurance, a similar organisation has been formed

115  See for the 1992 BIS Paper, Basel Committee, ‘Principles for the Supervision of Financial Conglomerates, in Report on International Developments in Banking Supervision (September 1992) ch VI. See for the 1993 IOSCO paper, Principles for the Supervision of Financial Conglomerates (December 1992). In July 1995 the Basel Committee published a report by the Tripartite Group of Bank, Securities, and Insurance Regulators: Report on the Supervision of Financial Conglomerates (July 1995). See for the Joint Forum in particular its Progress Report of 9 April 1997 and more recently for its 2004 and 2005 reports, www.bis.org/press/p051220.htm and www.bis.org/ press/p040524.htm.

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(the IAIS, also in Basel). In 1997, the BIS issued Core Principles for Effective Banking Supervision, amended in 2006 and 2012 which became an important worldwide standard. IOSCO and the IAIS also developed core principles for their business—see also ­section 2.5.1 below. The Committee on Banking Supervision remains the most important as, through the BIS, it has the world’s most important central banks behind it.116 It was earlier also referred to as the Group of 10 or G-10, but was extended in 2009 and now has 27 ­member countries, including both China and Hong Kong), represented by 45 regulators. It was responsible for the Basel Concordat mentioned in the previous ­section and the Basel Accords on capital adequacy, see ­section 2.5 below. IOSCO and the IAIS are looser organisations and have not acquired the same standing nor would they seem as effective, although IOSCO has gained in stature since the 2008 financial crisis. As we have already seen, all mainly operate through studies although the BIS in its Basel Accords (Basel I, followed by Basel II and now also Basel III, see s­ ection 2.5 below) concerning capital adequacy and in its earlier Concordat concerning international banking regulation (see the previous section) clearly meant to set industry standards which have indeed been largely implemented in the major industrialised countries. There is also the Group of 7 (Industrialised Nations) or G-7, the Group of 20 or G-20 set up by the G-7 in 1999 between systematically important countries and the Group of 22 (or Williard Group), also set up by the G-7 (in 1998) to study more in particular the stability of the international financial system. There is further the Group of 30 or G-30, which is an informal industry group that has produced some important studies in the field of systemic risk and global financial regulation. The IMF, the International Bank for Reconstruction and Development (IBRD) or World Bank, and OECD are also involved, the IMF particularly in connection with financial crisis management (for instance, during the last decades in Mexico, R ­ ussia, Asia and Argentina and since 2010 together with the EU and ECB also in Ireland, Greece, Portugal and Cyprus), and the OECD on regulatory reform (1997). In the IMF, a relevant development in this connection was the transformation of the Interim Committee, which was an informal ministerial body, also in charge of the co-operation with the World Bank, into the International Monetary and Financial Committee (IMFC), which considers international stability especially from the monetary and financial perspective. The IMF and World Bank also co-operate to supervise the BIS Core Principles in organising regular Core Principles Assessments (CPAs). The IMF has further a Financial Sector Adjustment Program, which assesses a broader set of standards also including those of IOSCO and the IAIS. A Financial Stability Forum (FSF) was set up by the G-7 in 1999 bringing together national authorities, sector-specific international groupings, and committees of central bank experts. It had a secretariat at the BIS and was intended as a think-tank to get a better grip on worldwide financial regulation in a broader sense, considering also the 116  Officially the Basel Committee was set up by the IMF in the early 1960s, in the context of the General Agreement on Borrowing (GAB), which created a special fund for situations in which the IMF’s own resources proved insufficient. It did much of the work that led to the IMF’s special drawing rights (SDRs) under the 1969 First Amendment to its Articles.

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capital flows, especially in terms of co-operation and co-ordination. It may indeed be argued that, in terms of financial stability, financial and capital flow regulation come together. Initially three working groups were set up to cover highly leveraged institutions, capital flows, and offshore financial centres. The FSF issued a Report of the Follow-up Group on Incentives to Foster Implementation Standards in 2000, but it was never altogether clear what its true role and focus were supposed to be. It became obvious, however, that all these institutions, organisations, committees and groups, together in one form or another concerned with the international financial architecture, did not present more than a patchwork that operated ­without much co-ordination. As of 2008, the G-20, in which the IMF and World Bank also participate, appears to be in the ascendancy. It notably includes the larger, newer countries like China, India, Russia and Brazil. Indeed, in the financial crisis of 2008–09, the G-20 was called together at heads-of-government level, at first especially to deal with financial stability and regulatory matters. In April 2009, it created a Financial Stability Board (FSB). The FSB was given a broadened mandate that covered all systematically important institutions including hedge funds and more broadly the ‘shadow banking system’. A Secretary General post was created with a secretariat continuing to operate from Basel. This creation was more important than it may have seemed at first and was followed by many countries including the EU domestically: see s­ ection 1.1.14 above. It moved macro-prudential supervision to the centre even if for the moment still poorly defined. No more than advice is given, especially to central banks, but it goes as such beyond the legal structure and framework of micro-prudential supervision. It may become an important policy vehicle, with a potentially similar status—it was suggested in ­section 1.1.9 in fine—to fiscal and monetary policy. Beyond this, the G-20 in this first meeting attempted to tackle the issue of tax havens, hardly at the heart of the crisis and merely a politically motivated gesture. Clearly the crisis was used first to deal with a number of long-outstanding but extraneous issues.117 Another task the G-20 set itself in 2009 was to revamp the principles of microprudential financial regulation worldwide, but, as already noted before, there emerged no clear insights into the causes and especially the timing or resolution of the crisis. While, ideally, banks should carry more capital against their risks, meaningful levels of capital could diminish economic activity to such a degree that it could become politically unacceptable. In the absence of any clear views, these matters were increasingly left to the Basel Committee, which thus regained its ascendancy and some of its status, which had earlier been undermined by the instant failure of Basel II. The G-20 was soon more concerned with macroeconomic measures to ease the economic crisis. It reconvened in September 2009 focusing on worldwide imbalances (but was even here constrained through China’s lack of interest) and growth, while taking over much of the role of economic policymaking from the G-7. In terms of revamping financial

117  See for the roots of this fledgling system or of the new international financial architecture (NIFA), JJ Norton, ‘NIFA-II or Bretton Woods-II: The G-20 (Leaders) Summit on Managing Global Financial Markets and the World Economy—Quo Vadis’ (2010) 11 Journal of Banking Regulation 261.

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regulation, it only managed to concentrate on bankers’ bonuses, a politically hot topic, which was, however, hardly the cause of the crisis either, more a symptom. Internationally, there are other more specialist bodies of longer standing such as the Committee for Payment and Settlement Systems (CPSS), which delivered important papers on payment systems (1999), and earlier on settlement risk (1996) and real-time gross settlement (1977). They were joined by IOSCO in the 2001 core principles for systematically important payment systems, the 2001–02 recommendations for securities settlement systems, and the 2004 recommendations for central counterparties. It was announced in 2010 that all three were being reviewed. There is also the Committee on the Global Financial System (CGFS), formerly the Eurocurrency Standing Committee, which acts in a more specialised capacity.

1.3  The 2008 Financial Crisis and its Effect on Financial Regulation 1.3.1  What Do We Mean by Financial Stability and Systemic Risk? As we have seen, financial stability has become a key issue and objective in modern financial regulation aiming to do things better in terms of risk management than individual banks can do even when properly managed and not tempted by short term benefits. Banks may overextend themselves whilst taking too much credit or market risk (including its market-making and proprietary trading operations) and ­neglecting liquidity risk. They may not invest enough in people and systems either (operational risk). It affects financial stability, but it remains hard to define as an objective, and difficult to say when the situation becomes dangerous, see also the discussion in ­section 1.1.2 above, and it may be achievable only at too low a level of economic activity. It is usually associated with systemic risk but it was found that when limited to the notion of interconnectedness, the notion of stability may become too narrow. Indeed, it was considered that financial instability may have many other causes like liquidity, societal leverage, the pro-cyclicity of banking, the economic cycle, bubbles especially in real estate where most banking crises originate, innovation and complacency. In fact, interconnectedness is unlikely to be the cause of financial instability but may reinforce it. Instability may also be sustained by the nature of regulation itself and by the public feeling of entitlement to credit or its expectation of liquidity upon demand. In the above, micro-prudential supervision as it has developed as a system of rules largely focusing on credit, market, and operational risk and to a more limited extend on liquidity risk was considered inadequate and insufficient. Macro-prudential supervision may be better able to respond, partly because many of the causes of financial instability are not micro-economic in nature, see the discussion in ­section 1.1.14 above. Rather, it should be assessed at each moment in the economic cycle how large the banking industry is to be. In the process, macro financial regulators should in particular seek to redress the extreme pro-cyclical nature of banking, see section 1.1.13 above. This was considered pure policy operating besides and at the level of fiscal and monetary policy. It throws the ball for financial supervision squarely back to public authority,

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including the consequences of regulatory failure. In fact, financial instability was largely seen as a consequence of government economic and social policy in which high leverage is favoured which can hardly make for a stable banking system. Also the question at which level of economic activity it is pitched, is a policy matter. It was also suggested that a resolution regime promoting bail-in through a contribution of depositors and senior bondholders was misconceived. Whatever the causes may be, the instability of the financial system is not due to them. In truth the system cannot be saved in that manner and always needs firm public support in times of crisis. That may be all the more true in a highly leveraged society, see further ­section 1.3.11 below. As noted, stability boards have been created in the meantime in many countries, even at the level of the EU and in the IMF, but so far all are advisory and have no original powers. In the US under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOC became supported by the Office of Financial Research (OFR) to improve the quality of financial data better to support financial policy makers and to more reliably spot the risks. Yet the scope, coverage and powers of these Boards remain less than clear under the rules they were created and operate. Probably more importantly, nothing of this has given rise so far to a more fundamental shift in the nature of financial regulation, which remains, basically of the micro-prudential rule-based type, see again ­1.1.13/14 above. It means that macro-prudential supervision remains in its infancy, at least in part because it returns the responsibility for financial stability firmly to public agencies which G-20 at the moment clearly does not want. Again, financial stability may be even more difficult to achieve in a highly leveraged society which is naturally more sensitive to shocks, notably the sudden drying up of liquidity or tightening of interest rates. It may be possible in this connection to distinguish three periods since World War II. The first was one of extraordinary growth which ended with the oil crises in the 1970s. There was a great improvement in working conditions, real wages multiplied dramatically for all, there was a strongly redistributive taxation system, and a social safety net was created that seemed affordable, although this progress was limited in its geographical reach and remained a typical Western phenomenon. Banking was dull in this period and was not given to a great deal of innovation. The capital markets flourished, however, especially the eurobond market came into being, but beyond that the financial scene remained subdued. Even the largest banks were relatively small, so were investment banks and until 1985 those involved in London in the eurobond market were tiny, Goldman Sachs eg not having more than 200 employees. The second wave was the period from 1980 ending in the financial crisis of 2008. There was a more liberal market oriented approach, first used to get the economy out of the oil shocks of the 1970s and attendant high unemployment, but it persisted. Leverage became an important feature, banking was reinvented to accommodate. Capital adequacy standards were reduced (in Basel I), the idea being that we knew more about risk management, had better hedging tools, and a reliable methodology to determine capital need.118 Although there was more regulation, supervision was lax, 118  Cf also TD Willet, ‘The Role of Defective Mental Models in Generating the Global Financial Crisis’ (2012) 4 Journal of Financial Economic Policy 41.

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confirming the Minsky view.119 It also bore out his view that innovation contributes to financial instability: an excess of financial engineering resulted which built on ever more leverage. Derivatives, securitisations, credit default swaps, central counterparties, the development of security entitlements in custodial holding systems, were other important innovations, suggesting comfort and greater efficiency, but often not fully tested. Internationalisation became normal for the bigger banks. Bank size multiplied and banking became unrecognisable and far from dull. The third period is the one after the 2008 crisis, which is characterised by the absence of a clear view of its causes, any clear guidance, and by regulatory and monetary experimentation, but also by a policy of confining banks, trying to make them smaller and again more national. Special rules were intended for the ‘too big to fail’ banks, which concept, however, remained unclear, see for this issue ­section 1.1.15 above. The emphasis was on more capital, not even on liquidity requirements although some rules were introduced in Basel III on an experimental basis as we shall see in ­section 2.5.12 below. More generally, all capital requirements were somewhat tightened, the overall result still being that banks were required to rebuild capital and create safety nets at the worst moment in the economic cycle and were then apt to falter in their liquidity-providing function especially to start-ups and small and medium enterprises (SMEs) when it mattered most. This regulation was and remained itself in essence pro-cyclical. Especially in Europe, this may have contributed to a more prolonged banking crisis and to a period of insufficient growth. The liquidity-providing function had to be assumed by Central Banks which created bubbles in real estate and stock exchanges rather than contributing to enterprise and growth of that nature. All the while, financial regulation was overhauled, although in essence it retained the established pattern of micro-financial supervision which was never truly made for an overleveraged society with banking and banking risks on this scale.120 Most importantly, because of its pro-cyclical nature, it stoked itself instability in these enlarged markets.121 Indeed, an argument had been made even before the crisis that this type of micro-prudential regulatory competition in a globalising environment and the attendant regulatory convergence at that level, may increase macro-economic volatility and in that way financial instability at the domestic level.122 To repeat, one other issue is that the regulatory aim of financial stability may be meaningless as long as it is not clear at what level of activity this is going to be reached or is desired, it was already mentioned in s­ ection 1.1.2 above. It will be argued below that we may not truly want it because it may come at too low a level of leverage

119  See also S Marjit, ‘Monitoring Success. On a Fundamental Principle of Financial Regulation’ (2003) 38 Economic and Political Weekly 1871; J Couppey-Soubeyran, ‘Financial Regulation in the Crisis’ (2010) 123 ­International Economics 13. 120  See CK Whitehead, ‘Reframing Financial Regulation’ (2010) 29 Journal of Financial Transformation 567, warning that new regulation is likely to suffer from the same deficiencies as the existing framework. It is submitted that this proved particularly so in not moving away from a pro-cyclical framework. 121  JH Dalhuisen, ‘Micro- and Macro-Prudential Supervision. Is the Present Model of Financial Regulation Destructive?’ Public Lecture NUS, Sept 2016, see ssrn.com under Jan Dalhuisen. 122  See P Arestis and S Basu, ‘Financial Globalisation and Regulation’ (2004) 18 Research in International Business and Finance 129.

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and economic activity. The notion of financial stability was therefore never a good yardstick or an aim that can be objectively achieved or results automatically from a given micro-prudential approach. Other contributing factors have been pointed out also, notably financial innovation and even prolonged financial stability itself, especially by M ­ insky,123 which may suggest less risk than there is, or when extrapolation is used—like eg in a value at risk (VaR) approach to assess market risk—may suggest an ever smaller market risk in good times.

1.3.2  Financial Crises and Immediate Causes of Regulatory Failure The discussion in this c­ hapter has considered so far: (a) what the banking industry itself can do about the various types of risks it runs, either internally through better liquidity management and management of credit, market and operational risk or with the help of rating agencies better evaluating and managing at least credit risk; (b) what the regulators can do and are likely to focus on and how regulation is structured; (c) what may reasonably be expected from financial regulation in terms of stability and protection not only of the public at large in the liquidity-providing function of banks (considering in this connection especially liquidity risk and its management), but also of depositors and investors in terms of conduct of business, and (d) how market integrity can be promoted. Financial regulation, which implies a form of governmental supervision, is abundant as we have seen and it is not true that there was systematic deregulation from the 1980s in the US or elsewhere as is often argued (see also the discussion in s­ ection 1.1.9 above).124 It largely came down to the repeal of the Glass-Steagall Act in the US, which had separated (to a large extent) commercial and investment banking. Rather, there was an abundance of new rules everywhere, certainly also in Europe, translating into ever larger compliance departments in financial institutions, but there was lax enforcement supported by ever lower capital requirements in Basel I and Basel II and (often) artificially low interest rates, which further promoted and sustained high leverage for all. As we have seen, financial regulation is now largely meant to promote stability (often at the expense of protection of customers and market integrity),125 meaning the prevention of financial crises, but over and again it is proven that at least micro-financial regulation and prudential supervision as we know and have developed it, is not effective in preventing serious problems,126 one reason being, it was submitted, that it is seriously 123  See also P Mirowski, ‘Inherent Vice: Minsky, Markomata, and the Tendency for Markets to U ­ ndermine Themselves’ (2010) 6 Journal of Institutional Economics 415. Rapid and forced deleveraging may follow, see CJ Whalen, ‘Integrating Schumpeter and Keynes: Hyman Minsky’s Theory of Capitalist Development (2001) 35 Journal of Economic Issues 805. 124  In the run-up to the financial crisis in 2008, the US government spent more than US$1 billion on financial regulation while regulatory authorities employed more than 12,000 people in Washington DC alone, see also DR Henderson, ‘Are We Ailing from Too Much Regulation’ in Cato Policy Reports (2008). 125  The 2011 IOSCO Systematic Risk Report indeed suggested that conduct of business and market integrity issues after the crisis increasingly become subservient to the stability issue. 126  See also CW Calomaris, ‘Financial Innovation, Regulation and Reform’ (2009) 29(1) Cato Journal 65. Here the emphasis is on the distorting effect of financial regulation, including safety nets, manipulation of credit

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pro-cyclical. It was said before that we live in a society that for its prosperity must take ever greater risks. In a highly leveraged society, banking is in the forefront and risk management and its sophistication then becomes a central theme. Regulation, if it has any meaning, must help to improve it but it often operates in the dark and then centres on simply reducing risk for its own sake or to forms of box ticking. This creates adverse side-effects, which, through overreaction or otherwise may starve society of the liquidity it needs to properly function and prosper in downturns when liquidity is needed most, again the pro-cyclical nature of banking and its regulation as we now know it. One other reason why, on present insights, financial regulation fails is that modern systems for information gathering and the mathematical models used might not be able fully to capture the net or aggregate risk and allow for proper stress testing, even though major banks spend enormous sums on systems. Much regulation relies and insists on proper disclosure, clearer perhaps in the securities business to promote more efficient and liquid markets, but it may not be adequate or sufficient.127 In any event, the past (and its simplification in models to the extent available) often proves an incomplete and unreliable guide, especially in a fast-moving world with ever newer products that may or may not be fully understood (which understanding often depends on a degree of hindsight in newer complexities and tests in crises) and may further rely on modern risk-management tools that may turn out not to be fully proven either. Thus, by 2008, the methodology behind Basel I and even Basel II proved defective or at least inadequate. Another issue in this connection may be that the technique of hedging in its modern variants is insufficiently understood, re-emphasising that risk management proper may be imperfect or misused. JP Morgan in 2012 showed large losses in this activity (although probably not much more than two per cent of the value of the underlying assets).128 Contributing factors may be the existence of large pools of funds outside the banking system, the shadow banks (see ­section 1.1.16 above), but nobody can say for sure.129 A more immediate reason for regulatory failure may

markets, leverage subsidies, and limitations on the market for corporate control. See further also M Prates, ‘Why Prudential Regulation Will Fail to Prevent Financial Crises: A Legal Approach’, Banco do Brasil ISSN 1518, suggesting that financial intermediaries live by the instability of the financial markets and its imperfections. Cf further also B Jackson, ‘Danger Lurking in the Shadows. Why Regulators Lack the Authority to Effectively Fight Contagion in the Shadow Banking System’ (2013) 127 Harvard Law Review 729. 127  See also the ESMA Chairman at the time, S Maijoor, Keynote Address International Capital Market Association Conference, 26 May 2011. 128  In real life, it may often take a crisis to test these structures properly, including their legal operation and viability. The traditional applicability in this regard of often atavistic domestic legal systems is increasingly proving to be sand in the machine from an efficiency point of view. It may mean low quality and often also creates too much uncertainty as to which domestic rule applies, even if they were adequate, especially in proprietary aspects of asset-backed funding in assets that move cross-border or are intangible, in set-off and netting, and more generally in matters of public order and public policy or applicable regulation. In any event, applying different national regimes to the international flows by cutting them into bits and pieces is unlikely to add up to a proper legal framework, see also the discussion in ch 1, s 1.1.21 above. 129  J Auther in his well-known weekly Financial Times column, ‘The Long View’, on 17 Sept 2016, eight years into the crisis, also commented that we are still groping in the dark for the truth about the financial crisis. Others think it is well known, see N Moloney, EU Securities and Financial Markets Regulation (Oxford, 2014) 4, referring to massive literature but largely relying on the 2009 Turner Review, A regulatory response to the global banking crisis, which was composed too soon, proved increasingly controversial, and was then forgotten. Sarin and Summers, n 66, show a sceptical view of present financial regulation, do not, however, propose any other model, but counsel

PART I  Financial Services, Service Providers, Risk and Regulation 601

also have been that there was insufficient insight not only into modern financial risk configurations,130 but also into the market psychology that causes a sudden loss of confidence.131 This is more properly the question of the timing of financial crises. Why do they occur when they occur while at other times the day of reckoning seems long postponed and rationality suspended? The idea that even on a daily or short term basis markets are always right or at least rational is clearly challengeable.132

1.3.3  The Lack of Academic Models It would appear that in the situations as we confront it today in (international) finance, academic models to guide us are largely non-existent or unreliable. Neo-classical economic theory, which relies on a sum of individual preferences, repetition, and predictability in that sense is often considered to fail us, but as we shall see there is no true other theory in place, be it Marxist, Keynesian or any other. Keynesian theory in

against complacency. Others accept the reality of boom and bust cycles as Minsky did, see JR Barth, G Caprio and R Levine, Guardians of Finance—Making Regulators Work for Us (MIT Press, 2012) and XL Freixas and JL ­Luc-Peydro, Systemic Risk, Crises, and Macro Prudential Regulation (MIT Press, 2015). 130  See also I Moosa, ‘The Myth of Too Big to Fail’ (2010) 11 Journal of Banking Regulation, 319, noting that the financial system mostly presents an equilibrium, but may morph into an unstable cobweb of risks and exposures which are poorly understood and may lead to precipitous firesales of assets, adding to the confusion and instability. Crises in isolated markets may then also spread whilst refinancing trouble in the case of short time funding or meeting margin calls are likely to further contribute to the crisis. Thus, trouble in bad assets may end up with trouble in the good ones. 131  See for a sceptical view of banking regulation generally, J Barth, G Caprio and R Levine, Rethinking Bank Regulation: Till Angels Govern (Cambridge, 2006). They signal the problem of governments failing to control themselves while regulating and, whatever their lofty objectives are, this attitude is likely to result in consequences which overall may be worse than incidental market failures. They questioned in particular the effectiveness of a system of capital adequacy standards (Basel II) in terms of preventing banking crises and highlighted further the dangers of deposit insurance in terms of moral hazard; they found that private-sector monitoring (through eg rating agencies) is likely to be more effective than regulatory monitoring; and concluded that strong regulatory powers in regulators are likely to be abused by them for ulterior ends, especially in countries with weak legal systems. See in the same vein earlier also JH Dalhuisen, ‘Towards a Single European Capital Market and a Workable System of Regulation’ in M Andenas and Y Avgerinos (eds), Financial Markets in Europe: Towards a Single Regulator? (The Hague, 2003), highlighting further the confusion in regulatory objectives and its debilitating effect on the quality and effectiveness of financial regulation; see further s 1.1.11 above. 132  It has long been seriously questioned whether financial markets (or indeed all asset markets) are rational— see notably HP Minsky, Stabilizing an Unstable Economy (New York, 1st edn 1986, 2nd edn 2008) who was interested in the effect of banking crises on the real economy and believed that illiquidity rather than (balance-sheet) insolvency was the true cause of banking crises and is promoted by financial innovation, which, while striving for greater stability, may well undermine it, eg through false notions of liquidity: see n 16 above. This was attributed to euphoria among lenders in good times who lend in this manner beyond what borrowers can repay in bad times. This is indeed only too common, see the discussion in s 1.1.12 above. In this view, the swing between credit expansion and credit crunch is considered a normal part of the business cycle, suggesting that regulation may not achieve a great deal. Asymmetrical information supply may be another or connected cause for markets not being rational but may present a more manageable regulatory concern, see also s 1.1.10 above. The BIS, in the so-called Basel Committee, see s 1.2.5 above, generally looks for macro-economic causes of instability, including accommodating monetary policies, reliance on (in)adequate technology, persistent rises in risk taking, and large financial leverage, but it proved no more able to spot or prevent major shocks or to advise how to get out of them.

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particular does not show great interest or confidence in monetary policy and related issues, probably borne out in the monetary experimentation after 2008, and concentrates on fiscal policy and stimulus. In any event, what may look like the truth today may no longer hold in 10 years’ time; there is no constancy, hardly any either in any social or economic theory that tries to explain better. We have no single model or probably no model at all that properly describes the modern banking function. Each theory may explain certain aspects at certain times but they never explained all and are often contradictory. In truth, what modern banking is and does and how it really operates remains or has become in many aspects an enigma. Only Minsky may have recognised it as a different force altogether which is becoming ever more dominant, also ruling over states, as financial flows undoubtedly do, whether we like it or not. If that is the case, the message is that we must learn better to live with the monster that we have created and on which we totally depend. It has already been said that it is part of the greater risk society must take to prosper: more risk is here more reward but also a greater downside in terms of stability, which should be controlled through ever better risk management, which can hardly be developed from above. Again, with present insights micro-prudential regulation may not add much and is often failing and may simply seek to reduce the risk level, but that is not the proper answer and a rough tactic that unavoidably affects future growth, which, although it should not be merely monetary, needs the stimulus of liquidity. In a modern society, no new idea can prosper and mature without it. Since the 1980s, we may well have entered a new paradigm in modern banking, see section 1.3.7 below, as yet insufficiently understood or accepted in terms of scale, sophistication, globalisation and credit culture, or simply leverage for all on an unprecedented scale, see also the discussion in s­ ection 1.3.4/5 below, much of which may not be captured in what we now know about liquidity and its management, credit and market risk, operational and legal risk, or in our present perception of rationality in finance. There seem to be other or newer forces at work of which we have so far only too faint an idea and which remain largely covered by the invisible hand of the market. What has become clear, however, is that finance is the great spider in a new web of societal activity and expectation. History may show that there were other causes that aligned at an unpropitious moment which regulation could not capture, leading to the 2008 financial crisis, such as the international capital imbalances and huge dollar overhang in China, which made credit for US consumers extra cheap and high gearing of society and of banks extra attractive.133 Low interest policies before the crisis and more rationally thereafter

133  Indeed the then US Treasury Secretary Mr Hank Paulsson believed that these imbalances were at the heart of the 2008–09 financial crisis. In particular, it allowed a low-interest environment to continue in the US, financed by excess Chinese dollar savings. It also suggested that there was a currency defect in the dollar/yuan exchange rate, although it can also be argued that the true cause was always American consumer demand. Along these lines, it was also suggested that the real cause of the trouble was chronic excess supply in countries like China, Japan and Germany. By 2008 alone, their combined trade surpluses amounted to $825 billion. Again, it is not a regulatory issue. The answer would more likely be higher exchange rates for their currencies and more consumer and government spending accompanied by less spending (and more savings) in deficit countries, especially the US (and a lower dollar). Rather, the hope in some surplus countries was that financing spending in

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meant continued accommodation. In fact, one flaw may have been all along in accommodating credit policies that had been more aggressively pursued since the 1980s in many advanced countries even in good times as part of the exigencies of the modern (welfare) state and the expectations of its population but that started to destabilise everything.134 Even before 2008, it created all kind of bubbles, including wage and benefits inflation on a considerable scale, if only to erode competitiveness in weaker countries.135 It contributed everywhere to over-extended banks.136 Governments, already over-indebted, had promised too much and induced or even leaned on the banks to provide easy credit for the rest of people’s expectations, especially in housing, cars and other consumer finance. That became then part of the social function of banks promoting economic activity at the same time but it constituted in many countries a significant change in credit culture and banking risk. In the meantime, banks were also asked increasingly to become funding partners in unprofitable or even unnecessary infrastructure and development projects, which are often attractive on their face as job creators and as benefits to insiders, but may be unmindful of the maintenance costs of what are often dubious ventures. Banks were finally also used as gatherers of money for national treasuries by buying their bonds with deposit money on an ever larger scale, even when these investments in governments became less safe. It will be argued in ­section 1.3.11 below that the lack of an international safety net and the sudden realisation that it did not sufficiently exist in respect of many international banks from smaller countries may have contributed significantly to the sudden collapse of confidence in 2008.

deficit countries instead (supported by massive government restructuring programmes in those countries) would maintain international demand. By 2018, it seemed more likely that tariffs were to be reimposed, at least by the US in what soon acquired the taste of trade wars. Others argued that there were multiple causes—see eg R Bootle, The Trouble with Markets (London, 2009) 8, noting the interplay between eight powerful factors which are in truth connected and by no means autonomous: a bubble in property, an explosion in credit, fragility in banks, weakness in risk assessment, error in monetary policy, super-savings in China, complacency and incompetency in regulators, and docility in outside assessors (rating agencies). A deeper cause was here spotted in deflation, indeed hard to explain in a world with extraordinary growth overall, and large fiscal shortages supported by serious money creation in the West. 134  In May 2010, The Basel Committee on Banking Supervision summarised what in its opinion had gone wrong: too much leverage, excessive credit growth, insufficient liquidity buffers, inadequate risk governance, no mitigation of the pro-cyclical effect of banking activity, too much systemic risk or interconnectedness. It asked the G-20 to delay recommending new measures until its own proposals of liquidity and capital had been finalised. To this end, the Committee already published in July 2009 its paper ‘Enhancement to the Basel II Framework’, amended in June 2010 for the capital charge in respect of non-correlation trading securitisation positions. 135  The pursuit of even lower interest rates created real estate and stock market bubbles, greatly beneficial to the rich who were not spending much more, but it was particularly detrimental to pension funds. It more generally delayed necessary restructuring measures and supported inefficiencies. A better effect might have been created by just handing cheques to the poor or indeed directing this new money towards infrastructure projects assuming they were more than just public works benefiting insiders. 136  The relation between strong financial markets and economic growth is often assumed and finds a great deal of support in scholarly writings, see for a review of these studies D Arner, Financial Stability, Economic Growth and the Role of Law, ch 1 (Cambridge, 2007). It sits uneasily with regulation as we know it and there is natural friction where in good times deregulation wins and in bad times, when banks are weakest, the demand for regulation increases, but not necessarily the insights into what is needed, cf also D Langevoort, ‘Global Securities Regulation after the Financial Crisis’ (2011) 13 JIEL 799.

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1.3.4  The Regulatory Picture in 2008. Shortage of Regulation? In ­section 1.3.1 above, it has already been noted that in all of this there was never a shortage of financial regulation—its basic structure has been discussed above in ­section 1.1.8 above. In retrospect, there was, on the one hand, inadequate or unimaginative and therefore inept liquidity supervision. On the other hand, capital requirements were objectively too low for the (credit and market) risks banks were forced or willing to take, while above all there was the important question of leverage itself. Banking supervisors have great powers to investigate and curtail the activities of banks,137 but the truth is that they seem mostly not to know what to look for or what to do with the information, or unable to judge what action to take while any attempt at restraint is not politically attractive in good times.138 Hence complacency. On the other hand, in bad times after a crisis, regulators might even start micro-managing banks for which they are ill-equipped: at least doing so should make them liable for the results.139 On balance, it may even be doubted whether regulating the incentive structure for managers (bonuses), which also became much of an issue and easy target, was properly perceived and here makes much difference.140 It was submitted that

137  Regulators may do so even per sector and it is perfectly feasible for them, eg, to set limits to gearing in mortgage lending or set standards, eg, in the loan-to-value ratios for borrowers and value mortgage-related assets on the basis of rental income. Some products could be forbidden altogether, at least for consumers, and car loans eg or credit cards curtailed. In the new issue markets, regulators have always been able to delay new issues, useful, eg, in overheated markets. They commonly also have tools to guard against risk concentrations of any sort in banks. In fact, they can do virtually whatever they want or find ways. The problem is not lack of power but lack of insight or lack of courage to call an end to the indulgence. Few politicians get elected on such a ticket. 138  It may in this connection also be argued that even though regulators have the power to demand the information, one problem is that this information is subsequently not sufficiently widely disseminated, either to investors or to academic researchers, for better analysis. Bank secrecy is often pleaded as a defence but it is hard to see why this lack of transparency should be tolerated in banks more than in other institutions, certainly as long as the basics of a level playing field are to be respected. A good argument can be made that (at least) how and to what extent these banks are closely connected in their businesses and may have become interdependent should be public knowledge. Since they also benefit from substantial advantages given to them by the public, it could be argued further that this should translate into greater transparency of their activities. There may be much greater need for this than for more micro-prudential regulation, which may become ever more unfocused and confused and may have considerable unintended consequences as we have seen. 139  Lack of effective banking supervision under existing rules might conceivably give rise to regulators’ liability: see M Andenas and D Fairgrieve, ‘Misfeasance in Public Office, Governmental Liability and European Influences’ (2002) 51 ICLQ 757ff. 140  Shareholders should be the first ones to be concerned, although in many countries, including the US, they have no direct influence on what is in essence considered a management issue, although this may now be changing, as it should. What are the criteria of success for bankers? In good times many are rewarded, probably excessively so at the senior level. As they say: ‘do not confuse a boom with brilliance’, but limiting rewards may make the best bankers move on or retire in bad times when they are most needed. Also, if bonuses are offensive, nothing limits a bank from doubling ordinary salaries or doing even more, as indeed happened in 2009. There is a connection here with the well-known principal–agent problem, therefore with the conflict between managers and owners but within organisations even between senior management and specialists leading to informational asymmetry, lack of understanding, and dependence on these experts higher up in the management chain. It translates into lower and younger management wanting immediate rewards. Whatever the cause and remedy, the fact remains that (a) many bonuses do not seem to be truly earned and that (b) the size of these ‘earnings’ is largely dependent on the size of the operation, therefore of the bank, and on cyclical developments which the ‘earners’ do not control either. On the other hand, if bonuses are directly related

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micro-managing banks through micro-prudential regulation as we now know it was probably always a dubious idea and, as became apparent, in any event largely futile in preventing crises. It was already said repeatedly that after a crisis, banking activity

to risk taking there is an obvious danger of instability, see also the 2009 Walker Report. There may therefore be a justified public interest in how these bonuses are structured and whether they are truly merited in a longer cycle, especially as these large payments may weaken banks and may therefore further contribute to instability, although it may also be considered simply a toss-up between the power of shareholders, management, and the tax authorities (who may gain because of higher taxes on bonuses) in terms of who gets what. In this game, shareholders alone do not appear to have sufficient strength (and claim more for themselves) but may also not sufficiently care about what is also (mostly) profitable for them. That may even apply to the tax authorities. An effective solution may be giving only equity, meaning a participation right to profits, and locking it in until retirement or at least for a considerable number of years. This would make bankers more careful not to lose it through bad management later, very much the older system of partnerships in investment banks, but access to an immediate cash portion is now rather the desire and was perhaps the true reason why partnerships were given up in the first place. A longer bonus horizon is unattractive for younger medium management and exacerbates the internal agency problem. These people often have the leverage. Here regulation may help but financial activity can easily move offshore and many youngsters are very mobile, not least also to better tax climates in respect of their bonuses in particular. Greater freedom in setting rewards and much lower taxation are part of the strength of Hong Kong, Singapore and Dubai as ever more important financial centres, which is not surprising. What holds their progress back is often an inadequate infrastructure with insufficient professional back-up, but this can be cured in the medium term. On the other hand, why customers, even corporates, pay such high fees for financial services which are often humdrum and repetitive is a mystery. It suggests a lack of competition due to regulatory and other difficulties in entering these markets. There is clearly no interest of insiders to broaden the field, nor indeed to over-man their own institution or franchise. Hence also the very long hours. Regulators fan this urge by (unintentionally) limiting entry. Another issue is the ‘morality’ of these bonuses and the fairness in society. In so far as resulting social divisiveness is claimed by people who have enough to live on, it is simply envy and there can hardly be a moral component to that, see also AS Blinder, AW Loh and RM Solow, Rethinking the Financial Crisis (Russell Sage Foundation, 2013) 127; it is also selective as film stars and premier league football players seem notably not to suffer from similar opprobrium. Whether more of this needs to be redistributed to those who cannot help themselves in bad times is another matter. Hence probably also the considerable increases in personal taxation after the 2008 crisis, at least in the UK, although probably as a temporary measure. In an ever larger economy, longer term, we may have to learn to live with greater differences in personal wealth. Even in a democracy, the rich have some rights to have their property and legal earnings protected against the majority. They are more likely to be the badly needed movers and shakers, however much resented, and they already pay a large proportion of all personal taxation. If not respected, they will simply leave and that would not appear to be immoral in the circumstances. The effect of their spending power should not be underestimated either. In fact in respect of the very rich rentiers, it could be argued that they are not there to be taxed—they can easily move—but that they are there to spend. In April 2009, G-20 issued its Principles for Sound Compensation Practices. In the UK, the FSA (of those days) implemented these principles in ­chapter 19 (‘The Remuneration Code’) of its Senior Management Arrangement, Systems and Controls (SYSC) Sourcebook. In July 2010, the European Parliament adopted a resolution limiting cash bonuses to 30 per cent of the total, while 40–60 per cent had to be deferred for at least three years and could be reduced if losses were subsequently incurred in the relevant activity during that period. 50 per cent would be paid in shares or in bonds that could be converted into shares. There would be a cap in terms of the proportion of the salary while exceptional pension rights were to be linked to the continuing strength of the bank. The authority for regulators to intervene is here assumed on the basis of the danger that tax money may ultimately be needed to refloat banks and also on the public licensing of the banking function but again it is doubtful whether lower bonuses would automatically mean more reserves and higher capital. Instead, there may be higher dividends, but restraint would mean that at least in bad times no high bonuses would be paid, although retaining the best in such dire situations should not be without considerable cost. Here again there is much posturing and window dressing by regulators after the fact. In any event, other ways will be found to reward the major players. If not they will do something else. In the EU, ultimately the new regime became part of an amendment to the capital adequacy regime, Directive 2010/76/ EC of the European Parliament and of the Council of 24 November 2010 (CRD 3) [2010] OJ L329/3 and was cast in terms of risk and risk management, financial stability and the need for a consistent approach EU-wide; see also s 3.7.3 below. Penalties could be imposed on offending institutions. CRD 4, see s 3.7.4 below, also introduced a bonus cap, very much objected to by the UK government, even before the ECJ (in a case ­withdrawn

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is commonly made to suffer with the unfortunate result that the liquidity-providing function of banks may become severely constrained when it matters most.141 Indeed, with present insights (and in the absence of a new academic model) doing something about this merely appears to amount to making banks smaller, which means reducing their liquidity-recycling function. But as banks provide the oil in the machine of modern economies through liquidity, the consequences in terms of economic contractions should be deeply feared or at least seriously considered in bad times. The idea that capital markets will take over may be true to some extent, but is probably fanciful especially to provide Small and Medium Sized Enterprises (SMEs) with funding: the cost would be high for issuers and there would be little liquidity for investors. Here Fintech and crowdfunding may prove more effective. It can only be repeated that if action is needed, it should mean restraining banks in good times when extra consideration needs to be given to the level of societal leverage, which, besides the pro-cyclical nature of banking, is perceived in this book as a key issue in terms of financial stability, but remains substantially ignored. It thus becomes a macro-prudential issue and is policy, not regulation proper any longer (which assumes a framework of rules); see the discussion in s­ ection 1.1.14 above. All the same, to the present negative attitude to all banking must be added the homeward trend in regulation and the potential demise of the international level playing field, which could amount to a form of de-globalisation and breaking up of the financial markets that may be tantamount to what happened to international trade in the 1930s after the gold standard was abandoned.142 This was ultimately found to have been disastrous. In the present situation it may reaffirm the need for the continuation of large banks with substantial freedom to operate worldwide as an economic necessity. It was already said that it is hardly conceivable that small national banks can meet the liquidity requirements of a globalised economy. It would require syndicating all larger borrowing requirements. Whatever the view, so much became clear after 2008 that in so far as financial regulation was concerned, it had proved inadequate to meet newer forces and ways of operating. It had not much of an answer to globalisation either: the growth and internationalisation of banking likely had outgrown existing banking regulation while nobody seemed to realise this

after an unfavourable opinion of the Advocate General), and is an idea also not supported in the US. In the view of this book, it should be part of macro-prudential supervision and the cap should apply only at the top of the market and economic cycle. It may even mean that bonuses (as well as dividend) become smaller at that time. The new regime was implemented in the UK in 2014 in a new Remuneration Code, see FCA, Dual-regulated Remuneration Code in SYSC 19D, Annex 5 (July 2015). In 2015, it was extended to other industries. The emphasis was increasingly put on personal responsibility of senior executives. By 2018 this regime will also extend to branches of foreign banks. See further G Ferrarini, ‘Economics, Politics and International Principles for Sound Compensation’ AEDBF A Post Crisis New Deal? (2010); G Ferrrarini, ‘CRD IV and the Mandatory Structure of Bankers’ Pay’, ECGI Working-paper Series in Law No 289/2015 (2015); and JM Fried, ‘Rationalizing the Dodd-Frank Clawback’ ECGI Working-paper Series in Law No 314/2016 (2016). 141  Again, this goes to the pro-cyclical effect of banking: see ss 1.1.13 and 1.1.14 above. Like good fiscal and monetary policy, the policy towards banks should also be anti-cyclical. A good argument can thus be made for deregulating banks completely in bad times except for conduct of business, market abuse, and manipulation, which should be fiercely combated under all circumstances. It follows that the capital requirements should vary depending on the cycle and could be reduced to zero at the bottom. It was argued that that is what macroprudential supervision may or should be all about. 142  See S Nixon, ‘De-globalisation and its Davos Content’, Wall Street Journal, 31 January 2012.

PART I  Financial Services, Service Providers, Risk and Regulation 607

in time or was willing to do much about it when it did not seem urgent. But what the true answer is, even now, eludes the politicians (as well as academics). It would appear that the G-20 in particular is incapable of newer thought, and wants to think smaller, but that is not a realistic option. In the meantime, the Basel Committee was largely discredited because of its insouciance in Basel I and II, although for lack of anything better it regained some credibility when proposing Basel III.

1.3.5  Policy Issues It was submitted that the banking crisis of 2008 and its difficult exit was and is foremost due to massive policy failure in the Western world where the entitlement society was reaching for the extreme in terms of financial benefits and stimulus, and tested the limits of the social welfare state and its funding, which a little later proved itself broken in many Western countries, hence the government debt crisis of 2010, of which the 2008 banking crisis then appeared to have been only the harbinger. In an era where the massive economic growth after World War II could hardly be sustained,143 especially in Europe and Japan, it appeared that people were trying to push the boat over the rocks. Bankers abused the situation, no doubt, but more fundamentally, banks were caught in the middle and were arguably no less abused by the system: what governments were not able to provide, banks were supposed to do, while regulators closed their eyes to the consequences or could not see at all. Thus as we have seen, capital requirements were seriously reduced in Basel I and Basel II, leverage ratios rejected and liquidity buffers ignored. That was policy. The ‘affordable housing for all’ was a most tangible early example of policy intervention of this nature in the US.144 It led to an excess of

143 

See for the US, R Robert, ‘Is the US Economic Growth Over’, NBER Working Paper No 18315 (2012). Indeed before the 2008 crisis, the sub-prime mortgage market in the US provided a perfect example of this spirit in which affordable housing for all was a political objective, which made participation in the subsequent housing bubble attractive even for the much encouraged poor, but it could ultimately not be sustained by banks, however widely the risk became spread, even internationally, although in the event it was not spread widely enough, especially not outside the financial sector itself. In the US this ‘affordable housing’ philosophy, meaning indirect housing support for the poor, was incorporated into legislation: see the 1977 federal Community Reinvestment Act (CRA). It allowed banks to refuse lending on the basis of sound banking principles but regulators, especially when approving new branches or bank mergers, had to check whether the needs of borrowers were met in all segments of society including low-income communities. In the meantime, the federal Alternative Mortgage Transaction Parity Act 1982 (AMTPA) deregulated the mortgage market and allowed a number of new options, especially adjustable-rate mortgages, balloon clauses, and negative amortisation loans. In 1994 the federal Homeownership and Equity Protection Act (HOEPA) was passed, introducing some mortgage product control especially to prevent high-cost financing and equity stripping, meaning the purchase and re-leasing of assets back to the former owner at even higher cost. The Fed was also given broader powers to act against unfair lending practices although it largely failed to develop these powers and was reluctant to use them to police the sub-prime mortgage culture. A special class of loans subsequently emerged (CRA loans), which were securitised (after 1997) to Fanny Mae (Federal National Mortgage Association or FNMA) and Freddy Mac (Federal Home Loan Mortgage Corporation or FHLMC), all much encouraged by the political establishments of those days. But inherent governmental support of this nature, which suggested some guarantee for this lending activity, distorted markets. As these mortgage lending risks were diversified through securitisation to semi-governmental agencies like Fanny Mae and Freddy 144 

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financial engineering which proved the proximate cause of the 2008 crisis. In the preceding euphoria, senior bankers were venerated and perceived as movers and shakers, in the UK given honours and large pensions even by socialist governments who liked this appearance of prosperity and declared boom and bust a thing of the past. When all turned sour, banks were blamed, knighthoods returned, pensions cut—perhaps all understandable to appease the public but it should never be forgotten how we got there in the first place: through government indulgence and encouragement, more so at the very top of the market cycle. It was policy. The essence seems to be that in developed countries we can perhaps look after the 15 per cent or so of our population that for all kinds of reasons cannot look after itself and remains undereducated or otherwise unable to participate even if we know that whatever we subsidise we get more of. But the nub may be that in the West, the middle classes themselves are asking for ever more benefits and protections and appear to feel that they cannot maintain their lifestyle without it—and they have the vote. In this perception, the rest should indeed come from the banks at low interest rates, therefore cheap credit, even in good times. We also want free education for our children and strong employment protection, which perversely may deny the few young we still have a proper start. There is also an ageing population that wants to live to a hundred and believes it is entitled to free medical care to get there and to 35 years of pensions to support the lifestyle it is accustomed to. But where is the money to come from? When exponential growth, as seen after World War II, disappears (although not the memory and expectation), this spells disaster for the modern state. Disaster for its banking system is then not far behind, although it is true that similar questions were asked after the two oil shocks in the 1970s and the subsequent high unemployment. Growth resumed later in the 1980s, whether or not as a consequence of Reaganite and Thatcherite market-oriented policies, and a new bonanza seemed possible. In the process, higher leverage became available for all whilst the capital adequacy requirements for banks were substantially reduced (Basel I and II), as we have seen, to supplement or culminate the reinvention of the financial services industry in the 1980s. It was followed and further supported by the communications revolution in the 1990s. Clearly, innovation drives growth, and it is helped by more liquidity (also potentially by cheaper energy or commodities as we were to see in 2015). It is further stimulated by monetary and potentially also fiscal policies, the danger being, however, that the growth they engender is temporary and may not be sustainable. It may be argued in this connection that interest rates were artificially low for long periods. Growth is not a monetary or fiscal phenomenon—it commonly depends on the increase in educated people and technology—although monetary and fiscal policies can provide the fuse. The idea that when money is needed for all its functions, a state just takes more from the rich or borrows more or otherwise prints money appeals in the short term to many and may well be an immediate solution to a crisis but clearly has its limits. Mac, they engaged the liability of the US government fully when real estate markets collapsed. The consequence was that these entities had to be formally nationalised in 2008. See for the requirement of originators retaining some ‘skin in the game’, n 24 above. In the US, it was soon diluted in order not overly to interfere with mortgage lending. By 2014, deposits of as low as three per cent were deemed sufficient and considered no bar to their securitisation by the Federal Housing Finance Authority (FHFA), which supervises Fannie Mae and Freddie Mac.

PART I  Financial Services, Service Providers, Risk and Regulation 609

Although it may restart the economy, it cannot substitute for innovation and entrepreneurial spirit in a larger and better educated population. In modern developed countries, there is probably a lack of moderation and an irrational expectation that growth can be fiscally or monetarily activated at will to pay for it all. It may crucially delay necessary restructuring and promote the power of local cabals. Particularly in smaller countries like Greece, Portugal and Cyprus, where there are often strong and ruthless insider groups that exercise power without much social or economic competition or control, there is a lack of political debate or calculated silence after the population at large is lulled into the promise of ever more benefits and public works until this is no longer s­ustainable.145 Indeed the smaller countries on the European periphery were always most at risk, but Europe as a whole proved also vulnerable. The US (through the Federal Reserve (Fed)) fell no less for repeatedly printing money and maintaining an artificially low interest rate for long periods to promote growth in an economic situation that was difficult after 2008 but far from dire. Much later this was followed in the Euro zone. As of 2018, it remains unclear and to be seen how such situations can be unwound without causing further shocks. The overall end result was and is the continued over-leveraging of government, banks and consumers with the possibility that all face a prolonged period of potential insolvency. It suggests that the democratic process itself may be too weak to exert discipline and that the modern state is increasingly ruled by crises. We talk much about a democratic deficit that must be filled but that is hardly relevant in bankruptcy where all options vanish. The question is rather how we got there in the first place. In situations like these, the ultimate consequence is that governments become the football of their creditors, as do all bankrupts, followed or possibly preceded by their banks. It hardly helps to invoke sovereignty notions if one cannot pay. Government must and should balance market forces but cannot do so if it is broken. In Europe, this has little to do with whether countries joined the euro or not, the euro in England often being portrayed as the cause of the problem, but how could more discipline, which the common currency requires, be the reason for an economic crisis? Even without the euro, countries have to face reality (as the UK also must). At least the euro-citizenry still has some real money. No wonder the euro has remained popular especially in the most mismanaged countries. Again, it is government and all it takes upon it and promises in good times that is at fault and it is immensely destructive. In a better world, it should never come to this. More realistically, it often feels that government is left there only to manage excessive leverage in order to prevent an inflationary blow out. In the meantime, in developed countries we may have to learn to live with more modest growth expectations in an environment where the super-expensive underclass, increasingly joined by the elderly, is becoming larger rather than smaller and strains the modern state severely. Where government fails to lead and gives in to popular demand

145  Even then, this is often not considered the fault of the ruling caste but rather of evil market forces operating from abroad or simply the result of unwillingness of the EU (or Germany) to help under the mistaken but self-serving belief in an entitlement to ‘solidarity’ from other Member States short of any major supply-side reform. It leads to strong rhetoric from these same local elites, ostensibly to protect the people, but it only serves to keep these unelected insiders in power and push the necessary structural reforms and adjustments out of sight.

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in good times and to populist pressures in bad, the result is that it loses all levers of power when they are needed most. Markets will take over. They know of no morality and the initiative returns to the strongest in society. This suggests that we need a new societal equilibrium in terms of wealth and its distribution but it can only be the result of a more rational debate and cannot be left to the political expediencies of the day. More directly to the point in the context of the discussion in this c­ hapter is what the proper role for banks is in this environment. Merely blaming them and making them smaller is no answer—as has already been said—an anti-cyclical attitude may be better. In the meantime, elsewhere, one billion Chinese will want cheap housing loans and another billion Indians a credit card. Two hundred million Brazilians are also waiting and so are many Russians and Indonesians. In fact so is all of the rest of the world and why shouldn’t they? What is the role of banking and banking regulation in that environment? These, it is submitted, are issues with which the G-20 should be more concerned, therefore with the liquidity-providing function worldwide and its scale in the next generation, the issue of leverage society can support, and the role of banks in the economic cycles, rather than trying to prevent the banking crises of yesteryear with more micro-prudential supervision. Unfortunately, the politically inspired and popular bank bashing after the crisis distorted and obscured this important discussion. Indeed legislators are very likely to make sure that yesterday’s banking crisis cannot recur but, unavoidably, without much insight into what may happen next. Again, with present insights it appears simply to amount to curtailing banking activity based on the romantic idea that yesterday’s banking was small, controllable and safe. This was hardly ever the case and there have been many banking crises; it was already said that small banks are riskier to which stress tests continuously testify. In fact, banks do learn, are much sobered after a crisis, and unlikely to make the same mistakes twice, even if they soon forget. Whatever they may do in these circumstances or whatever politicians say or want, it is a fact that the banks (and capital markets) have to carry about three-quarters of the funding of business and much else in the consumer sphere and municipal government financing, quite apart from their funding of senior government in the bond or capital markets. Again, limiting them in times of economic decline is a dangerous thing to do. Rather, it was argued, they need severe curtailing at the top of the cycle when nobody seems to care or sees anything coming. That should be the declared aim of macro-prudential supervision. To summarise: there is often complacency and therefore a lack of rigorous regulatory supervision in good times. Micro-prudential regulation is always and unavoidably late; the true risks (and abuses or excesses) of newer products and practices mainly become visible in their practical use, more particularly in times of financial stress.146 In this environment it may be unrealistic ever to expect a great deal from regulation in terms

146  It was reported in 2008 that under its supervisory powers, the Bank of Spain, alone among major central banks, had not allowed Spanish banks to invest in tranches of securitised foreign (sub-prime mortgage) products or CDOs, only to face the full force of defaults in unsecuritised (sub-prime) mortgages in the domestic Spanish market. Nor did this prevent the largest of the Spanish banks becoming seriously involved in the Madoff ponzi scheme, which provided a major international (and $50 billion) investment scandal crowning the hapless regulatory year 2008.

PART I  Financial Services, Service Providers, Risk and Regulation 611

of financial stability, at least as long as we expect banks to provide ever more liquidity. Public expectations of what especially micro-prudential regulation can do in this regard may prove wholly unrealistic. In the meantime, the role of macro-prudential supervision remains largely obscure. Again, we seem not to have figured out how modern banking truly works and what is needed to make it better on the scale that is now required. This being said, the concern about financial stability, financial risk and its management is real enough.

1.3.6  The Modern Credit Culture. The Democratisation of Credit It may probably be said that at least in terms of pre-2008 policy, everybody appeared to have been in the liquidity bonanza even if it was only realised later that there was one: regulators, politicians, the public, and of course the banks. This being so, when things went wrong, it was hard to point to a true culprit who could be curtailed or eliminated although in the popular press everybody got a swipe: greedy bonus-earning bankers, hedge funds, rating agencies,147 speculators/short sellers, accountants and accounting rules especially in terms of ‘mark-to-market’ practices,148 proprietary trading in banks, etc. There may be failings, even abuse, more likely in newer products—as has already been said repeatedly and it cannot be condoned—hence also the need for a much stronger emphasis on market integrity, but it may not have been the essence of the problem, only a manifestation, which problem ultimately translated into easy money for all as a matter of policy. In fact, not only was the whole regulatory system compliant in this regard, but monetary policy was also accommodating for similar reasons. Again, upon this analysis, in modern times it is government itself that is at the heart of financial instability and nobody may want it otherwise. This would at least appear to be part of the picture. It was already submitted in ­section 1.3.3 above, see also section 1.3.7 below that it may have engendered a new paradigm. ­Modern banking is different from that of the past in that it is forced to respond to a different credit culture and a liquidity demand on a scale unthinkable before, much supported by politicians who have increasingly been willing to ­accommodate

147  Rating agencies have a built-in conflict as they are paid, although not necessarily corrupted, by their clients who seek ratings. From this perspective, it would be better if they were paid by investors, but the latter are unlikely to foot the bill. See for early interest in the role of rating agencies, n 167 below, and for reviews after the crisis also the reports in n 155 below. 148  The need to mark to market (MTM), which requires banks to hold their investments at market values on a daily basis, creates problems when they become illiquid or when there are fire sales elsewhere. The rule could conceivably be limited to investment assets, including securitised tranches, acquired with short-term funding, or to those not meant to be held to maturity. The latter is mostly agreed but banks have to make an early choice and must demonstrate ‘positive intent and ability’ to hold these assets in this manner. If an anti-cyclical approach to capital adequacy were accepted—see ss 1.1.13/14 above—MTM would be much less relevant in bad times as banks would not be required to shore up their capital under existing capital adequacy requirements to allow for the connected write-offs. But MTM is needed even then and must be frequent for investments that depend on short-term funding.

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e­ xpectations in this regard, at least of the middle and lower middle classes where the vote is.149 Hence the reduction of capital adequacy in Basel I and Basel II to virtually zero—again, that was policy, much of which is easy credit for its own sake, although this kind of liquidity—part of which became recycling international payment imbalances and is therefore transnationalised or globalised at the same time—also figures and is explained and justified as a type of healthy growth elixir. But it has already been said that sustained growth cannot merely come from financial, fiscal and monetary measures but requires before all else innovative spirit and entrepreneurial talent in a better educated and larger population. Availability of easy credit in the above sense is commonly supplemented by ever larger governmental social, infrastructure and development programmes, which, however laudable, can no longer be easily funded or carried in a low-growth environment. In any event, the type of growth that would be necessary and which everybody now demands in order to cover all expectations would have to be so great and prolonged that one must wonder whether with present insights it would be ecologically sustainable. All the same, democratisation of credit, which means credit available upon demand on cheap terms, in the nature of a human right for all, is politically highly appealing and is greatly favoured in good times and as a continuing aspiration even in bad ones. To repeat, should consumers in developing countries become similarly involved in this credit society as must be expected when their expectations, sophistication and wealth increase—and why not?—there will be billions more people demanding access and we may be only at the beginning of a much larger leap into this type of financial servicing, now on a worldwide scale. It has already been said that these are issues the G-20 should more properly consider. Easy credit of this nature is likely to promote bubbles not only in real estate where banking crises often start. Stock exchanges are not exempt and may benefit the rich disproportionally. Commodity bubbles may follow. So may then wage and benefit bubbles. These may favour the less well-off also, but it creates serious social problems when these bubbles burst, not in the least when borrowers in these markets become stretched. Particularly in the housing market leverage is normal and tends to underpin house prices until they are no longer sustainable; leverage may be less of an issue in the equity and commodity markets where bursting of bubbles may as a consequence be less painful. Wage and benefits inflation ultimately requires adjustment of payment and support levels. Globalisation and especially robotisation complicate the inflation and employment picture further. An ageing population may present a strongly deflationary picture; it may well be the situation at present in the West, but a proper analysis of our problems seems to elude us. The true question may be whether all this debt will ultimately require an inflationary blow out to bring back more normal levels. History will tell. In the meantime, a major task of government appears to be the management of debt levels. The most direct political pressure on banks may be obvious in countries like China where the banking business is nationalised and where the increased demand for ­student 149  Hence we see major banks with balance sheets of over two trillion in dollars or euros, larger than the GDP of many countries. Even if GDP and balance-sheet totals are not directly comparable, it gives some idea of the magnitude, unimaginable even 20 years ago.

PART I  Financial Services, Service Providers, Risk and Regulation 613

loans, housing and infrastructure is habitually laid off on banks, which suffer as a consequence if these policies fail or become too expensive. Chinese banks are therefore regularly recapitalised by their government or their problem loans taken over by government or its agencies directly. This is one way of operating. But also in the West, there is similar pressure. If after Basel III, there is some retreat, the capital required in banks is still far too low to prevent serious crises. Again, this is policy without which modern banks could hardly function in the way that is now expected from them. It is baked into our modern society and it was already said that we want no less. Micro-financial regulation as we know it then becomes peripheral in its force and effect even if it could be properly focused. It will never save banks. As part of this new world, it must also be considered that cheap funding and high leverage is likely to be combined and used by banks not only for more lending150 but also for very different internal strategies, trading and investment activities allowing for large profits when things go well, serving shareholders, management and borrowers alike, not forgetting the tax man, but potentially also contributing to huge losses when the tide turns.151 This is proprietary trading. But once the squeeze is on and credit tightens, these schemes may not be able to continue or to be maintained, refinancing may become a real problem while other skeletons may fall out of the banking cupboard at the same time (eg weak supervision of consumer lending, or excessive amounts of short-term lending to private equity and hedge funds).152

150  This attitude in the investment books of banks may have contributed to the crisis of 2008–09. It resulted no less from earlier euphoria, so S Lall, R Cardarelli and S Elekday, ‘Reregulating Finance’ in IMF World Economic Outlook (October 2008). A leverage ratio under which banks must hold capital as a percentage of their assets total (three per cent in the US) may be an answer but was especially rejected in Basel II, as we shall see below in s 2.5.12, although the Americans, who had learnt the lesson earlier in the savings and loans crisis of the early 1990s, retained it for their banks, but it did not apply to investment banks, who could therefore be more highly leveraged while still showing adequate capital under the formal risk-adjusted rules. This became very clear in the summer of 2008. The Swiss Central Bank introduced a leverage ratio in 2008 regardless of Basel II. It was more difficult in EU countries, as the capital adequacy regime of Basel II, which did not provide for it, was incorporated by EU Directive (as of 1 January 2008) for all EU countries. Such a ratio is now part of Basel III (see s 2.5.12 below) and was adopted by the EU as a further amendment to its capital adequacy regime (see also the Working Document referred to in n 155 below) besides a so-called liquidity coverage ratio. It is conceivable that the leverage limits should be increased in good times and relaxed in bad times to achieve a similar anti-cyclical effect as there could be in the capital requirements. Again, this is very much the attitude in this book together with far greater transparency of banks for all, as part of macro-prudential supervision, see s 1.1.14 above. 151  See for proprietary trading n 27 above and nn 157 and 173 below. One may conclude that banks should not trade or invest at all—see also the discussion in s 1.3.10 below—but great diversity in financial products and hedging instruments is necessary for modern banking to operate while the management of the risks requires an active trading function in banks, whether in foreign exchange, swaps, options, futures, credit derivatives, repos or securitisation products, and of course also in their capital market activities like underwriting and market-making. Moreover, liquidity management requires investments, at least in liquid assets. It has already been said that the line between mere trading, investing and active risk management is here often fine or very thin. 152  Towards the height of the euphoria, the UK Cancellor of the Exchequer, later Prime Minister, declared the era of boom and bust over in the UK whilst the biggest bust since World War II was only waiting to happen. This was the era of “The Great Moderation”, a term coined earlier by the Fed Chairman during the crisis, B Bernanke, in Easter Economic Association, Feb. 20 2004, suggesting the ultimate victory of present insights in macro-economics. Some early academic contributions appeared on the crisis, see M McKee, ‘Financial Markets Turmoil and the Biggest Banks: Lessons to be Learned’ (2008) 23 Journal of International Banking Law and Regulation 404; MD Knight, ‘Some Reflections on the Future of the Originate-to-distribute Model in the Context of the

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1.3.7  A New Theme in Public Policy and a New Paradigm in Banking? In fact, by 2008 not only Western banks but by 2010 even some Western governments had reached the limits of their borrowing capabilities, causing eventually in Europe a run out of southern European government debt.153 This scenario presented a new theme in the subsequent discussions especially in these countries: what can we continue to expect from modern government? It must continue to balance business and the markets and provide for minimum safety and economic standards, but in modern societies, it constantly runs up against excessive expectations, poor discipline, the temptation to make unrealistic promises for the longer term, or even engage in questionable public works that give some up-front activity but need to be subsidised ever after and often favours insiders. There are also the dangers of unfocused, ineffective or inefficient regulation, societal ossification, and, above all, a much increased life expectancy and often low birth rate, which suggests a need for immigration, itself increasingly resented by the local populations. After the crisis, the immediate issue was how to provide some answers. For banks, the response was for the required capital to rise to between seven and nine per cent under Basel III in respect of their risk assets (in terms of a somewhat higher quality of qualifying capital as we shall see). But it has already been said that that is still too low to provide for serious management mistakes or substantial economic downturns when even good borrowers may default.154 It was already said repeatedly also that capital ­ urrent Financial Turmoil’, Speech Euro-50 Group, 21 April 2008, available at www.bis.org/speeches/sp080423. C htm; FS Mishkin, ‘On Leveraged Losses: Lessons from the Mortgage Meltdown’, Speech Monetary Policy Forum, 29 February 2008, available at www.federalreserve.gov; MWH Hsiao, ‘An Analysis of the Basel II Framework on Credit Derivatives Treatment of the Trading Book for Risk Mitigation Purposes and the Relationship to the Banking Book’ (2008) 29(1) The Company Lawyer; CB Onwuekwe, ‘The International Monetary Fund and the World Economy’, (2008) 23 Journal of International Banking Law and Regulation. 153  As highly leveraged governments had become the norm everywhere, at least in the West, it should not be forgotten that there had been an extra attraction or incentive for governments to promote more financial activity as they derived high tax revenues from it in good times. Even detested bank bonuses may attract high tax, 50 per cent or more, far higher than the alternative corporation tax and therefore preferable from a tax-collecting point of view. It is in the nature of modern government to spend these revenues even to the point of assuming large new liabilities on the strength of them. Again, this is electorally attractive but it also follows that when bad times come, governments cannot fund these programmes any longer for lack of revenue and also may not then have the money to save their banks. Soon a government debt crisis follows, which in turn is likely to lead to a second banking crisis because the banks hold much government debt. 154  The immediate result of substantial government support for banking in 2008 was that in reality capital rose well beyond eight per cent of risk assets in most banks, although the true meaning of this level of capital remained blurred by subjective judgement on individual risk weighting of assets, especially under Basel II, which became at the time the new universal standard for capital adequacy in banks, operative only since 1 January 2008, and immediately discredited—see ss 2.5.10–12 below. It had put the banks effectively in charge of much of their own capital adequacy requirement. In fact, in bad times, market forces themselves may require and impose higher capital and it was calculated that to regain confidence, at least 14 per cent was necessary for investors to restart supporting bank shares and provide new capital: see Alan Greenspan, The Economist (London, 20 December 2008) 114. This is of course not to say that the same confidence may later not be retained with less capital when euphoria returns. That is then the hope of many. The Swiss always added 20 per cent to the Basel requirements and doubled the regulatory capital during the crisis. It could easily make Swiss banking uncompetitive internationally. That was probably the policy as a small country like Switzerland could not save its large international banks without bankrupting itself. Some of this could also be seen in distressed Dutch banks (under EU pressure) retreating from the international scene.

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adequacy requirements of this nature never saved anyone except perhaps regulators who feel politically and morally discharged as long as this level of regulatory capital is verifiably maintained in the banks they supervise. Again, it was often accompanied by a lax liquidity policy, which in particular allowed banks to borrow short or use deposits to fund even their most illiquid investments. Under Basel III there was some change as we shall see, but only on an experimental basis. In this connection, in the eurozone in Europe, it should also be considered that the sudden possibility of cheaper funding had created a short-term bonanza for peripheral countries upon entry after 2001. The other side of this coin—the need for continuously restructuring up front as part of hard currency discipline where there was to be no inflation or printing of money—was never adhered to or soon forgotten. Governments could not stop spending (and borrowing). So did the banks in these countries and the consumer as a consequence. Labour cost and benefits increased on the back of this type of growth. In retrospect, it is not surprising that in the end the peripheral countries and their banks were hit hardest. It was submitted that in such an environment whatever new regulatory or supervisory constraints may be put on modern banking activities, they are unlikely to make much difference in terms of stability of the banking system and its internal discipline as liquidity management is obfuscated, the need for regulatory capital remains low,155 and leveraging of society remains generally favoured. That is a key insight and we may have much less of an option than may be thought.156 It does not necessarily clarify

155  After the events of 2007–09, undoubtedly there was tinkering at the edges of financial regulation. As we have already seen, especially the capital to be set aside for market risk under Basel II drew early attention, as did the question of liquidity—see the BIS Consultative Document: Proposed revisions to the Basel II market risk f­ ramework of 15 October 2008 and in some early EU proposals for amendments to the Capital Requirements Directive of 2006 (only entered into force on 1 January 2008), and further the EU Commission Services Staff Working Document on Possible Further Changes to the Capital Requirements Directive of March 2010. It set out seven areas of potential action. These were: (a) introducing liquidity standards including a liquidity coverage ratio meant to require credit institutions to match net liquidity outflows during a 30-day period of acute stress with a buffer of high-liquidity assets; (b) raising the quality, consistency and transparency of the capital base; (c) introducing a leverage ratio; (d) strengthening the capital requirements for credit risk in respect of derivatives, repos and securities financing activities; (e) introducing a counter-cyclical capital framework; (f) covering other systemically important financial institutions; and (g) creating one common rule book in Europe and possibly also appropriate prudential treatment of real estate lending. See earlier also D Tarullo, Banking on Basel: The Future of International Financial Regulation (Peterson Institute for International Economics, August 2008). In 2008, there had been other papers from the BIS and also from CESR (Committee of European Security Regulators, now ESMA, see s 3.7.2 below) on the role of ratings and rating agencies in structured finance (at first believed the real cause of the trouble) and from the Financial Stability Forum, see s 1.2.5 above, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (April 2008). It also asked for a strengthening of oversight for capital and liquidity, enhancement of transparency and valuation standards and practices, for reconsideration of the role and uses of credit ratings, increasing the regulators’ responsiveness to risk, and strengthening of the arrangements for stress testing in the financial system. These studies highlighted in particular the inadequacy of capital for off-balance-sheet conduits under Basel II. Securitised products held in trading books (like CDOs) may have attracted too little capital also. As the capital charge for operational risk may have been used to achieve relief from the credit risk capital requirement, there may also be a need for adjustment in this area—see also ss 2.5.7 and 2.5.12 below and for the G-20 efforts, n 292 below. 156  Within Basel II, which overall had earlier sanctioned ever lower capital levels, more may have been done, eg in respect of capital for the one per cent of risk of excessive market movements considered largely transient in the value at risk approach (VaR). Reference is in this connection also made to ‘black swans’ or extreme events that have not happened in the past and for which capital is not therefore set aside, but which may cause the greatest dislocation when they occur: see NN Taleb, The Black Swan: The Impact of the Highly Improbable (2007). It may

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the regulatory response either and does not produce a new model, only—as has already been said—smaller banks, which is likely to be counter-productive and merely a journey into the past. That things get out of hand from time to time is obvious, at least in retrospect, and that there was excess in financial engineering is also clear, but it was not the root of the problem which, it was submitted, centred on the nature of the liquidityproviding function at low cost for all as a matter of government policy and the very much increasing popular demands and expectations in this regard. They are unlikely to abate. These then are the issues that need to be more fundamentally addressed to arrive at an assessment of what the true future banking needs may be or become, especially from the point of view of liquidity and financial stability but then also from a point of view of future growth. If we cannot answer these questions, we should ask ourselves what we are doing with financial regulation and to what end? Financial stability in itself is not the answer. It was already said that it may only be achievable at levels of activity that are too low. In the meantime, it may easily be true that modern banking implies a ‘weapon of mass destruction’. This is now often associated with the trading culture in banks but it has already been said that banks, while holding large investment portfolios, must hedge against position risk. They must also hedge against credit risk in their loan and bond portfolios. They further have asset and liability management to consider, especially issues of liquidity, and they must constantly adjust. To this may be added their market-making in foreign currencies, repos and swaps, in investment banking also in bonds. This touches directly on liquidity and any (temporary) stagnation of the repos and interbank markets in this connection. There is also proprietary trading, as has already been mentioned, although small in most ordinary banks. Altogether this seemingly makes for a more speculative banking environment—which started when the first foreign exchange dealer came into the bank. Again, the treasury operation of some large commercial banks may now well resemble the operation of a hedge fund, financed by short-term deposits. As we shall see in ­section 1.3.10 below, the so-called Volcker rule is meant to curb this but its implementation has shown that such curbs are barely compatible with modern banking and the risks it must take and manage.157

promote the taking of excessive albeit remote risk. Here all is the fault of the VaR system. It underlines the fact, however, that at least in respect of larger risks, their occurrence and effect remain a mere matter of opinion. It is a judgemental issue and these risks can notably not be measured in terms of past experiences, therefore statistically, cf J Nocera, ‘Risk Management’ New York Times (4 January 2009). Nevertheless, they may bring the whole system down, but, at least theoretically, not much can be said about their occurrences and even less about when they may occur. With present insight it is therefore impossible to provide for them in a rational regulatory system unless one attempts to exclude all risk. As not all risks can be known, that is itself insufficient, quite apart from the unexpected consequences that each intervention of this nature may have. 157  The author has spent 11 years of his life in a senior position on the trading floor of a major international bank and knows full well that if not watched carefully, it becomes a circus of cowboys and gangsters to which the 2012 Libor scandal more than testified. But identifying the problem is not the same as solving it or wishing it away; it must be managed and cannot be eliminated. There is no way back from the trading culture. The implementation of the Volcker rule in the US (December 2013), see also n 173 below, showed this very clearly and remained contentious, subject to demands for review, especially in the US where the Administration started to relent after 2016. The present regime was only agreed after three years of deliberation and ended in some form of self-regulation: banks being able to show that their trading was for hedging purposes, underwriting or market-making, not short term proprietary, but it will all be a matter of interpretation (and ultimately agreement with the regulator in a

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All require trading and the rule and its limitations were under pressure from the beginning. We may decry this but it appears to be part of the way we have lived for some time. To repeat, the alternative is a less experimental environment with less liquidityproviding potential. Like weapons of mass destruction, we cannot wish these problems away and must learn to live with them even if there is no great clarity and there are no clear answers as to how this can be done better. It has already been said that it is human nature always to want to push the boat out as far as possible and see where the cliffs are. That is probably why we got this far in the first place, but it means also that we occasionally hit the rocks and that, at least in finance, the markets will turn us back for having demonstrated lack of sufficient insight and self-control. Traditional microprudential regulation was found unlikely to be an adequate substitute. Crises recur. This may prove particularly painful for households which operate on modest budgets and became used to more options. It was always dishonest and a grave political mistake to suggest that they had them and that otherwise banks would be able to help them out.

1.3.8  Different Attitudes towards the 2008 Financial Crisis and its Resolution It is easy to say that we need a more balanced society and new equilibrium, which would also produce a more balanced financial environment. It can hardly be the other way around, but as things now stand, the jack is out of the box in terms of the need and availability of liquidity and simply going back appears not to be an option and is politically untenable in terms of the social consequences: it is hardly possible to deny consumers and students their loans; it might not be good economics either. On the other hand, in one way or another, our lifestyle must be earned and there are no easy shortcuts. Although people in Occupy Wall Street and similar movements demonstrate for the continuation of their entitlement society, denounce everything that comes in its way, and see the financial services as their nemesis (rather than the world that financed excessive expectations in the first place), this is hardly realistic. It is an attitude that may easily lead to governments losing all levers of power (except to print money, where still possible, and call in hyper-inflation) because of over-indebtedness. This being said, these movements have a serious point where they ask for globalisation being balanced by legitimate public order concerns, but it may not be in the way they envisage. Such public policy may itself have to be increasingly transnationalised to be effective and may no longer be solely met at the national level in domestic terms or needs. This also concerns values and is a recurring theme in this book. It is an important issue in international finance and a legitimate preoccupation of the G-20 although one may well doubt its insights into what is needed and willingness to contemplate

‘compliance plan’), the final text of the document running up to 71 pages with nearly 900 pages of supplementary text which tries to provide guidance. Thus hedging must ‘demonstrably reduce or significantly mitigate specific, identifiable risk’. Underwriting and market-making must be ‘designed not to exceed the reasonably expected near term demands of customers’. In the circumstances, it is not surprising that there continued pressure to do away with the rule altogether.

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these issues, which, it was submitted, centre on the level of liquidity and leverage in an advanced society and how that is to be provided and managed on a world scale. The upshot is that without much of a compass governments, even the largest ones, may no longer be able to steer sufficiently. They may not even want to in good times. As already mentioned, it raises the spectre that only internationalised markets may be able to redress excess, often in punitive ways, with potentially dire social consequences for those who were lured into a false sense of security in the first place. With present insights and expectations, the most governments seem to be able to do is to smooth out the consequences once things get out of hand, but their room for doing so, even in this shrunken ambition, appears limited. A growth policy may need consideration, but with demographic limitations in the West, an ever faster ageing of the population in many countries, the aversion to immigration, a sclerotic regulatory situation, serious environmental limitations, and limited government resources left, this is a tall order. It has already been noted that probably more fundamentally, it is unrealistic to expect the after World War II growth potential to continue in developed countries and pay for it all, although, if innovation is the true cause of growth (and immigration), we may of course still be surprised. It has already been noted that somehow we got out of a similar hole after 1980, nobody knows exactly how. There may be deeper problems. To repeat, in this book one major task of governments is considered to be balancing market forces and defending a type of ‘society’ that we may perceive as being better and fairer, but it was said before that such a society is often hijacked by narrow interests groups or political and other elites, especially in smaller countries where the talent pool is limited and there is less competition while the democratic process may not be able to break this power; it often seeks to join it.158 Kleptocracies rule in many countries and use the democratic process to get there and the state resources subsequently to maintain themselves in their position. This happens even in larger countries—one may think of present Russia. Even in Germany the democratic process was hijacked by a bunch of gangsters in the 1930s. There is absolutely no reason to be romantic about the virtues of a society and system in which the majority is often bought off by promises which cannot be realised when it comes to the crunch. Help is then sought from other countries or the IMF (in the EU under a call for ‘solidarity’) largely in order to preserve the status quo. Again, market forces may then have a more legitimate balancing role to play: to limit the power of local elites. It is submitted that in this kind of ‘society’, youngsters in particular, especially if capable and willing—of whom in Western Europe in particular we have too few—may get a very bad deal because of these vested interests. Similarly, immigrants, even refugees are resented and said to offend local ‘cultures’ (of this nature!). It can be

158  It promotes inequality and the legal, regulatory and tax system is likely to be used to serve these interests. These elites get a bigger chance in smaller countries where there are fewer countervailing powers. Regulatory capture is one aspect of it, as was identified in s 1.1.11 above: banks may hold regulators and especially central banks captive. It is not only banks that may do so; in smaller countries it may be the families or persons behind the financial and industrial interests that warp the legal, regulatory and tax environment in their own favour and use politicians to help. Greater inequality may be the result. Regulation is by no means always neutral while ostensibly promoting the public interest.

PART I  Financial Services, Service Providers, Risk and Regulation 619

cogently argued that many of these countries might do better if market forces asserted themselves more strongly and broke those interests down. One sees here another side of globalisation. Countries must reform or perish; many are shown to be dysfunctional and cannot hide this any longer behind borders. But whatever the merits of globalisation in these aspects, there remains a great need for checks and balances, although not necessarily the present ones. Modern finance is an important aspect of that world. Its proper functioning is a major public interest and in crises there is an obvious need for public action. As for banks, the ultimate reaction to the financial crisis that started in 2008 was punitive action and more regulation especially through Basel III, as we have seen, but the initial political reaction159 at least in the US, was more properly a raft of financial measures aimed simply at promoting liquidity (the opening of the liquidity tap)160 joined by a special bipartisan government programme to stimulate the economy, the details of which were barely considered in terms of effect on employment or value for money. Neither was the funding nor exit strategy. This was the modern interpretation of the Keynesian philosophy of crisis management, which had become accepted wisdom, although originally it may never have been more than an intellectual model for the situation obtaining in the 1930s. It was tested on an unprecedented scale in 2008–09. In the process, the efficiency of all government spending to kick-start the private sector was assumed, whose recovery especially in terms of confidence was pictured as the only true solution to the crisis even if it meant more of the same. In the US, it was followed by a massive federal government plan to buy distressed assets from banks (in the Troubled Assets Relief Plan or TARP), which was probably better focused. Others on the other hand thought that it was better to clean up first as crises of this nature might be the only possibility to get back to some sense of order and to some form of moderation and discipline. Restructuring is then put at the centre rather than pasting over the cracks. The more likely need in this view was not only fundamentally to reconsider the basic tasks of government, its cost and efficiency in a modern society, but in that connection also the role of banks. Growth would have to come not from more government spending or cheap bank funding, but rather from deregulation, therefore from encouraging private initiative and from a greater confidence in its benign effects. Innovation would follow. This would result—so it was hoped and expected in this view—in a new societal equilibrium that would be less paternalistic,

159  As a matter of record, after the start of the financial crisis in 2008, the first concern for governments was to reflate the collapsed soufflé as fast as possible. What was thought by many to have been the cause of the problem, high gearing, thus became the solution at the same time. Consumer and corporate releveraging was then seen as a necessary process in itself: the credit society not only as a moral or human right, but also as economic necessity, again especially clear in the US and UK. In the event, the puncture, being in truth lack of confidence, proved fairly easy to heal, at least in the short term, but more heavy weather resulted when subsequently government debt itself became the problem and access to the capital market a serious issue for smaller countries. As government debt was substantially held by banks as part of their normal liquidity policy, it threatened a second banking crisis in many Western countries at the same time. Under the circumstances, central banks were repeatedly required indiscriminately to reopen the liquidity tap and this continued to be the picture even in 2014/15, highly indebted Japan and Europe now also participating, this time to loud applause from an ever more political IMF. 160  They were often of a highly technical nature; see for an overview HS Scott and A Gelpern, International Finance (New York, 2014) 44.

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but probably also subject to greater swings. People would have to be more self-reliant and the dependency and entitlement culture would have to be re-evaluated. In this approach, it required market forces to get society back to some realism. In fact, the democratic political discourse, whether in Europe or the US, was then considered not or no longer able to anticipate and smooth out difficulty. This view is resigned to our being governed by crises or market forces that take over if only to bring sanity. In this perception, the true problem with policy to the extent still available is moral hazard: any help or the expectation of it means loss of discipline. Austerity is not the objective but seen as the result and unavoidable to achieve reform—more than the minimum support or solidarity, which would only confirm people in their present attitudes: local elites would claim victory, their privileges strengthened. In the eurozone, this may have become more the German view without, however, any deregulation ethos. In the Italian and Spanish attitudes, rather the hope of and demand for more help became the essence of the debate, but there was also fear for the conditions. In the meantime, restructuring was engaged in in these countries but only enough to keep the interest rate on public debt within a sustainable range while trying to smooth things out in an undefined manner over a longer period. Even in the UK, structural reform has been slow and the government is looking for time, after 2016 overtaken by the Brexit drama. It seems that the choice between these two approaches, the one substantially working on the demand side, the other on the supply side, very much depends on one’s view as to how society operates and responds and how much restructuring is needed and on its pace. The first view is basically happy with the present state of society and the redistribution mechanism it entails. If necessary, it will raise taxes, print money and allow inflation to get things going again. Borrowing is healthy. The lack of activity is considered temporary and not fundamental. The supply-siders see it differently and consider the present set-up of society as basically flawed. Only structural reform will save it and it must come up front. A hard currency like the euro in the eurozone is an important part of the discussion. It requires constant structural reform as this currency will not take the stress through inflation or devaluation. It is therefore in essence a supply-side tool: EU Members having entered the euro might not have realised this. In the US in particular, one may expect the two views more strongly to compete. It is at the heart of the political impasse in Congress: the one side not being much worried about debt and a weak currency, the other fearing both and putting the emphasis on greater selfreliance and initiative. In this connection it may not be too fanciful to suggest that after 1989, at least in the West, with military pressures receding after the Cold War and globalisation taking a lead, another aspect may have entered the debate especially in Europe, the emphasis turning to accelerated economic development, to expansion of the welfare state and to living dangerously, now in the economic rather than military sense. This may have changed the attitude in many advanced states towards sovereign indebtedness and the affordability of social programmes. A new type of leader may also have emerged as older establishment perceptions were rejected or found to be suspect. The consequence may have been chronically less stable government financing and an increasingly unstable banking system accompanying it, but it must be admitted that it went well for some time.

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In the eurozone, there was a further aspect. It was already said that many weaker entrants wanted the low interest rates up front, then borrowed more, as much as they could, but did not restructure. For them this led to a severe crisis and in the case of Greece for calls to leave the common currency but it would likely have prolonged its structural weaknesses and potentially its sharp economic decline. Citizens would lose what little money they still had without much real hope of doing any better in the future. In fact, at the popular level, the euro remains popular in these countries and there might have been some understanding that the growth engendered before 2008 and the froth it created needed to be blown off. In the meantime, it also became clear that countries like the UK, which stayed outside the euro and were proud of their sovereign right to debase their currency, could hardly claim any better growth regardless of substantial devaluation. Rather the value of savings erodes while the little extra that elderly people would have had living longer disappears with dwindling pensions. Even so, if southern Europe cannot live with northern European discipline and match its skills, an orderly retreat from the euro could become a necessity for them although they would likely be poorer.161 The alternative would be substantial and continuous financial transfers to them. It is not the system of the EU, which is not a state and such transfers would therefore be unsustainable and any need in that direction could even break the EU. France is the key player and has had much difficulty in restructuring. Its economic health prospects lie with the north of Europe but its heart is in the south. When it asks for more economic integration and even one fiscal policy for the eurozone, it may mean the institutionalisation of financial transfers from Germany in particular. It is a different concept of European integration. As a minimum, France would need to offer a prolonged programme of reform that is sustainable and enforceable. Southern Europe might ultimately need some kind of Marshall plan, but it would mean more surrender of sovereignty. It was submitted all along that in a highly leveraged society, banks are likely first to feel the pinch in a crisis. Whatever their misdeeds, especially in terms of taking too much risk—a problem compounded where they become the essence of a credit society, the big spider in its web—in times of economic decline more bankruptcies commonly result among their borrowers, now much extended as a class, even among those who were once prime credits: a bank is never stronger than its clients, but the new element is size. In such situations, many of their more specialised and innovative investment products also became shaky and their hedges unreliable. Margin calls are threatened in their trading activities. After 2010, this was joined by an increasing risk in their government bonds portfolio when governments themselves were threatened with default. It produced a second wave of bad news for banks, especially in Europe as we have seen. The burden to support them may then fall immediately on the lenders of last resort (Central Banks) and ultimately on governments (taxpayers). This is unavoidable and, in a credit society and modern credit-driven economy, can even be seen as a true task of government, liberal gearing facilities and excessive leverage being government policy.

161  A dual currency may be an alternative in which past savings and debts remain in euros but further wages and debt would be in the local currency unless otherwise agreed, see also ch 1, s 3.3.4 above.

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Banking activity of this nature in any event yielded high tax revenues in good times. The need for such government support could thus be simply considered the other side of the coin: the general public being the prime beneficiary of cheap banking services and credit, which, as we have seen, in normal times have become largely available upon demand as a public good and policy objective.162 In bad times, it pitches governments against the full force of the markets while the taxpayer becomes the final payor or guarantor. It all assumes that government itself is not already over-extended and therefore less able to help, which became a real problem in much of Europe after 2010 and has in many countries remained so. This need for support puts the continuing desire to live beyond one’s means at the centre of the argument and may suggest its continuation either through the private or public sector. A process of orderly deleveraging is then abandoned or pushed back as inconvenient, debt perpetuated as a lifestyle for all, and growth of that nature and quality resumed as fast as possible. Again, whatever may be intended, financial regulation is not supposed to be a hindrance either. Little confidence can thus be placed in efforts at re-regulation. Going back to a romantic idea of smaller banks that can be well controlled domestically was also found to be an illusion. This is only to repeat that we seem to have serious difficulty with understanding the financial environment we have created in developed countries and on which we entirely depend, a situation which can hardly be reversed. As they say, nobody wants to stop the party while the music is playing. Perhaps it is not realistically possible. Whatever modern banking is now all about and whatever risk is implicit, the unexpressed hope appears to be that at least until everything goes off the rails, ensuing booms can make everybody better off and that the overall effects, even discounting serious financial crises and slumps, are demonstrably positive. Whatever the occasional shocks, there may be truth in this. One major financial crisis in 70 years may be cheap if one counts the economic gains of easy credit for all in terms of growth and lifestyle during the rest of the period. Indeed no one thinks much of three per cent annual growth on a sustained basis. On the other hand, a three per cent decline in one year during all of this period proved immediate ground for panic and despair. That would seem irrational, especially since unemployment overall did not rise much above 10 per cent (except in smaller countries that started to experience a severe government debt crisis and further banking problems); it was already said that higher rates of unemployment had been reported during the 1970/80s and in Germany again in the 1990s even without major financial shocks. These are not 1930s circumstances and do not go beyond the cyclical, painful as it may be, especially in smaller pockets

162  The danger is that financial crises spin out of control and the banking troubles hit the real economy, foremost through reduced lending or by other imbalances adjusting themselves, now also internationally. One may think of sudden adjustments not only of excessively low saving rates in developed countries (therefore high consumer spending), but also of the bursting of bubbles of all sorts (in housing and commodities, even in currencies, adjusting an excessively weak dollar and excessively strong euro or sterling), and the unwinding of large trade imbalances leading to smaller surpluses in developing countries, reinforcing higher interest rates worldwide, and less credit. Mispricing of assets in the search for higher yields may then also come suddenly to an end and market forces may redress the situation in such situations in an uncoordinated fashion. This may lead to great pain in the real economies in the short term, although conceivably to more balance in the medium term.

PART I  Financial Services, Service Providers, Risk and Regulation 623

of excess. Especially the US and the UK have long cultivated a credit culture of this nature, and are more used to boom-and-busts that result and to their detrimental effect on the stability of the financial system, which may regularly need large public support. On the other hand, they claim a more dynamic economic environment from which other countries then also benefit. This debate is unresolved and that is reflected in policy that remains ambivalent, coasting between the extremes. Where the debate between a more demand or supply side approach remains also fundamentally unresolved, we remain substantially rudderless, clouding the policy scene further. In that environment, aggressive experimentation and innovation is all that is left to meet and manage the ever greater demand for credit and financial products of all kinds, involving the activation of ever larger pools of liquidity, now at the international level on a mundial scale. Indeed, it was already shown that the period after 2010 became one of regulatory experimentation, ultimately leading to the consideration of a more macro-prudential approach in finance, although so far timid, see ­section 1.1.14 above. It was argued that in the present void of ideas, macro-prudential supervision may be the only realistic way forward for banks. A new point is that globalisation greatly increases volumes and that banking rescues may now have to be organised on a worldwide scale. This poses the question of an international safety net, which is still notoriously missing, see the discussion in ­section 1.3.11 below. It is also a question of cost and how that must be shared. By 2012, this had become a more acute discussion point, especially in the eurozone, and led to the Single Resolution Mechanism (SRM), which implies a multilateralisation of banking debt (see further ­section 4.1.4 below). It has an equivalent in the Dodd-Frank Act in the US and follows G-20 policy. How realistic it is to make depositors (although mostly protected up to Euro 100,000 in the eurozone) and senior bond holders contribute to situations of regulatory and supervisory failure, which is hardly their fault, is here another issue, and touches on bail-in and the idea that governments do not bear responsibility for financial crises, which in any event they are hardly able to ignore when arising. However that may be, it will be argued later in s­ ection 1.3.11 below that precisely the absence of such a safety net in respect of global banks may well have been the more immediate cause of the 2008 crisis when large international banks started to weaken and nobody could be sure who would support and save them. That may make the operation of an international support fund (rather than resolution regimes) the essence of modern globalised banking policy. This discussion might be completed by an observation made briefly earlier. Banking and the modern banking paradigm do not present themselves in the same way everywhere. Notably in Germany, there is a different banking culture: people live in rented accommodation and do not speculate in real estate. Most do not have a credit card, and they save money before they buy a car. There are large savings and a huge deposit base. This makes for a different world of banking, which is often unprofitable, very clear in its regional banks and even in the Deutsche Bank, but it may be more stable (except for the investment portfolio of banks or in their foreign operations where as a consequence greater risk is often taken as it is the only way for these banks to make real money). This suggests an important difference in culture, leading to a political divide among various EU countries which is quite fundamental and is relevant now that a new single

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banking system is operating in the eurozone: different countries may have very different banking environments and expectations in mind, at the political level not always realised. Another difference results: it may be a surprise to many that German households are poorer than most in southern European countries. An important reason is that Germans do not own their home. At the level of the private household, Germany is not a particularly rich country and that should be remembered when it comes to asking Germans to help others in their banking and other problems.

1.3.9  Problems with the Reform of Financial Regulation and Prudential Supervision After 2008 In a financial crisis, it is common for everybody to start demanding more regulation, while improper deregulation in earlier periods is in retrospect assumed to have taken place everywhere,163 but the discussion is likely to become unfocused as long as the provision of cheap credit or leverage for all, including the issues of liquidity and the effect of capital adequacy (or lack thereof), are not squarely faced. It has already been said that before the 2008–09 crisis, although regulation was ample, liquidity management was neglected, certainly also at the regulatory level, while the capital adequacy requirements were pushed down ever further: see Basel II and the discussion in ­section 2.5 below. Poor risk management was subsequently also blamed, especially securitisation, but, if anything, the risks had not been distributed widely enough in the events leading up to the 2008–09 crisis and, although illiquid assets were spread in this manner, the essence was that they were largely retained in the banking and insurance sectors. In fact, there may be too many conflicting underlying policy objectives, such as more stability and more credit at the same time, which shows particularly in a general inability to define more precise regulatory sub-objectives and may lead to greater future instability, to which regulation is then likely to contribute, see also the discussion in ­section 1.1.11 above. It has already been suggested in the previous s­ ections that financial stability may in truth not be wanted at all as it may mean a smaller economy and its immediate cost in terms of less growth, less employment and less social welfare could be considered too high. It becomes very hard to formulate sound regulatory policies or

163  In 2008, as we have seen, one claim was that irresponsible deregulation had taken place, of which, however, there was little evidence at least in Europe. In the US, it mainly came down to the repeal of the Glass Steagall Act, see also ss 1.1.9 and 1.3.4.above. There had been deregulation of markets (except in the area of abuse) but it was accompanied by a re-regulation of participants. There was also some shift from an institutional to a functional approach to regulation—see again s 1.1.9 above—a trend that arguably focused financial regulation better and can hardly be thought to have been incorrect or dangerous: money and foreign exchange markets were liberated in this manner and freed from political interference and manipulation of that kind. What was a fact, however, was that in Basel I and even more in Basel II, capital adequacy requirements were reduced as a matter of government policy, it was already repeatedly said. It is also a fact that newer products and services were substantially left alone in the lead-up to the crisis, mainly because it was not clear how far and in what way they produced dangers to the system. This is ‘regulatory lag’ and has been identified as an unavoidable side-effect of innovation. Only hindsight can give proper guidance here, even though it is true that in respect of securitisation in particular, there was awareness after the Enron debacle, see ch 1, s 2.5.10 above.

PART I  Financial Services, Service Providers, Risk and Regulation 625

standards in such an environment. Added to this is the fact that we have little insight into the underlying currents and none into the unintended consequences of more regulation. Above, a new paradigm was spotted in the operation of much larger banks that must support the globalisation of the world’s business. It is obvious that the present model and form of financial regulation is no panacea. It was said before that (micro-prudential) financial regulation as we know it never saved a bank; it probably never will.164 Excess is rightly decried, but it is doubtful whether regulation of this nature can define the point when excess or abuse occur and how these can be avoided.165 It is not its purpose. Recent refinement proposals will be dealt with below, but adequate regulation suggests a degree of fine-tuning that may not be realistically achievable. Again, micro-managing banks through regulation seems an inadequate approach even if supplemented by regulatory discretion in what is now called judgement-based supervision—see ­section 1.1.14 above. It is accompanied by new financial stability committees, as we have already seen also, to fill in policy as a matter of macro-prudential regulation, but that is no guarantee of it being forthcoming nor of it being meaningful when it does. It requires a much more dramatic change and must allow for variable capital adequacy, liquidity and leverage ratio requirements, as we have seen, starting in ­section 1.1.13 above. Daily regulatory oversight, in what is in essence the banking business itself, is not feasible—it amounts to a form of nationalisation, leaving this business to civil servants, which seldom proved a success in the past. It can only be repeated that managing banks is not the true role of banking supervisors of whatever type, who are not bankers and are ill-equipped for it. It would mean intervention by the perfect amateur and would likely make things worse. For this reason, regulators have traditionally operated within a legal framework of supervision that does not allot to them that task, unless, for better or worse, they or their governments become large shareholders at the same time, as in fact they often did during 2008–09. It amounts to a more direct form of intervention, potentially putting a bureaucracy in charge, but it is hardly a long-term solution. To repeat, given the political objective of liquidity for all, there is barely any superior insight of regulators or governments left into finance and how it should be regulated, while experimentation must be allowed for the banking sector to evolve further in view of the ever greater demands for liquidity and the ever greater risks that must thus be taken. In fact, there is evidence that deeper and more sophisticated financial services and markets aid growth in the longer term, even if it may be asked what the quality and sustainability of that growth is. Globalisation increasing this depth and spreading the financial risks internationally is thus potentially an important development. It is difficult to envisage global markets without global banking; it has already been said that the idea that banks should again become national carries serious 1930 economic Balkanisation overtones, now on the funding and money recycling side. But it is true that globalisation distributes the considerable swings in the fortunes of this business 164 

See also Sarin and Summers, n 66 above, who warn against complacency. Soon the IMF was mentioned as a likely candidate for a worldwide regulatory role, like some deus ex machina, but how? The Financial Stability Forum, see s 1.2.5 above, was not giving much guidance and certainly did not anticipate the financial storms of 2008–09 either: see for its Report n 155 above. 165 

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worldwide and makes regulation even harder. It has already been noted that billions of people around the world becoming first-time consumers in the years to come will add greatly to the challenge. Most may want a subprime mortgage and credit card at the same time. To conclude: it is at the practical level largely because of the uncertainties in liquidity management and the low and inflexible levels of regulatory capital fed by political and other pressures of the modern credit culture that regulation and prudential supervision may not achieve the proper discipline in banks or an adequate level of financial stability. Above in ­1.1.14 and 1.3.4, macro-prudential supervision as a separate oversight facility for banks with a flexible approach to capital adequacy and liquidity requirements and leverage ratios was thought to be a better answer. Anti-cyclical behaviour should be encouraged in this manner in particular and the size of banking in society should be determined by this agency at every phase of the economic cycle, much like fiscal and monetary policy is also separately determined. In the absence of such a facility, the credit rating requirements of rating agencies, however much criticised, may be more effective and up to date than micro-prudential supervision. In a good bank, it is the management itself that must provide the discipline and protect depositors and shareholders166 but it may soon be distracted by short-term opportunity and euphoria or simply greed, in the knowledge or at least expectation that some form of government bailout will always follow and may even keep the sitting management in office for lack of much alternative. Again, that is moral hazard, discussed further in ­section 1.1.11 above.

1.3.10  Areas for Regulatory Reform Indeed, throughout the 2008–09 crisis and subsequent debates, it remained thoroughly unclear what more or newer financial regulation could contribute. It basically requires a calming of the party before it gets out of hand but when and how? It has already been said that in good times, all will be against it. In bad times everybody gets a turn at being criticised, banks, hedge funds, credit rating agencies, etc, and everywhere there is the cry for more regulation.167 Political window dressing or point scoring follow,

166  The former chairman of the Fed, Alan Greenspan, reported to Congress in 2008 that he had been shocked to find out that management had failed to protect shareholders adequately. It may never have been high on their list. 167  It was in any event not true that these matters had not been considered earlier. In the US, in s 705 of the Sarbanes-Oxley Act of 2002, the Comptroller General of the US was asked, eg, to report on the role of investment banks in securitisation schemes, which was subsequently believed to have been one proximate cause of the 2008–09 financial crisis; see also ch 1, ss 2.5.4 and 2.5.9 above. These issues were thus raised well before the 2007–09 financial crisis but questions were not properly put and answered and much was soon forgotten. However, following the report, on 7 January 2005, the SEC adopted some new rules to address the registration, disclosure and reporting requirements, but only for publicly offered asset-backed securities in the US, and they did not extend to credit derivatives. 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. In retrospect, it may be considered regrettable that private placements of this type of security were not

PART I  Financial Services, Service Providers, Risk and Regulation 627

the ­long-term effects of greater caution on economic activity being overlooked, while at least some of the activity, if seriously curtailed, would simply move offshore, for example hedge funds, private equity and investment management. Thus the incentive structure could be seriously disturbed without any clear view of the consequences. The view expressed in this book is that banks should be strictly regulated at the top of the economic cycle and then be forced to restrain their business, build capital and liquidity, and become ready for the bad days that invariably follow. At the bottom of the cycle, capital adequacy and liquidity requirements should be relaxed. The same for leverage ratios. There is little point in constraining banks in bad times except in respect of the conduct of business, market abuse, anti-competitive behaviour, and similar activity. It was already said repeatedly that given the present credit culture, it is likely that banks will have to be saved from time to time; again it is simply the other side of the coin of encouraging or forcing them to lend to everybody—and governments should be ready for this to avoid panics or, better, rein them in when all seems well and require them to build capital and an international safety net at that time. Under modern resolution legislation, if a crisis occurs, depositors and bondholders may now have to contribute, but they are hardly the culprits and the cause of regulatory failure; it will often be the wrong moment for them to do so and may only increase the panic and encourage bank runs. In fact, it may well be asked whether these newer resolution mechanisms will be fully operated and were ever more than politically inspired subterfuges. Again, micro-managing banks through regulation is an intrinsically contradictory position and is unlikely ever to prevent a financial crisis. Worse, it was also pointed out that micro-prudential regulation as a rule-based system is pro-cyclical. Rather, the key issue is to identify the moment when the screws on banking must be tightened. In this approach we have macro-economic steering mechanisms at the fiscal, monetary and banking level, all to be counter-cyclical in principle; see again the discussion in ­section 1.1.14 above. We should concentrate on such mechanisms, for the purposes of this discussion especially on the policies for banks. They should be accompanied by regular stress tests to determine where we are, and the results of these tests and the parameters on which they are based should be published. To preserve the international playing field action may have to be called increasingly by an international agency and will mean, however, surrender of sovereignty. If one nevertheless still expects stability from micro-prudential regulation within a pre-established legal framework, some suggestions have been made above and the discussions may gel around the following cluster of ideas, but we must make up our minds first what we want to do in terms of providing liquidity for the multitude and in terms of societal leverage. We must subsequently decide what we want to do with globalisation of the banking sector. How are the biggest banks going to be contained

further considered. 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 considered in the US, well before the crisis: 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 the 2008–09 crisis in which they were much criticised was therefore not a new issue.

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in such an environment and what kind of competition will be encouraged? These are social/economic policy issues that must be resolved first and it was argued before that that should be the prime concern of the G-20. Is there a human right to credit, what is the social function of banks, and how is the banking world going to cope with this? Even this suggests some macro-economic consensus. We must then also be concerned with the international flows in terms of trade (im)balances and currency adjustments. What kind of growth expectations are realistic? How do they connect with environmental concerns? Must there be supervision to prevent boom and bust? The fear in 2009 was 10 years or longer of zero or modest growth, as in Japan after the financial crisis of 1990, and this has come about in many countries. What is needed to avoid this and can it be organised, or must regular economic contraction be accepted either because of lack of growth and/or in order to achieve greater financial stability? Or do we mean an automatic return to high gearing and pressure on banks to restart lending and provide more liquidity and leverage? In other words, is the cause of the problem also its solution? When it comes to improving micro-prudential regulation, there are the following cluster of ideas: (a) The accent of such regulation may have to be at least as much on liquidity management as on risk management, the latter concentrating on credit, market and operational risk and adequate capital in respect of these risks, but, as long as we think in fixed continuous requirements and rule-based micro-prudential supervision, it is not likely to save the system unless these requirements are raised to levels that would effectively kill most modern banking business or make it so expensive that there could not be liquidity for all. Also, who would want to invest in that kind of business? (b) If it is not possible to differentiate in such an approach and substantially to raise the capital and liquidity requirements168 even for those institutions which are clearly ‘too big to fail’ as it would put them at a structural disadvantage,169 it is still possible to make the capital adequacy and liquidity requirements at least anti-cyclical for all, that is to reduce them in bad times and increase them in good times, for new business in terms of capital perhaps conceivably at levels of 30 per cent or more, while such activity could no longer be financed out of call deposits, although there could still be differentiation according to types of lending. That is, however, no longer a rule-based system but macro-prudential supervision or policy.170 (c) This macro-prudential policy should be implemented or at least directed or signalled at the international level, possibly by the Financial Stability Board (FSB) or the IMF, see ­section 1.2.5 above, to prevent local politics from unduly interfering.

168  In the early US proposals that were published in June 2009, different treatment was not excluded for those banks that were considered too big to fail. This became accepted wisdom in Basel III, but it creates an unlevel playing field, see further s 1.1.15 above. 169  In the course of 2009, after the dust started to settle, it became clear that effectively the 30 largest banks now had about 70 per cent of the banking business worldwide. It is likely only to increase. 170  See for old fashioned banking, n 20 above.

PART I  Financial Services, Service Providers, Risk and Regulation 629

It particularly extends to liquidity supervision, therefore higher requirements in good times than in bad, meaning that at the top of the market long maturities in lending should be matched by long maturities in funding. It is the preferred attitude in this book. The key is always banking behaviour and strict supervision notably in good times when banks are at their most dangerous. (d) To curtail excessive leverage in a low-capital-adequacy environment, a leverage ratio is another idea already long implemented in some countries, especially the US,171 where there is a requirement of three per cent capital in the totality of all liabilities.172 That is now also followed in Basel III, but again as a fixed rule. Rather, it should also be put higher towards the top of the cycle, lower at the bottom, and itself become anti-cyclical and part of macro-prudential supervision. (e) Although a rough measure, the leverage ratio may indeed mean more capital and therefore less room for especially the trading activity in banks that even now potentially includes large position taking in foreign exchange, repos, swaps, securitisation products including CDS, which position taking may itself become highly leveraged, at least temporarily. It is likely to be supplemented by proprietary trading, which could thus be similarly curtailed. (f) Like lending, in banks these trading positions including proprietary trading activities are often funded short term (deposits or interbank) even if the assets so acquired are longer and may become illiquid. The same may apply to other parts of a bank’s investment book. Requiring a different approach to this funding mismatch in a bank’s investments became early an important idea behind the Volcker rule in the US,173 the main concern then being that deposits are not to be used for trading positions, and more particularly not for proprietary trading (assuming it could be clearly separated) or hedge fund and private equity activity either.174

171 

See s 2.5.12 below. Besides higher risk weights, it is thought that this leverage ratio could be particularly unfavourable to trade financing, which for this reason had been concentrated in European banks that so far had not needed to maintain this ratio. This is a low-margin, balance-sheet-intensive but large-volume business, in 2010 evaluated at about US$ equivalent of 10–12 trillion per year. Although largely uncontroversial, ready availability of trade finance is vital for it. For European banks there is the added problem of ready access to US dollars for this purpose as 75 per cent of this trade is dollar-based. In October 2011, the Basel Committee made some concessions in the area of capital adequacy but for short time trade financing only and not in the area of the leverage ratio. Cost will therefore also rise, not a good sign either for international growth. It again suggests differentiation per activity. 173  It has already been pointed out that this trading activity is often difficult to separate from risk management, meaning the constant and necessary adjustment of a bank’s open positions, especially in currencies, swaps, repos and securitised products or in other market-making activities. One could, however, impose a requirement to close all open positions overnight, including even those in proprietary trading, which are usually meant to be longer term although seldom longer than a few months. By 2010, political expediency in the US started to concentrate on this aspect of proprietary trading as the main culprit, but it is quite small in most banks and was not in itself the proximate cause of the financial problems either. Nevertheless, high gearing in these activities to the extent they go beyond ordinary trading may rightly be perceived as potentially destabilising the system; see further also n 28 above. What is ordinary trading is not easy to define, however, eg in the case of anticipatory trading needs of clients and keeping inventory to that effect. This gave rise to much discussion in the US, see also nn 151 and 157 above and in the EU s 3.7.11 below, on the Volcker rule, which remained contested and led to relaxation in the US in the Trump presidential era. 174  It was early realised that market-making required trading and that without proprietary trading, at least government bond markets would suffer. A so-called Tobin tax on trading, see n 181 below, could have a similar effect. 172 

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(g) Ring-fencing of trading activity in this manner175 recalls the old Glass-Steagall Act in the US, but now for all trading, to protect depositors better and limit the risk for governments that deposit guarantees are invoked or direct support becomes necessary. Hence the idea to spin off trading activities in separate companies that may be required to carry more capital for these activities, even though this kind of trading was not at the heart of the 2008–09 financial crisis. (h) Related is the notion of ‘narrow banking’ for small depositors: see ­section 1.4.6 below.176 It means that retail deposit-taking would be done through money market funds, themselves more heavily regulated, but it would follow that these moneys could not then be used for the general liquidity-providing function of banks. This became the UK approach and is a serious issue which could change banking dramatically, another important aspect being which investor would still want to invest in this type of banking. (i) Lending to highly leveraged hedge funds through the prime brokerage arm of banks might then be curtailed in similar ways, and may make more sense especially in terms of concentrated positions so as for the banking system not to underwrite asset and liability mismatches in these funds, which banks would no longer be able to use in their own activities. Hedge fund activity itself should otherwise continue; it is a necessary modern market function but probably not in banks.177 (j) Spreading banking risk through securitisation in the capital markets should continue to be encouraged also but not merely to lay the risk off on a small group of banks and insurance companies, often in private placements. Rather, risk should be more widely spread from the beginning through the capital markets to achieve the full benefit of securitisation so that no public/private action need be taken later to remove toxic assets from bank balance sheets. (k) Earlier ideas that securitisation itself should be curtailed178 were largely misdirected. Diversification of risk is essential for banks and securitisation is the connection between banking products and the capital markets. In fact, true securitisation (rather than private placement) in the capital markets and therefore their acceptance among professional investors may be the real test of these

175  In the US under these rules, ring-fencing of trading activity was joined by investments in hedge funds and private equity, which are also to be excluded. It concerned the entire banking group meaning that these activities could not take place in any part of a bank holding company—it is therefore no ring-fencing proper any longer (unlike in the EU as we shall see). It further required the parent to ensure that trading activity did not affect the deposit-taking function. Intra-group exposure had to be limited as well and contracts with other group members had to be ‘arm’s length’, cf the amended s 13 Bank Companies Holding Act, 12 USC par 1851. 176  See for the options also JTS Chow and J Surti, ‘Making Banks Safer: Can Volcker and Vickers Do It?’, IMF Working Paper WP/11/236, October 2011. The Vickers Rule was a typical UK response concentrating on the ring-fencing of deposits. The Financial Services ReformAct 2013, amending (further) the Financial Services and Market Act 2000 required each deposittaking institution to set up a special entity, which take the deposits from the public and are prohibited from exercising a number of functions, which are grouped as dealing in ‘investments as principal’, further to be detailed by order of the UK Treasury. As of 2019, the deposit base can only be invested in low risk assets. See for this and the EU response after the Erkki Liikanen report also s 3.7.11 below. 177  See for the US response n 175 above. 178  See for the abuse and excess of financial engineering, ch 1, ss 2.5.4 and 2.5.5 above.

PART I  Financial Services, Service Providers, Risk and Regulation 631

schemes, which could become a regulatory objective at the same time. As securitisation creates interconnectedness and therefore also systemic risk among the holders of securitised products, there is an implicit need, however, again to avoid large concentrated positions. (l) The role of the clearing and settlement functions should also be enhanced, which would provide at the same time more discipline in documentation, margin calls, and segregation and may facilitate also more orderly clearing and settlement in interbank, repo, and swap markets or even in securitised products. (m) Central Counterparties (CCPs) or similar clearing institutions are often considered here to be much of the answer but depend in their operation on sufficient standardisation of risk,179 which, especially in swaps and CDS, may be neither efficient nor realistic.180 If it was, the industry would likely have embraced it already. Securitised products trading (CDOs), repos, and even interbank lending may benefit from some further standardisation, which should be favoured by regulators and may then also provide for better close-out facilities. There is here, however, the issue whether CCPs as private institutions can be forced into this extended activity; can they reasonably manage the risk? (n) Most importantly, as participants (pre-approved clearing members) guarantee the proper operation of such CCP markets and guard against the effect of bankruptcies therein (assuming that in a banking crisis their major backers, usually the banks remain solvent), this could become a major regulatory concern and their weakness or demise may also bring the CCP down. Centralisation could then prove disastrous and margin calls may not help sufficiently as future payments may also depend on the guarantees of clearing member banks. 179  Indeed, in the early American proposals made public in May 2009, it was suggested that there should be more transparency in trading and pricing in derivatives markets, especially swaps, but also in futures and options and other than financial derivatives. This may well help the market activity in these instruments. Another proposal was a much increased use of CCPs to net out the risks of derivatives centrally—see for this facility ch 1, s 2.6.5 above; again, it posed at once the problem of standardisation and its confining effect on targeted risk management. 180  The introduction of a CCP in this business (see also ch 1, s 2.6.5) may substantially eliminate settlement risk as all participants guarantee each other and a system of margin would be introduced that could not solely depend on (deteriorating) credit ratings. This was one focus of proposals for a regular swap market in June 2009. It would also institutionalise proper supervision of the paperwork and management of margin calls. CCPs would thus create greater transparency and instil greater discipline in the documentation or, better still, net out a large part of the exposure in these products (which is probably no more than two per cent of the outstanding value. Indeed in 2008, it transpired that the netted-off exposure of Lehman to the market had been only around $6 billion. It was the un-netted exposure, which had spooked markets. Standardisation through CCPs might take away flexibility, however, and would cut out much trading profit, especially in large banks, but may be necessary to bring greater stability to these markets. Thus a sufficient level of standardisation and the limiting of OTC derivative transactions became the drift of much American regulatory thinking in the spring of 2009. Later, in 2010, centralisation of the risk in this manner, the need to balance it by margin calls even in respect of end-users, and the lack of flexibility in risk management that would be the consequence received more attention. In the EU, in the autumn of 2009, proposals for a Capital Requirements Directive (CDR) 3 emerged, see s 3.7.3 below and proposed much higher capital for trading positions but confirmed the ‘zero risks’ status of CCP exchanged products with the attendant exemption from capital requirements in respect of position and settlement risk in these assets, while increasing the capital levy on OTC derivative trades until fully settled. Minimum requirements for collateral and margin were foreseen for all CCPs so that they would not underbid each other. Non-financial firms such as commodities traders, oil companies, and airlines but also hedge funds, would be covered for systemic reasons. This was obviously problematic as it meant regulation outside the financial services industry proper. It nevertheless became the drift of the American and European proposals.

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(o) To impose a levy on all banks (or at least those ‘too big to fail’) to create a fund or insurance type of protection in good times was another idea that gained ground in 2010 and also found support in the banking industry.181 This would not be a tax therefore, the proceeds of which would be used for general purposes. (p) How this fund, which could grow large, would be invested and how these investments could be liquidated promptly when needed to support banks are important questions. Such a fund could also increase moral hazard further. It would reduce the tax that could be levied from banks in the meantime. (q) It raises in fact the question why governments, who greatly benefit from banking booms in terms of tax revenue, do not themselves set some of this money aside rather than spend it on new programmes and find themselves short in bad times when they may also be called upon to save their banks. (r) A variant would be for banks instead to create a class of bonds that governments would buy with these levies and in which other investors might also participate. They would be converted into capital in bad times. This is itself a variation on a theme under which all bond holders would in such times be converted into shareholders as is even now not unlikely under applicable bankruptcy schemes but which was not the approach taken when governments saved banks outside bankruptcy in 2008. Under so-called CoCo bonds this would be agreed.182 In this proposal, government-owned bonds of this nature would be converted first. Until such time, they would not be considered subordinated and would not count as capital in that manner. (s) Other ideas were that in any given economic cycle we should get used to the notion that banks will be insolvent for some time while their demise as recycling institutions would be undesirable. Thus those that are ‘too big to fail’ would have to be given some supervised and supported (legal) framework to continue their activity regardless of their insolvency which would then be deemed a temporary condition. (t) This came to be referred to as ‘resolution’. The concept may be connected with the operation of the fund or the facility to convert (certain) bonds into equity, mentioned in the previous indent. As has been said before, the accent should rather be on building better buffers in good times. Panics in bad times are hardly eased by asking for depositors’ and bondholders’ support in a bail-in.

181  Another idea had been a tax on all trading, the so-called or Tobin tax, which was at the same time to become an exit strategy for the substantial increases in government debt, but it would also hit necessary trading as risk-management activity. Moreover, this money would likely just disappear in government projects of all kinds in good times. The better approach could be its use as a forced regime of repayment of government debt below a certain percentage of GDP. Increased tax collections from banks could similarly be set aside. The preferred alternative may be building much more capital in banks in good times, which would reduce excess activity at the same time (see also what was said on the anti-cyclical effect of capital in ss 1.1.13/14 above). 182  In 2011, the Swiss government instituted a system of so-called CoCo (contingent convertible) bonds, which were bonds that could be converted by regulators into capital when needed. The idea was that these bonds would cover nine per cent out of a new capital requirement of up to 19 per cent of risk assets. The success of this idea will depend on the offered interest rate, but this market could become very large and dwarf the rest of the bond market in Switzerland. The trading prices would be a valuable indicator of the market’s judgement on the banks but the prospect of conversion would likely lead to an early price collapse.

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(u) The international dimension of modern banking is another substantial complication and raises the question which government would be in the driving seat when it comes to saving or resolving banks.183 It would go well beyond the special provisions for bank insolvency now already existing in the US, for example, and may involve the use of large public support funding in terms of lending of last resort and taxpayers’ money. In order to be effective, it should be organised at the international level and include some exit strategy, on which all could rely.184 (v) It would not be unexpected that during such periods of public support and supervision, all earnings must be retained and at least in principle there would not be a distribution to shareholders or employees. These facilities could ultimately prove profitable to governments when banks are refloated and better times arrive. That might easily pay for these schemes. (w) In organisational terms, there is much to be said for separating the stability issue and prudential supervision from (i) the regulation of products, (ii) the conduct of business and (iii) market abuse.185 In the US in 2009, there emerged in this connection also a call for a special consumer regulator. (x) This type of regulation could also cover money market funds, limiting their facility to invest in illiquid assets, requiring a minimum in cash assets, and limiting maturities.186 Stability is indeed a different regulatory issue, which immediately ties in with the facilities of lenders of last resort and government support for the system in times of crisis.187 It is also connected with monetary policy and capital flows.188 183  In the US, the facility is operated by the FDIC rather than the bankruptcy courts. Newly invested cash would later on be recovered from asset sales, while creditors other than depositors might also be asked to contribute. The FDIC has a measure of discretion as to whom to call. This is obviously problematic for long-term creditors, who might be treated more severely than short-term creditors. 184  It may be seen that such a lifeboat would then also be essential to preserve the clearing and settlement systems, which themselves depend on the solvency of their clearing members, normally the major banks. In this sense, all is connected and gives the banks that are ‘too large to fail’, see s 1.1.15 above, extra power. Moral hazard considerations may become irrelevant. It suggests that these banks fall into a separate class and are therefore the ones for whom a special insolvency regime must be devised to tide them over bad spells. Again this has to be an internationalised regime connected to a facility of an international lender of last resort and to a tax money provider. It may be questioned whether such a facility may be arranged around the IMF. There is, however, hardly anything else or it could be the Financial Stability Board (FSB), see s 1.2.5 above. It would mean a considerable surrender of sovereignty for which especially the larger countries, which still believe that they can save their own banks however much internationalised, may not yet be ready. During the 2008–09 banking crisis national authorities were still able to restabilise the system. It may be asked whether that could still be done next time in that manner once the majority of the Chinese, Indian, Brazilian and Russian population and businesses also want to key into international liquidity largely provided by Western banks. Only for the eurozone, a transnational regime was developed, see s 4.1 below. 185  In the area of products, a more individual product approach to supervision may well have to be taken, although again it is doubtful how much insight may be expected here from regulators, especially for newer products. In terms of regulatory supervision, it is connected to questions of excess and abuse of products and markets. Accountants, auditors and credit rating agencies have an important role to play here. It has already been said that abuse needs to be avoided but it is hard to define where it starts. A premium on whistle blowing may be another important tool here. On the other hand, ill-directed regulatory over-reaction is itself a risk to the system. 186  This was indeed an SEC proposal that came out in the summer of 2009. It also included suggestions to liquidate funds that had ‘broken the buck’, that is their value having become lower than the amounts put in by investors. 187  See for the issue of stability and at what level of economic activity it should aim, ss 1.1.2 and 1.3 above. 188  This may be relevant in the EU where financial regulation is still connected to the internal market in services but at least part of it has to do with capital flows. Financial stability is a broader issue.

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(y) Another aspect is the strengthening of corporate governance in banking, which failed no less than regulation during the financial crisis. The independent technical back-up of outside directors and greater independence for the riskmanagement, compliance and internal-auditor functions are here important steps that could create a better corporate balance. (z) The reporting of banks should become much more open, especially in their connected businesses, and become subject to much greater scrutiny by analysts and academics. The veil of secrecy on banking activity should be lifted as a matter of public order. It may seem minor, but it is not and would probably be one of the more important of all reforms. Regular stress tests should be performed and the parameters and results published. (aa) A final question is whether, and to what extent, the shadow banking industry should also be regulated (see s­ ection 1.1.17 above) and whether that can effectively be done without also making it smaller and depriving society of even more liquidity when it matters most. It is not true that all that is not regulated is suspect per definition. In fact, what is regulated may be more suspect because of its aura of legitimacy, especially if we do not know what we truly want from regulation or want contradictory things, or have no idea how to get there.

1.3.11  Effect of Internationalisation. The Lack of an International Safety Net. The Emergence of the Eurozone Banking Union and the Mutualisation of Banking Debt in the Eurozone There can be little doubt that internationalisation of the money flows complicates the regulatory picture in finance. It has already been said that on the whole internationalisation of financial services is necessary and beneficial to support the worldwide funding needs that are now sustaining modern economies from top to bottom and to spread risk in the financial services industry. Governments, banks, corporations and consumers all join in as borrowers while the flows of money and financial services have been substantially internationalised. This is likely to continue even though at present a form of Balkanisation may have set in, reflected also in a homeward trend in regulation, which remains in essence a national jurisdiction. However, globalisation without global financial funding and services is unrealistic. If we want its benefits to continue, upon a rational analysis, the free flow of financial services cannot be far behind. It is a sequel to the free flow of money, but is an obvious regulatory challenge. Indeed, the major currencies are now freely traded worldwide and convertible (except still for the Chinese Yuan).189 This has also aided the transnationalisation of the liquidity-providing function of banks that are themselves internationalised, grouping this business around a small number that have become very large in size. It can be seen as a normal consequence of banking and money following the internationalisation of the flows of goods and services and the horizontalisation of production and sale, 189 

See s 2.4.1 below.

PART I  Financial Services, Service Providers, Risk and Regulation 635

but it may also be an autonomous drive to mobilise liquidity worldwide to support ever greater needs for it domestically. The fact that financial regulation remains in essence domestic unavoidably presents deeper home/host-country regulatory jurisdiction problems and increases the adverse effect of multiple regulation, problems substantially resolved within the EU as we shall see, although not in WTO/GATS.190 It raises in particular the question whether the aim should be one international regulator or a regional one. Even in the EU, financial regulation remains a Member State jurisdiction although subject to considerable harmonisation supporting mutual recognition of these national regimes, the free flow of money and financial services and their promotion being a prime policy objective expressed in its monetary union, ultimately not to be defeated through the national character of financial regulation. The other important issue here is who would be the banks of last resort for such an international financial system and even more importantly who supports or saves these international banks or the system when problems occur? So far (again except in the eurozone to some considerable extent), an international system of support is noticeably lacking and would appear to be increasingly needed to react quickly in times of crisis as the situation in 2008–09 demonstrated. The real issue is then who supports or saves these international banks in times of stress and pays for it? It can hardly be the taxpayer of the country where the bank has its main seat if most of its assets and depositors are elsewhere. Where confidence ultimately depends not on regulation but rather on the expectation that governments will directly intervene and save the system when regulation has (again) failed, it means that a safety net as some alternative or first support system now requires internationalisation. As long as financial regulation as we know it cannot provide the necessary stability in a low-capital-requirement environment for banks, effective international action of governments and, probably to a lesser extent, of lenders of last resort, remains the foremost issue following the internationalisation of the financial sector and then goes well beyond the confines of home/host-country rule wherever it exists. As it cannot be certain to be sufficiently responsive and effective, the issue becomes one of the existence of a proper international safety net. It is indeed submitted that an immediate reason for the financial crisis in 2008—why it happened then and not earlier—was the increasing uncertainty as to the extent, nature and effectiveness of governmental action in internationalised markets with ever fewer but also larger international banks operating. After the shake-out in banking in 2008, it must be assumed that the trend towards fewer and bigger international banks will continue. It has already been said that the top 30 banks are reported to have 70 per cent of the banking assets in the world, which makes the need for international support structures in times of crises ever more important, not only in respect of the operation of large banks from smaller countries.191 A pre-existing international safety net would appear to be a necessary part of such a system. 190 

See below ss 2.3.1 (for the EU) and 2.2.3 (for GATS). Indeed it was reported in the summer of 2009, that the Swiss government was considering shrinking its internationally operating big banks if no international system for support was forthcoming. The implicit suggestion was that support for such banks could bankrupt the Swiss government. Hence also the increase of the 191 

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All the same, because of the increasingly important international dimension, in 2008–09, at the initiative of the US, reformulating the regulatory scene became a first objective of the G-20, considered effective in order to re-establish confidence, but no coherence in view emerged and G-20 avoided in the first instance the question of the international safety net.192 It was in fact left to the US to come up with proposals, which started to emerge from Washington during the summer of 2009. The efforts soon stalled in a highly politicised Congress, but also for lack of a clear view. Eventually the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed (commonly referred to as the Dodd-Frank Act).193 It did not and could not deal with the question of an international safety net, which needed to be followed by an international exit

capital requirement to 19 per cent, which makes much international business unattractive for Swiss banks. The Dutch government, seized the opportunity to make its banks retrench by forcing the sale of many of their foreign operations. An argument could be made that indeed it no longer makes sense for Western banks to fund the whole world. It may become far too risky, although very profitable in good times. 192  Rather, the G-20 leaders at their meeting in Washington in November 2008 endorsed a series of ­principles for regulatory action, such as demands that banks create bigger liquidity cushions, better assess their riskmanagement practices, boost capital requirements for certain risky investing practices, and promote greater financial market transparency. They also considered ‘colleges’ that bring together supervisors from different countries to swap notes on institutions they oversee. But there was little that was concrete and no talk of an international safety net when all fails. Rather, what was proposed in terms of regulation could have a short-term, pro-cyclical, deflationary effect, which seemed the opposite of what the Conference planned. It subsequently moved on to macroeconomic measures. Not much greater leadership emanated from the G-20 in subsequent meetings, including the one in Toronto in June 2010. Talks continued on stability, capital adequacy and liquidity requirements, a better crisis-management framework at global level, remuneration, OTC derivatives, corporate governance in financial institutions, and special tax on banking activity, particularly favoured by the EU. The problem was its use to either boost general revenue, which seemed to be preferred rather than to create a special buffer for banks. See at the time also B Eichengreen and R Baldwin (eds), What G-20 Leaders Must Do to Stabilise our Economy and Fix the Financial System at www.voxeu.org. Here the argument was that internationalisation of regulation and supervision is necessary but that sovereign regulators do not want to let go because they still foot the bill (and collect the taxes in good times). However, from this it would follow that, if there was a proper international safety net, international regulation and an international regulator especially at macro-prudential level in the IMF or another forum could follow. If the thesis of this book may be accepted that the key is to start to regulate severely and cut back banks at the top of the market for them to build capital, retain profits, cut down on bonuses and start building an international safety net, it would be for an international agency to call the moment, if only to preserve a level playing field between all international banks. Perhaps still illustrative for the thinking at the time, in the Wall Street Journal of 23 December 2008, the German Finance Minister set out what in his opinion should be done. The idea was to: (a) strengthen transparency and accountability—new financial products should be explained and no more excessive risk taken, although it remained entirely unclear what excessive means in this connection and whether it can be foreseen; (b) enhance sound regulation covering all markets, products and participants (including rating agencies), but the issue is the degree of regulation and on what exactly it should focus: except for abuse, markets should be free in order not to become manipulated or artificial, products and participants can be regulated but not in order to inhibit ordinary market behaviour and necessary innovation; (c) promote the integrity of financial markets, meaning better protection of investors, avoiding conflicts of interest and market abuse—this again touches on the products that can be sold and especially their proper valuation, therefore on adequate markets; (d) reinforce international regulatory co-operation; and (e) reform international financial institutions, including the IMF and the Financial Stability Forum (FSF), the latter, having failed miserably, was in April 2009 transformed into a Financial Stability Board, see s 1.2.5 above. Notably there was no talk of proper capitalising of banks and of the issue of high gearing or societal leverage. Also the issue of an international safety net, and how it was to be organised, operated and paid for, was avoided. Although macro-economic restraint was suggested, the impact of serious imbalances, like those in monetary and trade policy, were notably ignored. 193  Dodd-Frank itself ran into 828 pages, while the Act of 1933 had only 37. It required 398 separate rule makings, by the end of 2013 running into 14,000 pages.

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strategy for government support and a common attitude towards government aid in order for it not to become distortive of international competition in financial services. More importantly, an international guarantee of this nature could raise the question of moral hazard to an even higher level, that is the increasing reliance of bank managements on a government bailout or otherwise a solid international safety net, which may make them ever more irresponsible: see ­section 1.1.12 above. It is supported by the notion of ‘too big to fail’, see ­section 1.1.15 above. To counter this, there still has to be some cost of failure; indeed failure should be allowed. It became clear, however, in 2008–09 that this consideration had to be set aside completely when the demise of Lehman’s proved the last straw and a wholesale saving of the banking system became necessary.194 It now seems to be a feature of the whole system that in each economic cycle we may be faced with large struggling banks for a number of years. It has already been said that saving these banks may be considered a normal government task in the circumstances and a normal consequence of regulatory failure, but it is also a practical issue, no society can operate without banks. In any event, the possibility of individual bankruptcies as a threat to prevent this type of moral hazard is no longer credible policy. Bail-ins are hardly the answer in times of crisis either. They will increase the sense of panic. Again, a pre-existing international safety net may be. In the meantime, in the summer of 2012, proposals for a mini international safety net emerged in the EU for eurozone countries, in first instance inspired especially by the weakness of Spanish banks and the need to support them, for which initially EUR 100 billion had been set aside. The more immediate questions then became who was to provide this support, who would order and direct it, and what would be the ranking of the creditors? Subsequently a call went out for one banking regulatory regime within the eurozone, mutual support of all systematically sensitive banks in the area, and a common depositors’ protection scheme. A common resolution regime would be the normal supplement under which bond holders and even depositors (beyond the deposit guarantee scheme) would have to contribute to a so-called ‘bail-in’. But it can only be repeated that it is hardly the answer in times of severe financial distress and conducive to early bank runs when governments would likely be the only saviours left short of a sufficient safety net. For international banks it would in any event to have been decided which government or governments contribute and the manner in which they would do so. Again, the alternative was to create a resolution fund supported by them (and their banks), better still if it would also have borrowing power. In the EU much of this would probably need support in the Founding Treaties to truly stick, especially the operation of and contributions to the ultimate safety net, who could call the support, in which circumstances, and under what conditions.

194  While saving banks, it could still have been possible to require bond holders to be converted into shareholders (debt for equity swaps), so that the latter would have been diluted and there would have been a cost for both. That was not done and followed convention; the loss of confidence of bond holders is itself normally considered a major stability issue. What was also missing was a clear exit strategy for governments. In the crisis it was all postponed for later consideration and then became part of the resolution regime, see below the discussion for the EU and further s 4.1.3 below, which also required depositor concessions. Subsequent UK proposals for a new Banking Act on the other hand considered giving depositors a preferential right in the insolvency of a bank. This is a novel departure in banking.

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S­ imilar agreements could be made under separate intergovernmental agreements or treaties if not all EU Members wanted to participate. It very much became the idea for the banking union in the eurozone, expressed in the Single Supervisory Mechanism (SMM) of 2013, as we shall see in ­section 4.1 below, followed by a special Regulation creating the Single Resolution Mechanism (SRM) including, among other things, a Single Resolution Board and a Single Resolution Fund (SRF). The Bank Recovery and Resolution Directive for Banks and Certain Investment Firms (BRRD) was agreed in the EU at the same time, see ­section 3.7.16, and envisages for all Member States the appointment of competent authorities in charge of resolution plans including assessments of solvability and the setting of individual bail-in ratios, the implementation of the resolution plan, and support based on contributions from other banks. For the eurozone banking union, the SRM, while introducing a centralised authority for the eurozone, must be seen as building on it. Thus the BRRD is not replaced in the eurozone but remains necessary in particular for providing a framework for resolution EU-wide in Member States which are outside it. Particular problems for the SRM were the power of the Resolution Board to oversee the process and direct the banks. It also concerned the power to direct the funding operations earlier and eg order the type of bonds to be issued, such as CoCo bonds, and how many. It could also mean imposing levies on other banks and even fines on Member State governments to comply with and enforce Board decisions. In the EU, the legal issue is delegation of EU authority, which could require a direct EU involvement in the Board to retain the legitimacy of its operations. That would suggest an active role for the EU Commission but many found it difficult to give it ever more authority especially in areas where there may also arise conflicts of interests with its other functions. There were other fundamental questions. What was a proper level of regulation that would not kill off all modern banking; was the ECB, while becoming the regulator for the major eurozone banks at the same time, becoming in reality also the guarantor of these banks in an extended notion of lender of last resort; would all banks qualify or would there be an entry test and continuing conditions; why should strong banks be required to support the weaker ones in other countries thus weakening themselves; and what would be the ranking of deposits vis-à-vis other bank lenders, including the Single Resolution Fund (SRF)? By putting the ECB in the forefront, its own solvency also had to be considered. Again, Member States could not stay out of this, but as they had little money, they proved more than willing to put the burden on others, notably the ECB, even though this may hardly be the answer, as in difficult times everyone will start worrying whether this can save the system. Probably most problematic was the fact that any safety net organised in that context would not amount to a global facility on which all major banks could depend in a situation of stress. Even together, eurozone countries might be too small to save their banks unless they were to reduce them to such proportions that they would cease to be the main liquidity providers for the economy. It was said before that banks provide the oil in the machine of the economy, which is increasingly interconnected and globalised. Without them, the whole economic system as we know it collapses. If we do not want that, banks are likely to become even bigger and therefore ever less likely to be able to be saved by national or regional governmental forces. A safety net of this nature needs

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to be organised at a global level and include all system-sensitive banks worldwide to be effective. In the event, the SRM was agreed in principle in December 2013 and included the setting up of a Single Resolution Board to be activated by the ECB. The ECB decides whether a banks needs to be resolved but the Single Resolution Board (SRB) will take the decisions on how to do this, and national authorities have a say when large sums of money need to be inserted. The European Commission has the ultimate responsibility and may still refer any of the SRB’s decisions to the European Council for a political solution. Creditors, including depositors to the extent not guaranteed or secured, were made liable for at least eight per cent of the liabilities. It meant that if senior bondholders were forced to do more, depositors could contribute less. The SRF was also agreed, to be built up by the banks themselves up to an amount of EUR 55 billion. It shows the limited nature of this facility; it is not a general safety net. In April 2014, the relevant Regulation was passed—see further also s­ ection 4.1.3 below. This is supported by an inter-governmental agreement in respect of the SRF to allow for transfer of contributions collected nationally and the progressive mutualisation of the contributions. Indeed the Fund is meant as support, and certainly not as a take-over fund for banks. If it proves insufficient, responsibility will revert to national governments for ad hoc solutions. The SRM, SRF and SRB sit as second pillar alongside the SSM as first pillar and are its resolution arm. The SSM itself was agreed by a Regulation in October 2013 establishing the ECB as of November 2014 as the prudential supervisor of all significant eurozone banks (to be identified by September 2014). A third pillar may eventually be a common deposit protection scheme. Although it was already noted several times that the deposit protection scheme looks generous, it is at the same time the reason why its solvency may well be doubted in times of crisis, reason why especially the German government has resisted so far the mutualisation of the obligations. The system will become fully operational only by 2024. More may be agreed in the meantime (in the German view, greater pooling would require more sharing of sovereignty). Early stress became apparent in Portugal, Spain and Italy when important banks continued to require saving.195 It proved to be profitable in the US as it should be, but it is so far handled less successfully in Europe.

195  Loopholes and exceptions were found to the new bail-in regime and the need was not surprising. Especially the idea that senior bondholders should be ‘punished’ or even depositors for what was in essence regulatory failure was untenable, if only because they do not have the means of regulators (and indirectly government and tax payors) to be informed, see also E Avgouloeas and C Goodhart, ‘An Anatomy of Bank Bail-ins’ European Economy, 5 Dec 2016. As long as the whole system is not in crisis, these loopholes and exceptions may be enough but in a full emergency the whole new system would likely quickly collapse. Even the deposit guarantee schemes could be in serious danger. Under Art 32(1)(c) BRRD and Art 18(1)(c) SRM Regulation, any resolution activity including bail-in must be necessary ‘in the public interest’ and ‘necessary for the achievement of and … proportionate to one or more of the resolution objectives … and winding up of the entity under normal insolvency proceedings would not meet those resolution objectives to the same extent’. These criteria are not objective and leave in practice much needed wiggle room. See for the lack of recourse, s 4.1.5 below and for the issue of proportionality s 4.1.6 below. In 2017 the system was tested in Italy and Spain, see also text at n 611 below, earlier in Portugal where the resolution fund, still virtually empty but with government support, was used to save the Spirito Santo Bank after

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1.3.12  The US and European Regulatory Responses to the Financial Crisis In view of the lack of clear ideas and consensus, after 2008 much of the discussion at first descended into a turf war between existing regulators and an argument on regulatory restructuring and consolidation. Political discussion subsequently moved from better settlement systems, to bonuses, an extra levy on banks, and thereafter to proprietary trading, underscoring that there was indeed no clear view nor any great insights into the true causes of the crisis except for the feeling that banks had misbehaved and were too large but also that they were necessary for present-day credit culture to persist. Ultimately the discussion reverted to liquidity and especially capital adequacy while a new Basel III was proposed by the Basel Committee, which, although at first discredited through the ineffectiveness of Basel II, soon regained its status, now as think-tank for the G-20 for lack of any better. Its basic proposals in terms of liquidity management were a liquidity ratio and in terms of credit and market risk increased capital levels, which for core capital in Tier I would go as high as seven per cent to be achieved by 2020 while Tier I capital was to be calculated in a more conservative way. For certain products the capital requirement was increased. A leverage ratio was added. The effects on growth were thought modest but generally belittled at this stage. It remained to be seen what the attitude would be in years to come when the Western economies do not resume a growth pattern that is deemed sufficient, especially if lack of liquidity will be seen as an important factor. By 2018, the situation was hardly clearer in Europe. In the US banks had regained their strength and the US was doing better. It must be admitted that whatever resulted in new regulation—which was a bit of everything—with existing insights the effect of these changes on the health of the banking industry, on the stability of the system, and on growth, remained speculative, but at least the impression that something had been done was given. Greater powers for regulators at the national level became the result (in the absence of international regulators—even the Basel Committee is no more than a think-tank). It has already been said that the danger was a homeward trend in regulation, the abandonment of the international playing field for banks never mind Basel III, and the reduction in the globalised financial-service and liquidity-recycling function of banks. If globalisation is to be at the heart of any jump in growth worldwide—hence notably also the

a split in a good and bad bank, which itself immediately raised serious issues about which assets and liabilities were allocated to either. In Italy, the Monte dei Paschi di Siena was taken out of the full force of the system by the government declaring it fundamentally solvent and only needing ‘precautionary recapitalization’, with which the EU Commission agreed, citing ECB support for the solvency finding (without indulging in the criteria), and the fact that the non-performing loan portfolio was being sold to private investors, see EU Commission Press Release, 4 July 2017. State aid of Euro 5.4 billion was allowed. Also in 2017, the Veneto Banca and Banca Populare di Vicenza were not considered sufficiently large and were saved under national insolvency rules with Euro 17 billion government support whilst deemed exempt from the EU state aid rules under the EU Commission Guidelines. In Spain, Banco Popular was saved through a takeover by Banco Santander for one euro after a write-down of its capital and junior bonds. In all cases depositors and senior bondholders were indeed unaffected. In the meantime, the Federal Reserve of Minnesota President Neel Kashkari commented that bail-in ‘almost never actually works in real life … Governments are reluctant to impose losses on creditors of a Too Big to Fail Bank during a crisis because of the risk of contagion … Taxpayers are on the hook’, http://medium.com@neelkashkari.

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2013 proposals for a Transatlantic Trade and Investment Partnership between the US and EU, by 2018 on ice—then it is hardly logical to break up the banking industry along national lines, putting at risk the international liquidity-providing function. Again, the only idea on the table was that smaller was beautiful, going back to a fanciful world in which banking was thought to have been safe, which it never was. It was more like an admission of a lack of insight into what was needed. The result was undoubtedly more power for regulators who had proven not to have such insights either. It was nevertheless also the tenor of the 2010 Dodd-Frank Act in the US, which proved to be an omnibus Bill with all kind of ideas along the lines discussed in ­section 1.3.10 above, but which left much to later implementation and gave no more than some framework for reform, except that it made the $250,000 deposit insurance permanent. Again, the impression was given that something had been done, but upon proper analysis it was not clear what and substantially much of this looked like rearranging the chairs on the deck of the Titanic, with much more bite at the fringes, however, resulting in much higher compliance cost and probably less activity.196 In Europe the discussion was mainly on capital and liquidity ratios. What became obvious in the discussions on Basel III in particular was that more capital would be required but also that it would never be enough to stabilise the system. The cost in terms of employment and future growth would be too high. Thus banking on the scale we now know it remains a highly dangerous but necessary activity in our kind of society and is perfectly capable of destabilising society profoundly. It may even bankrupt governments (and central banks) at times, but it has repeatedly been said that it is a force on which we wholly depend and with which we have to learn to live better, and we can curtail it at the top of the market, when it is at its most dangerous, not in bad times when it is needed more than ever. Whatever its merits, it should be repeated that there is a significant confidencebuilding or rebuilding element in all modern regulation and prudential supervision thereunder regardless of its effectiveness. This is psychology and it appears that the public remains more likely to support and deposit money in a system which it considers regulated and supervised. As such, the public at large is likely to continue to see regulation and supervision as some kind of confirmation of the soundness and stability of the system as a whole, especially in terms of liquidity—although legally speaking there is no such guarantee implied, and the comfort so given through a semblance of regulation may in practice prove wholly illusory. So it was in the 2008–09 crisis, as it had been earlier in 1997–98 and in most, if not all other financial crises.

196  Academic discourse on the subject did not prove much more revealing. No new model was presented in the US. Some of the early discussion became stranded in a debate on whether reform legislation would be recognised as experimental and lapse, to be re-enacted only with regulator support based on experience of the new regime, see R Romano, ‘Regulation in the Dark’, Yale Working Paper 2012, SSRN, following R Romano, ‘The Sarbanes-Oxley Act and the Making of Quack Corporate Governance’ (2005) 114 Yale Law Journal 1521. See for a similar approach to future regulation in the corporate area, SM Bainbridge, ‘Dodd-Frank: Quack Federal Corporate Governance Round II’ (2011) 95 Minnesota Law Review 1779. Against this, JC Coffee, ‘The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be Frustrated and Systemic Risk Perpetuated’ in E ­Ferran, N Moloney, JG Hill and JC Coffee (eds), The Regulatory Aftermath of the Global Crisis (Cambridge, 2012) 301.

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No matter its modest preventive merits and effect, in commercial banking regulatory concern is now indeed directed not so much at the protection of individual customers or clients, but rather at the public interest more generally in terms of financial stability or systemic risk. This explains much of the modern regulatory interest in (a) capital standards, now joined by liquidity, (b) proper management, and (c) adequate system support. In this approach, the protection of depositors comes foremost from deposit guarantee funds, which also proved inadequate and too limited to prevent panic during the 2008–09 financial crisis when governments were required to do a great deal more and top up this protection to calm depositors and thereby stabilise the system. It is only to say that regulation as we have it again proved to be no panacea. Conduct of business and product issues, especially for consumers and small investors, may increasingly be supervised by other regulators, as we shall see. The issue of market integrity, as the third prong of public concern, is not one of traditional regulation but rather of civil and criminal remedies where more needs to be done. As just mentioned, in the US the 2010 Dodd-Frank Act called for further implementation in most areas, but it immediately set up a Financial Stability Oversight Council (FSOC), one of the main functions of which was to designate financial institutions with over $50 billion of assets as systematically important and therefore in need of special treatment. The result was more federal supervision, therefore even of state-chartered banks, although for the rest it was unclear what the FSOC could do in laying down better policies guarding chiefly against systemic risk; see also ­section 1.1.13 above. It could result in termination of their activities; in the case of other financial institutions it could result in examination and recommendations to the primary responsible regulator. In the banking regulatory area proper, the Act concentrated on capital requirements, consumer protection and proprietary trading, the latter becoming known as the Volcker rule.197 It also contemplated asset securitisation, covered bond and credit derivatives reform198 and an extension of CCPs’ activity and derivative (including swap) clearance Considerable emphasis was placed on the adverse influence of interest groups and the world of lobbying while there continued a strong belief in financial regulation of the micro-prudential type per se and its virtues, even in favour of regulation of markets rather than participants, and in the collection of measures contained in Dodds-Frank. Any questioning was derided as free marketeering and Tea Party extremism, but there was hardly a critical analysis of the virtues of Dodds-Frank and of its problems, for example with clearing non-standardised products, the Volcker rule, executive compensation, etc. The role of, and need for, the liquidity-providing function, now substantially globalised, was hardly placed at the centre of the discussion. Banks and systemic risk were held to be key problems in this connection, especially the ‘too big to fail issue’, not the leveraging of society as a whole. The cyclical nature of regulation was noticed, however, it being increased in bad times on the rebound, unmindful of unintended consequences, and forgotten or unenforced in good times, but no fundamental new approach was suggested and piecemeal reform amounting to regulatory micro-management of intermediaries appeared to be the answer (at least for capital market activity). Building capital in the manner of transforming debt into equity was left to the situation of an approaching insolvency, in practice far too late to be effective and likely only to aggravate the situation. Finally, there was concern about shadow banking but little explanation of whether or how it contributed to the crisis and realistically what to do about it. 197 

See for its implementation n 173 above. In January 2012 the Commodity Futures Trading Commission (CFTC) and SEC issued a Joint Report on International Swap Regulation pursuant to s 719(c), and concentrated on the points earlier highlighted by the G-20 (see n 192 above) being (a) that all standardised derivatives be cleared through CCPs and traded on exchanges or electronic platforms (which could be within a CCP), (b) that OTC derivatives be reported (to a trade repository or TR), and (c) that non-centrally cleared trades be subject to higher capital requirements. It reported varied progress across jurisdictions. 198 

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in that connection.199 Mutual funds including hedge funds and private equity activity were potentially also affected: banks could not invest more than three per cent of their Tier I capital in private equity and these funds, while all private funds, including hedge funds, unless small, had to register with the SEC) and were made subject to regular reporting. Venture capital could be exempted, the definition being left to the SEC. In the EU, equally a stability board was created: the European Systemic Risk Board (ESRB), see also ­section 1.1.14 above and 3.7.2 below, followed by a series of Directive amendments and also a number of important new Directives and Regulations. It started with the need for banks to hold at least five per cent of securitised product in an asset securitisation200 and was followed by amendments to the capital adequacy Directives based on the initial agreements in Basel III.201 In the areas of derivative trading, clearing and reporting, the European Market Infrastructure Regulation (EMIR)202 reinforces CCPs while the European Securities and Markets Authority (ESMA) in Paris (the successor to the Committee of European Securities Regulators or CESR) has ultimate responsibility for implementation as an EU body rather than an association of national bodies. The important 2004 MiFID, allowing for the trans-border movement of financial services, was also amended, not least in the area of derivatives, to cover OTC products and to require some of them to be traded on exchanges or electronic trading platforms.203 In November 2011 a regulation was agreed on short selling and certain aspects of CDSs.204 A regulation on credit rating agencies was passed in 2009.205 In the area of mutual funds, the Alternative Fund Managers Directive (AFMD)206 began to cover also hedge funds and private equity while for open-ended funds, it was further agreed that UCITS (Undertakings for Collective Investments in Transferable Securities) be updated.207 The Market Abuse Directive (MAD) was in for full replacement through a regulation and a new Directive (MAD 2), notably extending its scope to newer trading platforms (MTFs) and other trading venues. Other EU initiatives were the Consumer Credit Directive, the revival of the Mortgage Credit Directive, and further updating of the Payment Services Directive and the 2009 Regulation establishing

199  The CFTC approved final rules in 2012 implementing s 724 of the Dodd-Frank Act in the Protection of Cleared Swaps Customer Contract and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions. It prescribes how cleared swaps and related collateral must be treated prior to and after bankruptcy. The basic idea is for intermediaries to segregate cleared swap customer collateral, updating earlier rules in this area. 200  See n 24 above and Directive 2009/111/EC of the European Parliament and of the Council [2009] OJ L302/97 (CRD 2). 201  This concerned the Capital Requirements Directive 4 (CDR4), see further s 3.7.4 below. 202  See s 3.7.6 below. 203  Other main issues in the revamp of MiFID were (a) access of regulators to information that is presented in more accessible form, where there is also a connection with the Market Abuse Directive regime, (b) increased transparency in OTC pre- and post-trading reporting, (c) extension of the pre- and post-trading reporting requirements from equity to similar instruments, such as exchange-traded funds (ETFs), fixed income, CDS and other OTC products; (d) passporting rights for branches of foreign entities under a single branch authorisation procedure; see further s 3.7.5 below; and (e) payment for research and information supply by intermediaries. 204  See s 3.7.9 below. 205  See s 3.7.13 below. 206  See s 3.7.7 below. 207  This concerned investments in transferable securities, ETFs, index tracking, portfolios, efficient portfolio management techniques, total return swaps and strategy indexes.

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technical requirements for credit transfers and direct debits in the EU area, also known as the Single European Payments Area (SEPA) Regulation, none of which was directly inspired by the financial crisis. Only later in 2012, as we shall see, was there talk at EU level on the splitting up of banks, excluding trading activity and moving to forms of narrow banking. In the meantime, the deposit insurance was put at EUR 100,000 minimum with a pay-out date of three days (rather than 30 days earlier). It may be noted that many of the concerns in the EU are the same as those behind Frank-Dodd in the US so far with the exception of the Volcker rule which, however, was also catching on in Europe. There the idea was at first rather that trading in banks should be extra-taxed (the Tobin tax, originally designed for countering extreme volatility in currency markets) although this was strongly resisted by the UK: much trading would simply go offshore. To prevent this, the so-called residence principle was considered: it would tax any trade authorised by a group that was located in the EU, even if the actual transaction were executed in London, New York or Hong Kong. Whatever the soundness of this principle, it was soon realised that banks would find ways around it and institutions could change their residence quite easily. The proposal was also otherwise much criticised but had support especially in France and Germany although subsequently weakened even in these countries. It would further reduce bank profits and therefore their capital rebuilding and lending activity. With the completion of the programme of the original G-20 Washington Declaration of 2009, which focused on capital, liquidity and leverage; hedge funds; rating agencies; and the OTC derivative markets, implemented (in a fashion),208 regulators could believe their work done and feel satisfied. They had certainly been able to retake the initiative as they always do after a financial crisis and a period of greater liberalisation, in Europe represented in the 1998–2005 Financial Service Action Plan coming to an end. An extra impulse became the threat of banking failure to Member States and their sovereign borrowing capabilities. In the process, the EU was able to recast and achieved a major expansion of its powers in the financial area (including fund management, which was not directly part of the G-20 programme). Perhaps the creation of the European System of Financial Supervision (ESFS) in 2011 was the most obvious immediate expression under which the European Supervisory Authorities (ESAs) for banking, securities markets and insurance were created, see ­section 3.7.2 below. They had extended quasi-rule-making powers subject to important administrative rulemaking by the Commission (strongly supported by the EU Parliament), underpinned by the facility to issue Binding Technical Standards (BTSs) at the initiative of the ESAs. The ESMA has especially benefited from this although its new authority did not go altogether unchallenged up to the level of the European Court of Justice (ECJ).209

208  See n 192 above and also N Moloney, ‘Resetting the Location of Regulatory and Supervisory Control over EU Financial Markets: Lessons from Five Years On’ (2013) 62 IC LQ 955. 209  In Case C -9/56 Meroni ECR 133 (1957758), it was decided early on that it is not possible for the EU to delegate its authority to agencies and that principle was retested in connection with the powers of ESMA in connection with short selling. In this connection, it started a public consultation in 2017 regarding its future technical advice to the European Commission on the Short Selling Regulation (SSR).

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The other aspect of the post-crisis EU attitude is that the group of participants covered by regulation has been vastly expanded, for instance assets managers under the Alternative Investment Fund Management Directive (AIFMD), proprietary traders, dealers and market platforms under MiFID/MiFIR, OTC markets under EMIR, and rating agencies under CRA I-III. More doubtful, is the increasing intervention into the market mechanisms itself under the Short Selling Regulation, the extended MiFID regime, and EMIR, which goes well beyond the prevention of abuse and risks market manipulation. Access from outside to the EU has increasingly been curtailed to those who subscribe to the EU model. This may sound fair enough for all who want to operate on its territory but it is a severe set-back to international operations requiring rather mutual recognition of (different) regulatory regimes (and not equivalence) assuming they are all competent. It implies a threat to wholesale markets operating mainly from London, more obvious after Brexit. But the more important question was always whether the amended regulatory regime could effectively handle this vastly extended empire, live up to its ambition, and especially in commercial banking what its effect was on much needed liquidity. For the eurozone ultimately, in a separate development, the creation of a euro banking union with a single regulator for banks (the ECB) created a substantially new situation of EU involvement in the Single Supervision and Single Resolution Mechanisms (SSM and SRM), which was summarised above in s­ection 1.3.11. See further ­section 4.1 below, also for the resolution regime.

1.3.13  Ways Ahead It may be argued that we live in a Faustian pact with finance. The liquidity-providing function is so central to a leveraged society that there is no way to redress this situation without serious consequences, not only for growth, but also for the type of (semi-) capitalistic society from which we derive our present economic prosperity. It may not be not enough for all but probably better than the alternative. It was also said that such a society must take much risk and cannot prosper without it. It is doomed to do so, no growth can be expected without it which is expected to pay for it all and thus becomes crucial in everything. The key then becomes risk management, or perhaps leverage and growth management whilst banking moves to the forefront. In fact, the entire banking scene was recast in the 1980s to make these newer developments in leverage possible: hence also the newer risk management tools in CDS, futures, options, swaps and securitisations, but it was not sufficient and what was considered manageable, not least under Basel I and II, proved wholly inadequate. We appear not to have the academic models to sufficiently steer, so much became clear after the 2008 financial crisis. The result has rather been experimentation leading to an ethos of retrenchment, the idea being that smaller local banks under the national regulators are safer, but it is no way to operate in a globalised world where billions of other people need more liquidity for them to catch up and prosper as well. In the meantime in Western Europe growth was reduced to a trickle with the fear that

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this would ­continue for years. That held out the prospect that the social welfare state would become entirely unaffordable. Government, banks and the public alike may become financially weakened except for a small, rich upper class which cannot carry the full load either, already pays by far the largest slice of tax, but may become ever more invisible. Banking in order to prosper and fulfil is liquidity-providing function properly will have to be given sufficient room. If we do not have that confidence, we are in serious trouble because regulation as we now know it is not going to save the day. In any event it was argued above that given its strong pro-cyclical nature, there is no point in regulating banking from the perspective of stability at the bottom of the market. All capital adequacy and liquidity requirements should disappear; bankers themselves must bring the banks back to health. Rather, it was argued that banks need to be seriously curtailed at the top of the cycle when heavy capital requirements should come in for new business, a leverage ratio and also strict liquidity requirements. Calling the moment and the way that is done was perceived above as a macroeconomic policy facility that needs to be exercised worldwide and it should be one of the concerns of the G-20, IMF or the FSB. This is policy that should further be closely connected with the building up of an international safety net for the biggest banks, which are likely only to become larger. The idea of smaller banks and society taking less risk in this manner was considered a romantic dream along the lines that small is beautiful, but it has already been said several times that smaller banks are much more risky and cannot provide in aggregate the liquidity society now needs. There is here a related idea that the slack can be taken up by the capital markets, but that is highly unlikely in respect of SMEs, let alone individuals, if only because of the cost, except perhaps through advanced forms of crowd funding which is likely to remain limited in volume. In any event, with manipulated low interest rates, which may not properly cover the risk, there may not be much interest from investors who see better bubbles elsewhere where a great deal more money can be made. As of June 2017, the US government in a Treasury Report started seriously to reconsider the present state of micro-prudential supervision in the US and the Dodd-Frank changes, especially by reviewing the implementation under the powers the US government has under the Act and had exercised. The idea was to scale back this regulation, in the process also meaning quite openly further to strengthen the US banks, which had recovered quicker and better than others, in their international competition. It was seen as the beginning of a long reevaluation process by the Republican administration meant eventually to dismantle Dodd-Frank altogether. In the meantime, the House approved the Financial Choice Bill repealing key provisions. The Volcker Rule was one of the first targets, another was the Consumer Financial Protection Bureau (CFPB), which was held to be insufficiently accountable in view of its large rule-making powers. The ‘skin in the game’ rule for securitisations was proposed to be abandoned. The Community Reinvestment Act (CRA) which predates Dodd- Frank and means to favour lending to low income and minority communities was also under attack. The ‘too large to fail’ and banking resolution regime of the Dodd-Frank Acts would be revised later. A new idea altogether was that against holding more capital, banks should be able to avoid most regulatory oversight aiming at financial stability, notably the capital

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adequacy and liquidity requirements. There were also proposals for lowering the leverage ratio for repo transactions which had lost 20 per cent of their volume since 2012. Cash and deposits were taken out of it altogether. More assets are to be defined as liquid, one reason being that massive central bank intervention has made them so. Cost/benefit analysis was to be more rigorously pursued.

1.4  The Essentials of Commercial Banking 1.4.1  Major Aspects of Banking. Supervision and the Role of Banks of Last Resort It has been said above that commercial banks and capital markets are the prime facilities in society to recycle money. After the more general discussion in the previous ­sections of this activity, either through the banking system or the capital markets, the risks, especially in terms of financial stability, and the problems with regulation, we will deal in the next s­ ections with banking and capital markets’ activity separately and more particularly. Banks’ main tasks are to (a) gather deposits from the public; (b) provide loans to the public; (c) organise payments; and (d) generally provide liquidity to the economies they serve, that means to governments and their agencies, corporates and other banks, or to individuals, mostly consumers. This general liquidity-providing function, also referred to as the monetary function of banks, is regulated as part of monetary policy, and will not be further discussed in these macro-economic aspects. It is further regulated in terms of financial stability as we have seen and it was submitted that this has also obtained an important macro-supervisory function, even if it may still be under developed. But here we will deal with liquidity foremost at the micro-level, that is, in the relationship between a bank and its clients, although this suggests in itself an important economic and social function. It means that a proper banking system ensures that people and companies not only may safely ‘park’ their money with banks in the form of deposits but will also have access thereto, notably to retrieve their money or make (bank) payments. They may, if sufficiently creditworthy, also obtain further liquidity facilities from their banks, such as overdrafts, credit cards and loans with longer maturities. As such, banks, if operating properly, provide reasonably cheaply and efficiently longer-term liquidity to their clients so that they can properly plan. In this sense, the banking system offers a vital recycling function, the essence of which is as we have seen that the banks gather shortterm money through deposits and repackage them in longer-term loans. As has already been noted in the previous sections, this function should be clearly distinguished from that of the capital markets, which do this in a different manner by providing direct contact between capital providers (or investors) and capital seekers (or issuers) in terms of risk-bearing capital (shares) or of borrowings (bonds). That is the area of investment securities and investment services or investment banking, which will be more extensively discussed in s­ ection 1.5 below.

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From a regulatory point of view, the essential feature of commercial banking was traditionally the public deposit-taking function. This makes sense, as the public wants its money to be safe and this was until quite recently still the point of departure in the UK banking laws, as we have seen (Banking Act 1987, s­ ection 3) now superseded by the Financial Services and Markets Act (FISMA 2000), which does not define banking activity (regardless of the EU definitions in this area) but makes the business of taking deposits a licensed activity. In the EU (Article 1 of the First and S­ econd Banking Directives, replaced by Article 1 of the Credit Institutions Directive in 2006 and now by Article 4(1)(1) of the Regulation of 2013 on the Prudential Requirements for Credit Institutions and Investment Firms), and elsewhere in case law,210 this deposit-taking function is often seen in combination with, and inseparable from, the lending function. That puts the emphasis indeed foremost on the recycling function of commercial banks. In the US, the National Bank Act (12 USC s­ ection 24) and, in Germany, the Banking Act (­section 1(1)), both often amended, use a list approach instead, in which common activities of banks are enumerated. This raises the question which activity or minimum of activities makes an entity a bank. It is a key issue, as it would lead to licensing and supervision, therefore regulation. There may here be a margin of doubt, and there are in any event borderline cases: is, for example, deposit-taking for investment purposes in or outside the banking definition? It will depend on how the money is held. If segregated from the investment managers’ own funds, there is no deposit. This illustrates a bank deposit’s particular status. As we have seen, making a deposit in a banking sense means giving up ownership rights and converting these into creditors’ rights against the deposit-taking institution. This is a key distinction and demonstrates the legal essence of the bank deposit.211 In this connection, commonly requesting deposits as a down-payment for the sale of goods or real estate is not banking activity. Neither is, at least in the UK, margin call activity under derivative contracts.212 These moneys belong to clients. It shows that the context in which deposit-taking takes place must also be considered. Banking laws will have to be specific to avoid problems regarding their applicability and the regulatory jurisdiction of banking regulators. As just mentioned, for commercial banks, the deposit-taking function attracted the most immediate regulatory attention: hence the traditional regulatory concern for the safety of the deposits and the protection of depositors. In turn, this created a concern for the banking risks

210 

Comrs of the State Savings Bank of Victoria v Permewan, Wright Co Ltd (1915) 19 CLR 457, 470. The creditor/debtor aspect of the relationship between banks and their clients was established early in common law: see Foley v Hill (1848) 2 HCL 28 and Joachimson v Swiss Bank Corp [1921] 3 KB 110, 127. In civil law, it follows more directly from co-mingling and its system of proprietary and contractual rights. It allows the bank to deal with client moneys as if they are its own and it need not account for its actions in respect of them to its current account holders and depositors. Although the bank is as a result an ordinary debtor, its treatment may still be somewhat different on the basis of custom and practicalities. Thus money that is due to the client may be retrievable by the latter only upon proper notice at the proper branch, especially if large amounts are involved, but payment instructions can be less easily restricted in amount (assuming there is a sufficient positive balance), although banks may insist on a number of days for clearing. 212  SCF Finance Co Ltd v Masri (No 2) [1987] QB 1002. 211 

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and the continued liquidity and solvency of each bank in the system. As noted in ­sections 1.1.7 and 1.1.10 above, there are now also other regulatory concerns and considerations, such as those concerning banking products sold to clients and the manner in which this is done. The integrity of markets is another. One major issue in this connection is that problems in (major) banks can seldom be seen in isolation. Illiquidity, for example, may easily affect other banks that have lent to the bank in trouble, if only through the interbank market, or because payments are expected from such a bank on behalf of their clients but are not arriving. Thus the interbank lending and the payment system, and finally the general system of liquidity, including repos-financing, may become affected by illiquidity of one of the banks in the system. Also through their trading books in terms of settlement risk or through repofunding and swap exposure or in credit derivatives, banks become interconnected. This is the area of systemic risk, see ­sections 1.1.2, 1.1.7 and 1.1.15 above. The question of bank insolvency and the two forms it may take was discussed in ­section 1.1.3 above. Illiquidity of banks is a situation in which they are short of money to meet their payment obligations. It is important to realise that that does not need to mean that they are also insolvent in a balance-sheet sense. Economically, insolvency arises only when their total liabilities exceed their assets. Illiquidity may arise much earlier and is connected with an imbalance between liquid assets and liquid liabilities as we have seen and is a maturity issue. It should therefore be realised that in legal terms, depending on the applicable bankruptcy laws, illiquidity of this nature may denote insolvency leading to bankruptcy proceedings although there could still be an economic surplus. All the same, there will be serious and instant problems if a bank cannot fulfil its payment obligations as they mature, raising the spectre of its immediate liquidation in bankruptcy proceedings. Once this becomes known, other depositors are likely to also want to retrieve their money. It will make the situation worse and may be the start of a bank run. As mentioned, more banks may then become involved as they may not be repaid on any interbank loans earlier given to the bank with liquidity problems. It may engender a liquidity crisis at these banks as well. That is the beginning of systemic risk. We have seen a replay of this in the crisis of 2008–09. In such situations, even the payment system may become affected as bankruptcy of one bank may create complications, not least in electronic clearing of payments: see ­chapter 1, ­section 3.2.4 above. The result may thus be that payments may altogether become difficult to make or receive. The inclination for citizens is then to keep their money under the mattress and make and receive payments in cash, but it is back to a lower form of economic life. Companies cannot operate in this manner, and for private citizens it is likely that there is too little money in circulation to accommodate all their cash needs. Barter may be the next step, and the modern economy dissolves. This is not academic. It happened in Russia in the 1990s, when a proper banking and payment system failed to develop. No wonder that central banks will step in. To repeat, they will not then do so as banking supervisors (which in any event they no longer are in countries like Germany and Japan). For regulators, it is too late and supervision will be shown to have failed. Rather central banks will enter as lenders of last resort, although it may be a misuse of this function—see ­section 1.1.6 above. If that also fails because they may not have the

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means, governments, or in fact the taxpayer, will have to take over. This commonly happens in financial crises. Liquidity and (credit, market and settlement) risk management thus remain at the heart of a bank’s activity, but it has been said above that lax liquidity management and a regulatory capital requirement that is too low contribute to frequent regulatory failure. Indeed it may be seen over and again that modern banking regulation hardly minimises systemic risk. It must be assumed that this is policy, see ­section 1.3.7 above. It would require much more drastic action in the direction of imposing much stricter liquidity and higher capital requirements or narrow banking— see ­section 1.4.6 below—which may be politically unpalatable: it could exclude large parts of the population from credit and may restrict growth. After 2008, Basel III, as we shall see, started to recover some ground in these areas, but nothing in it is likely to prevent banking crises in the future. It would mean curtailing banks much further, which would likely have severe consequences for the economy as it operates today. The remedy was thought to be a variable capital adequacy and liquidity regime as well as variable leverage ratios depending on the economic cycle; that is macro-prudential financial supervisions, see ­section 1.1.14 above.

1.4.2  Types of Banks and Their Operations. Non-banks and the Shadow Banking System Deposit-taking from the public, lending to the public, or more generally providing liquidity to and organising payments for the public is or has become the traditional remit of what is usually called commercial banking, but banks may do much more. Thus they often act also as security brokers for account holders and in this manner provide investment services in the capital markets. In this capacity, they may even act as buyers and sellers of investment securities in their own name but for the risk and account of their clients. This is the typical function of a securities broker. It is a natural extension of their commercial banking role, as they will be in a good position to deal with investment transactions for those who hold accounts with them with positive balances. They may go further and also arrange alternative funding for their corporate clients, especially in the capital markets, which for the best borrowers may often prove cheaper than bank loans. It is the issue of disintermediation, to be further discussed in ­section 1.4.8 below. They may in that context even engage in underwriting activities. Subsequently they may actively trade in the securities so issued and even make markets in them. In the US, these underwriting and trading activities are traditionally the remit of investment banks. If combined with commercial banking, they make for so-called universal banks. That is the continental European model. It is less common in the UK and was forbidden in the US under the Glass-Steagall Act of 1933 (­section 20 of the Securities Act), when, during the Great Depression, the combination of commercial banking and underwriting risk in other than government and municipal securities was deemed too risky for commercial banks unless such underwriting was only incidental to their business.

PART I  Financial Services, Service Providers, Risk and Regulation 651

It was one way to limit banking risk, therefore through separation.213 Under pressure of disintermediation and the resulting reduction in commercial banking income, the separation was not considered to make any longer sufficient economic sense and the Glass-Steagall Act was repealed in 1999 by the Financial Services Modernisation Act (or Gramm-Leach-Bliley Act)—see also ­section 1.1.9 above. Full affiliation between banks, insurance companies and securities companies is now permitted in the US but only through a bank holding company; straight mergers are therefore not possible. In the crisis of 2008–09, the question of separation received renewed attention, the true issue being first commercial banks engaging in proprietary trading and often acting like a hedge fund in their treasury activities and investment books, and second investment banks lending large amounts of money to hedge funds in their prime brokerage activity, which in turn they might have borrowed from commercial banks who may also fund hedge funds more directly. In this manner, banks not only start operating themselves as hedge funds, but also take the risk of much external hedge fund activity, see further s­ ection 1.3.10 above for the Volcker Rule introducing considerable limitation under the 2012 Dodd-Frank Act, since 2016 in the process of being again relaxed, at least in the US. Investment banks (in the UK often called merchant banks, which, however, also tend to do some lending to their clients and often also take deposits, at least from companies, and need then to be licensed as deposit takers) may thus do much more than underwriting and trading investment securities. They are, for example, also likely to have a corporate finance department giving corporate advice on how best to structure the balance sheet of their client companies or even their activities. Advice on how best to fund is closely related to this activity, as is the merger and acquisition advice practice. Investment banks are also likely to engage in securities brokerage activity and investment management. Like commercial banks, they usually also take an active view of their own investments and tend to make money out of their own investment portfolio activity, in which they may take substantial risk balanced by up-to-date risk-management systems and skills. Again, this is proprietary trading. As such, they may be more specialised and aggressive than commercial banks, which tend to engage in these activities mostly as an extension of their normal trading activities in foreign exchange, swaps, repos and securitised products, although they may also go further and start operating like hedge funds as already noted, likely to be funded in that case by call deposits. One thing investment banks could not do in this connection was deposit-taking. That would require a (commercial) banking licence and turn them into a universal bank. In fact, as noted before, at the end of the 2008–09 financial crisis, the major surviving US investment banks, Goldman Sachs and Morgan Stanley, became commercial banks, while others, like Merrill Lynch, had merged into them so that true US-type investment banking as a special activity came to an end, except for small specialised institutions. 213  This concept of incidental business was lately much expanded, while so-called ‘­section 20 companies’ were authorised after 1989 as subsidiaries of bank holding companies, provided their underwriting income (from nongovernment securities) did not exceed 25 per cent of their gross income. The 1999 Gramm-Leach-Bliley Act which abolished Glass-Steagall does not affect these s 20 companies, but diminishes the need for them.

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The reason was that during the crisis the major investment banks needed the liquidity of the US central bank and therefore became supervised by the Fed. This being the case, they wanted to take advantage, at least to the extent that they could then also take deposits from their major (corporate) clients. Hence the banking licence. If commercial banks also acquire an insurance component, again increasingly common at one stage in continental Europe, we often speak of banc assurance. In that case, the insurance activity remains, however, usually in a separate legal entity because of its different regulation and capital requirements. Again in the US, the combination of banking and insurance was precluded by law unless the activity was incidental.214 It has already been said that they may now also be combined through holding companies in which each of these functions still remain distinct at the subsidiary level. There are also so-called non-banks. These are institutions that provide loans or financing to the public but do not—and are not allowed to—fund themselves through deposits. Finance leasing and factoring companies are traditional examples, but also investment banks, if offering loan facilities, and money market funds, hedge funds, private equity funds and numerous other types of funds. Together they are sometimes referred to as the shadow banking system and may as such require licensing but that will not be a banking licence. This has already been mentioned in ­section 1.1.17 above. The shadow banking system is hard to define but is getting bigger and bigger and may pose difficult questions in terms of financial stability as we have seen.

1.4.3  Commercial Banking Products, Unsecured and Secured Loans, Leasing, Repos, Receivable Financing, Syndicated Loans, Trade and Project Finance As we have seen, one of the elementary tasks of commercial banks is to gather deposits from the public and to provide loans to their customers. On the funding side, they will have paid-in capital and retained earnings and also have access to the capital markets and issue bonds. They may borrow short term in the interbank market, that is, from other banks (mostly overnight) if they have such needs. They may also borrow from their own central bank, again usually short term to cover liquidity shortfalls. It is part of the bank-of-last-resort function of central banks to offer this facility—see s­ ection 1.4.1 above—and is a normal facility in ordinary times. On the asset side, they provide loans to the public. They will also invest in investment securities, notably government bonds, which are traditionally considered to be relatively safe and liquid as they can be sold quickly in the case of liquidity needs and do not, as we shall see, normally attract a large capital adequacy penalty either. Liquidity needs will arise when there is a shortfall in new deposits or when old deposits are withdrawn. They may of course also result from banking losses connected with operating expenses, failures of borrowers to service their debt, foreign exchange trading, swap book losses, or poor investments. These investments are normally made through a bank’s treasury operations, in which a bank’s money might be used for investment or more speculative purposes. In fact, 214 

Nationsbank of North Carolina v Variable Annuity Life Insurance Co, 115 Sup Ct 810 (1995).

PART I  Financial Services, Service Providers, Risk and Regulation 653

as we already have seen, these treasury operations of a bank could amount to hedge fund activities in which a bank may even become a large borrower in respect of these activities themselves (or use their deposits for this activity). In all events, in large banks, these treasury operations may be of substantial proportions as are foreign exchange, swap and repo book dealings. The more traditional source of profits in banks remains, however, in the maturity mismatch between assets and liabilities, which will be discussed in the next ­section together with an analysis of the other risks banks run, especially credit risk, which is the risk that borrowers do not repay. It remains the heart of the banking activity, but is now often accompanied by other sources of income deriving from the trading and investment books of banks, although not all banks engage in this type of activity beyond managing their trading books. It has already been noted that it became contentious after 2008 and led to curtailment, first in the US under the so-called Volcker rule: see ­section 1.3.10 above. On the loan side (or in the loan book) of a commercial bank, one might find many different types of products. First, it has already been noted that loans may be unsecured or secured. Of the former, credit card advances, student loans and similar consumer debt are the most obvious categories. Then there are the overdraft facilities in the current or checking accounts, but many large syndicated loans or standby facilities to business are also likely to be unsecured. Among secured loans, the real estate mortgages are probably the best known. They are loans secured by dwelling houses or commercial property, therefore by specific, fixed assets or collateral. There may also be loans secured by equipment, inventory or accounts receivable. They are special in so far as they may entail so-called floating charges, which cover collateral that may vary from day to day as the composition of inventory and accounts receivable of a borrower is subject to constant change: see c­ hapter 1, ­section 2.2 above. It means that the notion of asset individualisation, basic to many proprietary systems, is here fundamentally abandoned, the reason why this facility remains legally contentious in many countries. Under floating charges, the collateral (or security objects) provided will change accordingly, so that goods that are sold are free from the charge but new inventory is automatically subject to it. Thus future assets may be covered in the charge with the security interests relating back to and receiving their rank from the date of the security agreement rather than from the date that the goods are produced or the receivables emerge. Receivables that are paid will in this approach reduce the loans or may be retained as working capital and new receivables will then automatically support what remains outstanding. These various possibilities are best developed in Article 9 of the Uniform Commercial Code (UCC) in the US. For a comparative study of the collateral laws in the major industrial countries see c­ hapter 1,­ sections 1.2–1.6 above. A bank may also engage in more complicated funding activities such as finance leasing, repo financing and the factoring of receivables or receivable financing. They are likely to present conditional sales of assets to the bank, techniques discussed in c­ hapter 1, ­section 2.1 above and summarised in Volume 2, ­chapter 2, s­ ection 1.7. Another aspect of a bank’s activities is trade financing. This concerns the issuing of letters of credit or other types of guarantees, arranging collections and discounting bills of exchange. There are often important international legal aspects to consider in this

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activity, which were discussed in c­ hapter 1, ­section 3.3 above. Important as they are, these activities do not, however, directly result in loans. Normally, a bank is reimbursed immediately for the payments it so makes and paid a fee for these services. While trade financing used to be an important business, even to the point that there were specialised trade banks, this is now less common and, with the improvement of communications worldwide, trade finance activity has relatively declined in banks, even though letters of credit in particular continue to constitute an important banking service. Syndicated loans and project financing are other important modern commercial banking (loan) products, normally associated with large-scale financings, which, because of their size or the location of the project, often acquire an international flavour. In syndicated loans, banks group together to extend credit to large borrowers, which may be corporations, public entities or even states. These loans often have a standby function as credit line and may not then be (fully) drawn down. In that sense, they are of interest also to borrowers, corporate or other, who would otherwise access the capital markets directly, which would mean, however, an immediate draw down. They may still do so later. Banks receive a fee for these standby facilities even if not used. An alternative for large borrowers is the issuance of short-term commercial paper or even medium-term notes. Syndicated loans may also serve a bridging function. There are not then standby but of a temporary or short-term nature only, for example where a takeover has to be financed immediately while more permanent financing will be determined later, often by making use of direct access to the capital markets (through the issuing of new bonds or shares). A special advantage of syndicated loans for borrowers is that they constitute one loan package and allow corporate treasurers to deal with only one agent bank (for the entire group) rather than with a multitude of banks that each require their own terms and documentation. The group itself may be small and be constituted by the major house banks of a borrower. They may also be large and project oriented as in the case of the original Eurotunnel financing in 1987, which involved around 160 banks in various layers of the syndicate. The agent or syndicate arranger is usually appointed by the borrower and will approach other banks to form a consortium or syndicate. There may even be more than one arranger or there may be co-arrangers or sub-arrangers, also called lead, co-lead, managers or co-managers. They are usually the largest contributors in the group, who thus become entitled to special arranger and management fees. All will share in the participation fee and in the annual facility or commitment fee. Sometimes the treasury department of the borrower itself retains the role of lead manager. The arranger may undertake the syndication on a best-effort basis, or may constitute within the syndicate an underwriting group that will guarantee the completion of the facility against a further fee. As just mentioned, there may be different layers of borrowing in terms of length of commitment and maturity of any loans drawn down. Some of them may even be subordinated, especially when syndicated loans are merger or project finance related. There may be a secondary market in these participations. It means that they can be ‘traded’, but the legal nature of the commitment or obligation is such that normal trading may not be anticipated. That is commonly reserved for assets and not for liabilities. Standby commitments or liabilities can only be transferred through (a form of)

PART I  Financial Services, Service Providers, Risk and Regulation 655

­ ovation, which requires consent of all relevant parties. If loans have been extended, n they are assets from the point of view of the bank and the right to interest and principal may be transferred through assignment which does not require consent, but both novation and assignment require various forms of borrower involvement and cooperation depending on the applicable law: see also Volume 2, c­ hapter 2, ­section 1.5.5. A way around these formalities is granting a sub-participation but this means that the original participant is not discharged and its balance sheet not cleaned out, see for subparticipation also ­chapter 1, ­section 2.5.1 above. Project finance is often associated with the financing of special capital projects in emerging economies but need not be limited to them. The idea is here that the bank financing is tied to a project and serviced only from the project’s future cash flow. It could be said that the banks acquire an equity interest in the project itself. If there is a shortfall in cash flow, the borrower is discharged. Legally, the banks are likely to receive the assets as collateral and, if possible under applicable law, also the cash flow as a future asset. If there is a specially incorporated company holding these assets, banks may receive a charge over the company’s shares as well. Loans under this kind of facility may be syndicated and there may be different currency participants and subordinated debt participants (resulting in so-called mezzanine financing). Besides the vital segregation or ring-fencing of the project and its cash flow from the other business of the borrower and the details of the financing itself, the project will also receive considerable attention from the prospective financiers. Depending on the nature of the venture, the project may involve at the same time construction contracts, equipment contracts, labour contracts, independent expert feasibility studies and supervision arrangements, power and water supply agreements and insurance policies during the construction period. Often there is at least some combination of these features. There may also have to be in place relevant governmental licences and undertakings as to the applicable foreign exchange and tax regime and consents as to the retention of cash flows abroad. There need to be assurances that after completion the necessary supply agreements for the operation of the project and sales or lifting agreements will be in place and be implemented. Proper management with the necessary operating agreements (and experience) for the construction as well as the operating stage will often be another matter of great interest. They all concern the repayment viability of the project and its eventual completion, start up and continuation. As for the future income streams, they will have to be divided and the amounts to be set aside for the operations and the repayment of the loans will have to be determined in advance. Financiers may even reserve a percentage of net profits after full repayment. Because of the multifaceted nature of this type of financing, the documentation is likely to be voluminous and complex, although not necessarily intellectually challenging. From the banks’ perspective, risks must be limited as far as possible. Covenants will normally be entered making loan advances dependent on continuing governmental approval and the successful completion of succeeding stages of the project. Applicable law and jurisdiction/arbitration clauses will also be considered for their effectiveness in eliminating or reducing the various risks (including legal risk) attached to the financing and to the project itself.

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1.4.4  Commercial Banking Risks Traditionally, all banks take a number of risks to make money. They were identified in ­section 1.1.3 above. Most normal is for banks to fund themselves through short-term deposits at low interest rates and to lend longer at higher interest rates. In fact, this mismatch or maturity transformation has always been fundamental to the commercial banking business and is the source of its inherent profitability. It allows banks to pay their operating expenses and eventually a dividend to their shareholders after retaining a portion of the earnings and add it to capital. It is a form of position risk, and there is here a basic exposure of all banks, which requires them to take a view on their ability to continue to attract short-term funding against a reasonable price on a continuous basis but also to weigh this against their long-term lending or investment commitments in terms of liquidity management. In ­section 1.1.4 above, liquidity risk and management was explained and also the regulatory concerns in this aspect and the meaning and threat of cash flow insolvency. Other mismatches may follow: a bank may borrow in the capital markets or interbank markets at floating interest rates, but lend in fixed, or vice versa. It may also borrow in one currency and lend in another.215 In its asset and liability management (ALM), a prudent bank will balance its assets and liabilities as part of its ordinary activity on a daily basis. The liquidity of its own (government) bond portfolio, through which it is in essence a lender to governments, will allow it to make rapid adjustments here by selling or buying certain classes of bonds in terms of interest rate structures, currencies and maturities. More rapidly still, in terms of currency and interest mismatches, it may take the necessary steps through the modern derivatives (options, futures and especially swap) markets, the operation of which was explained in ­chapter 1, ­section 2.6 above. This will allow it to make instant adjustments in exposure on both the asset and liability sides of its balance sheet. Thus all commercial banks will have to be and are mismatched to some extent to make money. This is normal in banks. Since, at least from the perspective of a bank’s shareholders, this is what banking is all about, regulators did not normally supervise that risk, as they did not want to become involved in the bank’s business itself. It could also make them directly liable for a bank’s failings. Nevertheless, there is concern and the more modern approach became increasingly to require disclosure of large mismatches. Banking regulators also regularly verify whether banks have sufficient (risk-­management and other) systems in place at least to measure their positions and mismatches on a continuous basis. This is a matter of operational risk. The ­liquidity-risk aspect should have been a more direct regulatory concern but was neglected. Yet it 215  In this connection, a word may be said also about the so-called carry trade. It is very common. Entities borrowing in one low-interest-rate currency (say the yen) may convert the proceeds into a high-interest-yielding currency (say the US dollar). It can be very profitable but theoretically it suggests weakness in the higher-yielding currency (in this example the dollar), and when it falls there would be a currency loss upon repayment of the harder currency (here the yen). In fact, theoretically, the gap in interest rates should be the same as the gap between the spot and forward exchange rates. Yet in practice the higher-yielding currency, which is deemed the weaker one, often strengthens because it is more sought after. That makes the carry trade extra profitable, but it remains a speculation and if these trades unwind, or have to be hedged in a currency panic, they may lead to large losses and promote currency imbalances.

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became an important feature of the 2008–09 crisis, as we have seen and after the 2008 banking crisis the increased capital adequacy requirements in Basel III were matched on an experimental basis by a regulatory liquidity regime to be implemented by 2019 (see ­section 2.5.12 below). Traditionally, regulators focussed rather on credit risk but in modern times increasingly also on position or portfolio risk and settlement risk (and now also on operational risk), again not in order to run the positions themselves, but only in terms of setting and implementing general rules and limitations for the entire industry (although the implementation remains bank specific), of which the capital adequacy rules in respect of these risks are the most obvious: see s­ ections 2.5.2ff below. Here the fear is that a bank’s liabilities may start to surpass its assets. That is balance-sheet insolvency, as we have seen, which may trigger a bankruptcy of the bank, although the fear of it is likely earlier to induce a liquidity crisis (or bank run) and cash flow insolvency. It was said before in s­ ection 1.1.3 that the lack of liquidity, not capital, is the true killer of banks. It was also noted in this connection that the capital required, first under Basel I and later under Basel II, proved in the event wholly inadequate to provide for the risks. Basel III increased the capital required after years of reduction (and deregulation in that sense) but such an effort must always be weighed against the modern demands for liquidity and it has already been said that truly safe banking is no longer socially acceptable. Few would be able to borrow. Especially consumer debt would be severely curtailed. It is clear that underestimating or neglecting the risks is induced in particular by political and social pressures on banks to lend to all, see ­section 1.3.6 above, leading subsequently to excess in the banking operations themselves. This has in turn a close connection with systemic risk, as discussed in s­ ection 1.1.2 above, and need not be repeated. Above, a number of specific risks inherent in commercial banking, especially credit or counterparty risk were already noted. Credit risk concerns the creditworthiness of borrowers. A bank will habitually counter this risk through: (a) ­diversification, if necessary promoted by securitisations (see c­hapter 1, s­ection 2.5.1 above) or sub-­ participations; (b) avoidance of large exposures to any single borrower; (c) collateralisation; (d) third party guarantees or credit derivatives (see ­chapter 1, ­section 2.5.2 above); and (e) covenants in loan agreements (which would allow a bank to call the loan when the debtors’ credit deteriorates). Also (f) netting out mutual positions may be another tool: see ­chapter 1, ­section 3.2 above. It will also (g) hold capital against these risks, less if these risks themselves are better managed (see ­2.5.2ff below) also for the calculation. These risk-management facilities, especially collateralisation or other asset-backed funding techniques, were more extensively discussed in ­chapter 1 above. Especially in their investments, banks will also incur position or market risk. These risks are connected with securities positions a bank may hold but a bank no less runs position risk in its foreign exchange, swap, repo and other trading books. As we have seen, a bank is likely to have large investments in government bonds as a liquidity buffer but is now also likely to have large short-term positions in its trading activity. Market risk reflects here the effect of market movements (and not of the counterparty’s credit) on the value of the positions held. Thus commercial banks may incur ­considerable

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market risk from that perspective. It was also mentioned that, in modern times, banks’ treasuries are often run more aggressively and may become like highly geared hedge funds: see for these funds c­ hapter 1, s­ection 2.7.3 above. All kind of other products may also be traded or held for some time and then incur market risk as well. Position risk is managed through hedging, especially with derivatives (options, futures and swaps), as was explained in ­chapter 1, ­section 2.6 above, and through diversification, or securitisation, which removes the assets from a bank’s balance sheet altogether. In respect of tradable securities in which there is a market price, the positions are likely to be valued on a daily basis. This is called ‘mark to market’, so that profits and losses of this nature are immediately transparent and realised (in the daily profit and loss account of a bank). It assumes that market prices can be easily established, which is problematic in illiquid products or in products that become illiquid in adverse market conditions, a problem that emerged in respect of securitised products in banks during the 2008–09 financial crisis. Again, holding capital against these risks is the final safety net, the capital requirements being mitigated if proper hedging is in place. That raises questions about the quality of such hedges. For calculations, see ­2.5.9 and 2.5.14 below.216 Thus the value of fixed bonds varies according to the prevailing interest rates in the market. If they go up, a fixed-rate bond portfolio is worth proportionately less. But also in its loan book, a bank incurs position risk. This would be clear if these loans were also marked to market on a daily basis, as interest rates fluctuate in the market, thus affecting the value of the loan book. Lower market interest rates mean a higher value for fixed-rate loans and vice versa. Marking to market of the loan book would mean regular revaluation on the basis of current interest rate movements. This is uncommon in commercial banks and is not normally required by regulation, but it is nevertheless clear that, when interest rates go up, a fixed-interest-rate loan portfolio is worth less and there is a theoretical loss which may, however, be temporary (depending on interest rate movements being reversed). It means that (barring credit risk) even though the loan will be repaid in full on the maturity date, a bank could have done better if it had lent for shorter periods. Mostly a bank does not mind as it looks mainly at the so-called spread between its cost of funding and its loan income and any maturity mismatch in this connection. In any event, market interest rates may go down later so that the bank could still be winning. Another common risk, especially in connection with securities activity, is settlement risk. It is the risk that arises when market positions are taken and assets are bought or sold or options or futures are acquired in them. These positions may not settle on the agreed day because of a default of the counterparty or a hitch in the settlement system,

216  The ‘mark to market’ principle came under attack during the financial crisis of 2007–08 when banks felt that they were unduly undermined by sporadic fire sales of layered products from securitisations which pulled non-sellers down at the same time—see also n 148 above. Since these were illiquid products often held until maturity, it was felt that they should remain booked at acquisition values. Some relief was subsequently given under international accounting standards, but the question remained that acquisition or theoretical values might be entirely unrealistic in products that are very market sensitive and indeed may never be repaid. Proper write-downs for credit risk are then in any event necessary. The immediate consequence is that more capital must be allocated to these holdings, which may be very difficult or in any event most inconvenient in times of financial crisis.

PART I  Financial Services, Service Providers, Risk and Regulation 659

as a consequence of which there may be no delivery of the underlying securities while payment has already been made (or vice versa). The loss of a deal in this manner may also deprive the bank concerned of the profit in the position or, if used as a hedge, of this protection.217 Settlement risk may be mitigated by better settlement systems in which administrative errors are ironed out by independent agencies (Euroclear and Clearstream in the euromarkets) and assets are not handed over (through the intervention of these agencies) if there is no simultaneous payment (delivery versus payment, or DVP). They may also provide proper clearing and netting facilities (see ­chapter 1, ­section 4.1.4 above). There may also be central counterparties (CCP) facilities, as in derivative trading (see ­chapter 1, s­ection 2.6.4 above and for the EU ­section 3.6.14 below), which provide considerable protection against settlement risk in particular. Capital will have to be set aside for settlement being late and more if it is retarded further or not likely to take place at all. In payment and similar settlement systems, settlement netting is another important means of reducing settlement risk: see ­chapter 1, ­section 3.2.3 above. Again it is built on the concept of simultaneity or at least on a mutual set-off facility among all transactions during the settlement period, which is likely to be one or two days. It may also reduce liquidity risk in that only net amounts are paid at the end of the periods. Banks must also have sufficiently knowledgeable staff to trace the risks, conduct a proper asset and liability management and maintain proper systems. This is ­operational risk. It should at the same time reduce the systemic risk. Here again, modern banking regulation will require capital to be set against this operational risk even if the methodology remains contentious: see ­section 2.5.10 below. A bank should also be aware of the legal ramifications of its business (legal risk), for example in the loan business and the products it uses in this connection (such as project financing or syndicated loans), the legal effectiveness of the collateral it negotiates (such as mortgages or receivable and inventory financing) and of its hedges, including the legal aspects of derivatives trading and swaps and of netting arrangements in clearing and settlement, the legal aspects of its involvement in the payment system, and of its other activities such as finance leasing, repo financing and securitisations. Understanding these products and facilities better from a legal point of view was the subject of the previous chapter, which also showed that globalisation may unsettle the legal basis of these facilities and products further. The overall banking relationship with clients through the current account and the rights and obligations of a bank in this connection should also be legally clear: see for this aspect ­section 1.4.9 below. As has already been observed, it is a fact that notwithstanding much supervising and greater sophistication, commercial bank insolvency remains frequent. The South American crises and the savings and loan situation in the US greatly affected the 217  The so-called Herstatt risk is a closely connected risk and derives more directly from risks inherent in the currency transfer system. It arose when the Herstatt bank in Cologne went bankrupt in 1972. In its foreign exchange dealings some counterparties had already provided it with Deutschmarks in Germany while they were receiving only later on the same day the counter-value in US dollars from Herstatt in New York. It is a question of simultaneity, which is here often disturbed because different currencies are mostly settled through their own central banks, which may operate in different time zones. Euro settlement therefore comes before US dollar settlement and yen settlement before euro settlement. Because of the intervening bankruptcy of Herstatt, foreign exchange creditors were not paid the US dollar amounts and became competing creditors in respect of them.

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banking system there in the 1980s and early 1990s, and in the savings and loan crisis large government bailouts became necessary, which even then cost the US taxpayer in the region of $200 billion. In Scandinavia, whole banking systems had to be saved in the 1990s. In Japan, the banking sector needed rescue at the same time, for which the equivalent of at least US$ (equivalent) 500 billion was set aside (although the total may easily have been $1,000 billion or more). Chinese banks were for a long time in a similar position in connection with loan burdens derived from or imposed by a centrally state-run economy and needed many new capital infusions, organised by the state. In the 1990s, large bank write-offs became necessary also in France where Crédit Lyonnais had to be saved several times. Even in Switzerland, large write-offs were required in 1996 in connection with real estate lending. In Russia, the banking system was in deep trouble from the beginning of the 1990s. Few deposits were offered as banks were often used by their owners for speculative investment or other purposes, not for loan business or money recycling.218 A contributory factor was the lack of transparency in company accounts, which inhibited corporate lending. Russian banks did not therefore assume their liquidity-providing function properly, while their payment function was undermined by the general lack of confidence, culminating in a crisis in 1998. This lack of a solid banking system holds the whole economy back. The situation in the Far East during the 1997 crisis, especially in South Korea, re-emphasised in the meantime another key risk in banking: the mismatch between assets and liabilities or between short-term borrowing in foreign currency and longerterm lending in the local currency to local borrowers with doubtful economic projects. The 2008–09 banking crisis in the developed world probably had many causes that came together at an unpropitious moment, discussed, together with the regulatory response, in greater detail in ­section 1.3.2 above.

1.4.5  Risk Management in Banks In the previous section, the main risks and hedging techniques in banks were discussed and the central role of risk management in banks was highlighted throughout. The various products used in this connection were mostly discussed in c­ hapter 1 above but as part of this general introduction into commercial banking in this s­ ection 1.4, it may be useful to summarise some aspects and mention first the modern collateralisation facilities to cover credit risk. In particular mortgages to protect real estate funding have already been mentioned, and also floating charges to protect working capital funding. It has already been said also that the best expression may be found in Article 9 UCC in the US. Substitutes in terms of asset-backed funding are finance sales of which finance

218  In the event, the Russian banks lent their money back to the government, which would offer government-owned companies as security for repayment. When the state of Russia subsequently defaulted, these banks acquired many of these companies for very little. Many of the so-called oligarchs developed their considerable wealth on this basis.

PART I  Financial Services, Service Providers, Risk and Regulation 661

leases, repos and some forms of receivable financing are ready examples. Again, they were also extensively discussed in ­chapter 1 above. To reduce credit risk further, socalled credit derivatives may now also be used, which are in fact a type of third-party guarantee of credit risk: see more particularly ­chapter 1, s­ection 2.5.2 above. Other risk management facilities have been mentioned also: the diversification in the loan portfolio; more traditional guarantees of third parties (such as parent companies); cross-default covenants in loan agreements; and securitisations (which remove the asset from the balance sheet altogether). For market risk we have the modern hedging instruments: options, futures and swaps, and again securitisations. In terms of risk management, something more may be said in particular about derivatives, securitisations, and credit derivatives. They often catch the eye and require some understanding for a better insight into the financial services industry, its operations, the considerable risks it takes, the possibility of the rapid adjustment of these risks, and the regulatory response. They are powerful risk-management tools. Only some of this will be repeated here in order to provide examples and a fuller picture of banking activity and the importance of risk management in banks. Derivatives in this context are financial products that derive their value from the value of assets traded in other markets. Financial options and futures are the normal types, but interest rate and currency swaps are other important examples. Financial derivatives of this nature may be used to make a profit by playing markets, but they are in the present context mainly of interest as risk-management tools geared to quickly change market or position risk and are then of great importance as hedging instruments, which implies the possibility of taking positions opposite to the ones banks have, thus promptly neutralising this type of risk. They are not appropriate to change credit risk and are more likely to add to it as new relationships are created. The way the hedges work is that to protect an underlying position, a put option may be bought which allows a sale at a specially agreed price during the option period. Should the price of the underlying assets fall, they can still be sold at the higher option price. In a future, the whole position may be sold for the present price but delivery at a later date. Any price fall then becomes irrelevant too. In a swap, a fixed-interest-rate cash flow may be exchanged for a floating-rate cash flow, important if an increase in interest rates is expected. As to details, 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. A put option gives the option holder the right (but does not impose a duty) 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 itself to the option being exercised against it at the agreed price. The writer immediately receives a price or premium for its willingness to accept that exposure. The futures contract 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 mean selling the asset forward at (more or less) current prices. A future of this nature gives a seller the right, and imposes on him the duty, to sell and deliver the

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underlying asset to the buyer on the agreed date for the agreed price. A 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 contract. The difference is that the delivery of the goods and payment will be delayed until a future date when the price is likely to be different. In the case of financial derivatives there is another important feature as at the appointed date they may always be settled in money. In that sense, they are contracts for differences. During their period, the positions may be transferred if there are regular exchanges on which this can be done, as there are in some standardised options and futures.219 In such cases, a profit can be taken at any time or a loss may be fixed by getting out in the manner explained in ­chapter 1, ­section 2.6.4 above. Swaps are the other traditional example of derivatives. The term ‘swap’ does not in itself denote any particular legal structure. The common feature is that either the one or the other party will pay a certain sum if a particular event occurs. In finance an exchange of accruing cash flows, normally resulting from different interest rate (fixed or floating) structures, is common. The result is an interest rate swap. For instance, I have a bond portfolio of $100 million at five per cent interest for five years. I fear that interest rates may go up and that I will be locked in. So I exchange my fixed-rate income for floating-rate income. The latter adjusts with the interest rate. If it goes up to six per cent, I am the winner. At that moment I may want to retransfer to fixed, locking in a one per cent gain for the rest of the maturity period. Swaps could also be in different currencies (that is a cross-currency or cocktail swap), in our example from dollars into yen, for instance, if I expect the dollar will go down against the yen. There are then two possible variables. The value of the swap thus depends on the relative value of the accruing cash flows that have been temporarily exchanged, and there may be a profit or a loss depending on the movement in the underlying values. Securitisations provide both important credit and position risk-adjusting mechanisms. Under them, risk is transferred to a special purpose vehicle, or SPV. It may concern a transfer of the underlying risk assets or only certain risk in respect of them. The newly created entity may raise the money to pay for the assets in the capital markets (hence the term ‘securitisation’) or may lay the risk off in the capital markets in the way described in detail in ­chapter 1, ­section 2.5.1 above. This is the heart of financial structuring or financial engineering, which has acquired great importance and is done on a large scale. The spreading of risk in this manner is generally seen as a great advantage, certainly also by regulators, but is not free from excess, as the Enron debacle in 2001 and the instability in the financial markets during 2007–08 showed. Again reference is here made to the discussions in ­chapter 1, ­section 2.5.5 above.

219  Otherwise, a future can only be neutralised by engaging in an opposite transaction, often only obtainable from a different party for the same maturity date. Thus if one has sold the underlying asset at a fixed price while the market price of that asset is now lower, there is a profit in the future that could be protected by buying that asset back at the lower price in another future (now as buyer) for delivery and payment at the same date as the earlier future.

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Credit derivatives offer an important technique to move only credit risk from a balance sheet. They operate in fact in the manner of a guarantee but have become greatly more sophisticated: see for details ­chapter 1, ­section 2.5.2 above.

1.4.6  Broad and Narrow Banking. Sharia Banking. Market-based Monitoring of Banks All in all, commercial banking has often proved to be a dangerous business. Instances of insolvency remain frequent. It is a function of the low capital base with which a bank is allowed to operate compounded by liberal lending attitudes in good times and often poor liquidity management, which shows particularly when traded assets suddenly become illiquid and need to be refinanced in order to hold longer than first envisaged or otherwise must be disposed of in a fire sale. This scenario was discussed extensively in ­sections 1.1–1.3 above. The consequence in bad times is the possible loss of the liquidity-providing function of banks, systemic collapse, and real concern about the continuing efficiency of the payment system without which no modern country can function. It may render regulators, central banks (as lenders of last resort), and even the public purse (when a whole banking system starts collapsing) the effective captives of the banks as noted in ­section 1.1.12 above. Moral hazard is effectively built into this system. Although it was generally thought unlikely to happen, it all played out in the summer of 2008. Moreover, the operations of commercial banks may lead, in good times, to an autonomous extra infusion of liquidity in the system that may well prove inflationary and destabilising, while in bad times, when the survival of these banks themselves may be at stake, they are likely to restrict liquidity, causing an autonomous additional deflationary effect. This is procyclicity: see s­ ection 1.1.13 above, reinforced, it was argued, by micro-prudential regulation. Of course, in their monetary policies, central banks may affect the short-term interest rates (or even the longer-term ones by buying government bonds) and thereby try to slow down or accelerate lending activity. Yet banks play distinctive roles here and the short-term interest rate mechanism in which central banks have a major say may not always be determinative or fully effective in providing extra liquidity or in curtailing it. In any event, there are likely to be considerable time lags. It was proposed above in ­section 1.1.14 that it is much more effective to control banking activity at the top of the cycle as a macro-prudential policy function. Whatever the reasons, banking regulation and supervision as we know it today, either by central banks or by other banking supervisors (in Germany and Japan where banking supervision is not or no longer the sole preserve of the central bank) has, as we have seen, never been truly successful in preventing large banking collapses with their potential effect on depositors, liquidity and the payment system. The banking industry now functions in essence as a semi-public utility, for all practical purposes subject to an implied government guarantee (bailout), notwithstanding more modern experimentation with curtailment of the rights of bond holders and even depositors (bail-in, see s­ection 1.3.11 above and ­section 4.1.3 below), but operates in a private manner.

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­ unctioning privately is here considered a substantial benefit in terms of innovation F and efficiency even if it may lead to serious excess and, as in 2008–09, to considerable instability in the system. At least in normal times, it is considered to make liquidity cheaper and easier to obtain. It also allows for the operation of a payment system that is often cross-subsidised by other banking activities or considered a function of deposittaking. It may then justify a lower or even zero deposit interest rate. The innate instability of the commercial banking system, which regulation as we know it has hardly been able to reduce, has for some time given rise to competing ideas. Especially the notion of narrow banking has been repeatedly put forward as an alternative. It does not allow consumer deposits and the payment system to be operated by commercial or universal banks in the present manner, therefore as integral parts of their overall business. They would be required to split off their consumer deposittaking business and put deposits into separate money market funds (or subsidiaries) with limited investment possibilities largely confined to the government bond markets in matching currencies in the nature of a money market fund.220 A variant of this approach is the one in which banks would fully back their low-interest-rate deposits by safe liquid assets such as treasury bills and commercial paper set aside for the purpose and legally ring-fenced. In all cases, ordinary loan business is then to be avoided or curtailed. The payment activity would also be split out into a separate activity with its own capital through a separate subsidiary. Regulatory supervision would essentially be limited to these two activities and would not then have to be heavy as there is little risk involved. For the rest, banks would be run as non-banks, fund themselves in the capital markets or through deposits from corporate clients (also called wholesale clients) as did some banks that have no private customers such as JP Morgan in the US before it became part of the Chase Manhattan group, and the former Industrial Bank of Japan (IBJ) before it became part of Mizuho group in Japan. They would be essentially unregulated and allowed to go under. Present generous capital adequacy requirements (which may be as low as eight per cent of risk assets, as we shall see) would disappear and banks would have to capitalise themselves better as they would otherwise have difficulty in attracting funds (including corporate deposits) in competition with other banks. This in itself could reduce the risk of their failure—so the argument goes—and moral hazard would disappear although, to preserve liquidity, central banks might still not be indifferent to systemic risk, even though the payment system and smaller deposits would be separately protected.

220  In the crisis of 2008–09, money market funds also faced problems however. They had sometimes funded special investment vehicles (SIVs) used by banks in the securitisation of their banking assets, for parts of which high ratings were obtained which had induced these funds to buy commercial paper from these SIVs but whose high rating in the event did not hold up: see also ch 1, s 2.5.3 above. This meant that shares in these funds started to trade below par or had ‘broken the buck’. This goes against their avowed policy to give investors their money back whenever they want, while often offering higher interest rates than banks do. It may now lead to more regulation and capital adequacy requirements (but also governmental guarantees for investors), increasing cost and lowering returns, at the same time inducing customers rather to keep their money in banks. See for the Volcker and Vickers rules, nn 173 and 176 above and for the shadow banking system s 1.1.17 above.

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Overall, liquidity would probably suffer and it may also become less easy for small depositors to arrange overdraft facilities and credit cards, which would then also become more costly. Retail deposits would no longer be available for the loan business. That could cause banking to shrink very considerably as one of its main functions is precisely giving long loans funded by short-term deposits. Even for companies, banks would have to be more careful. Because of the need for extra capital, all bank services would become more expensive. Banks would have to be run as normal businesses and no longer as businesses indirectly guaranteed and therefore subsidised by the public purse as if they were semi-public institutions. While adopting commercial standards of behaviour, the costs of the system would be shifted to customers and shareholders, therefore to those most directly concerned, rather than be borne by taxpayers, again the idea behind a bail-in. This is a key element in this approach. Some of these ideas and their consequences have already been discussed in ­section 1.3.11 above. In the UK, the 2011 Vickers Report drove in that direction and demanded ringfencing of retail, followed by the Financial Services Reform Act 2013 which demanded this type of reform to be implemented by 2019. The idea was to protect retail from investment banking operations, especially to safeguard the deposit-taking and payment function for them. It initially was to apply only to the largest UK banks and was thought that it could affect up to 25 per cent of a bank´s assets depending on the client base and was seen as some reversion to earlier practices. It was also considered a means of limiting leverage, retail funding in overdrafts, credit cards and mortgages being part of the ring-fencing. The retail activity could not engage in derivative transactions, engage in proprietary trading, originate, underwrite, trade, lend or make markets in securities, and provide services to non-EEA (European Economic Area) customers. Unsecured lending to other group entities could be no more than 25 per cent of capital resources and secured lending (against highest quality collateral) no more than 50 per cent. More capital was required than under Basel III. Guarantees, indemnities and similar commitments within the group were to be limited. It should be noted that under the EU passport, foreign banks operating in the UK are not subject to these limitations and this creates an important dichotomy, probably an issue after Brexit, but also applies to smaller UK banks, which are, it was considered, less prone to such other activities. Sharia banking is sometimes thought to be comparable to narrow banking in the sense that it discourages high gearing in banks (see for Sharia finance ­chapter 1, s­ ection 2.1.7 above). As all depositors have a business-related interest, their return depends on how much money the bank can make. They are in fact a kind of stakeholder, even though not technically equity owners. Since the bank itself cannot invest in interest-bearing instruments or in any guaranteed returns, it must, however, in order to earn a return, itself take risk in other activities or investments, which may restrain it further. It is clear that its general liquidity-providing function is here also constrained. This type of banking is likely to be inefficient in terms of cost. Nevertheless, like much Sharia teaching, it is bent on restraint and may therefore well forestall a boom-and-bust mentality in banks. In bankruptcies, stability is further buttressed by the expectation that under Sharia law shareholders will not hide behind notions of limited liability. Another idea is to have banks issue subordinated public debt, which is debt ranking lower than deposits and other borrowings but just above share capital. The daily pricing

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of these securities would then provide a market assessment of a bank’s risks and regulators could on this basis order banks to reduce risk (or increase capital). There would no longer be dependence on more or less sophisticated risk-management systems but the market view would determine regulators’ action and the level of the required capital. It follows that lower valuation of these subordinated bonds could soon drive these banks out of business as the cost of more capital would become too high to compete. As noted throughout, banking is a dangerous business. History shows that commercial banks in their present operations often take too much risk as measured against their capital, especially at the top of the economic cycle. They are allowed to do so in order to provide random liquidity at lower interest rates to the whole economic system and provide cheap payment services. The corollary is the implied governmental guarantee and taxpayers’ exposure (bailout), now increasingly accompanied by bail-in experimentation, see ­section 1.3.11 above and ­section 4.1 below. The price for banks was regulation, even if it has proven to be hardly effective in preventing financial ­crises so far. Nevertheless, regulation seems to be able to create a semblance of order and a facade of respect that underpins the public’s confidence in the system, however fictitious. This was noted at the end of s­ ection 1.1.10 above. No less important in this connection is the deposit guarantee scheme, even if its solvency itself is not guaranteed. All the same, they may make most retail banking customers largely indifferent as to which bank they use and to that bank’s fate. That in itself is a further reason for bank management to relax. It is the issue of moral hazard—see again ­section 1.1.11 above.

1.4.7  Commercial Banking Regulation and Banking Regulators. International Aspects Commercial banking regulation, like all financial regulation everywhere, largely follows the pattern established above in ­section 1.1.8: authorisation (with requirements of fitness, reputation, infrastructure and systems, capital adequacy and business plan or profile) and prudential supervision. Especially the role of capital adequacy requirements and how the necessary capital is calculated will be discussed more fully below. For banking regulators there is traditionally less interest in conduct of business and product supervision and more in institutional regulation. The focus increasingly became financial stability, as we have seen, not the protection of clients. An important aspect of modern bank regulation is in this connection the creation and operation of deposit guarantee schemes for deposit holders, allowing regulators to focus ever more on the stability issue. However, the protection of deposit holders may vary greatly under these schemes. In the US, it is now US$250,000 per depositor; in Germany it is traditionally unlimited. In the UK, the covered amount is much smaller (£80,000), although exceptions had to be made by governments everywhere in the 2008–09 ­banking crisis. In the eurozone it is now EUR 100,000. Again, nothing guarantees the solvency of these schemes in a crisis. In Europe, central banks are normally also the banking regulators except in Germany where there is a separate agency and in the UK where banking supervision was brought

PART I  Financial Services, Service Providers, Risk and Regulation 667

together with the supervision of the other financial services under the Financial Services Authority (FSA) in 1996. This was also done in Germany in 2002 where the BaFin covers banking, investment and insurance services. Since 2012, in the UK, the Bank of England has regained the supervision of banks through a subsidiary, the Prudential Regulation Authority (PRA), which also supervises insurance companies but not investment firms unless they pose substantial risks to the stability of the system.221 The sufficiency of the Basel capital framework, the continued access to wholesale funding, and the adequacy of senior management’s judgement is here no longer assumed. Henceforth supervision is to encompass policies on a firm’s resilience (­capital, liquidity, leverage and large exposures), supervisory assessment and intervention, and policies to support orderly resolution in the case of failure, at least that became the idea. There is now a separate authority for financial conduct in the UK, the Financial Conduct Authority or FCA, largely the rump of the former FSA. The emergence of the ECB, which issues the euro and is, within the European System of Central Banks (ESCB), in charge of monetary policy in countries that adopted the new currency on 1 January 1999, did not in itself change the banking supervisory system. Member State central banks or alternative national banking supervisors continued to be in charge of bank supervision although arguments had been made for centralising this function also within the EU.222 As of 2012, a supranational approach was, however, being considered for the eurozone. It also posed the important question of lender of last resort for this system, which was then considered to be extended to providing liquidity for banks in distress, earlier identified as rather an abuse of this function. It was believed that more supervision would be the proper safeguard and banks could only enter this system if they fulfilled and maintained entry conditions. History will tell whether these precautions prove realistic but as of 2013, a Single Supervisory Mechanism (SSM) was set up in the eurozone by Regulation followed by a Single Resolution Mechanism (SRM) in 2014 (see ­section 4.1 below). For the rest, the system in the EU only required co-operation between s­ upervisors: see Articles 42, 132 and 139 of the 2006 Credit Institution Directive, which ­consolidated

221  See also the Bank of England and FSA paper: The Bank of England, Prudential Regulation Authority (May 2011). 222  See M Andenas and C Hadjiemmanuil, ‘Banking Supervision, the Internal Market and European Monetary Union’ [1998] European Business Law Review 149. The problem of the decentralised banking regulation after full implementation of the European Monetary Union (EMU) was raised early on also by B Eichengreen, Should the Maastricht Treaty be Saved? (1992) 74 Princeton Studies in International Finance 42, and later by R Kinsella, ‘The European Central Bank and the Emerging EC Regulatory Deficit’ in D Currie and JD Whitley (eds), EMU after Maastricht (London, 1995) 103. Yet the EU approach was clear and against centralisation of the banking supervisory functions (as it is against creating one EU securities or insurance regulator). There are in any event institutional (jurisdictional) and conceptual (subsidiarity) problems with such centralisation in the present EU set-up. The greatest problems are likely to come not from a lack of centralisation but from any EU-based commercial bank with large non-EU activities facing financial difficulties in those activities and from the problem for any central bank in the EU to act as lender of last resort in such circumstances. It was unlikely that the ECB would take over that role in times of crisis but it was indirectly forced to do so in a major way during the 2007–09 banking crisis and thereafter when a government funding crisis developed in Southern Europe. Consolidated supervision on a global scale, either through the BIS or otherwise, may be part of the answer. Within the EU, co-ordination between banking supervisors is still an issue and this may itself give rise to the creation of a new level at which supervision of EU-wide banks is exercised, see ss 3.4.2 and 3.7.2 below.

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the earlier Banking Directives (following the 2000 Credit Institution Directive), ­Articles 56ff of the 2004 MiFID, and Article 38 of the 2006 Capital Adequacy Directive for Investment Firm. But as of 2009, more co-ordination was sought through the creation of a new committee structure: see ­section 3.7.16 below. A Bank Recovery and Resolution Directive now provides a framework for a bail-in mechanism in all EU countries (without mutual support) and was enacted in 2014 (see ­section 3.7.16 below). For the eurozone this was further refined in the SRM as just mentioned. In the US, there is a more fractured system of banking supervision, which has always been characterised by a fear of big banks and big banking regulators. First, there is in the US the division between state and national banks and further the limitation on branching: see also ­section 1.2.2 above. There is also a different supervisory regime in respect of them, with further differences depending on whether state banks have deposit insurance or not. In this system, national banks are regulated for safety and soundness by the Office of the Comptroller of the Currency (OCC), while state banks are regulated by the states subject to federal limits, but state banks that have deposit insurance are also regulated by the Federal Reserve Board (Fed) if they are Fed members (like all other banks that are such members), and otherwise by the Federal Deposit Insurance Corporation (FDIC). The present regulatory system and particularly the powers of the Fed became important issues, however, during the discussions on a new regulatory set-up in the US in 2009–10. As regards international aspects of banking regulation, the Basel Concordat of the BIS has already been briefly mentioned in ­section 1.2.4 above (see for its implementation in the EU ­section 3.6.6 below). Under it and its 1992 amendments, both the home and host regulator must approve foreign branching and in the supervision of the foreign branch the host regulator will only defer to the home regulator’s supervision if it is comfortable with the supervisory capability of the home regulator. The BIS itself is the bank of the central banks, was originally created (in 1930) to manage German reparation payments and is directed by the central bank governors of the G-10, now extended to 27 members—see ­section 1.2.5 above. It provides a regular meeting place for central bank governors and is also the think-tank for banking regulation through its important Committee on Banking Supervision.223 In ­section 1.1.14 above, macroprudential supervision was mentioned. For financial stability, it may be eclipsing the present (micro-prudential) regulatory framework. Policy and discretion is revived in this manner behind the facade of regulation and it may be asked whether this type of supervision should be exercised by regulators (in this case central banks) who have little accountability. More importantly, it also suggests the failure of the traditional (micro-prudential) supervision approach in this area.

223  While in modern cross-border banking the division of regulatory tasks between home and host country is thus well known, it was considerably tested in the BCCI case, where there was confusion about what was the host country: the country of incorporation of the bank (Luxembourg) or the place where it had its main operations (the UK). As we shall see in s 2.3.4, the EU substantially incorporated a system allowing for home country rule: see for a summary also s 1.2.1 above. In this regard, in the Preambles to both the Second Banking Directive (SBD), now superseded by the Credit Institution Directive (CID), and to the Investment Services Directive (ISD), now the Markets in Financial Instruments Directive (MiFID), the desirability of the combination of the registered and head offices within the same jurisdiction was accepted to avoid confusion about who is the home regulator.

PART I  Financial Services, Service Providers, Risk and Regulation 669

1.4.8  Intermediation and Disintermediation of Commercial Banks As set out in the previous sections, a major task of commercial banks is to provide liquidity to the public. It means that they fund private citizens, for example through overdrafts or mortgage lending, and businesses mainly through overdrafts and corporate loans. They may also fund governments or municipal authorities. Of course, businesses are funded also through capital contributions of shareholders and through loans from other sources, often the same shareholders. They may also be funded through direct access to the capital markets in which they may issue bonds to the investing public, as banks always did. If not closely held, they may also issue shares to the public in the capital markets. Governments and governmental agencies or municipalities traditionally also issue bonds in the capital markets and in this manner may avoid the intervention or intermediation of banks, which is costly. In fact governments and their agencies are normally the largest bond issuers, followed by commercial banks. They may still choose a banking syndicate to underwrite their bonds as was common for smaller countries when issuing in the eurobond market in other than their own currency. They may continue to do so after the introduction of the euro if they wish to facilitate international placement. As a result of increasing numbers of corporate issuers accessing the capital markets directly, commercial banks have been losing their traditional intermediary role of capturing the flow of funds by taking them in as deposits or by borrowing themselves (directly in the interbank market or through bond issues in the capital market) and subsequently lending these funds to those requiring them. Naturally, banks will borrow at the lowest rates and lend at the highest rates possible to increase their spread and profits, often by offering longer-term loans. To avoid the cost of this bank intermediation, first-class borrowers such as governments, banks and good companies have therefore always tried to access the capital markets directly by issuing bonds (or shares) to the investing public in competition with each other and many private companies are now able to follow suit. This is also attractive for the investors. In this manner they are likely to receive a better return on their money than they could get from banks on their deposits. In addition, they may also obtain instant liquidity by selling their bonds whereas any higher-yielding term deposits with banks are basically illiquid and may be held by these banks until maturity. There is for investors also a possibility of making some profits if bonds rise (because interest rates fall) although there is of course also the risk that they may fall (when market interest rates rise), but their full face value will be paid at least at maturity. As just mentioned, more recently, many large entities requiring capital have been able to turn directly to these investors in the capital markets to obtain the corresponding savings in their funding. Although this facility is still mainly reserved for the better credits, even weak and new corporates are now able to access the capital markets in this manner directly by offering so-called junk bonds, which have a much higher coupon compensating for the extra risk. The result was the (partial) side-lining of commercial banks in their deposit-taking and loan activity. This process is usually referred to as bank disintermediation. It cuts

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into the business of banks, which thus lose their safest and largest borrowers as well as their long-term depositors. It not only affects the quantity of the banks’ business but also its quality, as only lesser credits still need banks, presenting them with a higher average credit risk and greater monitoring costs. Banks have therefore been forced to enter other businesses, and the logical sequel for them was the arranging and underwriting of these capital market incursions of their clients. Hence their desire to enter the investment banking business and the pressure that followed in the US to do away with Glass-Steagall restrictions in this connection. See also s­ ection 1.1.9 above for its final demise in 1999. Yet experience shows that only true investment banks are strong in this business. The US investment banks, which were precisely the products of Glass-Steagall in the 1930s, long remained the best. Typically they join this underwriting or advising activity in respect of new share and bond issues with market-making, brokerage, corporate advice, merger and acquisition expertise, and investment management activity. However, as already mentioned, the 2008–09 financial crisis overwhelmed them also and they started to need liquidity from central banks when short-term funding through the capital markets dried up. They thus became subject to greater supervision, which motivated the two last big ones—Morgan Stanley and Goldman Sachs—to ask for a banking licence in the summer of 2008 to at least give them the benefit of taking deposits from the public, even though after Basel III, they may no longer be able to be used for trading and illiquid investments. The result was in many ways that the situation from before 1934 was re-established. In fact all major US banks now have embedded investment banks while the last two independent investment banks of substance became bank holding companies also. When in 2009–10 the discussions veered towards separating the proprietary trading activity from banks, it should be understood that that was not merely or even mainly the underwriting and market-making activity in capital market products, but rather the trading in all products including foreign exchange, repos and swaps or securitised products and credit derivatives. Indeed, the concern was that deposits were used to fund illiquid positions. This was behind the so-called Volcker rule. It therefore became a matter of liquidity management. The problem was, however, how this trading could be separated from the needs of risk management in the same products in these banks (see also the discussion in ­section 1.3.10 above).

1.4.9  The Banking or Current Account Relationship and Agreement Banks and their regular customers enjoy a contractual relationship, not merely in respect of deposits. The legal characterisation of that relationship has given rise to problems because the relationship is often multifaceted. Indeed, many different services may pass between a bank and its client such as deposit services, payment services, credit card and overdraft or loan services, if not security brokerage services as well. Mortgages are also likely. For corporate customers there may also be standby agreements, receivable finance, and inventory financing (this concerns working capital), and letters of credit or other forms of trade financing.

PART I  Financial Services, Service Providers, Risk and Regulation 671

In many aspects the banking relationship allows one party (the bank) to unilaterally fill in major conditions unilaterally and change them (eg interest on deposits and fee structures). This unilateralism is at variance with normal contract theory, which on the whole avoids these potestative conditions (in French terminology), meaning one party filling in major terms at will. It is balanced by the right for the client to close the account at any time and withdraw positive balances and cash deposits, but it is different, for example, for time depositors, where banks may still set the interest rate unilaterally. As a minimum, it would suggest some objective standard in the reward, related as it may be to market rates, and no discrimination. First, the multifaceted nature of the relationship. One key question is whether there is one umbrella relationship to which all present and future transactions of whatever sort (or at least in the payment, deposit and lending sphere) between a client and its bank are legally subordinated and in which they are integrated, or whether each transaction must be considered on its own, important in the case of a default or anticipated default in any one of them (short of contractual stipulation to the effect). Do all positions mature and can they be promptly netted off? At least for customers with regular income, the current account relationship suggests a framework for other services. Within it, credit card, overdraft services, loan business (especially mortgages) and time deposits may be created. Security or other investment transactions in which the bank acts as broker are also normally conducted through it. These additional services will all arise under specific agreements to the effect, of which, however, the current account is likely to remain the centre. It is important to understand that the existence of a current account in itself is not commonly considered to confer any right on the client to additional services beyond cash withdrawals (either at the branch of the account or—at the bank’s option—also through other branches or cash machines) and payment services to the extent of any positive balance of demand deposits. The bank is not normally obliged to do anything else as a result of the current account relationship, even to provide a cheque book. Thus a bank is not under an inherent duty to provide more services, even to offer (upon request) fixed-term deposits for any positive balances (unless saving accounts, which are fixed-term deposits against higher interest rates, are offered to the public at large) and certainly not to extend any overdraft facility or give a credit card or engage in investment securities brokerage or other services for the client. Although smaller companies are often in need of financing that is perfectly legitimate and justified, it cannot be considered the (public) duty of banks to help them either, therefore without regard to the considerable cost of monitoring such clients, although governments may exert pressure especially in this segment of the loan market or may favour the setting up of special development banks for them. Whatever the precise status of the current account, it is thus clear that additional services are not typical for a true banking relationship, nor therefore time deposits or mortgages either. But it would seem that if there are such additional services the current account, as centre of the relationship, is and may as such be seen as the anchor of the entire relationship and indeed it then has the function of an umbrella or framework agreement. This is the notion of integration, the meaning of which needs further investigation. It operates foremost de facto as all charges accrued under any of the

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other services and all moneys owed under them are likely to be debited and credited to the current account and thus be netted out on a continuous basis to the extent they are mature or become so. Even where only a mortgage is given, it is not unlikely that a current account is opened at the same time through which the regular payments are conducted (in terms of debits to the current account of the borrower) and which are settled through that current account. The key feature of the current account in this kind of broader relationship is that it is by its very nature in constant flux as it nets out the cash side of all the client’s transactions on a continuous basis, including payments, new deposits and withdrawals. If there is a positive balance, there will be a deposit aspect; if there is a negative balance, there is an overdraft or loan aspect. One could also say that mutual lending results under it between the bank and its client, at least if there is an overdraft facility. The current account is thus the expression of a dynamic relationship in which the position of net debtor or creditor changes all the time between both parties. This framework comes particularly alive when there is a set of multiple transactions and the question then may arise of whether there is a single contractual framework which allows for a netting of all mature debits and credits and in the case of a default in any transaction between a bank and its client even for a total liquidation, perhaps upon acceleration of all maturities. It is thus to be considered in how far such a right for the bank follows in the case of default of its client, or even a fear of default, also if no relevant (default or cross-default) clauses to the effect were inserted in the various agreements. It would limit the bank’s further exposure in effect terminates the relationship entirely but it may be doubted, as we shall see, whether the umbrella nature of the relationship or the existence of the current account go that far. It may require more. Through the current account arrangement and its (standard) terms, a bank usually has an express or implied contractual set-off or netting right and a lien on all that it holds for its client in respect of all the client owes it.224 Such terms indeed support the notion of integration and the umbrella idea, but it would be under specific terms. In this vein, if the bank takes out special protection, such as mortgages for its housing loans, these mortgages could be structured also to cover any other outstanding debt of the client. If not, the mortgage may stand more alone. In England, there is the rule that if a particular overdraft is secured, any subsequent overdraft is not automatically covered by the same security while any repayment is deemed to be in respect of the older overdraft,225 save of course contrary stipulation, but the set-off

224  There is an important difference in that the netting affects all the balances automatically, while the lien only reaches assets in custody and will require an execution before proceeds can be added to the set-off and netting. This is likely to affect not only custody accounts, but even the contents of strong boxes that may hold client securities and valuables in the bank, but for no more than necessary to cover any net deficit. In respect of the banking lien on the assets, which may thus be rolled into the liquidation, it is possible, however, that there are higher-ranking specific charges in respect of these assets for the benefit of other creditors of the defaulting banking customer. These will have to be respected. It should be recalled in this connection that bank deposits, as distinguished from the contents of safe deposits or custody accounts, result in the depositor becoming only a creditor of the bank so that there is no need for any lien or charge on the customer in respect of these moneys which the bank has already received in ownership. 225  Rule in Clayton’s Case (1816) 35 ER 767.

PART I  Financial Services, Service Providers, Risk and Regulation 673

and netting facility as well as the banking lien will continue until all is liquidated. It follows from the foregoing that in the case of a default in any of these contracts, there are several lines of defence for a bank and positive balances in the current account may be used to fill the void. There may also be the trigger of cross-default clauses inserted in each of the relationships to effect acceleration and a netting out of all assets and liabilities if not considered implicit in the nature of the relationship itself. Indeed, on the European continent, the connection between the various accounts of a client with its bank and the creation of the bank’s lien is commonly established under the general banking conditions of a bank, which are signed by or at least sent to all clients when a client relationship is established. In common law countries, general banking conditions of this nature used to be less common and banks may rely more on established practices and case law, itself often accepting implied conditions.226 The essence is that through the current account all financial movements between a bank and its client may be expected to come together and will be netted out and settled, even in England now increasingly supported by banking conditions, regularly updated and sent to clients. If there are more current accounts in one relationship, they will be consolidated. The conclusion is that the banking or current account relationship can be seen as the essence of the banking relationship and is one of duration and flexibility, essentially resulting in a conduit leading to an overall netted creditor/debtor relationship, which will be in flux all the time. It suggests an array of banking services of which the payment, deposit and credit supply functions are the most important; the first two are always implied in the current account relationship and the latter may result from the mere current account relationship, which may turn into a negative balance or debit on occasion, usually subject to the duty to immediately cover the deficit, but may become more flexible when connected with an overdraft facility. The debtor/creditor characterisation resulting from a mere deposit does not therefore fully explain the banking relationship, which seems more the netted result of a number of facilities, including in particular a payment and potential lending function in the current account. In fact, the rendering of other financial services such as the granting of loans and brokerage services which may be other obvious aspects of banking, are alone not the legal essence of the banking relationship but are rather accessory. Civil law in its legal characterisation may put primary emphasis on the different contract types and may be less concerned with the overall or umbrella relationship. There may thus be an instruction agreement in the case of payments, a deposit agreement in the case of deposits (often not defined, however, in the relevant legal system but commonly distinguished from loan agreements), a loan or overdraft agreement in the case of client borrowing, or a brokerage agreement when securities transactions are executed for clients. In that case, there may also be a custody agreement. Greater characterisation difficulties may exist in leasing and factoring, which are agreements that in many civil law countries remain also undefined. Looking for and defining special types of contracts is indeed the habit of civil law, one of the reasons for its difficulty in defining an overall (banking) relationship when there are different kinds of transactions

226 

The unitary approach follows in England from Joachimson v Swiss Bank Corp [1921] KB 110.

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involved and in establishing a connection between the individual contracts or banking services or products. It may thus have to be left to the banking conditions to clarify these issues, although they are often not even signed by the client and usually unilaterally updated by the bank. But in common law there is some tension too. Particularly in Germany, considerable thought has been given to the banking agreement (Bankvertrag). In that country, it is not considered directly connected with the opening of the current account, but rather it seems to be based on the understanding of a longer-term credit relationship, which does not cover non-credit transactions. Its impact is thus not extended to other than the typical banking relationships in terms of payment, deposit-taking and credit facilities, if any. All individual deposit and credit agreements depend on it, however, and are likely to be co-ordinated by it. So even here, the umbrella idea unfolds. It means that once such a relationship is in place, requests for payment, deposit and credit services under it must be considered seriously, and can only be refused on good grounds. Termination of the banking agreement by the bank would also require proper justification. On the other hand, no cross-default is implied or simultaneous termination of all deposits and credit agreements upon the end of the banking relationship. As such, its importance may not go beyond what general legal principles of good faith already provide in Germany.227 There are other issues that need to concern a lending bank and that are often summed up in terms of lenders’ liability. They concern the giving of negligent advice to borrowers, pressuring them into accepting loans or similar facilities, failing to warn them against imprudent borrowing, and improperly administering, calling or accelerating a loan.228 A bank should also be careful not to step in the management’s shoes and effectively become involved in the management of its borrowers. It could lead to a postponement of its own loan facility in the case of a bankruptcy of the borrower. In common law countries, this is the important issue of equitable subordination. In a similar vein, a lending bank should avoid enabling the borrower to pretend increased creditworthiness vis-à-vis third parties while the bank itself retains the highest (undisclosed) priority in the case of a default. In regulatory terms, this is conduct of business, which so far has had less impact in commercial banking as regulatory objective as we have seen, but it is rightly becoming more important and has led in the US to a special retail banking regulator. It may be clear from the above that the current account agreement or the banking relationship has many special features. It has already been said that unless otherwise

227  RH von Godin, Kommentar zum Handelsgesetzbuch, Dritter Band (Berlin, 1963) ss 343–72, at 365, Anm, 1.2 ziff 2; see also KJ Hopt, Der Kapitalanlegerschutz im Recht der Banken (Munich, 1975) 393ff. See for dogmatic criticism on the umbrella idea or Rahmenvertrag, C-W Canaris, in H Staub, Handelsgesetzbuch ­ Grosskommentar, Dritter Band, Zweiter Halbband, ss 352–72 [1978] Bankvertragsrecht, Rdn 4. See also C-W Canaris, Gross Kommentar HgB, Bankvertragrecht I [1988] Rdn 2ff. He notes that either party may terminate the relationship at any moment; any mutual obligations depend on the objective law, not on an implied banking relationship agreement. In the context of the good faith requirement of s 242 BGB, similar rights and duties as construed under the banking agreement result. The emphasis on fiduciary duties may make the need for such a contract redundant,(see also J Koendgen, ‘Neue Entwicklungen im Bankenhaftungsrecht’ [1987] RWS Forum 1, 138ff, but might not extend to set-off, proprietary and enforcement issues upon ending a banking relationship. 228  See also R Cranston, Principles of Banking Law, 2nd edn (Oxford, 2002) 221 and W Blair QC, Banks, Liability and Risk, 3rd edn (London, 2001) ch 1.

PART I  Financial Services, Service Providers, Risk and Regulation 675

agreed, it is special also in that the bank is usually free to set the interest rate on positive and negative balances and impose its (standard) charges for any movements in the account. It may unilaterally set many other conditions, indeed its whole fee structure, and even change them unilaterally. This is a unique situation as contracts that leave it to one party to determine the main terms are often considered void. In French terminology, it makes these contracts potestative—as has already been mentioned. In order for contracts of this nature to stick legally, the remuneration and charges may have to be reasonable as an objective criterion, making them at the same time also ascertainable, but there may be a wide margin. The terms should also not be discriminatory between customers of the same bank, and different treatment must therefore be justifiable from a point of view of increased credit risk and volume of business. The regulatory concern is here often limited to the proper disclosure of such charges beforehand, but it may be doubted whether that is sufficient. At least as far as setting the deposit interest rate is concerned, it might be considered the natural counterpart of the deposit being withdrawable at any moment and the access that is thus created to the payment system. It is true that the client can terminate the current account at will. But other banks will behave just the same. The large discretion of banks in matters of their own reward should therefore solicit a higher degree of regulatory supervision in these aspects than is now normally exercised. Banks are here in a dominant position, at least in respect of their smaller clients, and their unilateral action, even if authorised by some general standard terms, is a proper area for regulatory concern where so far too little is often being done, although in the US under the Dodd-Frank Act, a special consumer regulator was created. Even if there is some agreement with the client in respect of interest and charges, it seems that such an agreement can still be terminated by banks at any time. Here again, protection can come only through regulatory oversight. Changing banks is the theoretical answer but it is not easy for customers and other banks are likely to behave similarly. In fact, there may exist parallel or concerted behaviour in a monopolistic environment, supported in many countries by general banking conditions agreed between all banks. If banks often have a bad name with their (smaller) clients, it is because of this situation. When bank rescues become necessary and taxpayers must come in, it makes for extra resentment.

1.4.10  The Democratisation of Financial Services and its Effects. A Human Right to Credit and a Public Function for Banks? Given the central function of the current account, the preliminary question becomes who is entitled to open and maintain a bank relationship through this type of facility. In this connection, it is important to realise that without a bank account proper it is hardly possible to function any longer in the modern world. It is crucial, and a key question is therefore whether all members of the public and companies, especially also the smaller ones, are in principle entitled to open banks accounts with whatever commercial bank that is open to the public and what services they may subsequently

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reasonably request beyond making call deposits and participating in the payment system, such as, for example, receiving a debit or credit card or other consumer credit. It must then also be asked whether the costs of these services are reasonable, can still be unilaterally set or changed by the bank, and under what conditions such accounts may be closed or services discontinued, the practical effect of which may be the elimination of the client not only from the banking system, but also from the payment system and society as a whole. In this connection, the public liquidity-providing and payment functions of banks may need to be more carefully considered, in exchange for which banks de facto are receiving some public guarantee against their insolvency, as explained above in ­section 1.1.6. Indeed, in most modern countries, all who wish to do so can open some kind of bank account, or at least banks would have to be careful to refuse them without some good cause. It allows the customer as a minimum to deposit money in order to make payments to others and also receive payments into their account, even if, in the case of private persons, only social security benefits (a particular reason why governments often insist that even the poorest members of society will be allowed to open bank accounts in order to facilitate and protect these payments). The resulting current or checking account cannot then easily be closed by banks either, short of the customer starting to run a deficit, which, without an overdraft facility, could be seen as a form of default but could easily be prevented by the bank itself.229 It suggests that a bank either refusing the opening of the account or ordering the closing of the account must do so for cause and that it can no longer act purely at will, even in respect of richer clients. However, it has already been said that the opening of a current account is likely to allow the customer only minimum services in terms of the withdrawal of any demand deposits and payment services, and both only to the amount of a positive balance in the account, subject further to regular bank charges (assuming that these are reasonable). If these charges are the only cause of the deficit in the account, this might not be enough for the bank to close it. On the other hand, it might not even allow the customer a cheque book. That at least would appear to be

229  In the US, there is some long-standing case law in this connection: see Elliott v Capital City State Bank, 103 NW 777 (Iowa 1905) and Grants Pass & Josephine Bank v City of Grants Pass 28 P 2d 879 (Oregon 1934), which emphasised the freedom of the bank to refuse demand deposits and to provide other services unless directed otherwise by banking law. The only obligation of banks was to repay deposits (if not time deposits) upon demand. In more modern times, the issue of refusing access may be less straightforward and could even become one of human rights in the case of discrimination on the basis of sex, religion, colour, disability, etc; see also the Canadian Charter of Rights 1985, c H-6. There may also be anti-boycott rules or other public policy considerations. In fact, in a modern banking system, low income of the prospective client or little anticipated banking volume are unlikely to be accepted as sufficient reason for the refusal or termination of an account, but concern, especially for ethics (viz money laundering) and credit, remains legitimate even when accounts are only given in order to make payments against deposited funds. Especially in France, the Banking Law of 24 January 1984 was specific in balancing the contractual approach, which gives banks discretion, against a more public policy-oriented attitude. Under Art 89, banks are exempt from the anti-boycott provisions but under Art 58 anyone refused a bank account may apply to the Bank of France for it to appoint a bank where the petitioner can open an account. This service may be restricted to cash operations. It is understood that there is no right in such forced accounts to a cheque book or to credit card facilities, but it may be different for a debit card.

PART I  Financial Services, Service Providers, Risk and Regulation 677

the situation in France. It means that the account is limited to incoming payments and cash withdrawal services only. A particular aspect of the current account not being terminable at will by the banks is that the entire banking relationship cannot be undermined either by a simple termination of the current account. Even in respect of a proper termination of the current account, a grace period for the client to make alternative arrangements may still be deemed implied except in the case of a default or the threat thereof, which may result from the unwillingness or inability of the client to keep the current account in balance. Even so and regardless of the umbrella function of the current account, specific transactions between a bank and its clients in terms of fixed deposits and loans with fixed maturities may not be affected by termination of the current account and they may come to an end only under their own terms, which could, however, include a crossdefault clause or other termination provision predicated upon special events including the termination of the current account for cause. But even acceleration must be invoked with care. In the US, there is some guidance in this connection in s­ ection 1-309 UCC, which requires good faith in accelerations at will. Even if good faith is generally a subjective notion under s­ ection 1-201(20), that cannot be so if the reference to it has any meaning in this context. This being said, credit risk must be constantly re-evaluated by the bank in respect of each banking client and deterioration unavoidably has an effect on the continuation of the relationship and types of services and on the rates a bank can offer. On the other hand, if the overall net position of a client with its bank remains positive, under more modern law, a bank may have to be extra careful when refusing special deposits or additional credit facilities, certainly if it commonly provides these to other clients in similar positions and discrimination may then become an issue. That may be so even among its poorer clients if others in the same situation are given or continue with these facilities intact. The democratisation of credit, which was earlier identified as a particular aspect of the operation of a modern society, especially clear in the US and England (see ­section 1.3.6 above)230 might play a further role here, even if it does not give account holders direct rights to credit either. Yet monetary policy and conceivably also financial regulation are increasingly geared to it. This is becoming a serious political issue, while it is clear that, particularly in the US, there is an undercurrent of political pressure to grant credit to the poorer strata of society too. The affordable housing policy was mentioned in this connection. It can be argued that this was an important origin and proximate cause of the financial crisis in 2008–09. More broadly, it translates into sub-prime mortgages, credit cards, and other consumer credit or generous overdraft facilities and more generally into easy credit conditions for all. The UK has a similar credit culture, which contrasts notably with the one in Germany and most parts of the continent of Europe, where many people live in rented accommodation, credit cards are only given to the rich, and overdrafts and consumer credit are limited, or in

230  See for the political element in the US in particular n 144 above and for the ‘boom and bust’ attitude text at n 152 above and s 1.3.6 in fine.

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any event little used.231 Germans even save before they buy a car!, see the comment at the end of ­section 1.3.8 above. As already mentioned, there may also be an effect here on financial regulation. In countries like Germany in 2008–09, a cry went out for more regulation to curtail excess. No ideas were proffered as to how exactly this should be structured but the suggestion was that banks should become more selective and as a consequence be smaller and perhaps also less international (therefore not tap international markets for this type of banking activity). It may be wondered and was already asked whether that is ultimately acceptable to the US/UK way of doing things or even a productive response in a fast globalising world which needs ever more credit. Many live more happily in boom-andbust scenarios where there are occasional shake-outs but where it is also believed that greater freedom and creativity are promoted by freer access to credit, even if this makes for a more fragile banking environment, banks never being stronger than their clients, structurally weak by their very nature, and often given to excess. Yet in the longer term, it may also give rise to a faster growth scenario overall because initiative is easier to fund and there may be more liquidity to support and expand ongoing business. The democratisation of credit is an important social and economic phenomenon that needs independent consideration and leads banks further into the direction of being considered social or public institutions, other facets of which are low capital requirements, deposit guarantees, support in times of crises and regulation, but also moral hazard and the possibility of increased irresponsibility. In ­section 1.3.6 above, it has already been said that in many countries this is now considered to be the way we live.

1.4.11  Fintech and the Potential Effect on Commercial Banking In the previous chapter, attention was given to the blockchain and its potential effect in area of payments, see c­ hapter 1, s­ ection 3.1.10, and on other modern financial products, in particular hedging instruments, see c­ hapter 1, s­ection 2.5.12 for securitisations, ­section 2.6.12 for derivatives. The theme was resumed in s­ ection 1.1.18 above. The potential is a complete transformation of commercial banking as we now know it. Should the payment function disappear, there would obviously be a major effect on the deposit taking facility of banks, but it would require substantially all payments to take place in the new system where purchase orders and orders for services, including lending, may also be integrated. Operating old and new side by side would probably prove to be inefficient. It would then also affect the service industry itself and its operations. Major standardisation aided by smart contracts would result especially in the professional sphere which could put all kinds of intermediaries under severe pressure. Technology would be decisive and put legal argument in the ­background. 231  In that atmosphere, house prices in Germany have not risen much since 1992 until 2016 and bubbles of that sort were avoided. The consequence is that banks cannot earn much money in Germany either and German banks are then tempted to invest in riskier products abroad. Hence these banks did not avoid the general banking turmoil in 2008–09 either.

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The smart contract would be transnational and may incresasingly dispense with a legal system altogether (beyond its own). It is what it is and the system itself determines its meaning and what it is for its participants, see further also the discussion in Volume 2, ­chapter 1, s­ ection 1.1.10.

1.5  Capital Markets. The Essentials of the Investment Securities Business and its Regulation 1.5.1  Major Types of Securities. Negotiable Instruments, Transferable Securities and Investments. Book-entry Systems and Securities Entitlements In the previous sections, we dealt more particularly with the recycling of money through the banking system and with the main feature of modern banking activity, of banks, their risks, risk management, stability, and regulation. It is now time to deal in greater detail with the other method of recycling money: the one through the capital markets where those who have the money, the investors, meet more directly those who need it: the issuers. Banks are here disintermediated: hence issuers instead of borrowers and investors instead of depositors. If there are intermediaries, they are of another type and called investment banks. They are mostly advisers and therefore fee earners, except if also underwriters and market-makers when they take their own risk as we shall see, but this risk is incidental and different from the risk a commercial bank takes, which results from it taking in deposits as owner and lending out this money at its own risk and for its own benefit. Investment banks could never do so and cannot treat client assets as their own. This is the issue of segregation which is a key issue in capital market services. Bonds and shares (the latter also referred to as stocks or equities) are the major capital market instruments, sold by an issuer to the investing public. Indeed the facility of a sale of documents is the preferred method of fundraising in the capital markets. These documents are commonly referred to as securities and are likely to take the form of transferable securities. This means that investors may easily dispose of them, again by sale, subsequently to hold cash or to buy shares in other companies or bonds from other governments or corporate borrowers on the relevant formal and informal or electronic exchanges on which they trade. This transferability is directly connected with the liquidity of investments and is therefore an important issue which requires a particular legal form for the investment but also a practical facility to trade, therefore the existence of markets with efficient trading and settlement facilities. In this connection, it is necessary first to discuss negotiable instruments as they are the traditional form in which investment securities are made transferable. They are instruments issued to bearer or to order. In the latter case, they are issued to a named person or entity or to its order or transferee. These instruments have a long history and date from medieval commercial law, or the international law merchant of those days, perfected by the trading practices established in the eighteenth and nineteenth centuries. In the payment sphere, they led to the development of the bill of exchange and cheque as transferable instruments; in the capital sphere, they led to the development of bonds

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and shares as transferable investments; and in the goods sphere they led to the development of bills of lading and warehouse receipts. The latter are often called negotiable documents of title. In this vein, negotiable instruments are documents of title concerning money. They were explained in greater detail in Volume 2, ­chapter 1, part II. The essence is that if they are properly expressed in bearer or order form, they are negotiable per se and are transferred in the case of bearer paper by the simple (­physical) handing over of the document and in the case of order paper by endorsement and handing over to the endorsee. Even the subsequent nationalisation of commercial law through the nineteenth-century codifications on the European continent and much statutory law in common law countries have not changed these basic principles. It may even be argued that these documents or instruments have always continued to enjoy some underlying international status in the laws merchant and any tampering with these fundamentals will immediately affect their negotiability everywhere, including under local laws.232 In fact, it has been argued above that these instruments truly belong to the international marketplace.233 In the case of shares and bonds, the fact that they are negotiable instruments means that they meant to incorporate the underlying shareholders’ claims (or rights to vote, dividends and any net dissolution or winding-up proceeds, and to corporate information) or bondholders’ claims (to coupon and principal payments at maturity making them promissory notes). This is at the heart of their easy transferability. It makes possible the simple ownership transfer avoiding the more complicated assignment or novation route, which would otherwise be indicated for the transfer of monetary and other claims and would involve the issuer (although less in an assignment than in a novation: see Volume 2, c­ hapter 2, ­section 1.5.5). Anonymity of the investment is another result in bearer paper. Nobody knows who the investors are until they claim a dividend or coupon, but these are mostly themselves also embodied in negotiable instruments that may be detached from the original bond or share and may anonymously be presented to the paying agent appointed by the issuer. Another important aspect of this type of investment securities is that, as they are negotiable instruments, succeeding owners are likely to take free of any defences previous owners may have had against them for defective transfers earlier in the chain of ownership. Securities of this type are therefore easy and (legally) relatively safe forms of investments with the added advantage that they may easily be reduced to money by trading them, when needed, in the relevant markets. They are then liquid, which is an enormous advantage assuming always that there are sufficiently developed markets and that there is a reasonable demand for them. Shares and bonds may also take the form of register(ed) securities and are not then true negotiable instruments but they might still be transferable. For shares, transfer is in that case pursuant to the approach taken by the applicable company law. It will normally require a change in the shareholders’ register held at the seat of the company 232  It is true that domestic law in some countries may be more restrictive and eg require the bill of exchange and cheque to be expressed to order only, but by being endorsed in blank they become bearer instruments all the same. 233  See Vol 1, ch 1, ss 1.4.2 and 3.2.2.

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and a transfer even on a stock exchange would not be perfected without it. It means a form of so-called dematerialisation, in the sense that there are no share or bond certificates proper. It results in paperless trading and transfer, a great advantage as paper is increasingly difficult to handle while bearer paper also raises safety issues for investors: if lost or ending up in the wrong hands, investors may have forfeited their investment. Registration of this type is common under company laws in common law countries like England where, however, certificates are still issued. They are not then transferable by themselves, but only proof of the investment. Registered shares of this nature dispense with confidentiality notions and allow the company to monitor the identity of its shareholders, which companies often like to do. For governments, there may be tax verification advantages. Also in this case, transfer is not through assignment or novation but rather through notification to the share registrar, although it is less easy than in the case of negotiable instruments and takes more time. In modern custodial systems, transfer of shares and bonds may increasingly be effected through book-entry systems kept by custodians. Companies such as Euroclear and Clearstream (formerly Cedel) in the eurobond market then hold the underlying (bearer) instruments as depositories and could deliver them to end-investors but they are increasingly immobilised at the level of these depositories and stay there, while these depositories will issue so-called securities entitlements to investors (or their brokers) against the securities they so hold. This provides for a system of ownership through registration with the depository or sub-custodians and presents a more advanced form of dematerialisation of investment securities. In this way electronic holding and transfer in a book-entry system of these entitlements becomes possible and is now mostly preferred. For investors, this results in securities accounts with intermediaries, usually their brokers, who themselves will hold back-up securities accounts with the depository (or other intermediaries in a chain). This is much the same as money being held through bank accounts with banks. In fact, investors now normally have a cash and securities account with their broker. For securities, the result is a system of layers or tiers of entitlement holders in which investors normally hold their securities entitlement with their broker, who in turn has entitlements with other custodians higher up in the chain. The ultimate custodians will have an account with a depository who will act as the legal owner as far as the issuer is concerned—see for greater detail Volume 2, ­chapter 2, ­section 3.1.1 and for a summary ­chapter 1, ­section 4.1 above. At least to protect against assignment or novation requirements in the case of transfer, these newer systems often need the support of the objective law, mostly through legislation, to make an easy transfer possible, which in the case of international transactions may raise the question of the applicable law or its transnationalisation, also in order to characterise the nature of the entitlement (as a new type of proprietary right, particularly in civil law countries) and the rights held thereunder. More generally, the key to the success of these modern systems is: (a) the easy transferability; (b) the preservation of confidentiality; (c) the protection against defects in the transfer in terms of finality (innate in negotiable instruments) and/or in the back-up in terms of the protection of bona fide purchasers (potentially resulting in dilution of the other clients of the broker in the same securities); and (d) most importantly, proprietary protection

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in the case of a bankruptcy of any depository being the registered owner and of any other intermediary/sub-custodian holding securities accounts for clients/investors. Here it is often clearest to characterise the security holder as a beneficial owner in respect of his pro rata interest in an underlying pool of fungible securities held by his intermediary (who himself may have no more than a book-entry interest with another custodian or a depository) and to which the end-investor has no direct access, but which are not owned by the intermediary either and are in respect of him segregated assets (for which he acts more like a trustee). The consequence is that in a bankruptcy of the intermediary in a proper legal set-up there must be a form of segregation and the back-up assets must be transferred by the bankruptcy trustee to another broker at the first request of the investor. That is the key and also the difference between a security and a bank account. It retains for the investor a notion of ownership of the investment, even if this type of ownership is highly qualified. In the US, Article 8 of the UCC presents an advanced example of this approach, which also goes to the transfer of this type of interests and (more indirectly) to its proprietary status (see the discussion in Volume 2, ­chapter 2, part III). One sees here a shift from the traditional negotiable instruments to what are now more commonly called transferable securities, which are a broader class of securities that may therefore have lost the status of negotiable instruments or even registered securities. It should be noted in this connection that negotiability is a term of art, much more than transferability. Transferable securities may also cover specialised types of financial instruments such as derivatives, therefore futures and options, and, for professionals, swaps. These so-called derivative products are not securities proper, therefore negotiable instruments, like shares or bonds or not even dematerialised securities, but are contracts with counterparties, which achieve some special form of transferability only if they are standardised and dealt on formal exchanges that allow for dealing in these standard contracts, as modern futures and options exchanges do. Rather than providing a system of transfers, these exchanges in fact operate on the basis of entering into opposite positions and normally offer a possibility of subsequently closing these contracts out for ‘sellers’ who will be paid or will have to pay the difference at the moment of ‘sale’, while ‘buyers’ will be offered new similar contracts against a similar price (allowing for market spreads). In formal derivative exchanges, there is mostly a system of a central ­(single) counterparty (CCP) which offers a close-out and netting facility in this ­manner: see ­chapter 1, ­section 2.6.4 above.234 There are thus many different types of transferable securities or (derivatives) products and some may be intrinsically much less transferable than others. Shares and bonds may themselves also be subdivided. Shares may be in the form of ordinary or preferred shares. There are also hybrids such as bonds convertible into shares and warrants. Warrants are a special type of option usually issued by a company at a certain price (or premium) allowing the owners to acquire new shares in the company at a specific issue or striking price during a certain period of time. These warrants are sometimes 234  Non-standardised or atypical OTC futures and options and all swaps can be entered into or unwound or transferred only in co-operation with the counterparty under the relevant contracts or neutralised through hedges, which means taking opposite positions independently. Major commercial banks may hold themselves out as ready counterparties in this respect, especially for swaps (swap warehousing): see ch 1, s 2.6.4 above.

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also issued by financial intermediaries who may hold a portfolio of the underlying company shares. They may be issued in the form of negotiable instruments but need not be. As far as bonds are concerned, there are fixed and floating interest rate bonds or notes. Notes usually denote a shorter maturity (not more than five years). As far as the maturity is concerned, there is short-, medium- and long-term paper, and there is likely to be a difference in the manner in which the different types are issued and placed. Consequently there is commercial paper (CPs issued by corporate borrowers) and there are certificates of deposit (CDs issued by banks) as short-term or money market paper. Then there are medium-term notes (MTNs), usually for no longer than three years and often much shorter. Then there are longer-term bonds, which may even be perpetual. Except for government bonds issued in the domestic currency, they are, as just mentioned, typically underwritten by a consortium of investment banks headed by a lead underwriter. The intermediaries used for placement of these securities tend also to organise a trading facility in them which may be formal through listing on an exchange, or informal (OTC) between market-makers (whose role will be explained in ­section 1.5.8 below) willing to act.235 Although, historically, negotiable instruments are the classical example of securities, for regulatory (and investors’ protection) purposes, the definition may thus be drawn wider in terms of transferability. In truth, modern regulators now mostly ignore definitions of this sort and aim at covering all investment products with a view to best protecting investors. Thus the Financial Service and Markets Act 2000 in the UK maintains a list in schedule 2 to which the Secretary of State has power to add from time to time but there is no definition (bank deposits have here even become ‘investments’ in this sense). In the US, s­ection 2(a) of the Securities Act 1933, dealing mainly with the public issue of securities, and ­section 3(a) of the Securities Exchange Act 1934, dealing mainly with the listing on and operations of stock exchanges, contain a list of instruments (again, as in banking, the US uses the list approach here). One of them is the so-called ‘investment contract’. In the reference to this kind of contract, the US Acts provide for considerable flexibility and this type of contract and its definition holds an important key. The term is undefined, but case law236 looks for schemes that involve investment money in a common enterprise with profits to come solely from the efforts of others. The emphasis is thus not on the negotiability of the securities per se nor even on transferability by some other means, although it seems to remain an important element, but rather on their investment nature.

235  There may also be a difference in the way these instruments are issued and placed with investors. Bonds and shares when issued are often underwritten by investment banks who thereby guarantee the success of the issue (against a fee). It means that to the extent there are no investors at the agreed issue price, these investment banks will buy the issue themselves. Generally, neither short-term paper nor MTNs are underwritten but usually only placed by an intermediary on a best-effort basis against prices from time to time indicated by the issuer. Banks may, however, give standby credit lines if not enough money is raised in this manner, which can be a great burden on them when these markets dry up. 236  SEC v WJ Howey Co 328 US 293 (1946).

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The US Acts provide in this connection that the context is also relevant and may determine that the indicated instruments are not securities. Thus CDs issued by national banks were not considered securities because they were federally insured while national banks are already subject to comprehensive regulation so that further protection through the securities Acts was not called for.237 The same goes all the more for bank deposits (unlike the new British approach since 2000). For purposes of the Glass-Steagall Act, now superseded and which required a distinction (and separation) between banking and securities business, swaps were not considered securities either and commercial banks could, as a consequence, freely deal in them, but in other contexts, such as that of investor protection, they could be considered securities. Again the context is important. In the UK under the Financial Services and Markets Act 2000 as amended, the central theme is the regulation of investment businesses, which are businesses conducted by firms dealing in investments (either as principal or agent), arranging deals in investments, managing investments, giving investment advice or operating collective investment schemes. As just mentioned, the term ‘investment’ is not defined either, but covers a wide range of products listed in schedule 2, which also contains a long list of exceptions and explanations. Currency and interest rate swaps are covered, but not pure commodity trading unless there is an investment element. As just mentioned, a peculiarity in the UK is that ‘deposits’ are now defined as investments, with the consequence that banks are now regulated much in the same style and manner as securities intermediaries in respect of their (regulated) activities. It may be doubted whether this was wise. It confuses banking and capital market activities. It also ignores the nature of the deposit, which becomes the property of the bank. On the other hand, in the EU in the 1989 Directive concerning the Public Offer Prospectus, now superseded by the Prospectus Directive of 2003, effective in 2004, and the Regulation of 2017, effective 2018, the focus was on transferable securities, which were defined in a list approach (see also Article 2(a) of the 2003 Directive, whilst the Regulation under its Article 2 (a) conforms to MiFID II, see below). They are shares in companies, debt securities having a maturity of at least one year, and any other transferable securities giving the right to acquire any such transferable securities by subscription or exchange. In the earlier 1977 European Code of Conduct relating to Transactions in Transferable Securities, they were defined as securities, which are or may be the subject of dealings on an organised market, a much narrower definition. Earlier, in the 1993 ISD, transferable securities were defined (Article 1(4)) as shares in companies and other securities equivalent to shares in companies, bonds or other forms of securitised debt transferable in the capital market and included any other securities normally dealt in giving the right to acquire any such transferable securities by subscription or exchange or giving rise to a cash settlement (excluding i­nstruments of payment). In Article 4(18) of the 2004 MiFID, they mean those classes of securities that are transferable in the capital markets (and not money markets) such as shares, bonds and any other securities giving the right to acquire or sell such securities 237 

Marine Bank v Weaver 455 US 551 (1982).

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(with the exception of instruments of payment). This is followed in Article 4 (44) of MiFID II of 2014 which substitutes ‘transferable’ for ‘negotiable’. Again, it is clear that the term ‘security’ itself here remains undefined and that under EU law the conceptual switch to ‘investments’ has not yet been fully made. The ISD, and more recently MiFID and MiFID II, only define the terms ‘investment firm’, ‘investment service and activity’ and ‘investment advice’, and do this also with reference to a list of ‘instruments’ (neither ‘investments’ nor ‘negotiable’ instruments), which contains, besides transferable securities, also money market instruments, financial futures and options, swaps and forward rate agreements (FRAs), credit derivatives, and units in collective investment schemes (see Annex I, ­sections A and C of MiFID and MiFID II). Thus transferability, although important, appears not to be the only or even essential element as some of the mentioned instruments may not always be transferable. In fact, in the EU also, in terms of regulation and regulatory aims, investors’ protection is the unspoken objective and that depends on the meaning of ‘investment’, which, even if remaining undefined, generally speaking acquires significance only in connection with a person who invests its money with a view to receiving a financial reward through the efforts of others. For banks, their loans are not normally deemed investments or investment instruments in this sense and therefore do not benefit from investor protection, that is special protection of the bank as ‘investor’ in loan products (unlike a bank’s investment portfolio, which may include considerable numbers of bonds, usually those of governments). Also from an accounting point of view they may be treated differently. At least in commercial banks (it may be different in investment banks), bank loans are not ‘marked to market’ on a daily basis (meaning that they are not revalued daily on the basis of their market value); bonds and notes usually are. In the loan or banking book, the position or interest rate risk is therefore not immediately discounted, but the credit or counterparty risk are taken into account in that provisions will be made from time to time against this exposure and capital must be held against this risk also. This touches on capital adequacy requirements, which will be discussed in greater detail in ­section 2.5 below. We already have seen that in their investment book, banks may also buy bonds and notes. It makes them in fact lenders to the issuers of these instruments. Here they are more properly (professional or institutional) investors. On a ‘mark-to-market’ basis, the value of bonds and notes in a bank’s investment portfolio or trading book are adjusted daily. Under applicable law or practices, banks (at their discretion), if they are holding these securities to maturity, may, however, also designate these bonds and notes to their banking rather than to their investment or securities book (which may have capital adequacy consequences) so that their intrinsic loss or profit remains unidentified. It means their value as a banking asset is not adjusted daily on the basis of prevailing interest and foreign exchange rates, because they are seen as long-term banking commitments that are not traded. As banking assets they will then only be subject to the capital adequacy requirements of the bank in respect of credit or counterparty risk and need not worry about capital adequacy to cover market risk.

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1.5.2  Securities Markets and Their Organisation. Official Markets As we have seen, securities are for their liquidity closely connected with markets. In the previous ­section we discussed the notion of transferable securities. Markets suggest trading and capital markets and their operation therefore presuppose transferability of these securities, although not all are transferable. Conceptually, the capital market works wherever the demand for money meets the supply, here expressed in terms of the demand for investment securities meeting the supply. In these markets, savers or investors offer excess funds, which those who need capital may want to attract. In ­section 1.1.18 above, markets, their functioning and regulation have been discussed more generally. This subject will now be revisited. The issuing activity in the capital markets is normally referred to as primary market activity, the subsequent trading as secondary market activity. The primary and secondary markets in this sense can be formal or informal or OTC markets. For shares, they are normally formal markets or stock exchanges on which these instruments are listed, such as the New York, London or Tokyo Stock Exchanges. For bonds, the government bond market is also often formal and then usually functions as part of the official domestic stock exchanges in the currency of the country concerned. In these exchanges, there will often also be a ­section for corporate bonds issued in the domestic currency. These are therefore instruments that are typically bought and traded in the domestic markets. These markets are mostly also open to foreign issuers who are willing to list and qualify for listing in these formal markets. There will be formalities: listing and issuing prospectuses will be required and sometimes registration with regulators like the SEC for all public issues trading in the US, see s­ ection 1.2.3 above. Foreign investors usually also have access to such exchanges (directly or through their own brokers with the help of local brokers), although there may still be foreign exchange or currency limitations. These formal exchanges may also accept for trading foreign listed shares, which then trade in either their own or local currency depending on the rules of the relevant exchange. Foreign shares may also trade on such exchanges in the form of (US or European) depository receipts (ADRs or EDRs) and are then usually quoted in the currency of the country of the exchange: see Volume 2, ­chapter 2, ­section 3.1.5. As noted in ­section 1.1.18 above, there are also informal or OTC or telephone markets, of which the eurobond market is by far the most important example. The eurobond market and its development will be discussed in ­section 2.1.2 below. In the US, the NASDAQ is often considered such a market as well, although it has obtained a formal structure in the advertisements of quotes and in the price reporting of listed securities and is regulated as such via the National Association of Securities Dealers (NASD). It is an electronic exchange, originally merely a quotation system meant to be more efficient than other exchanges, reducing spreads in this manner. The absence of an official floor and the prevalent telephone interchange between the participants formally leads America still to consider the NASDAQ an OTC market, but in all major aspects it is now a formal market. It has indeed been seeking official stock market status to compete with the New York Stock Exchange (NYS) and maintains a listing

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requirement depending on companies being listed with the SEC, having at least three market-makers and meeting requirements in size. It proved particularly successful in attracting new companies like Microsoft, Apple and Cisco whilst modernising also the IPO facility. Other markets, such as the euromarkets for eurobonds, the swap markets and the foreign exchange markets, are more truly OTC or informal markets, even though if operating within the EU under the MiFID (and earlier the ISD) there now has to be as a minimum transparency in pricing. As already mentioned, the derivatives markets are also mostly informal or OTC, even domestically. Only certain standard option and future contracts are traded on more formal option and futures exchanges: see c­ hapter 1, ­section 2.6.4 above. When shares are issued in informal markets like the euromarkets, this is usually done in tandem with a domestic official listing so that a tranche or several tranches are also quoted on one or various official domestic stock exchanges. It is less common for eurobonds, although they tend to be quoted in at least one official stock exchange, usually London or Luxembourg, as many institutional investors maintain such a formal requirement for investing in them. The interesting aspect of the euromarkets is that they are not merely informal, and thus in essence unregulated, but they also allow for: (a) the issuing and trading of a special kind of (transnational) negotiable instrument (at least for bonds) expressed in whatever currencies issuers choose; and (b) underwriting, repo, and trading practices that may also have a transnational legal character: see further ­section 2.1.3 below. The same may now apply to the more modern securities entitlements held by investors with intermediaries (chiefly their brokers) in modern book-entry systems like those of Euroclear and Clearstream (see ­section 1.5.1 above and Volume 2, ­chapter 2, part III). For bonds, the eurobond market has become the largest bond market in the world, even bigger than the US government bond (or Treasury) market and reached a total new issue amount of US$1 trillion (equivalent) in 1998, was at US$2.5 trillion (equivalent) in 2005 and US$4 trillion (equivalent) in 2009 (excluding privately placed MTNs). It serves large corporates but also governments (who often accept here underwriting) and supranationals like the World Bank (IBRD) and the European Investment Bank (EIB). Because of the existence of the eurobond market, it has become relatively uncommon for issuers to issue in domestic markets other than their own, although these markets may still present opportunities for lower-cost funding at times. Thus a German corporate or international agency may issue in the domestic US (Yankee), UK (Bulldog) or Japanese (Samurai) bond markets in respectively US dollar, UK sterling and Japanese yen bonds. In practice, these domestic markets cater only for issues in their own currencies. Informal markets may not lack infrastructure and the euromarkets clearly have one. They have their own standards and practices: see s­ection 2.1.3 below. Most importantly, they also created their own clearing, settlement and custody functions through Euroclear and Clearstream (formerly Cedel). The distinctive feature is that this has all been organised informally by the most important intermediaries in this market themselves, to great effect. It is true that these intermediaries in the euromarkets (investment banks) are now often (lightly) regulated for this activity in the place from which

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they operate, mostly London, especially following EU Directives as just mentioned, but that does not so far affect the operation of the euromarkets as such, although to avoid cumbersome price-reporting requirements, recognition was given to ISMA (International Securities Market Association) (their trade association, now merged into ICMA (International Capital Market Association)) as a reporting centre for post-trading price information: see also the next section. After Brexit it could be asked whether it was wise for this market to allow it to be sucked into domestic structures rather than insisting on and protecting its transnational character. Formal markets or stock exchanges usually have several specific features, which one is unlikely to see in informal markets. They require: (a) listing of the shares and bonds quoted on them; (b) supervision of the issuers and the setting of rules for the issuing activity; and (c) a regular information supply and the operation of a publication facility in that connection. They will also (d) provide secondary trading facilities, determine the type of trading system, maintain a price publication system and set the rules in connection with these trades; and (e) provide a clearing and settlement system in respect of the trades executed on the market (see for the techniques also ­section 1.5.7 below). Clearing means here the process of transmitting, reconciling and often also confirming payment orders or security transfer instructions prior to settlement. In its more advanced forms, it may mean the netting out of positions between the various participants (mostly on a daily basis) and establishing the final positions for settlement. In settlement, the transactions or the result of them after netting are effectively executed and the relevant securities or payment accounts credited and debited. Often this is done through the simultaneous exchange of payments and securities by a (neutral) intermediary or settlement agent, in the euromarkets Euroclear or Clearstream (who may be clearers at the same time). Clearing in this connection is not therefore to be confused with settlement but is rather the manner of simplifying it between participants if doing numerous transactions between themselves. It facilitates the flows of moneys and securities, eliminates funding needs and reduces costs. The clearing then concerns both payments and the delivery of (fungible) securities, which are netted according to participant and type of security: see also ­section 1.5.8 below and Volume 2, ­chapter 2, ­section 3.1.4. The functions of clearing and settlement now often go together but that is strictly speaking not necessary. See for the EU the discussion in ­section 3.6.14 below. Official option and futures exchanges have (like informal markets) less concern about issuers and listing particulars, including prospectuses, and concentrate instead on the types of standard contracts that can be offered on them. A facility to close them out, transparency in the quoted and done prices, and reliability in clearing and settlement will be their major focus, where they have often advanced to the CCP mode of settlement: see ­section 1.5.8 below and ­chapter 1, ­section 2.6.5 above. As already mentioned, in connection with the listing, official exchanges will require a prospectus in which the issuer presents the major financial and business information about itself. In the case of shares, the listing often coincides with the offering of new shares, although that need not be so. In the case of bonds that is almost always the case. The listing and public offering prospectuses will then be similar and may be issued simultaneously in one document. For listed shares there may be later increases in

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capital leading to what is called secondary offerings (in the primary market!). They will require a new issuing prospectus, not necessarily a new listing prospectus. In the US since 1933, these exchange functions or activities must, in the case of ­public issues, be preceded by registration of the issuer with the SEC, which requires a prospectus on that occasion. Prospectuses of this nature give rise to prospectus liability of the issuer if subsequently it proves that wrong or misleading information was given. Advisers and underwriters may also become affected, but usually only in the case of gross negligence. In the EU, on the other hand, this function largely remained a stock exchange affair and the official exchanges will also deal with the requirement of updating market-relevant information. It is to be noted that in the EU Directives have been issued in this area of listing admission and listing prospectus requirements and of interim reporting of listed companies, now consolidated in CARD (Consolidated Admission and Reporting Directive) under the 1998 EU Action Plan concerning a European Market for Financial Services—see also ­section 1.2.1 above and ­section 3.5.10 below. These listing prospectus requirements are to be distinguished clearly from public offering or issuing prospectus requirements, which affect all public offerings whether or not on a formal exchange (but may be contained in one document if the listing and public offering are simultaneous, as just mentioned). In the EU, public offerings were the subject of an earlier 1989 Public Offer Prospectus Directive, subsequently superseded by the Prospectus Directive of 2003, now the 2017 Regulation: see again s­ ection 3.5.10 below and ­section 3.7.14 below.

1.5.3  Unofficial Markets, Globalisation of Markets, Euromarkets As may be gathered from the previous section, informal markets may have less structure than formal markets, but like the eurobond market, are not without it but may confine themselves to two activities only: (a) issuing activity including underwriting; and (b) market-making or other forms of trading. They were already mentioned above in ­section 1.1.18 and will be discussed further in ­section 1.5.8 below. In the case of the eurobond markets, prospectuses and continuous information on issuers are often of lesser concern for investors as only the best issuers can come to these markets and reappear regularly while investors, who are largely professionals, will also be informed through other channels. It means that, for them, prospectuses are less important. Liquidity is their first priority, thereafter cost-effective and safe clearing and settlement. To provide a safe clearing and settlement function, Euroclear and Clearstream (formerly Cedel) were especially created and operate separately from the informal market itself on a purely commercial basis. They are, however, owned and supervised by the major market-makers in the euromarkets. All official exchanges have a way of advertising quotes or prices and by their very nature concentrate supply and demand. Informal markets develop their own practices, which, as in the euromarkets, usually means a market-making system with quotations of spreads per market-maker to other market-makers and selected brokers: see for these secondary market-trading systems ­section 1.5.5 below. One could say that

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the whole foreign exchange market is in a similar position. In informal markets, the market-makers together form the market and are only informally known and their prices or spreads were traditionally not widely advertised. Swaps and repos markets are of this type also, although it was mentioned in c­ hapter 1, s­ ection 2.6.5 above that there is an important move to bring swaps at least into a more regular clearing framework. For repos in the eurobond market we have Euroclear and Clearstream. In the euromarkets, certain self-regulatory organisations have appeared, which have created some further order and standards of behaviour. They were the International Primary Market Association (IPMA) for the issuing or primary activity and ISMA (formerly the AIBD) for trading or secondary activity, since 2005 consolidated into the International Capital Market Association (ICMA). In fact, only ISMA issued binding rules (for secondary trading); IPMA operated according to a system of recommendations (for primary market activity), which were, however, always followed and had great authority. It should be clearly understood that these organisations were and are there primarily to create order among their members and not to protect investors, although the latter also benefit from the increased dependability and regularity in these markets. See for the operation of the euromarkets further ­section 2.1.2 below. The informal euromarkets so far operate mostly from London and the intermediaries (not issuers) located in London were unregulated but have, since 1986, been subject to UK legislation in terms of authorisation and prudential supervision, subsequently much affected by EU Directives and Regulations, including a system of price reporting for the members operating from London. In practice, the issues in these markets were from the beginning often still accompanied by a prospectus, mostly because eurobond issues tend to be listed on a stock exchange (Luxembourg, sometimes also London). It was already mentioned that, although trading hardly takes place on these exchanges, certain institutional investors may, under their own rules, not be able to invest in bonds that are not officially listed, the reason why this listing takes place. It was a choice issuers could make but it was not part of the euromarkets scenario and they were exempt from the EU Public Offer Prospectus Directive of 1989 (Articles 2(l) and 3(f)), which required a prospectus to be issued before any public issue is launched. This is now different under the 2003 EU Prospectus Directive and 2017 Regulation, at least in respect of issuers from EU countries to whom a liberalised regime will apply only in respect of bond issues that have denominations in excess of EUR 50,000: see more particularly ­3.5.10 and 3.7.14 below. Thus euro-­ securities may still be sold without prospectus or other proper forms of advertisement to professional investors or larger companies and investment trusts who take the larger denominations. Nevertheless, there was a gradual regulation of the euromarkets when operating from the EU. A sequel was the pre- and post-trading public price information requirement. In this connection it should be considered that one key advantage of issuing in the euromarkets always was that they could be accessed instantaneously to take advantage of favourable price movements so that any prospectus preceded the closing but not the launch of the issue and it was earlier accepted that that advantage needed to be preserved, although that is now less clear under the newer EU Directives. In the US,

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for SEC registrations, the problems of delay were overcome through the facility of shelf registrations, which allow all relevant information, including a prospectus, to be prepared with the SEC, subject to regular updates. This shelf registration is then valid for two years. Regardless of domestic regulatory encroachment, often benign, globalisation has reinforced the operation of the informal markets, and they have now often become the favoured venue for the more sophisticated issuer and investor. Competition by more informal markets and trading facilities is also encouraged by the appearance of all kind of (electronic) trading platforms or so-called Alternative Trading Systems (ATSs). In the EU, the term multilateral trading facility (MTF) is now more commonly used— see further ­1.5.6 and 3.5.7 below. There is no doubt that, especially for institutional investors in the professional circuit, in secondary trading the move has long been in the direction of unofficial trading directly with the main investment banks as informal market-makers. These market-makers constitute the secondary market in eurobond trading. The question is then whether modern regulation within the EU will remain sufficiently supportive of these practices to allow them to continue to be conducted from the EU territory, especially London, whose status post-Brexit needs then also consideration. Even in large share dealings, official exchanges are now increasingly relegated to the smaller deals for private investors, who, as a consequence, must bear the considerable cost of these exchanges. Professional investors will simply go wherever they can get the deal most efficiently and cheaply executed and take the market with them. They may also avoid the cost of brokers and deal with market-makers directly, except if they want to remain anonymous. These intermediaries, including brokers and market-makers, are still likely to access the formal markets on a regular basis, however, to balance their books. It was already said that safety in settlement is an important issue for investors in these informal markets. To repeat, in the euromarkets, they have the organisations of Euroclear and Clearstream (after the merger of Cedel with the settlement arm of the German Stock Exchange) to help them, and these organisations now also settle domestic (mainly the best-known government) bonds traded on the informal secondary euromarkets, and have also started share transaction settlement, therefore supporting their trading in the informal transnational markets. For shares, the domestic clearing and settlement facilities remain important, however, and are often still operated by domestic stock exchanges, which have a kind of monopoly, although they may no longer be able to limit their settlement systems to deals executed on their own exchanges. The considerable issuing activity in the eurobond markets, the substantial volume of international tranches of new share issues in the euromarkets, and the extraordinary volumes in secondary trading in these markets (much increased through repo transactions) testify to the success of the informal segments of the capital markets. This activity underlines their increasingly transnational character and integration in one worldwide market, of which domestic exchanges now form only one part, and they feel the pressure. When communications were slower and more difficult, it was normal for

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them to carve out their own markets behind their own currencies and governmental or corporate issuers. To this end, they provided and regulated an issuing facility and a centralised physical facility or floor for secondary trading on which brokers could meet the matching agents (or specialists) in order-driven exchanges and market-­makers in quote-driven exchanges: see for these systems ­section 1.5.5 below. Their various ­functions of regulators, price or other information distributors and settlement organisers came together here. On the whole, competition from informal markets has proved healthy for the regular (local) exchanges and has made them more efficient while forcing them to abandon their monopoly structure and parochial often self-serving practices. Not only does their market function now face real competition, their other functions, such as price, and other information distribution and clearing and settlement, may easily be taken over by others too, who may be able to carry them out more cheaply and efficiently. In the US, as we have seen, registration of public issuers and the regular information supply early became an SEC rather than an exchange function. It made the function of the official exchanges in the primary markets increasingly administrative and that trend has continued. It was already said that exchanges may also not be able to monopolise their settlement and clearing systems any longer. In option and futures trading, on the other hand, the formal markets may become more important because of their unwinding and special settlement functions (but only for certain standardised types of contracts). Here the operation of CCPs is important and of particular interest: see ­chapter 1, ­section 2.6.5 above. Larger companies are in any event likely to feel a need to be quoted on the largest stock exchanges in the world but it means that the smaller exchanges are left not only with smaller investors, but also with the smaller domestic companies that generate little turnover in their shares and they are likely to have difficulty covering their cost as a consequence. The emergence of the common currency (euro) in Europe has created further pressure, especially on the smaller domestic European exchanges. The largest will probably continue to play an important role. In the past, the London and Frankfurt exchanges unsuccessfully tried to merge. The exchanges of Paris, Brussels and Amsterdam merged into Euronext, later joined by Lisbon, to retain their clout. In 2002 Euronext also acquired LIFFE, the derivative market in the UK. The end result may be one or two European exchange systems in the major shares and derivatives contracts, much as the NYSE functions in the US (without, however, a derivatives market). In 2007 the NYSE merged with Euronext. A bid by NASDAQ for the London Stock Exchange failed, however. In the meantime, the large Chicago derivative markets (CBOT and Chicago Mercantile Exchange) merged in 2007 and adopted the name CME Group. Cost cutting, efficiency and expertise are here the issue, even for the larger exchanges. Short of such formal consolidation, alternative, largely delocalised or transnationalised, informal or electronic markets may be reinforced or newly created. The same goes for the clearing, settlement and custody services or functions in these markets. In this connection, the role of CCPs in clearing and settlement organisations should not be discounted either (see also s­ ection 1.5.7 below) and it is conceivable that they will ultimately become the true informal markets.

PART I  Financial Services, Service Providers, Risk and Regulation 693

1.5.4  The Primary Market and Security Issuers. International-style Offerings The primary market is the new issue segment of the capital market and concentrates on new issues and issuers. They may issue in either official or unofficial markets, the term ‘market’ being used here as before rather in the abstract, as the meeting place or facility (which need not be physical and could, for example, be only on the telephone or electronic) between those who require capital and those who are able to provide it and not necessarily as a physical place or a so-called market floor. As we have seen, the issuing activity, if public, now commonly requires a prospectus. If the issuing is done in an official market there are also likely to be listing requirements, which again may centre on a prospectus. To repeat, in such cases, the issuing and listing prospectus may be the same. In the previous section, it was mentioned that in the euromarkets more relaxed rules prevailed, still retained under the 2003 EU Prospectus Directive and 2017 EU Regulation in respect of all issues with large denominations at least for bonds, whether international or domestic. No listing is required per se (even if it is for eurobonds, often still done in Luxembourg or sometimes London to accommodate those institutional investors who under their rules may only invest in listed securities) while in any event some prospectus may still be issued at the option of the issuer, but then only after the initial announcement whilst informal trading in the so-called grey market on the basis of ‘if and when issued’ may already take place. It is indeed the traditional method in the euromarkets where most trading in any issue is likely to take place in that grey market, therefore before any prospectus is issued and the issue is closed. Under the present prospectus regime greater problems may arise in respect of international equity issues with issuers from the EU: see also s­ ection 3.5.10 below. In socalled international-style offerings, already mentioned also, there are likely to be various tranches of one issue, each targeted at different official or unofficial markets (often including the euromarkets). They may also concern issues issued into Asia and, to the extent permissible, sometimes even into the US. Outside the country of the issuer, these issues may conform to transnational, more informal market standards and tend not to be subject to any kind of domestic regulation unless the issuer wants to issue in any particular domestic market also. Most large issues will be underwritten by an underwriting syndicate, which in international offerings will most likely be an international syndicate: see for the underwriting techniques and placement functions ­section 1.5.7 below.

1.5.5  The Secondary Market and its Trading Techniques Formal and informal markets will determine the types of secondary trading systems they operate. Traditionally, there are in essence two possibilities: a quote- or price-driven system and an order or auction system. In the quote- or price-driven system, there are market-makers who quote bid and offer prices for the securities in which they are market-makers on a continuous basis

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during market hours. The difference between their bid and offer quotes is their spread or profit margin. They are free to set this spread (unless required by an issuer to make markets in the issue within an agreed, often narrow spread). Yet they must compete with other market-makers. Large spreads then mean that they do not want to do serious business as others offer to buy the securities in question for more and sell them for less. To get closest to market prices, sophisticated investors in a quote- or price-driven system will not reveal whether they are sellers or buyers but will be asking for the spread, and the market-maker has no right to require disclosure of whether the investor is a seller or buyer. It means that the market-maker will not be able to move the spread against the investor, who could take advantage by doing the opposite of what the dealer may think and as a consequence either acquire the securities more cheaply or sell them for a higher price. The market-maker will thus be forced to stay as close as possible to the middle price in the rest of the market. This is at the practical level a vital investors’ protection. An example may clarify this point. Say A wishes to sell a security and sees a marketmaker’s advertised spread at 99 (bid)–101 (offer). It means that the market-maker is willing to buy at 99 and to sell at 101. Approaching the market-maker for confirmation of this spread, a market-maker sensing that A may be a seller may move his spread to 98–100. A can only sell at 98. A’s defence is to turn buyer at once and buy for 100. It may allow him to sell higher, make an instant profit and the market-maker would be penalised. This system thus protects A against predatory practices. The market-maker could widen the spread instead, say to 98–102. But if market prices are near 100 it would mean that no one would want to sell to or buy from this market-maker, who in this manner effectively signals or must accept that he is not participating in the market any longer and has or does no business. That is what widening spreads means: market-makers place themselves outside the market unless all other market-makers do the same. In other words, in a competitive market the need for business will encourage market-makers to narrow their spreads, which at the same time will protect the customer against market-makers’ abuses. Order or auction systems do not have market-makers but work on the basis of a matching system of offer and bid limits set by prospective sellers and buyers. There are matching agents (or specialists) in this market but they do not take a position (although they may be under a duty to smooth the markets if becoming irregular and may have to determine an opening price and do business at that price). They perform therefore in essence only an administrative function, which in modern times may be taken over by computers. Bids and offers that do not match are returned to the investors for adjustment or withdrawal. In the price-reporting system, these prices will be reported as unexecuted deals. It is clear that the quote- or price-driven system is more suitable for large orders or for illiquid company stock or corporate bonds, since there is much more flexibility in a market-making environment where the market-makers provide liquidity by risking their own capital. In a market-making system, the market-makers must give quotes for all the issues in which they profess to make a market and there is therefore likely always to be a price, although there may be large swings and heavy discounts. An order- or

PART I  Financial Services, Service Providers, Risk and Regulation 695

auction-driven system is most suitable and cheaper for regular trades in well-known shares or bonds with regular quantities of supply and demand. When there are large swings in such markets, there may be little to match, however, and this system is then less effective as no deals will result. Again, there is a cost to the market-making system and that is in the spreads, which may become large when illiquid positions are involved. On the other hand, particularly in the more liquid eurobonds, they may be very small. It may make market-making hardly profitable while there is a (market or position) risk for market-makers who will lay off this risk as fast as possible, either with other clients or with other market-makers (the street) or in formal markets where existing in the same securities. Spread costs do not exist in an auction system, but a small fee will have to be paid for the matching service in order to keep the system going. These costs are separate from any brokerage fees. The London Stock Exchange (LSE) and the euro (bond) markets were typical quoteor price-driven systems, but as through competition between market-makers the spreads are often driven very low, it is becoming less interesting for market-makers to make markets in regular issues and alternative order-driven systems are now set up in these markets. The LSE is now predominantly order-driven. The NASDAQ system in the US remains quote driven, again logical as it often concerns smaller stocks in which there may not be regular supply and demand, although some very large stocks also figure, like INTEL and Facebook where large orders may also suggest market-making. The NYSE, Tokyo Stock Exchange, and the continental European exchanges are, on the other hand, all order-driven. However, in New York, there is a possibility for larger orders to move ‘upstairs’ to a market-making environment so that they will not disturb the more regular flows in the Exchange. Derivative markets also tend to maintain a quote-driven system as do foreign exchange markets. Market-makers in regular exchanges are often given more time to report their deals so that they can unwind their positions without the market being informed of them, which would make it more difficult to reduce their risk.

1.5.6  Internet or Electronic Issuing and Trading. ATSs and MTFs. Black Pools, HFTs and Crowd-funding Internet, electronic or online securities dealings are a normal consequence of the popularity of modern electronic communication facilities. Also here, the issuing and secondary trading, as well as mere brokerage, should be distinguished. For market activity, the term Alternative Trading Systems (ATS) is commonly used. The EU, in the 2004 MiFID (effective since November 2007), uses the term multilateral trading facility (MTF), especially for secondary trading: see more particularly s­ ection 3.5.7 below. That is followed in MiFID II of 2013. In the US, for individual investors at first two main electronic methods developed— the first a more informal one in which sellers and buyers operate more individually and incidentally, usually on the home page of an issuing company, and mainly concerning secondary trading. These pages are often company sponsored to increase the liquidity

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of their shares. Bids and offers may be freely withdrawn and prices are individually negotiated between the parties. The company will not become otherwise involved and does not receive a fee for the facility but may provide a settlement facility. This is called the bulletin method of dealing. It is conceivable that in this manner issuers may also directly advertise and offer new shares on their home page together with roadshow information. They then become direct counterparties to the buyers of their shares. In the US, the bulletin board primary and secondary activity must be approved by the SEC but there is obviously a problem with foreign company home pages accessed from the US and US investors are likely to be on their own here if not protected by the regulators of those issuers. Regulatory burdens could in any event deter companies from opening their own home page to this activity, an important reason why crossing systems became more popular. Each has its own rules, but most execute deals at an indicated time at the mid-point of the highest bid and lowest offer prices within a range set by the participants. In the US, in most of these schemes only NYSE- and NASDAQlisted shares were involved and they were settled through these established exchanges with which the online trading systems are likely to be connected. In the other, crossing method of dealing, there is more formal centralisation of supply and demand by an agency arranging for a computerised matching system between sellers and buyers. The agent providing this service may or may not be one of the established matching agents or brokers. In this method there could also be issuing activity. Especially for this crossing method, there could be the question of information supply on price and volumes, possibly the question of listing and in any event the question of regular information supply on the affairs of companies whose shares are so traded. Are these crossing systems effectively exchanges, and should they be regulated as such? Depending on how they are organised, they may well fall under the definition of an exchange. There is certainly also the problem of securities fraud, which has much to do with the existence of the shares offered and the proper clearing and settlement of the transactions. The trading might also be manipulated and false markets established.238 On the other hand, the modern electronic media themselves allow investors real-time trade data, company, financial and regulatory news in abundance and an instant insight into official market reactions. The official markets may, however, become less liquid and reliable as price indicators when losing business to the informal markets, which price-wise they nevertheless indirectly support with their supervision, pricing and anti-fraud mechanisms. This is sometimes seen as a free-ride and unfair-­competition problem. An internet primary offering and secondary trading facility may, however, more properly be seen as only the natural consequence of the easier access to information generally and the possibility to react more promptly. By reducing the involvement of intermediaries, there are of course important timing and cost-saving aspects in electronic trading for investors and issuers alike, but also

238  See on the regulatory issues in the US, PD Cohen, ‘Securities Trading Via the Internet’ [1999] Journal of Business Law 299; see also P Nyquist, ‘Failure to Engage: The Regulation of Proprietary Trading Systems’ (1995) 13 Yale Law and Policy Review 281. See for securities fraud, JJ Cella III and JR Stark, ‘SEC Enforcement and the Internet: Meeting the Challenge of the Next Millennium, A Program for the Eagle and the Internet’ (1997) 52 The Business Lawyer 815.

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investor protection and regulatory issues closely connected with practical aspects such as the proper advertising and clearing and settlement of these transactions. It should be borne in mind that many of the electronic investors may be small or retail investors, although institutional investors may use similar methods. For professional dealings in particular, greater sophistication developed, which resulted in further forms of disintermediation of the traditional intermediaries, notably broker-dealers in their various activities as brokers and market-makers as well as official markets, raising further regulatory issues. The essence is that there are now many different and often more effective ways of connecting participants in which technology indeed assumes an important role. Bypassing established frameworks itself entails a form of deregulation which may become an added stimulus innate in this type of progress and attaches to all novelty. On the other hand, it may also be that regulatory facilities and exemptions may be magnified in this manner beyond what was originally intended. It is the true problem with all financial regulation that can hardly develop an ex ante framework except perhaps at the level of abstract principles of protection of which disclosure was always the essence, at least in public offerings and trading activity,239 but what is ‘public’ has itself come under pressure. Stability of the financial system, proper conduct of intermediaries, and issues of market integrity may then start to present themselves in a different light and technical innovation may more fundamentally affect these three prongs, which financial regulation usually had. One way of progressing is to create large connected pools OTC between various market participants in which buy and sell orders for investment securities are immediately matched in an electronic communication network (ECN). This may connect entire trading books of banks and investment portfolios of major clients and amount to private exchanges not directly accessible by the investing public and not subject to price reporting, including pre-trading price reporting. That is at the heart of so-called black pools avoiding extra commissions or market spreads. It was facilitated by the repeal of SEC Rule 390 in 2001, which removed the monopoly of regular exchanges in the trading of their listed securities. As such, black pools may be seen as successors to large or block trades in auction systems, which were usually (allowed to be) arranged outside the formal market. This facility may be connected with High Frequency Trading (HTF), often considered contentions.240 It represents or adds up to an automatic market operating on the basis of algorithms. It is commonly criticised for promoting complexity and lack of transparency in a network of intermediaries who collect fees, commissions and rebates from order flows or volume and are seen to exploit this complexity for their own sake. As serious is the charge that they engage in front running, therefore positioning themselves in the market ahead of end-investors whose order flow they know, often by buying or receiving this information from regular exchanges.241 It conceivably

239  See eg Chr Brummer, ‘Disruptive Technology and Security Regulation’ (2016) The Fordham Law Archive of Scholarship and History. 240  Notably M Lewis, Flash Point (2014), later converted into some popular film. 241  Regular exchanges in the US must disclose quote updates and trades to one of two centralised Securities Information Processors (SIPs) where end investors can obtain consolidated price information and knowledge

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amounts to a form of information arbitrage242 and assumes that HTF firms in these automated systems can increase or decrease their inventory in the split-seconds offered. But perhaps the greatest danger is that the traditional liquidity-providing function of market-makers in a price or quote driven trading system, see ­section 1.5.5 above, may be undermined, streamlined or automated to such an extent that it could lead to a ‘flash crash’ or sudden market collapse for lack of liquidity. The question thus becomes: who are the liquidity providers in this system, crucial especially in stressed m ­ arkets?243 It should be noted that concern is here sometimes also expressed about insider dealing244 but traditionally a distinction is made in this connection between insider dealing based on corporate information and on market information, see ­section 1.1.20 above, the latter mostly still being condoned. These developments were accompanied by the emergence of Rule 144A trading platforms creating similar facilities in the private placement market in such a way that reporting obligations in the secondary market under the 1934 Securities Exchange Act could be avoided. Although the private placement issuing activity was exempt from the disclosure requirements (under certain conditions, see s­ ection 4(2) and Regulation D of 1982), secondary trading (reselling) had always been a more difficult area, complicated by long holding requirements. Rule 144A brought clarity in this regard in 1994 for ‘qualified institutional investors’ or QIBs (see s­ection 1.2.3 above). Subsequently, creating electronic platforms between these investors allowed the benefit to be maximised. It led to further forms of disintermediation: brokers and dealers relying on phone lines. Inadequate information and hence hot tips were eliminated. It allowed the market in private placements to explode in the US and by 2006 it had surpassed the public placement market in volume. Companies whose shares were thus created and traded did not need to release regular financial statements.245

about outstanding orders (bid and offers and their ‘limits’). But exchanges are also allowed to sell the same information ahead of the SIPs publication even though it is normally a matter of split seconds; there may also be no time difference at all. However, the National Best Bid and Offer (NBBO) requirement based on the SIP quotes may technically allow intermediaries (in this case HTF firms) with earlier information to position themselves better. But this would seem to be foremost a matter of competition between intermediaries and a reward for marketmaking and the price for all orders being filled promptly. That would benefit end-investors, who might, however, have to pay a marginally higher price for purchases or receive a marginally lower price on sales, assuming always that they could be assured of better prices pursuant to the next update of the SIP. The essence is that there are marginally higher transaction costs in all price driven systems compared to auction systems. That is the cost of greater liquidity and quicker deals. 242  Low latency trading strategies exploiting sub-second information asymmetries thus become possible. There has been regulatory scrutiny and litigation but also the formation of a new stock exchange, the Invertor’s Exchange (IEX) approved in the US as a public exchange in 2016. 243  Frequent Batch Auctions (FBAs) have been proposed as a remedy to determine a single market price at distinct moments in time rather than continuously to eliminate any information advantage, but in such an auction system, there may not be much incentive to provide liquidity at all, so that there would be many unfulfilled orders and the pricing might be suspect. 244  See R Adams, ‘Attorney General Vows to Crack Down on “Insider Trading”’ New York Times, 9 Jan 2014. 245  Thus Goldman Sachs created the Tradable Unregistered Equity Platform in 2007 (GSTrUE). The NASDAQ exchange followed with the Portal Market. Others created similar platforms among themselves. The question remained liquidity and issuers that exclusively issued in these markets had problems after 2008. GSTrUE closed. But a reformed NASDAQ OMX re-entered the market in 2013 alongside SharesPost, which organised swapping shares of private (Silicon Value startup) companies for cash. Importantly, this new facility gave issuers power over who could trade, volumes and timing, which was reminiscent of the older bulletin method.

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Another relevant development in this connection was so-called crowd funding, already mentioned in s­ ection 1.1.18 above, which could also be used to enhance liquidity in the private place secondary markets under the Jumpstart Our Business Startups Act (JOBS Act). It made use of social networks rather than of special coding in ECN or dark pools. One issue was whether this is securities activity, regulated as such. No shares or bonds are issued but in the US there is in this connection the more basic concept of ‘investment contract’ as a basis for regulation, under which profits or similar returns come from a common enterprise and the efforts of others, see ­section 1.5.1 above. The private placement exception did not seem helpful as there was a ‘general solicitation’.246 The JOBS Act was intended to provide clarification in this regard and was signed into law in 2012. Titles II and III are of special interest and provide an example of regulatory rather than technological enhancement. It made it possible to solicit from the public $1,000,000 within one year through a website of a regulated broker-dealer or through a lightly regulated website called a ‘funding portal’. For the regulation of these newer types of activity through ATSs in the US, see also s­ ection 1.5.9 below. It was accompanied by Regulation National Market System (or NMS) in 2007 requiring orders to be diverted to best price venues, which acts as an informal but powerful connection between all markets better to protect investors. In the EU, in its newer Directives, the MTF is the expression for ATSs. The 2004 MiFID, effective since 2007, deals with them. They may be operated by (a) investment firms as defined, or (b) market operators which are regulated markets such as the LSE and others. The MiFID does not deal with how they effectively operate. It should be understood in this connection, that the prime objective of MiFID was the promotion of trans-border financial activity in the EU and the free movement of the related services under home regulation, also called passporting. Again, what connects all these facilities is, as in the US, the best price requirement—see s­ ection 1.5.9 below, and similar pre- and post-trade transparency requirements. Article 5(1) MiFID set out in general terms the requirements for authorisation of investment firms as a condition for their operation EU-wide. That also affected the operations of MTFs if an investment firm is engaged in that activity. Under Article 5(2), market operators operating an MTF were exempt from these requirements as they were already authorised and subject to stringent pre- and post-trading standards under Articles 36ff. In fact, these pre- and post-trading standards were key for MTFs under Articles 29 and 30, which under Article 31(5) and (6) were entitled to the passport, that is to say that Member States had to facilitate MTF access to and use of the MTF systems by remote users or participants in their territory. The general approach was that MTF operators notified their home regulator that they wanted to extend their services to other EU countries and the home regulator informed the host regulator who had to co-operate and could not impose a supplementary regulatory regime; see further s­ ection 3.5.7 below.247 246  Facilities like AngelList therefore started to limit access to accredited investors, the retail public thus being increasingly excluded. 247  The question when an MTF service is cross-border may also be an issue: see earlier s 1.2.1 above. In the EU the CESR developed a connectivity test under which the essence is the provision of direct access by the MTF

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MiFID II built on this and continues to distinguish between regulated markets and MTFs but also introduced a new concept of organised trading facility (OFT). The MTF activity itself is now covered in Section A of Annex I point 8 and includes all multilateral systems operated by investment firms or market operators which bring together multiple third party buying and selling interests in financial instruments in the system, in accordance with non-discretionary rules in a way that results in a contract in accordance with the provisions of Title II of MiFID II. ESMA maintains a database of MTFs which are subject to transaction reporting. MiFID II clarifies that MTFs are notably not allowed to execute client orders against proprietary capital or actively to engage in matched principal trading (see for a definition Article 4(1)(38)). It means that when an MTF interposes itself, it is considered to do so on its own account and becomes subject to the full provisions of MiFID, to which proper MTF trading is otherwise an exception (Recital 23). It is an obvious issue of conflicts of interest which has given rise, however, to the question whether intragroup activity of this nature is still exempt under Article 2(1)(b). Mere facilitating activity for no profit in the case of large orders should probably also qualify for the exemption.248 OTFs cover multilateral systems which are not regulated markets or MTFs and in which multiple third party buying and selling interests in bonds, structured finance products, emission allowances, or derivatives are able to interact in the system in a way which results in a contract. Whilst regulated markets and MTFs are now subject to similar entry requirements, OTFs may notably determine and restrict access depending on the role and obligations they may have in respect of their clients assuming always that there is no discrimination. They are, however, subject to similar requirements in terms of position limits, transaction reporting and market abuse provisions, clearing obligations, and margining requirements and regulated in Title II MiFID II and Section A Annex I point 9 (see also, Preambles 9 and 14). They are often perceived as a catch of all platforms that are not regulated as MTFs. In the meantime, discount brokers are also increasingly accessed online, especially by day traders. They might not be operating an MTF proper, which is defined as a system that brings together multiple, third-party buying and selling interests in financial instruments. They may still need a passport as investment firm, but as they may be and often are accessed directly from foreign countries, from a regulatory point of view the applicable regime may be foremost that of the accessed party who provides the facility or service. As that party is likely to also make clear the conditions for payment and settlement, there may not be any cross-border service and a need for passporting: see also ­section 1.2.1 above. It leads in essence to mere regulation by the home country of the service provider, at least if the broker does not solicit business in other EU countries

to users or participants in other Member States. This covers placing screens or establishing trading platforms but also delivery of software or other information to facilitate access via the internet to the home facility for residents in other EU Member States. Their direct access to the MTF’s home base without such additional support in host states may, however, render the MTF service purely local in the home country and not a matter of passporting. 248  Art 2(1)(d) of the Implementing Regulation (MIFIR) (EU) 2016/824 of May 25 2016 sets forth technical standards.

PART I  Financial Services, Service Providers, Risk and Regulation 701

or provides additional services or facilities there. This approach is borne out by the 2000 EU E-commerce Directive (although there is still a narrow exception for small investors’ protection under Article 3, which is very reminiscent of the general-good concept—see for this concept ­section 3.1.2 below).

1.5.7  Modern Clearing, Settlement and Custody Clearing and settlement were briefly mentioned in s­ ection 1.5.2 above. It will be discussed further in the context of the EU concerns in this area in ­sections 3.6.14 and 3.7.6 below. Settlement was, in this connection, identified as nothing more than the completion of a trade as a consequence of which the seller receives the proceeds and the buyer the investment securities. It is therefore the method and the occurrence of payment either in cash or kind. Clearing is a technique of simplifying this process among intermediaries acting for their clients during a certain time frame, usually one day. Instead of settling each trade with each other, they will attempt to net them out bilaterally or in a more sophisticated set-up multilaterally. This may apply to payments as well as to (fungible) securities.249 Custody is a resultant service where intermediaries hold the investments for their clients and concern themselves also with the administration of income in the form of dividends or coupons and with information supply. Custody of investment securities in its modern form is closely connected with the book-entry system for investment securities, resulting in security entitlements or security accounts, discussed in greater detail in Volume 2, ­chapter 2, part III and summarised in c­ hapter 1, s­ection 4.1.1 above. Formerly, when securities were issued in the form of bearer instruments, it meant holding large amounts of paper, which, with the increase in investments of this type, became unmanageable in the 1970s, first in the US, then also in Europe. The result was the already mentioned immobilised and dematerialised way of holding investment, which became a system of securities entitlements or accounts held with brokers (much in the manner of a bank account held with banks), who would themselves have similar accounts or entitlements with sub-custodians and eventually with a depository who would figure as the legal owner of the securities vis-à-vis the issuer (and hold them usually by way of a global note or registered security only). This way of holding and dealing in securities has simplified the clearing and settlement function greatly as no physical action and paperwork is any longer involved. Custody acquires a different dimension here. At least in civil law countries, it is likely to result in a new sui generis proprietary right. Notions of transfer and possession may acquire a different legal meaning here also. This legal structure may even become transnationalised in international custody, clearing and settlement systems as a matter of customary law in that trade. It allowed the settlement and clearing techniques to be further refined: see Volume 2, ­chapter 2, s­ ection 3.1.4.

249 

See also HF Minnerop, ‘Clearing Arrangements’ (2003) 58 The Business Lawyer 917.

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Clearing and settlement is now normally combined with an information matching facility in which as a first step buyer and seller will confirm their trades with an independent third party or clearing and settlement agent through whom trades are subsequently settled but who would only do so 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 documents against payments facility, in which no title transfers before these formalities are completed. Simultaneity is re-established through an independent agent who has no interest in the transaction and there is no transfer through the mere sales agreement. Again, it suggests the operation of customary law at the transnational level in this type of trade, greatly facilitated by the abandonment of paper securities and the operation of a book-entry system. It implies a delayed transfer or even an own type of title transfer in these transactions, which ties it to the receipt by the clearing and settlement agent 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 prime object here is the limitation of settlement risk. Of course, if late settlement or no settlement results under these rules, the party in default may still be liable for damages. In modern clearing systems, the clearing and settlement agent will have bilateral agreements with all participants in the system under which the agent holds sufficient money and securities from each participant in a way that inter-day debits and credits (of fungible securities and moneys) become possible on a constant basis. The clearing agent in such systems is likely to be the sub-custodian of all participants who hold securities as well as bank accounts with this agent and may also organise a multilateral settlement system between them. That leads into modern clearing systems operated by so-called clearing houses, which indeed facilitate the settlement function further. That is the reason why modern clearing and settlement are now mostly referred to together. It operates on the principle of netting out of mutual positions at regular intervals, usually on a daily basis, and works most efficiently in a multi-participants set-up, 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 at the end of the day Broker A (on behalf of his clients) owes B 50 shares in company Y, B owes C 50, and C owes D 50, while C also owes A 50. In such a situation, it is obviously advantageous that instead of four physical transfers, C simply delivers 50 shares in Y to D. The result would be one physical (net) transfer of securities. Assume (in this example) that all prices of the transactions were the same, there would also be one physical (net) payment. 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 clearing and settlement agents. These participants in turn would settle with their clients by adjusting their cash and security account. The number of settlements is not reduced, simply the movement of assets and cash. This simplification through clearing significantly reduces the costs of settlement and also the settlement risk. That makes it of great interest also to regulators. Clearing thus becomes a risk-management tool. It raises the legal nature and status of netting

PART I  Financial Services, Service Providers, Risk and Regulation 703

agreements, which in international systems may also be transnationalised—compare also ­chapter 1, ­section 3.2 above. Again, a modern book-entry system for investment securities and electronic bank transfers for proceeds facilitates this operation as even net amounts of securities and cash need no longer be physically transferred either between the clearing agent and its members or between the members as brokers and their clients. 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 also operate as depositories, therefore as the legal owners of all securities issued against which they issue securities entitlements to participants, but this is not necessary for the operation of modern clearing. These clearing systems furthermore tend to operate as banks to their members to facilitate the payment side of the clearing and settlement. Another evolution in this system is the appearance of the central counterparty CCP. It allows all securities transactions to be conducted with one CCP, who acts as buyer or seller in all cases on the basis of back-to-back agreements with the members of the systems (operating for their clients). 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 then net both the original purchase contract and the new sales contracts out and pay the seller the difference if there is a profit, otherwise the seller pays. Immediate settlement thus becomes possible and reduces settlement risk further. In the case of a sale, 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 will likely 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). The CCP will never accept uncovered positions and will never take risks in that sense. For present positions of individual investors, there may be margin requirements, reflecting any mark-to-market losses. They will in fact result in daily payments of profit or loss, respectively to the investor by the CCP or to the CCP by the investor: see further ­chapter 1, s­ ection 2.6.4 above. This CCP system is practised in official derivative exchanges, not (yet) at Euroclear or Clearstream or in modern payment systems. It is naturally attractive for end-investors who combine liquidity with a safer execution facility.250 Of course, the CCP could go bankrupt, but is normally guaranteed by the participants in the system. This is achieved by the interposition of so-called clearing members in whose name all deals are done (activated by brokers who are approved by them) and who are the only intermediaries with whom the CCP will deal. Again modern derivative exchanges provide the most ready example, but increasingly there may also be CCP in OTC derivatives (interest rate swaps in particular), often encouraged by regulators and modern legislation. It also provides a measure of transparency in terms of pricing and volumes and is in that connection often advocated especially for CDSs. Harmonisation or even standardisations

250  In the EU, this is now the subject of the so-called EMIR or the European Market Infrastructure Regulation: see s 3.7.4 below.

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of terms and conditions are needed to achieve further simplification: see ­chapter 1, ­section 2.6.5 above. Without it, there is no maximum benefit, but tailor-made derivatives as risk-management tools remain important, especially in CDS (although even then documentation could be standardised). Although they could still be cleared by CCPs, the latter may not then act as counterparty but merely as clearing agents in the above manner and may not wish to do more because it is more complicated, costly and risky for them. In the meantime, this CCP facility may show the close modern connection between clearing, settlement and securities markets. These markets could dissolve altogether in this way in modern clearing and settlements organisations of this type. It may be one way of the future, therefore also for securities trading, and would mean the end of official stock exchanges as we know them today. Returning to clearing, it has already been said that not every intermediary can be a member of clearing systems, especially not the smaller brokers, for lack of financial clout. 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 often 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 through introducing brokers, of which the investors must be informed.251

1.5.8  The Role of Investment Banks as Underwriters and Market-makers New issues of shares and bonds (except mostly government bonds in the domestic currency) are normally underwritten when an underwriting syndicate guarantees placement. Alternatively, placement may occur on a best-effort basis. Examples of this are the dealerships in the placement of shorter-term interest-bearing paper such as CDs, CPs and MTNs. They do not require the intermediary taking any risk but there is also less reward in the fee structure. Another aspect of this latter type of placement is that it is often an ongoing effort in which different prices may be quoted by the dealer on the instruction of the issuer depending on prevailing market conditions from day to day.

251  Except if there is a so-called ‘omnibus account’ between introducing and clearing broker under which the former maintains its own record of customers’ trades and provides statements. These are usually larger brokers who have nevertheless decided to farm out part of their settlement and custody functions. Beyond this, in the US, the clearing brokers were required to exercise full regulatory supervision of the introducing brokers, including their sales activity, and were responsible for this. The justification was that the clearing brokers took 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 on the other hand it remained vital 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 are for the rest supervised directly by the SEC.

PART I  Financial Services, Service Providers, Risk and Regulation 705

The underwriting process, on the other hand, results in a series of special agreements, first between the issuer and the lead underwriter—often called the subscription agreement—and subsequently between the lead underwriter and the rest of the consortium or syndicate—the agreement between underwriters or the underwriting agreement. Here the issuer is not a party. There may be a third layer of agreements, the selling agreements, between the underwriters and selling groups, which are groups of dealers who will participate in the placement on a best-effort basis. Selling group members habitually receive some discount on the offer price. Again, the issuer is not directly involved. Depending on the types of securities offered and services required, there are considerable variations in the substance of these agreements, but the essence is always the same. The key is that on the closing date, pursuant to the underwriting agreement, the underwriters must provide the issuer with the total amount of the issue (minus fees and agreed costs) whether or not they have been placed with the public. What is not placed is divided among the syndicate members according to a distribution formula agreed in the agreement among underwriters. Underwriting implies considerable risk, and for the underwriting much depends on whether the issue is properly priced. If the price is too high, the risk for underwriters is much greater. Pricing itself is a matter of agreement between issuer and underwriters in which the issuer sets the pace and underwriters are likely to give expert advice. It cannot always be entirely impartial as a lower price makes placement easier. There is here an obvious conflict of interest between issuer and underwriter. As an alternative to underwriting, in the eurobond market there developed the so-called bought deal, under which the syndicate would buy the whole issue at the beginning, place it on the joint book of all the syndicate members according to the agreed formula, and subsequently sell it. It is a cleaner way of operating but requires the investment banks to apply more capital to the underwriting function. As has already been mentioned, an important aspect of this primary market activity and public placement in the US is the preparation of the SEC registration, which requires disclosure with a prospectus and an ongoing information supply. It denotes the regulation of the issuer. In the EU, there was the public offer prospectus requirement under the Public Offer Prospectus Directive of 1989, also already referred to, with an exemption for eurobond issues. It did not mean that eurobond selling in the US was also exempt from SEC registration (except where it fell into certain categories of foreign investments or private placements: see s­ ection 1.2.3 above). If the issuer requires the listing of the issue on an exchange, there will be further formalities and disclosure requirements. It has already been said that this system was reviewed in the EU under the 2003 Prospectus Directive (see further ­section 3.5.10 below), which also brings the eurobond market within its scope, with a number of exemptions especially for bonds with a denomination of more than EUR 50,000. A new issue, even if underwritten, need not be publicly placed, either in the formal or informal markets, and so-called private placements are very common. They tend to be more informal, may not need a prospectus either (see in the US s­ection 4(2) of the 1933 Act and Regulation D under that Act, which exempts from registration some other limited offerings as well) and are usually targeted at a small group or at one investor. They may be tailor-made issues but still be in tradable form, although

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their private placement nature will affect the tradability. It may be further curtailed by transfer limitations attached to the issue to preserve the private placement character. In such cases, often it is the investor, who, through an investment bank, makes it known what it requires in terms of investments and the investment bank will then try to find an issuer. Again, these targeted private placements may still be underwritten, often as a way to reward the investment bank and to qualify for underwriters’ league tables. As placement is in such cases assured, the underwriting fee is likely to be modest. In the US, under SEC Rule 144A, see also ­section 1.5.6 above, the private placement rules were considerably widened to allow companies to issue securities to small groups of large (professional) investors without registration, disclosure, prospectus and continuous reporting requirements. It is particularly important for foreign companies as US companies which issue shares to investors are normally already registered with the SEC and subject to their information updating requirements. A special trading and settlement system was organised by the NASD for these types of privately placed securities (PORTAL). Large and frequent issuers may of course attempt to do away with underwriting and the facilities of investment banks altogether and save themselves the cost, but they may still value advice on the various windows of funding opportunities in the various markets and on pricing. Also, they do not have the specialised staff to organise the placement. As frequent and large issuers, they are, however, normally able to negotiate lower underwriting fees. In bonds, another aspect of the issue is the role of the paying agent who pays the coupons and repays the principal to the investor on the appointed payment dates. This agent may also have some other functions such as notifying investors and keeping contact with them. The situation can be further formalised by making the agent an (indenture) trustee of the issue, especially important when a change in conditions may have to be negotiated or when conditions change. Such a trustee will often be given certain powers in this respect in advance (in the trust deed). Because of the cost to the issuer, such a trustee will normally function only in larger, more specialised issues. In eurobonds, there are likely to be paying agents only. There may be a number operating in different countries to give investors a choice in their collection of interest and principal. That may be important to them in connection with the confidentiality of their investment or foreign exchange restrictions and taxation. In the new issue or primary market, there often obtain special rules on s­ tabilisation. Under them, the lead underwriter will intervene in the market to stabilise the price of the new issue if needed to allow for a large flood of new paper to be placed without a price collapse. It is particularly relevant in the case of a secondary offering of new shares. The practice is controversial because there is an element of market manipulation and it is in any event more questionable for an entirely new issue (primary offering): see also s­ ection 1.1.18 above. Nevertheless it is usually allowed on the condition that the activity is disclosed while it is going on. A related way for underwriters to protect themselves, especially if other market participants are trying to short the issue, driving the price down, is to buy up all surplus and subsequently squeeze the shorts (short squeeze) who will, in order to cover their position, ultimately have no option but to buy from the underwriters at prices

PART I  Financial Services, Service Providers, Risk and Regulation 707

­ ictated by them. Related to this tactic is a so-called ramp where there are short posid tions in the secondary market known to a market-maker who dominates the supply. The market-maker may in fact have induced the market to shorten in order to take subsequent advantage of his position in this manner. This is likely to be much nearer market manipulation than stabilisation or a defensive squeeze. A more modern way for the syndicate to defend itself against sudden market movements, especially through precipitous sales of its members, became the fixed offer technique. Under it, the lead manager enforces discipline in the syndicate by obliging members not to offer securities at a price lower than that set by the lead manager until such time as the latter allows the syndicate to be broken, usually when the lead manager is satisfied with the degree of placement. This practice has some features of a price cartel but is better seen as an alternative to stabilisation. In the secondary market, the operations of investment banks are of particular interest when they operate as market-makers: see ­section 1.5.5 above. Normally in informal markets such as the eurobond markets, they will do so either because they accept that obligation vis-à-vis issuers for whom they did the underwriting or because they have an interest in providing that liquidity in view of the possibilities of making some money (through their spreads). For the more prominent issues, it may also be a matter of market profile. Such market-making will in principle go on for the life of the issue, which in the case of shares and perpetuals is indefinite, although, as mentioned before, few eurobond issues are actively traded after an initial period and market-makers may drop them from their list. As a consequence, there are many illiquid issues in the eurobond market and most of the new issues only trade actively during and immediately after the launch of the issue. This is trading in the grey market on an ‘if and when’ issued basis as the securities are not yet issued, which happens only at the closing; see also ­section 1.5.4 above. If a closing does not follow, all trades are void. Emphasis on trading on the grey market means that after an issue has been closed, most investors hold the bonds until maturity. As we have seen already, market-making is typical for the more informal markets and investment banks as market-makers will often form the heart of these markets, like they do indeed in the euromarkets. They will normally use their screens to advertise their quotes (or spreads), but only to the most important investors or brokers who will know who and where they are. The larger market-makers will also use sales forces to access the public and call possible investors. These in-house sales forces will receive the inquiries of the investing public and effectively form the link between market-maker and investor. These sales forces are not brokers to the public and not under similar duties to avoid conflicts of interests. They are paid for by the market-makers themselves and contacting them should not give rise to fees. Market-makers also deal directly with each other (street trading) and even operate on formal markets to adjust their books and lay off their risks. Investors themselves may either approach a market-maker directly (via its sales force) or use their broker to do so (in which case they will have to pay a brokerage fee). Market-makers may not, however, be willing to take calls directly from smaller investors because of the extra regulatory burdens this may put on them. It may also present problems in clearing and settlement as small investors are unlikely to be party to the relevant clearing and settlement

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organisations or systems. Thus the euromarkets are typically markets for professional investors and brokers only.252 These brokers may again be investment banks but at least for smaller investors, they are more likely to be commercial banks, which act as brokers for their banking customers. An investment or universal bank must be careful to combine the functions of market-maker and broker in respect of one client at the same time. If a brokerage fee is demanded, the banker/broker has as a minimum the obligation to test the entire market to obtain the best price for its client, as we shall see in the next section, and that may not be its own. If a broker is forced by the rules of its own organisation to deal solely with its own trading desk (and disclose whether its client is buyer or seller), the broker becomes an extension of it. In that case, the broker acts as a mere sales representative and should not charge a brokerage fee on top of the market spread payable to the same organisation, while the client should be warned that in this way it is unlikely to get the best spread or price.

1.5.9  The Role of Investment Banks as Brokers and Investment Managers. Investors’ Protection, Fiduciary Duties Formal and informal markets need to be accessed by investors and, especially for the latter if small, that may not be easy. The use of brokers is therefore normal. They make it their business to represent their clients in their investment business and conclude and settle their deals. Especially in quote-driven or market-making systems (to be discussed shortly), their expertise will also be necessary to find the best deal among the various market-makers. In the LSE before deregulation through the so-called Big Bang of 1986, investors could not directly access the market-makers or jobbers and always needed a broker. That is now no longer so as the monopoly was broken, but in practice brokers are ordinarily used to find the best price and execute the deals. In modern book-entry entitlement systems, they are also the custodian with whom clients keep their securities account. Traditionally, brokers deal in their own name but for the account of their clients who also take the risk: see for contractual agency Volume 2, ­chapter 1, part III. The broker is then an agent, usually undisclosed, so that it incurs its own obligation vis-à-vis the counterparty to settle the deal (even if the principal or client does not come up with the securities or the money). On the other hand, if the broker defaults or demises, the client by disclosing the agency may be able to establish a direct relationship with the counterparty. In this way, the client may collect the price directly for sold securities or obtain the securities directly by offering the purchase price. If proceeds or securities are already in the hands of the broker, the principal may claim them directly. At least this is in brief the position at common law. In civil law, the situation is more complicated but it is moving in a similar direction. 252  See for the operation of black pools and HFTs, s 1.5.6 above. It complicates the picture which was here reduced to its simplest more traditional form. See for the operation of quote- or price-driven system, s 1.5.5 above.

PART I  Financial Services, Service Providers, Risk and Regulation 709

In more modern systems, especially for smaller deals, there may be self-dealing, called internalisation in the EU 2004 MiFID (effective since 2007), meaning that the broker will deal with clients from its own account. If the transaction is done through exchanges (normal for larger transactions), the broker will only deal with another broker who will not disclose the end-investor. It follows that normally there is never contact between end-investors. That shortens the transaction chain and the respective end-investors are principals only in respect of the transaction between brokers. In this sense, endinvestors deal with the market and not with special counterparties. This situation is not fundamentally changed when investment securities are held in security entitlement systems: see Volume 2, c­ hapter 2, part III for greater detail. The broker in its activities on behalf of the investor will, as agent, be subject to a number of fiduciary duties of which, under common law, the traditional ones are the duties of care, loyalty and confidentiality.253 That is so even if there is self-dealing, when in particular the question of the best price arises. In securities operations, this translates principally into a duty to advise the client concerning product and risk, taking into account its financial situation (‘know your customer’ and ‘suitability’ rules). It also requires the broker to obtain best prices for the client (‘best price or best execution’ rule), to avoid aggressive tactics and unjustified turning over of the portfolio to obtain more commissions (‘churning’), and to eliminate all conflicts of interests by brokers postponing their own. Thus the broker should not compete with its client for similar deals or take first when only a limited number of securities are available at a lower price or can be sold at a better price (no front-running). The broker must transfer to its client all direct and indirect benefits of the transaction, including commission rebates, research information (soft commissions) etc. The broker can deduct only the agreed fees. In modern financial regulation, these rules tend to be reinforced, even in civil law countries, and additions are made. Thus an audit or paper trail must be kept by the broker identifying in its own records the details of the instructions it received from the client and their timing. Telephone tapes here may provide further proof of client instructions and discussions with them, although they are in most markets not yet obligatory. Orders and transactions should be time stamped to show who has the earlier and better right and whether the agreed price corresponds to the market. Proceeds should remain segregated in special client accounts, well separated from the broker’s own. This is the principle of segregation of client funds. Investment compensation schemes are likely to supplement the system. But in common law there has always been a problem in that parties can exclude fiduciary duties by contract and this can be done through standard terms. This is obviously questionable in respect of smaller investors who may not have the power

253  Although it is assumed that fiduciary duties apply to brokers, it must be noted that in the US, where brokers must also have the best interest of their clients at heart, fiduciary duties proper were reserved mainly for investment managers. This created confusion about the proper duties of brokers and became an issue in the revamping of financial regulation in 2009, which sought to make brokers subject to fiduciary duties similar to those of investment managers.

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to resist. It may have a parallel in ordinary banking in cases of misselling and improper advice.254 Without such a fiduciary duty, especially the duty of care, the intermediary has merely a duty not to make explicit misrepresentations regarding its products. However, to treat customers fairly is a modern concern, see ­section 1.1 above, which may well transcend to contractual framework of services especially in respect of smaller investors, and ­English courts have started to respond.255 In the EU, MiFID II also deals with the issue.256 This may be seen against a background wherein on the European continent, these protections often remained more rudimentary, mainly because the agency notion is less well developed in civil law. Fiduciary duties are not as such a special class of duties under civil law either. In modern law, they are often fitted in as disclosure and negotiating duties of good faith but this development is only in its early stages. The EU ISD in Article 11 gave expression to some of these protections to effect harmonisation but they were not properly set within the agency structure. Neither are they in MiFID, the replacement of the ISD. It is hard to expect much harmonisation here in the implementation of what is in essence a key private law concept or notion (agency) in Member State laws. But what may probably be said is that the good faith notion in civil law has a much more mandatory character, is indeed often considered mandatory (see Volume 2, ­chapter 1, ­section 1.3.10) and more difficult therefore to discard. Freedom to contract is not as fundamental to the civil law notion of contract either, which developed as a consumer law concept, different from the common law model which came from commercial law and means foremost to provide a roadmap and risk management tool for professionals. In fact, implementation legislation on the continent often remains elementary, especially in the notion of postponement of interests, not charging spreads and brokerage fees at the same time, and segregating client assets. The whole notion of tracing assets under a broker also remains underdeveloped in civil law, which has a great disadvantage in this area and thus retains a substantial handicap in the proper protection of investors. Although notions of good faith are now commonly used here instead of fiduciary duties, as just mentioned, they have not yet fully developed in this area and depend on regulation. They cannot go into the proprietary aspects either. Investment managers give their clients advice on how to handle their portfolios. Such advice is also inherent in the brokerage function, unless the broker acts as an ‘execution-only’ broker, who usually operates against a lower fee. The client normally retains the ultimate decision and brokerage accounts are usually non-discretionary. Investment or asset managers, on the other hand, are often given discretion by their investing clients to operate for them in the markets in a discretionary manner. It ­normally requires a contract in which a certain investment strategy is mapped out: see further ­chapter 1, ­section 2.7.1 above. 254  See K Alexander, ‘Bank Civil Liability for Misselling and Advice’ in D Busch and C Van Dam (eds), A Bank’s Duty of Care (Oxford, 2017) ch 9. 255  Rubenstein v HSBC, [2011] EWHC 2304 (QB) and Crestsign v The Royal Bank of Scotland, [2014] EWHC 3043 (Ch). 256  Arts 24 and 25. It distinguishes in this connection however on the basis of the nature of the service(s) offered or provided to the client, taking into account the type, object, size and frequency of the transactions; the nature and range of products being offered; and the retail or professional nature of the client or potential clients, see Art 24(14).

PART I  Financial Services, Service Providers, Risk and Regulation 711

As brokerage de facto often means that the broker’s investment advice is followed, such an investment policy is mostly also contained in the client agreement between broker and client, at least if the client is a retail client. This fits in with the ‘know your customer’ and ‘suitability’ requirements of the brokerage relationship. Where there is formal or de facto discretion, the intermediaries’ duties vis-à-vis their clients are accordingly enhanced. Even if the client retains the last word, the broker is not without duties and must warn against inadvisable investments within the ‘know your customer’ and ‘suitability’ rules. But the broker is discharged from liability if it has done so and the client persists. Caveat emptor then remains applicable and there is certainly never a general right for small or inexperienced investors to lay off their risks on their brokers if markets turn against them. In the US, reference is often made here to broker/dealers. Section 3(a)(4) of the Securities Exchange Act 1934 defines the broker as any person engaged in the business of effecting transactions in securities for the account of others (but does not include a bank). Under ­section 3(a)(5), a dealer is defined as any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. In the US the functions are normally combined, hence the frequent references to broker/dealers, but should be clearly distinguished and not give rise to conflict of interests. Under ­section 15, both must ensure adequate employee supervision, financial responsibility and sufficient capital and fair dealing with customers, including protection of customers’ securities and funds and monitoring sales practices. In turn, these functions should be clearly distinguished from those of exchanges. They are defined in ­section 3(a)(1) as organisations which constitute, maintain or provide a marketplace or facilities for bringing together purchasers and sellers of securities or otherwise providing the function commonly performed by a stock exchange as that term is generally understood. There is much confusion about this definition and especially informal and now internet or electronic markets or ATSs may not always fall within it, especially the bulletin board type: see s­ ection 1.5.6 above. They may, however, fall within the definition of broker/dealer in that they bring buyers and sellers together. It all has to do with registration and its formalities and with supervision. Since 1998, Rule 3B-12 has been in operation especially to cover ATSs, giving operators the option between regulation as an exchange or broker/dealer, in the latter case with additional requirements depending on their activities and volume. It was a compromise imposed because of the fundamental distinction in US regulatory law between brokers, dealers and markets. It falls a long way short of devising a regulatory system for a modern electronic market under which only participants, not markets, are regulated. They should be free, except to safeguard integrity and avoid abuse.

1.5.10  Insolvency of Securities Brokers. The Notion of Segregation, Tracing and Constructive Trust in Respect of Client Assets In the previous ­section two major risks of engaging a securities broker were identified. One problem is the duty of care of the broker and the conflicts of interest that may arise between the broker and its client. The other problem is the insolvency of the broker.

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The common law of agency and its fiduciary duties traditionally have a number of solutions for conflicts of interest. As noted before, civil law may be more handicapped and has to develop the necessary investors’ protection as far as duties of care and conflicts of interest are concerned within the context of its notion of good faith in contract, which may now also include certain disclosure and implementation duties. Not all civil law countries are equally oriented here however. Especially in southern Europe, the notion of good faith in contract remains less well developed with a resulting further handicap in developing notions of investors’ protection against conflicts of interest: see for the good faith notion Volume 2, ­chapter 1, ­section 1.3 and for its operation in the law of agency, Volume 2, ­chapter 1, ­section 3.1.4. In the case of a bankruptcy of the intermediary (broker) or (undisclosed) agent, civil law also needs to develop further, particularly in the aspect of segregating and tracing (a) client assets (notably client securities and moneys) in possession of the broker; (b) client assets still in the process of settlement (and therefore not yet with the broker); and (c) claims of the agent against third parties in respect of client assets that have not yet entered settlement (and are therefore still with the counterparty). In the first case, the assets may be individualised and held as such at the broker in security accounts and are likely pooled as fungible assets at the level of the back-up by the broker. When investors still owned securities directly (and not through a system of security entitlements) they would be held at third parties with whom the broker had custody accounts in respect of securities. This is still likely to be the situation in respect of client money held in a client account with a bank. Fungibility of assets always led to problems in bankruptcy as it is harder to identify assets. Many modern securities, especially bearer securities, are fungible by definition although they might still be identified by number. Money is always fungible, although even banknotes have numbers. On the one hand, the simplification through clearing that fungibility allows significantly reduces the costs of settlement and also the settlement risk. That also makes it of interest to regulators: see ­section 1.5.7 above. But the other side is that fungibility, and the pooling that results, destroys the ownership concept in respect of these assets. At best, there is a joint interest with other investors in respect of the same class of assets, but if there is commingling with the broker’s own assets, title might be lost to the broker altogether. That is a special problem in civil law, which does not know the tracing concept. Hence the concept of client accounts with third parties, but as long as only the name of the broker figures on the custody or cash account, there may still be a problem in civil law countries, the trust concept being unknown. Trading for others or holding assets for others in the broker’s own name is therefore a major complication in civil law and a main danger for clients. There is a progression in investors’ protection in this area, however, which results from the book-entry systems for investment securities as discussed more fully in Volume 2, ­chapter 2, ­section 3.1.6, where there is a form of segregation implied and the investor at least holds some proprietary rights against the broker/custodian. The essence is as follows: if the securities are expressed as book-entry entitlements with a broker, who in turn has back-up entitlements with depositories or other custodians, the client may have rights against the broker at the level of the back-up

PART I  Financial Services, Service Providers, Risk and Regulation 713

(which are pooled if the broker has more clients who are investing in the same securities), but (now mostly) only if the broker/custodian defaults in its duty to give the investors the rights to the dividends, voting rights, distribution of any winding-up proceeds, and corporate information, which are the essence of their securities’ entitlements. At least they will have a right to appoint a replacement intermediary for their entitlements and demand the relevant back-up for it, valid especially in a bankruptcy of the broker. A key is here that the right to redirect the security entitlement survives the bankruptcy of the intermediary maintaining a book-entry system of security entitlements for its clients. This may be seen as a proprietary issue and protection and segregation is assured in this manner. What we are concerned with here are thus in essence proprietary questions, more fully discussed in Volume 2, c­ hapter 2, ­sections 3.1.3ff and in common law largely covered by the equitable notions of disclosure, constructive or resulting trust and tracing within agency or custody relationships. Civil law has no true equivalent or answer here and must develop its own property notions in this connection to provide adequate investors’ protection against an agent acting on behalf of or in the name of clients or against a broker/custodian that operates a book-entry system for its clients. Again, these issues are of particular interest should the broker go bankrupt. This is broadly the picture, more extensively discussed in Volume 2, c­hapter 1, ­sections 3.1.5–3.1.6 in connection with the concept of agency proper. From a legal point of view, this may be elaborated as follows. While dealing for its client, the broker is normally an undisclosed agent in common law or an indirect agent in civil law, although third parties often realise that the broker mostly does not act for itself. That may make a difference as an agency upon disclosure or a semi-disclosed agency creates under common law direct ties between the principal and the third party. In civil law, this type of agency, under which the broker normally acts in its own name (but for the account of the client) excludes, in principle, any direct ties between a third party and the principal or client of the agent, even upon subsequent disclosure. Under modern civil law, this may be different only if the third party has already performed towards the broker. In that case, the client may be able at least to claim title to all identifiable tangible assets (including securities) which the broker acquired for the client, but there may still be doubt as to: (a) any claims the broker still has on third parties (usually their brokers) for performance (on behalf of the principal or client); (b) any moneys or pooled securities that the broker has so acquired; or (c) any moneys or securities the broker may have put (in its own name) with third parties, such as banks for deposits and custodians for securities.257 Again, the problem is more fundamental in respect of assets that by their very nature are fungible.

257  In civil law, disclosure of the investors/clients may in law not operate as putting them automatically in the position of the bankrupt brokers vis-à-vis counterparties, clearers, bankruptcy trustees, banks or depositaries in the proprietary aspects of the transaction. Specific statutory provisions may now underpin the possibility of clients retrieving specific tangible assets acquired by the agent for them so that title shoots through to them, as eg in Art 3.110 of the 1992 Dutch Civil Code. However, these statutory provisions may only apply to allocated and individualised securities that physically exist (therefore normally bearer securities) and not to proceeds or residual performance claims against counterparties as many civil law jurisdictions still have problems in characterising proceeds or claims as assets. Also the notion of segregation into client accounts of moneys or pooled assets creating joint property in them may still not be fully accepted.

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To repeat, there are here in principle three possibilities: tangible assets (securities) may still be with a seller (or its agent), or they are with the broker for the buyer, or they are with a third party in the nature of a client account. They might also still be in the clearing and settlement circuit. Therefore, in the case of a securities purchase, shares bought are either still with the counterparty or already delivered to the broker, either physically (individualised or pooled) or more likely pooled through a third party (client account), while the purchase money may still be with the broker, either physically (individualised or pooled) or in a pooled client account with a bank (but in the broker’s name) if not already paid out to the seller. Conversely, if there is a sale, the shares may still be in the seller’s account, or physically with the broker (either individualised or pooled) or they may already have been delivered to the third party, who may have paid for them, to the broker, who may have the money physically (either individualised or pooled) or may have put it in a pooled client account or already have transferred the money to his client. Whether a sale or purchase, the securities or proceeds may also still be in the clearing, resulting in the transfer of unscrambled net amounts of securities or moneys that remain unallocated between clients even though transferred or at least allocated to the broker or other intermediary who may have gone bankrupt in the meantime. The key is always whether the client has in these circumstances: (a) direct rights to any uncompleted performance of the counterparty (upon disclosure of his interest); or (b) a proprietary right in any securities and moneys already with the broker (either physically, in an individualised or pooled manner or more likely in a bankrupt broker’s pooled, individualised or own account with his bank or custodian). As already mentioned, this is (outside the area of book-entry systems) foremost a matter of agency law and the possibility for the client to directly claim his assets in the (constructive) possession of his broker. Closely connected is the question of proper segregation of ­client

Without further statutory provisions, such as the Kapitalanlagegesellschaftsgesetz of 1970 in Germany, it may mean that in civil law countries for securities not yet delivered to the broker, the investor may still be unable to establish its own position vis-à-vis counterparties or in the clearing. Any securities or moneys already in the clearing are at risk in any event of still going first to the bankrupt broker as member of the system although they may be collected in segregated client accounts, which even then may not, however, provide full protection against the broker’s bankruptcy if remaining in the broker’s name. In the Netherlands, by special statutory provision (Arts 7.420–7.421 CC), the claim to securities and proceeds still with the counterparty is now statutorily assigned to the investor upon disclosure of the agency. This still seems to subject it to all the complications concerning assignments, including the set-off of any unrelated claims the counterparty may have on the broker. This is undesirable as the investor’s assets are used in this manner to pay for the debts of the broker to a counterparty who is generally aware that the broker is unlikely to have dealt on its own account. Even at the beginning of the nineteenth century, the unfairness of this set-off was noted in common law in Baring v Corrie 2 B & Ald 137 (1818). Other possibilities are to assume instead of a statutory assignment some trust structure for which civil law is ill-equipped, or to apply the rules of direct agency upon disclosure of the indirect agency in the common law way and trace. It may be the best practical solution. The implementation of the EU Investment Services Directive (ISD) required a proper system of segregation, which, it is submitted, must include forms of proprietary tracing to be meaningful, but it was from this perspective mostly incomplete in most EU countries. Under its successor, MiFID, the situation may not be much better. The true reason is the underdeveloped notion of (indirect) agency in civil law and of the notions of segregation and tracing or constructive trust. Again, the result is a competitive advantage for common law brokers who by law afford their clients better protection, not only against their own misbehaviour, but also against their insolvency.

PART I  Financial Services, Service Providers, Risk and Regulation 715

assets (either under the broker or in client accounts organised and held by him) or otherwise (upon commingling) the question of tracing into the broker’s own accounts, a concept more controversial in civil than in common law. At the level of both the bank or custodian and the broker (depending where the assets are), there may be special arrangements which complicate this picture further, although they may also result in better protection for investors if the broker goes bankrupt in the meantime as we saw. It follows from the foregoing that what concerns us here in particular is (a) the modern role of clearing and settlement and (b) the status of modern book-entry entitlements.258

1.5.11  Other Activities of Investment Banks. Fund Management, Prime Brokerage, Corporate Finance, and Mergers and Acquisitions. Valuations Apart from their involvement in the primary and secondary capital markets discussed above, investment banks engage in many other activities. Their role in funds, fund management, and hedge funds or private equity as special examples, has already been discussed at some length in c­ hapter 1, ­section 2.7 above to which reference is made. For hedge funds, prime brokerage acquires a special importance here as the prime brokers, usually investment banks, administers these funds and provides important ancillary services not only in lending money on a considerable scale, but also in terms of securities lending when hedge funds short the market. Investment banks are likely to be involved and prime brokerage has become an important business for them. Another more traditional activity of investment banks is the rendering of corporate advice. This is especially relevant for mergers and acquisitions but it may also involve advice on the type of financing that may be the most suitable and obtainable. It may in fact result in advice on the rearrangement of the entire liability side of the balance sheet and often involves capital market activity in terms of issuing new shares or bonds. It may even go further and also cover corporate activity, which may result in a complete reorganisation of the company. The type of advice will of course depend foremost on what the client wants but may also be volunteered by investment banks. This part of investment banking activity will be done in the corporate finance department. Again, mergers and acquisitions are the most important slice of this activity. It is ­cyclical,

258  As to unsettled transactions, in a book-entry system, the issue of indirect agency and disclosure of the agency to make the title to the shares shoot through to the client, and the issue of segregation may not truly arise any longer as in that case all is a matter of instructions, crediting and debiting, much in the manner of modern payment instructions as we saw, which the broker implements following his clients’ sales or purchase orders. But if the broker has operated on a securities exchange and not internalised the deals, there would still appear to be a question concerning the clients’ direct rights in respect of any net number of securities that result for a broker from the clearing (pending unscrambling of this net number for distribution among the clients). There is also the question what the clients’ rights are if the broker’s own entitlement higher up in the chain has already been adjusted for any purchase and there is ultimately the status of any rights to still unsettled transactions and money, which rights are also in the broker’s own name. Again these matters are more fully discussed in Vol 2, ch 2, pt III in connection with the operation of book-entry systems of securities entitlements. See for a summary also ch 1, s 4.1.1 above.

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fashion prone, and invariably subject to major disappointments as many mergers ultimately fail to achieve expected objectives and savings. The figure is sometimes put at 30 per cent of the total, while of the rest about half encounter major integration problems. The anticipated added value is often not there. This normally becomes clear, however, long after investment banks were involved and gave advice. For them the more interesting immediate consequence is that major redistributions of unwanted assets are likely to follow in a round of larger or smaller disposals. At least the agitation surrounding mergers and acquisitions or the threat thereof prevents complacency in corporate life. One way of looking at it is as a self-destructive process that may give rise to new life and have a cleansing function. As such it can be seen as an indispensable component of modern business. There will be corporate and related regulatory complications, especially in unsolicited or contested mergers and acquisitions. ‘Poisoned pills’, which are defensive tools triggered when an unwanted takeover is threatened, directors’ duties, shareholders’ information, veto or consent rights, and minority shareholders’ protection issues will come to the fore. There are likely to be further complications under securities laws when the target is a publicly quoted company. Mergers and acquisitions often also have trans-border aspects— particularly in the larger transactions in which foreign subsidiaries or assets are invariably involved. Naturally this creates further practical and legal problems. In international cases, the application of domestic takeover statutes (like the Williams Act in the US) or (informal) codes (like the Takeover Code in the UK) is likely to become an issue also, especially in contested bids. Other important issues concern the valuation of the company to be acquired and, if new shares are issued by the acquiring company in exchange for the shares in that company, also the valuation of the acquiring company itself in relation to the value of the company to be acquired. These valuations are likely to play a major role in contested bids. There are various methods to establish values and this is one of the most important tasks of investment banks that become involved as advisers. For this activity, they may or may not need to be authorised and supervised; it depends on the applicable domestic law. The 1993 EU ISD, superseded by the 2004 MiFID (see s­ ection 3.5.3 below), did and do not require it per se, but to avail themselves of the EU passport for these services (see ­section 3.3 below) they need to be authorised (although that may be part of a broader authorisation). Valuation can be done at several levels. One may look at the assets and liabilities of a company or, if its shares are quoted, at the share value. They are of course related but not necessarily directly. A complicating factor is that the assets and liabilities as presented in the balance sheet may be historical and may have to be revalued in which context off-balance-sheet items, such as contingent liabilities, will also have to be taken into account. This can be done and the debts and other liabilities will then be deducted from the revalued assets. This gives a value but it is likely to be tantamount to valuing a company at its immediate liquidation or break-up value. In a merger situation, more important may be the going concern value—therefore the value over and above the break-up value. This is sometimes also called goodwill, which is shorthand for expertise, positioning in the market, relationships, the effectiveness of patents, and especially future growth

PART I  Financial Services, Service Providers, Risk and Regulation 717

prospects. It follows that disagreements over proper value may be considerable, especially in contested takeover bids, and particularly over the earning potential of a business and its future cash flows (normally understood in terms of net earnings—and therefore earnings after expenses, but before interest payments and tax (EBIT) and with a deduction for estimated future investments). These total estimated cash flow streams are then discounted to a present-day value by using an interest rate, which involves a further judgement on future interest rate developments and an estimation of the so-called ‘equity risk premium’. Here the question is the extra return that shares, which are riskier, should yield over (government) bonds and the volatility (or ‘beta’) of the specific company’s shares within the market. This nevertheless allows for a present-day value being put on cash flows that may be received a long time from now. In other words, if Swiss Francs 1,000 is going to be earned in year 10, its present value can be found after deducting compounded interest over a 10-year period. Modern calculators will give the answer instantaneously, but the two imponderables remain the estimate of the profit in year 10 and the development of interest rates during the 10-year period. In both cases, huge assumptions are likely to be made, especially in the area of anticipated growth rates. This method of valuing is common, however, and assumes that the value of a business is in essence the total of all its cash flows until the end of its existence, properly discounted on the basis of a realistic interest rate. Normally a range of outcomes will be produced, which may be averaged. The more they differ the greater the risks for the acquirer. In connection with valuations, the trading multiples of similar companies and the acquisition multiples of precedent transactions are also closely scrutinised. Multiples include the classic price/earnings ratios, which divide present share prices by present profits per share, and increasingly EBITDA-based multiples which divide the value of a company’s shares and its debt by its EBITDA (earnings before tax, interest, depreciation of assets and amortisation of goodwill). These multiples allow a quick comparison between a proposed purchase price with its implicit multiples and the multiples investors are currently paying in the stock market or were paid in precedent transactions. Especially for agreed takeovers of publicly quoted companies, valuation issues will focus on the value of the shares. Of course, there is likely to be a daily quote, which should be indicative of real values. Theoretically, they should equal the discounted cash flows per share (or at least the discounted total anticipated dividend stream and any residual liquidation value including retained earnings), but market sentiment may affect the price, especially when rumours of an imminent takeover circulate in the market. This may explain substantial daily swings, which might lead to adjustments in the valuation. It is also said in this connection that ‘efficient markets’ constantly discount new information, which means that share values become subject to a ‘random walk’. In any event, in a takeover situation, a premium may be paid. This is often a practical issue (to induce present holders to part with their shareholding) but may also be justified on theoretical grounds as a result of the synergies arising from the transaction. Synergies arise from a takeover as the earnings potential of two companies should be greater when they are combined as opposed to when they operate as stand-alone entities, due to basic economies of scale but probably also to the reduction of competition. The likelihood of subsequent disappointment has already been signalled above.

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All these valuation methods can and have been criticised and in takeover situations are often twisted to obtain the desired result. For the present purpose of showing what investment banks’ corporate finance activities involve, it is not necessary to go into them in any greater detail.

1.5.12  The Risks in the Securities Business. Securities Regulation and its Focus. The European and US Approaches What are the typical risks and concerns in the securities business of which the modern securities regulator needs to be aware and which of these risks require regulation? What should be the focus of modern securities regulation and how should it be organised? A first observation to make was that for investment banking traditionally the concern was not on systemic risk. Investment banks were seen essentially as small players who provided a certain number of services but were as such no threat to the financial system. In the 2008–09 financial crisis, this view was severely tested and it became clear that the activities of investment banks, their proprietary trading positions, and liquidity requirements for themselves or as prime brokers were such that they could pose a threat to the whole system. In the US, the Fed was forced to provide liquidity to them as lender of last resort. It entailed more supervision whereupon the largest, Goldman Sachs and Morgan Stanley, opted to obtain a full banking licence giving them the advantage of taking deposits in particular from their large corporate client base. It meant regulation as ordinary banks and effectively the end of investment banking as a separate activity. Investment banking activities nevertheless survive. Here we take a functional approach to regulation (see ­section 1.1.8 above) and look therefore at the type of activity first, such as the issuing activity in respect of issuers, the underwriting activity of investment banks, their market-making activity, brokerage activity, investment management activity, clearing and settlement and custody activities. Even stock exchanges as such may still be regulated in this context, but also now more likely per function in respect of those who exercise them. How this is done is borrowed from banking regulation and can chiefly be broken down in the manner as set forth in ­section 1.1.8 above in terms of authorisation, prudential supervision, conduct of business and product supervision. As to the objectives of functional regulation in banks, they may be very different in respect of each of these functions as we have already seen. Investors’ protection is, at least for retail, often the professed aim, but there is also the reputation of the relevant financial centre, openness and anti-competitive considerations to consider. Although systemic risk may not always be great and was earlier less of a problem in this area, since the 1990s the EU has required authorisation and prudential supervision of both the underwriting and market-making functions. In the primary markets, solvency of the underwriter could indeed be a special concern to investors who have paid up but are not yet issued the securities, although the issuer might well take over in such cases, even though proceeds of a placement not yet paid to the issuer may also be endangered upon the insolvency of the underwriter. The underwriting obligation itself will also be affected, but these obligations may devolve on other members of the syndicate if there are any.

PART I  Financial Services, Service Providers, Risk and Regulation 719

As to the market-making aspect in the secondary markets, there is normally also little risk to investors except in the potential manipulation of prices and the quoting of spreads. Whatever other concerns there may be, they are also likely to be in terms of insolvency risk and particularly the protection of client assets under these circumstances. But the insolvency aspect is less important than in banking, as we have seen. The law substantially protects the principal against the insolvency of its broker through segregation duties and tracing possibilities of bought securities or sales proceeds, at least in common law countries, where a form of segregation is here always implied. It has already been mentioned that in civil law this area remains much less developed and often requires special statutory intervention, which may or may not prove adequate for investors: see s­ ection 1.5.10 above. In all cases, the separation of client assets and funds remains thus greatly important, as are investor compensation schemes, which makes brokers’ insolvency also less of a threat so that the main emphasis of regulation here will be the strengthening of investors’ rights against incompetent or unscrupulous brokers who prefer their own interests. Hence the elaboration of the fiduciary duties in regulation in common law or of the disclosure and execution duties in regulation in civil law. They allow or should allow for more protection in respect of unsophisticated investors. It means a strengthening of private law concepts. In the primary market, regulation of issuers may prove to be more important than that of intermediaries. In particular there are the registration, disclosure or prospectus requirements of the issuer and the prospectus liability connected with the issuing and listing of securities. This is commonly also considered mainly a question of investor protection, even though professionals may now have better ways of checking up on issuers while the prospectus requirement has never meant much in the euromarkets. As noted before, there was an exemption for these markets in the earlier EU Public Offer Prospectus Directive, and under the 2004 EU Prospectus Directive requirements, bond issues with large denominations also remain effectively exempt. On the other hand, regulators in domestic markets, such as the SEC in the US, may have the power to forbid all issues they do not like. As just mentioned, in both the primary and secondary markets, another concern may be the monopolisation of particular market functions such as those of brokers and market-makers by exchange members while limiting the access of outsiders and setting the market-making rules and brokerage fees. This was considered the case in the LSE before the Big Bang in 1986. In this connection, there may still be special concern about the accessibility of the clearing and settlement systems of exchanges by outsiders. In respect of them the more common concerns about authorisation, prudential supervision, conduct and products are less relevant. To repeat, modern regulation, especially in the securities industry, regulates participants according to their function, especially underwriters, brokers, market-makers and, to a lesser extent, market-facilitating institutions such as stock exchanges, clearing and settlement systems or custodians, therefore, in principle, all those who are in between investors and users of capital or all those who are involved in the flow of money from savers back to capital users. As was discussed in s­ ection 1.1.8 above, modern regulation will or should no longer attempt primarily to regulate markets as such except to guard

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against fraud, insider dealing and other forms of manipulation. In the securities industry there are other concerns, such as an efficient and cheap complaints procedure for smaller investors. The result may be civil liability of an intermediary for breach of the rules, and criminal liability for major offences like market manipulation and insider dealing. This civil and criminal liability may be extended from the intermediary firms to their personnel. While, as in the UK, (official) markets themselves are not or no longer the prime focus of regulation and the emphasis is on the participants and their services and on investor protection needs, it follows that at least in organised markets, settlement and custody agencies may increasingly be deregulated. In the UK, authorisation is not a prerequisite for the operations of the organised markets, or settlement and custody agencies. That was done to avoid monopolies. They may still obtain some official status through official recognition however. That has been the UK system since 1986. Official recognition implies conditions, but it may reinforce the status of these organisations and may also reduce their (price) reporting and other disclosure burdens to which they are now made subject when operating in or from the UK. The clear objective is for informal structures in the securities markets to become part of the system so as to create a market framework with sufficient resources and more reliable facilities. That is also very much behind the recognition of ATSs in the US and MTFs in the EU. Here US law remains stricter and probably more old-fashioned. Section 5 of the 1934 Act requires that securities exchanges are all registered with the SEC unless exempted under ­section 6 and regulating themselves as self-regulatory organisations (SROs), but always subject to SEC supervision. As already mentioned above, although in the US the NASDAQ is often presented as an OTC or informal market, as a registered SRO it is an officially regulated market and as such quite different from the informal markets such as the eurobond market in Europe. The US approach remains different from the European one, not only in the regulation of official and unofficial secondary markets, but also in the greater emphasis on registration of new issues in the primary market. The type and expertise of investors is not considered (except under the limited private placement exception of ­section 4(a)(2) of the Securities Act 1933). One result is a suspicion of all foreign securities as regards the way in which they are issued and offered, which seems unwarranted in view of the modern information facilities concerning issuers and international trading facilities: see for the unilateral US response to the internationalisation of the securities industry ­section 1.2.3 above. At least in respect of the professional investor, the more proper response would appear to be an integrated international framework with a division of regulatory labour between home and host regulator, as now exists within the EU, combined with a facility for issuers to access foreign markets under home-country rule and supervision (passporting).

1.5.13  Securities Regulators The result of functional regulation is that banks, investment banks in particular, may have various regulators. Thus in the US, broker/dealers and exchanges are subject to

PART I  Financial Services, Service Providers, Risk and Regulation 721

SEC registration followed by forms of self-regulation through their own organisations (SROs) per function or activity, like the exchanges for the products they deal in and the NASD for securities operations of their members, although always supervised by the SEC. In the UK, there were others for securities and investment management activities but after 1997 they were merged into one central supervisory authority also covering commercial banking and insurance (the FSA). The self-regulatory parts of regulation then faded. After the change in the UK government in 2010, supervision of banks, insurance companies and all investment firms that could pose a risk to financial stability was brought back to (a subsidiary of) the Bank of England, the PRA, as it was felt that the issue of financial stability was better handled by them—see also ­section 1.4.7 above. A separate Financial Conduct Authority (FCA) was created. The FSA was accordingly broken up. Financial regulation is naturally a political issue, and although the principles are becoming more uniform and therefore to some extent depoliticised, enforcement remains politically sensitive. In the banking area, as we have seen, the regulators were from early on organisations separate from government, usually central banks. Although the latter functioned in Europe often as nationalised entities, they are now mostly independent (at least in the euro countries). Securities regulation, to the extent it existed, often made ministries of finance or economic affairs the ultimate regulator like, until 1986, the Department of Trade and Industry (DTI) in the UK. Most was done by the official exchanges. This system seldom proved successful. By creating separate agencies such as at first the SIB, then the FSA and now the PRA and FCA, in the UK259 and much earlier the SEC in the US, governments and official exchanges now mostly take a back seat in enforcement. Enforcement has become more independent, professional and better equipped, while the costs, as in the UK, are often put on the financial services industry, which, however inconvenient for this industry, at least provides adequate funds.260 But it has also been shown in s­ ection 1.1.13 above that in matters of financial stability, a policy approach has revived, now behind the facade of (macro-prudential) supervision. In the US, the SEC is the overall securities regulator assisted by SROs under its supervision and by official (registered) exchange markets. The most important SRO is NASD) and the most important exchange the NYSE. The derivatives markets in the US have their own supervisory authority however.

259  In the modernised set-up in the UK after 1986, day-to-day regulation was initially left to SROs in the various segments of the securities markets (under the supervision of the SIB now superseded by the SFA). Of these, the SFA (for securities and futures investments) and IMRO (for investment management services) became the most important. They issued rules following the SIB’s guidelines and models. It was subsequently felt, however, that this whole system was not sufficiently transparent and that especially the smaller investor had no proper insight into or knowledge of the availability of remedies under the various sets of rules and complaints procedures. Thus in 1997 a new agency was created in the UK, the Financial Services Authority or FSA, into which the SIB and the existing SROs were merged and which acquired at the same time banking and insurance supervisory functions, the former from the Bank of England, which retained responsibility for monetary supervision. In this connection it also retained its role as lender of last resort, while the UK Treasury remained responsible for the institutional framework of regulation and the statutory instruments but it had no operational role in financial regulation and was also not responsible for the activities of the Bank of England and the FSA in this respect. 260  In France, since 2003, the Autorité des Marches Financiers (AMF) is now the sole securities regulator (replacing the earlier CMF and COB). Banking supervision remains under the Ministry of Finance and the French central bank.

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The SEC, as the oldest major securities regulator in the world, is also by far the most experienced and sophisticated. The SEC has broad rule-making powers under the 1933 and 1934 statutes and also issues policy and interpretative releases, staff legal bulletins, interpretative and no-action letters and even telephone interpretations. Nevertheless, increasing doubts have been expressed as to the process of its regulation and the piecemeal nature of it. It has resulted in a true patchwork of rules not easy for the outsider or even the experienced lawyer to comprehend. More importantly, it is slow to change when fundamental rethinking is required, sticks to what it has and mostly adds, while favouring existing structures and official markets. This has long led to criticism.261 It may well be that the freer UK approach to the development of alternative markets, as explained, has the edge. The 2010 Dodd-Frank Act does not fundamentally change the approach and not the regulators either. In fact, it sustains the patchwork approach.

1.5.14  International Aspects of Securities Regulation Not only domestically but also internationally, the modern emphasis on the regulation of investment service providers implies a functional approach. Thus the emphasis is not or no longer on markets or institutions as such but principally on the type of service provided by the various intermediaries or demanded by market participants and, in international dealings, subsequently on the role of the host regulator. This is conduct of business and product supervision. Where freedom of cross-border financial services is promoted, as in the EU, the emphasis is likely to shift to home regulation with (provided it is reasonably sophisticated) a lessening role for the regulator of the investor (host regulator). This is an important development, of which we may also see more within GATS (see further ­section 2.2.3 below). In commercial banking, there was always a lesser emphasis on conduct of business and product supervision, more on capital and infrastructure as we have seen. It has been mentioned before that the functional approach to regulation of the type of services rather than of the institutions that provide them cannot easily cover the need for 261  See MH Wallman, ‘Competition, Innovation, and Regulation in the Securities Markets’ (1998) 53 The Business Lawyer 341. The applicable legal regime in respect of prospectuses has been much debated in recent times in the US but has not found a response from the SEC. For a discussion, see HE Jackson and EJ Pan, ‘Regulatory Competition in International Securities Markets: Evidence from Europe in 1999—Part I’ (2001) 56 The Business Lawyer 653. Their research in Europe points to free markets and competition leading to higher voluntary disclosure (not lower) with the prospect of greater proceeds. See more recently, however, also J Fried, ‘Should Corporate Disclosure be Deregulated? Lessons from the US’, Law and Economics Workshop Paper 4 (UC Berkeley, 2007). The author argues against the market function in this area on the basis of the American experience. See earlier F Easterbrook and O Fischel for serious doubts about the fairness and efficiency of mandatory disclosure systems, ‘Mandatory Disclosure and the Protection of Investors’ (1984) 70 Virginia Law Review 669—response from JC Coffee, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70 Virginia Law Review 717. Issuers’ choice of regulatory alternatives is another approach: R Romano, ‘Empowering Investors: A Market Approach to Securities Regulation’ (1998) 107 Yale Law Journal 2359, and S Choi and A Guzman, ‘Portable Reciprocity: Rethinking the International Reach of Securities Regulation’ (1998) 71 Southern California Law Review 903. It assumes that basically all regulatory regimes are sufficiently close so that no major policy or public order issues are involved. The true questioning of traditional regulatory attitudes in the US goes back to G Stigler, ‘Public Regulation of the Securities Markets’ (1964) 37 Journal of Business Law 117.

PART I  Financial Services, Service Providers, Risk and Regulation 723

institutional capital and infrastructure. In that sense, regulation can never be entirely functional, at least not for banks or other systematically important financial institutions. As capital and infrastructure are particularly important for commercial banks, they therefore remain subject to a stronger form of institutional regulation, more so than investment banks. This in itself promotes a home-regulator approach as supervision of these aspects of international banking is better centralised at home. The consequence is that the concern for capital and infrastructure is also more properly a home-country affair. Given that in investment banking activity the regulatory concern is rather for conduct of business and products, therefore the protection of clients, host regulation is more natural, at least for cross-border activities and products in the retail area, although not necessarily for professional dealings. Indeed, the host regulator may be particularly concerned with small investors and the investment products and investment services offered to them. On the other hand, there may be less host-country concern with service providers and their duties, either as underwriters and placement agents or market-makers, and often even less as matching agents or specialists, information suppliers, clearers, custodians, brokers or investment managers. This may, like authorisation and prudential supervision, all be left to home regulators to the extent they feel a need to become involved. The sequel to internationalisation and the freer rendering of financial services crossborder is likely to be some division of tasks along these lines between home and host regulators but ultimately with emphasis on the home regulator’s role, especially to avoid a multitude of regulators and a duplication of supervision. In this connection, the home regulator would naturally be more interested in licensing requirements and prudential supervision, the host regulator in the services and products foreigners offer in its territory to retail investors. To make this division of regulatory tasks work, there may be some harmonisation needed in the basic concepts and objectives of regulation. This is the approach in the EU (see ­section 3.3 below) after an earlier period in which the EU appeared more interested in the workings of and co-operation between the different existing formal stock exchanges in terms of admission to listing, listing and regular reporting requirements, although it later also became concerned with public offerings of securities in general, therefore also those being issued off-exchange in the informal markets. In the end, the EU understood that it had to focus on the services and the service providers and not on market operations, and divide the regulatory tasks with a bias towards home regulation although with some exceptions for (small) investors’ protection: see again s­ ection 3.3 below. This was the drift of the EU ISD, now superseded by MiFID (see s­ection 3.5.3 below and for the unilateral US approach to cross-border securities transactions s­ection 1.2.3 above). Within GATS, host regulation remains for the time being the normal attitude, except perhaps for some incidental telephone selling. This even applies to the authorisation requirement as it originally did within the EU. The host-country concern with conduct of business and (small) investors’ protection should extend not only to the avoidance of conflicts of interests and the formulation of duties of care but also to the aspects of segregation and tracing. In these areas there is also a need for some harmonisation of basic principles. It is to be noted that

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Article 11 of the EU ISD did do this to some extent for conflicts of interests and duties of care, but it had not begun to do so in the aspects of segregation and tracing and neither does MiFID: see ­section 3.5.6 below. This would mean a substantial re-evaluation of the principles of agency in both their contractual and proprietary aspects as particularly geared to the securities business. Although, in the European Principles of Contract Law in its ­chapter III and now in the Draft Common Frame of Reference in its Book IV D, there are some provisions on agency, the particular securities trading aspects are not addressed.

1.5.15  Fintech and the Capital Markets As we have seen in ­section 1.1.18 above, Fintech sofar has made some impact in the payment system by producing bitcoins, see further c­ hapter 1, s­ ection 3.1.10 above, and also in crowdfunding. In the previous c­ hapter it was also considered that it holds out promise in securitisation and derivatives, see ­chapter 1, ­sections 2.5.12 and 2.6.12 and in ­chapter 1, ­section 4.1.8, its potential was discussed for intermediated investment securities holdings, where the custodial structure may become redundant. This is relevant in the present discussion about capital market operations. The problem is as ever where this potentially new world comes into contact with the older present set-up in terms of practices and regulation, therefore the going in and coming out of this system which cannot be avoided until it becomes absolutely dominant. This is an achilles heel in its progress to maturity. In the US the case of Overstock proved the present limitations, see also section 1.1.18 above. It is agreed that in principle under Section 8-102(a)(15) crypto securities can be issued and traded even under the present legal system as ‘uncertified securities’ but in practice this only works in a permissioned system. Although the UCC (and state corporate law) require an issuer to keep a transfer ledger, usefully, it does not prescribe the method, but whether and how tokens are subsequently traded under ­Section 8-102 (a)(15)(iii)(A) is unclear and seems to depend on the mechanics in a permissioned system. Moreover, intermediaries who are holding securities for others must forward proxy statements (SEC Rules 14b-1, 14b-2, 17 CFR ss 240.14b-1, 240.14b-2), which requires identification of the beneficial owners. The combination of private and public keys prevents that in a blockchain system, another reason why in the case of Overstock it required a permissioned system under which each customer was required to open an online brokerage account with Keystone, also to get access to the relevant ATS, so that ultimately not much seemed to be gained except in having a different kind of stock traded in the existing markets or alternative trading systems. This also attracts the traditional regulatory oversight. A special issue is here how creditors of such a security interest holder may recover from this interest. It requires access to private keys in order to perfect an attachment and organise a stay on any subsequent transfer, for which relevant programming may not (yet) be available. In the Overstock scheme it meant access of Overstock, the ATS and Keystone to the private keys of customers, another reason why the original aims of its proponents cannot presently be met.

Part II  International Aspects of Financial Services Regulation: The Effects of Globalisation and the Autonomy of the International Capital Markets. The Developments in GATT/WTO, the EU and BIS/IOSCO/IAIS 2.1  The Globalisation of the Financial Markets and the Informal Liberalisation of Finance 2.1.1  Autonomy of the International Capital Markets. Its Extent and Meaning In commerce and finance, internationalisation or globalisation means essentially the free movement in goods, services, payments and money cross-border. In more modern times, freedom of communication and free movement of technology should probably be added. Free means here free from tariff and non-tariff (largely regulatory) impediments, not of course from payment for goods and services rendered and information or technology transferred. Although substantially prevailing before World War I (in fact mostly until 1929 or even later until the general abandonment of the gold standard), the free international flows in commerce and finance came to a sudden halt thereafter and their liberalisation is in modern times a relatively new phenomenon, challenged again by 2018 at the American initiative. The 1930s started an era of extreme nationalism in commerce and finance, resulting first in paper currencies that became purely national facilities and whose exchange rates allowed for competitive devaluations. This invited ever more protection against the consequences in terms of cheaper exports through the imposition of higher trade barriers by importing countries in the nature of import restrictions (contingents) or tariffs. The result was a race to the bottom in international trade, which was substantially halted although there remained always an international market for new technology (lamps and radios in those days) and scarce commodities (oil and gas) but imports of this nature were also closely supervised and local manufacturing by foreign technology holders encouraged, at least for commodity products. Major nationalisations of oil and gas licences also followed, first in Mexico, which in this area subsequently led to export rather than import restrictions. The consequence was that, as far as the free movement of goods was concerned, immediately after World War II, import restrictions and other protections were rampant and average tariffs estimated to be as high as 40 per cent. Some early relief was obtained through the General Agreement on Tariffs and Trade (GATT), which entered into force on 1 January 1948 (see ­section 2.2.1 below). However, rather than through this formal structure, later followed more intensely for Europe in the EU

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(see ­section 2.3.1 below) and subsequently even worldwide in the World Trade Organization (WTO) (see further ­section 2.2.4 below), the international liberalisation of at least the financial services was more properly propelled by the spontaneous globalisation of the financial markets. The first and early manifestation of this trend came as early as the 1960s with the development of the eurobond market referred to earlier in Volume 1, ­chapter 1, ­sections 3.3.2/3,262 see further the next section. It became an early expression of the autonomous effect of the freeing of capital flows and investments and facilitated eventually also the more formal freeing of related financial services in the GATS/WTO and especially the EU as we shall see. It had an early and crucial impact—it is submitted—on the entire globalisation process, at least in finance and also restarted legal transnationalisation that had been abandoned in the nineteenth century even for international transactions although some of the old law merchant was retained in the international marketplace (see Volume 1, ­chapter 1, ­section 1.4.4) but it was eclipsed by the idea that all law was henceforth national.

2.1.2  The Eurobond Market and its Main Features. Euro Deposits At the origin of the liberalisation process and internationalisation or globalisation of the financial markets and the services provided in them, especially since the 1970s, was (a) the accumulation of large pools of US dollars outside the US in the 1960s because of the US trade imbalances; and (b) the virtual closure of the US domestic (Yankee) market for foreign dollar borrowers through tax measures (the 1963 Interest Equalisation Tax) as a measure against the capital export from the US at the time and the practical need to find alternatives. This led to a capital market structure that became the eurobond market, whose internationalisation was supported by some inventive legal structuring showing ways of tapping the offshore pools of dollars while (a) avoiding local restrictions on bond issuing in a foreign currency by domestic issuers through the use of offshore issuing and underwriting facilities; (b) facilitating placement through sales predominantly or exclusively outside the country of the issuer or of the currency; (c) avoiding withholding tax on the bonds through the use of bearer bonds issued by tax haven finance subsidiaries as issuers; (d) safeguarding the freely transferable nature of principal and interest payments by using paying agents in various countries giving the investors a choice; and (e) freeing the use of the proceed-currency and its conversion into others, ultimately by developing the currency swap market.263 With the creation of ever larger offshore pools of funds, also in currencies other than the US dollar as a result of other large international trade imbalances and the various

262 

See for a description also HS Scott and A Gelpern, International Finance, 20th edn (New York, 2014) 743ff. The use of tax haven finance companies had another aspect, in that these companies would normally lend the proceeds back to the parent so that there had to be some tax treaty that exempted interest payments by the parent to the subsidiary from withholding tax in the parent country. In this connection particularly the Netherlands Antilles became important for US companies as it had such a tax treaty with the US (through the US/Dutch tax treaty). 263 

Part II  International Aspects of Financial Services Regulation 727

oil crises in the 1970s, this emerging transnational market subsequently began to cover European currencies as well. By the late 1980s, it had become one of the largest capital markets in the world264 and affected more and more the practices of the European domestic bond markets, although in some countries like France, Germany and the Netherlands, eurobond issues in national currencies targeted at foreign investors still had to be underwritten in the national financial centre (to support the local banking industry) so that it remained subject to restrictions (a queuing system being sometimes also maintained as a matter of monetary control). It should be noted immediately that the use of the term ‘euro currency’ in this connection had nothing to do with the much later emergence of the euro as a common currency in parts of the EU. The various segments of the euromarkets increasingly adapted to uniform rules and practices of a deregulated nature based on international market conditions and practices. Domestic activity followed and became more difficult to distinguish to the point that local government bond issue and placement activity in Europe started to conform to internationalised underwriting and placement standards found in the euromarkets. The operation of the eurobond market also had an important effect on withholding taxes on this type of borrowing/investments. Under pressure of internationalisation, they were increasingly abolished for sovereign debt, first in the US in 1984 and in Germany in 1989 (in France for foreign investors in the same year). At the same time, it became easier in the US to use domestic finance companies for raising funding internationally, although there remained a concern about US investors not paying tax on their holdings of this type of security.265 In many countries, other exemptions emerged, especially in terms of registration or prospectus requirements when eurobonds were sold to institutional or professional investors. This was not done in the US but under Regulation S in issues that occurred outside the US (meaning that there was no direct placement or selling in the US), the issuer would only have to register with the SEC in the US (which would require a prospectus) if there was a ‘substantial US market interest’ (SUSMI) in the securities offered (see also s­ ection 1.2.3 above).266 Although participants in this market would still pay considerable lip service to domestic rules and practices, it became clear that whatever could not be done in one

264  Even from the US there was increasing reliance on funding in the eurobond markets, especially for larger corporates: see S Peristani and J Santos, ‘Has the US Bond Market Lost its Edge to the Eurobond Market?’, Working Paper FED (March 2008). 265  That led in the US to the so-called TEFRA (Tax Equity and Fiscal Responsibility Act 1982) Rules, the purpose of which was to disadvantage bearer securities—see also s 1.2.3 above. They could not be sold into the US during the issuing period except at a fiscal penalty. Eurobonds were exempted, however, provided three criteria were met: interest was to be paid outside the US, the bonds and coupons had to bear a ledger warning US persons (as defined) of the US tax regime, while there had to be a reasonable assurance that the bonds would not be sold to other than qualifying US persons (such as financial institutions which were likely to pay tax and not therefore to private investors who might be less inclined to do so). 266  This especially affected US issuers, whose paper was more likely to be bought by US persons. If there was a SUSMI, there had to be a 40-day seasoning period during which US investors could not buy these securities. The idea was that, barring proper disclosure, they could only do so once the market had priced in all eventualities of the issue. To prevent US investors taking advantage of bearer bonds, the issuers would then only issue a global note so that during the seasoning period all dealings would be known as investors could only buy and sell their interest in that note by notifying the issuer (or its depository).

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country was now often done from another. The key was that it became the investors and not the issue, issuer, intermediary or market that primarily bore the brunt of any domestic regulation and taxation, the burden of which thus largely shifted to the investors’ place of residence and their relationship with their own regulators and tax authorities. The euromarkets and the eurobonds issued have often proved difficult to define, precisely because of their multifaceted character. In fact, there emerged bonds that could be less than perfect eurobonds.267 For the purposes of the exemption to the 1989 EU Public Offer Prospectus Directive (see also s­ection 3.2.4 below), euro-securities in this sense were defined in Article 3(f) as transferable securities underwritten and distributed by a syndicate of at least two members from different states and offered on a significant scale in countries other than that of the issuer and that may be subscribed for or initially acquired only through a credit or other financial institution.

The Bank of England268 said in 1991 that eurobonds are traditionally defined as bonds which are issued and largely sold outside the domestic market of the currency in which they are denominated and are typically underwritten by an international syndicate of banks, are exempt from withholding taxes, and are bearer in nature. There is no one single definition, and the description of eurobonds and the effect largely depend on the setting in which the definition is used. The market aspects of this development were substantially strengthened by modern technology, with its increase in communication, facilitating cross-border underwriting, placing and trading activity, in which connection the nature of the bond as a bearer instrument was also important, subsequently followed by a system of book-entry entitlements and modern clearing and settlement systems (see c­ hapter 1, ­section 4.1). It led to ever greater use bolstered by instantaneous access of issuers to this informal market and by improving price transparency worldwide by way of telephone or electronic (screen) trading. It facilitated the creation of more flexible and cost-effective capital market products, ultimately supported by currency and interest rate swaps, which themselves implied a facility further to avoid domestic restrictions. Eventually, the euromarkets also started to cover equity products. These markets always were often a centre of innovation and sophistication with a measure of self-regulation through the International Primary and Securities Market Associations (IPMA and ISMA), since 2005 merged into the International Capital Market Association (ICMA) operating from London. However, where the syndicates were organised in established financial centres, their participants requiring some presence in these centres could often not escape regulation in terms of authorisation, capital adequacy and prudential supervision, also for eurobond activity, this being investment business. That became clear in the UK after the 1986 Financial Services Act. Syndicate and placement activity itself also became subject to conduct of business rules, for example in matters of stabilisation, protection

267  See for a list of definitions JH Dalhuisen, The New UK Securities Legislation and the EC 1992 Program (Amsterdam, 1989) 19. 268  (1991) 31 Bank of England Quarterly Bulletin 521.

Part II  International Aspects of Financial Services Regulation 729

of clients against aggressive sales techniques, and especially in the price reporting of bid and offer prices and done transactions (pre- and post-trade information). Euromarket activity, at least to the extent operating from London, is therefore no longer unregulated but the art of the UK legislator became to strike a balance and avoid restrictions which would move the whole industry to another country. In this partial re-regulation, it has so far been largely successful, and harmonisation of the rules to the extent pursued under the EU Directives has not detrimentally affected the euromarkets, which continue to have London as their centre but are still structured as an offshore market. This form of regulation, especially in respect of pre- and post-trade information reporting, and later also in the imposition of a prospectus requirement (except for issues with large denominations) may even have been a support for these markets and their credibility. Yet since the 1998 Action Plan, the EU has encroached more and more on the international unregulated markets and proved more of a long-term threat, as we shall consider below. This is partly out of ignorance but also out of suspicion and the irrational feeling, widespread in the EU, that anything unregulated has less validity and legitimacy or is outright suspect and subversive. This attitude appears to have deep roots in Germany and France, but there is little in the history and operation of the eurobond markets that supports it. Whatever the official attitudes, it may be seen from the above that domestic and international markets grew closer, that deregulation in this area followed also domestically, and that the practices in the capital markets became more uniform worldwide. Withholding tax and the use of offshore finance subsidiaries became less important, although as noted before, some domestic regulation was eventually allowed to impinge also on the euromarkets, in the EU driven by its Directives especially in the area of preand post-trade price reporting and later the prospectus requirements, at least for issues in smaller denominations. There emerged an environment in which global offerings could alternatively be used, meaning an offering simultaneously in the international and a number of domestic markets. For large issues this is an important facility as it increases investor interest and liquidity subsequently. The concept dates from a World Bank bond issue of 1989. There is one currency and one price. Naturally all regulatory and other requirement in each market must be fulfilled but the approximation of the rules and practices in these markets have made this manageable.269 It is now also a formula for international share issues. Euro deposits, on the other hand, should be clearly distinguished from the pool of funds used to buy eurobonds. The latter were in origin offshore funds to which domestic investors could freely add if allowed to by their own foreign exchange regimes. Much of this is now history, superseded by the free flow of most currencies worldwide achieved during the last 30 years. The situation concerning euro deposits was fundamentally different but is now also mainly of historical interest. The Russians started them after they withdrew their dollar deposits from New York in the wake of the 1962

269  See for more details especially from a US perspective, E Greene et al, US Regulation of the International Securities and Derivatives Markets, 10th edn (Wolters Kluwer, 2012).

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Cuban Missile Crisis. Subsequently, similar deposits, at first in US dollars, were moved by US citizens abroad for them to avail themselves of higher interest rates elsewhere, which were possible outside the US because of the lack of regulation requiring deposittaking institutions to maintain mandatory non-interest-bearing reserves in respect of such deposits. They added to the pool of euro dollars already existing but were a separate segment of that pool with its own interbank circuit in which these higher interest deposits could also be re-lent to other banks and finally to other end-users.270

2.1.3  The Legal Status of Euromarket Instruments and Underwriting Practices It can be argued that the financial instruments issued in the eurobond market, in particular the eurobond itself, originally as a bearer negotiable instrument, have a transnational property status and derive this from the international law merchant, especially from its customary law component, where all negotiable instruments originated: see Volume 1, ­chapter 1, ­sections 3.2.2 and 3.2.3. This is so regardless of the contractual choice of law clause as, in proprietary matters, the applicable law is not at the free disposition of parties, meaning that a contractual choice of law is here not decisive. As English law confirms, transnationalisation of the ownership structure of the eurobond as bearer instrument and its negotiability is the result in which connection ‘the existence of usage has so often been proved and its convenience is so obvious that it might be taken to be part of the law’.271 The transfer and protection of bona fide purchasers or holders of these bonds are then also likely to follow internationally accepted practices, recognised and accepted in domestic laws, which may well extend to the types of conditional or temporary ownership rights (repos) and security interests that may be created in them. This is an important theme. Prevailing modern book-entry systems of transfer, which replaced the earlier bearer negotiable instruments (at least at the level of trading and holding the securities), may also underscore the transnational status of the instruments, the interests created in them, and the protection of third parties,272 although there is here an important tendency to see the register as still being located at the place of the intermediary which has reintroduced domestic notions of the holding of these securities, not usefully so, it is submitted; see also Volume 2, ­chapter 2, ­section 3.2. 270  These deposits were normally not meant to be paid out (or to be used for payment purposes) outside the US. If repayment was demanded abroad or cheques drawn against them elsewhere, it was often thought that these were only payable in local currency, although that view was abandoned in England as no implied term to the effect was found, see Libyan Arab Foreign Bank v Bankers Trust [1988] 1 Lloyds Rep 259. Transfer is thought normally to occur through the clearing facilities in the country of the currency, therefore for US dollars in the US, as these deposits are usually held through book entries in corresponding banks in the US. This has raised the further issue whether these deposits remain subject to embargos imposed by the country of the currency, mostly the US in respect of foreign Arab US dollar deposits (held in foreign banks or in foreign branches of US banks mostly in London). There is here even a danger that they may become subject to the mandatory laws of several locations, therefore in the country where the deposit is arranged and in the country of the currency. This problem does not arise in respect of eurobonds. 271  Bechuanaland Exploration Co v London Trading Bank [1898] 2 QBD 658. 272  See also JH Dalhuisen (1998 Hart Lecture), ‘International Aspects of Modern Financial Products’ [1998] European Business Law Review 281, and Vol 2, ch 2, s 3.2.1.

Part II  International Aspects of Financial Services Regulation 731

As already mentioned, the taxation, foreign exchange, underwriting and placement rules may be similarly affected by transnationalisation. Domestic restrictions or limitations, even if of a mandatory nature, may then not or no longer be deemed properly to impact on the instruments and underwriting and placement practices in this offshore market either.

2.1.4  Central Bank Involvement Only the US, Canada, Australia and New Zealand never attempted to restrict the offshore eurobond issuing activity in their own currencies (as we have seen, notably the US maintains strict selling restrictions into the US or to US citizens anywhere for registration and now especially tax reasons). Countries who still do so can maintain this attitude only through co-operation of other central banks using their combined influence on prospective underwriting banks which they supervise. In fact, the same used to go for countries like Germany, France and the Netherlands, which, although allowing a eurobond market in their currency, long insisted on all underwriting activity being conducted from their own financial centres through a subsidiary or at least a branch of the underwriting entity in these centres. With further liberalisation within the EU, especially under the Second Banking Directive (as at 1 January 1993), in 2000 replaced by the Credit Institutions Directive, itself recast in 2006, now under the 2013 Regulation, see ­section 4.1 below, and under the ISD (as at 31 December 1995—see s­ ection 3.3 below), as of 2007 superseded by the 2004 Market in Financial Instruments Directive (MiFID—see ­section 3.5.3 below), now followed by MiFID II since 2013, see ­section 3.7.5 below, this restrictive attitude became illegal within the EU. It is thus increasingly difficult to maintain, at least visà-vis other EU financial centres, while the continuing internationalisation is likely to reinforce further adaptation. With the introduction of the euro in 1999, the domestic market in most local currencies in any event disappeared in most EU countries.

2.2  The Formal Regime for the Freeing of the Movement of Goods, Services, Current Payments and Capital After World War II 2.2.1  Cross-border Movement of Goods. GATT Besides the autonomous impetus of globalisation in the financial services industry discussed in the previous sections, which ultimately proved an important stimulus to the entire globalisation movement, there was from early on after World War II a more formal movement for liberalisation of the international commercial flows. This came to be centred around the GATT, which, in reaction to the tariff wars that developed in the 1930s, provided some system of checks and balances in which no Member State was

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required to do anything at all except to make sure that no further tariffs were imposed so as to prevent a further race to the bottom or competition in imposing ever higher tariffs that had bedevilled international trade ever since the end of the gold standard regime in the 1930s, as we have seen. It is the standstill agreement flanked by the duty to extend all reductions in tariff to all Member States, That was the most favoured nation clause. It could result in further disparity: a country that had a similar tariff structure with another country, could all of a sudden find that it was at a disadvantage in respect of this country if it made a concession to a third country, but it was also possible and indeed more likely that this disparity derived from having entered the arrangement at different tariff levels to start with. That could happen especially when there were new entrants in GATT, coming in at a higher level. Such a new entry, notably in respect of China in 2001, would normally give rise to extensive negotiations to determine this entry level, which in turn could signal a deeper integration in the world economy. Again, any later concessions in respect of a single country would then affect the tariffs in respect of all others. The GATT entered into force on 1 January 1948 under a Protocol of Provisional Application, therefore as a provisional agreement among its members only. Originally, there were 23 original signatories, largely developed countries, increased to 149 by 2006, including China and many developing nations. Of the main countries, only Russia awaited admission, which was held up by Georgia, unanimity being required for the admission of new members. Although Russia stated in 2009 that it was no longer interested, this proved not to be the case and it was admitted in 2012. GATT, although at first provisional, survived as the only part of what became an abortive attempt (largely due to opposition in the US Senate, which had in the meantime turned Conservative) at creating an International Trade Organisation (ITO) under the Havana Charter of 1948, which resulted from an earlier 1946 United Nations Conference on Trade and Development. From the US point of view, GATT was not a formal treaty so that a different form of approval could be used, thus avoiding the two-thirds majority rule in the Senate (a procedure later also used for WTO). It was subject to the procedure of ratification in most other countries. However, under international law it has the status of a treaty, even in respect of the US, as international law does not make a distinction according to the manner in which these international agreements are approved in each Member State. The ITO itself had been meant to have powers of its own and an autonomous decision-making process to stimulate international trade (Articles 75 and 77). The saved GATT (which had been drafted at the second preparatory meeting for the ITO to deal with an immediate system for tariff reductions) then adopted to some extent the ITO mantle. Not having an autonomous decision-making infrastructure, it required unanimity, however, for any further steps and in any event provided only a (partial) system to promote international trade, limited to physical goods. It nevertheless introduced an important mechanism and fundamental method for a gradual reduction in tariff protection through (a) the standstill agreement, (b) the most favoured nation (MFN) clause, and (c) a reciprocity notion based on national treatment. This meant in essence that: (i) under the standstill agreement no member country could introduce further unilateral restrictions on trade including any

Part II  International Aspects of Financial Services Regulation 733

increase in tariffs; (ii) under the MFN clause benefits given to any one country had to be extended to all other GATT members; and (iii) under the notion of reciprocity and national treatment internal taxation and other regulation could no longer be used to discriminate against products from other Member States. Production and import subsidies were not deemed illegal per se, however, regardless of their trade-distorting effects but anti-dumping charges could be imposed by Member States on the importation of products dumped from abroad. With the standstill agreement in place, it was believed that classical economic theory, which since Adam Smith and Ricardo assumed that liberalisation, even if unilateral, was in the ultimate best interest of all nations, would work its way. There was no free trade ethos per se and it was left to each Member State to discover its own best interest in this connection. In this approach, no interdependence or negotiation model was institutionalised, one reason why no need for the ITO had been felt in the US. Nevertheless, regular multilateral negotiation rounds to reduce tariffs among members became a feature of this system and tended indeed to be propelled by a free market ethos. The last round was the Uruguay Round, which was the eighth, implemented on 1 January 1995. The results of these rounds were by no means always accepted by or became binding upon all members, while others remained in default of the objectives that they had agreed. Nevertheless, average tariffs for goods are now estimated to have been reduced to below five per cent and they may be as low as three per cent after the full implementation of the Uruguay Round. Thus, free movement of goods under GATT has largely been achieved with the notable exceptions of agricultural produce and textiles, which remain particular stumbling blocks. In these two areas, the Uruguay Round measures intended to phase out quotas, to cut subsidies and replace them with tariffs to be reduced over time, and to eliminate other non-tariff barriers. Although the free trade ethos was not the driving idea behind the original GATT, as we have seen, at least the standstill agreements and MFN and national treatment rules were not intended to inhibit it. Apart from the negotiation rounds to reduce tariffs, free trade was also more directly promoted in other ways. Indeed, the Marshall Plan for Western Europe had been a substantial early encouragement of the liberalisation process as the US government insisted that recipient nations promised to balance budgets, free prices, halt inflation, stabilise exchange rates, and remove trade barriers. In the 1960s and especially in the 1970s (probably connected with the oil crises of those days), there was some lack of interest but in the 1980s the internationalisation or horizontalisation of the production process worldwide, therefore market-related forces themselves, became another crucial facilitating factor in this liberalisation process feeding upon itself. That is globalisation. Another important part of this process already identified was the progressive internationalisation of the market for financial services and even of capital leading to international capital markets as exemplified particularly by the eurobond market as shown in the previous s­ ections and which started the whole process of market liberalisation from the 1960s onwards, at least in finance but it had repercussions in other areas. These autonomous developments made possible the creation of the WTO at the end of the Uruguay Round. It was in fact a more modest version of the ITO as originally envisaged by the Havana Charter, but arguably adopted a somewhat different

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­ erspective while reinforcing the focus that had developed in the meantime on the p interdependency and negotiation model with free trade indeed as the main objective. This remains in essence the position. It is an imperfect system that has worked. Only in more recent times has it become subject to more fundamental criticism as some consider it now too producer driven and free trade oriented while giving insufficient attention to other aspects of free trade such as the environmental and labour consequences. The technocratic approach of the modern GATT/WTO is here sometimes also criticised regardless of its achievements and notwithstanding the difficulties in pointing to any adverse effect, even in respect of developing countries. Greater openness and a better political input is advocated but it is not clear who, beyond the Member States which so far represent the political element, could be given a voice (such as certain non-governmental organisations or NGOs) and whether the result would be any more balanced. In fact, as the development of the EU has also shown, it is not uncommon for institutions of this nature to arise in the international order before a broader input can be achieved at the level of individual and non-statist organisations and greater democratic legitimacy can be firmly established. In the EU, it was at first left to the processes in Member States to achieve (indirect) accountability here. Greater participation by the European Parliament, now directly elected, seems so far not to have achieved a greater feeling of participation among the population. This remains a problem in all institutionalised internationalisation efforts, including the modern WTO.

2.2.2  Cross-border Payments and Movement of Capital. IMF Free movement of capital was never itself considered part of the new order after World War II. The Bretton Woods Agreements of 1944, including the IMF Treaty and the creation of the IBRD (‘World Bank’) did not mean to liberalise capital movements and accepted that each country could continue to insulate its own capital market. There followed a system of managed exchange rates and exchange rate adjustments with the possibility of emergency liquidity assistance from the IMF to smooth out currency instabilities and limited access to capital markets and foreign currency, again especially to avoid the threat of competitive devaluations and subsequent trade wars. The IMF rules did concern themselves, however, with the liberalisation of payments for trade (except for countries that claimed an exception: see for details, c­ hapter 1, s­ ection 3.3.2 above). Contrary to the GATT arrangements, these more limited rules were considered to have direct effect in the Contracting States. It meant that, after the war, the arrangements put in place concentrated on trade in goods and related current payments only, while the capital markets (and services) were allowed to develop in isolation, each with their own national practices, interest rate structures and products, only varied by the developments in the eurobond market, as discussed in the previous sections. At first, this new system gave governments (a) a strong position in influencing interest rates and indirectly the cost of borrowings in their own currencies; (b) especially

Part II  International Aspects of Financial Services Regulation 735

after the final breakdown in 1973 of the fixed exchange rate system agreed at Bretton Woods, a virtually unfettered right to devalue their currency (as had existed in the 1930s) to suit their own purposes, usually under their general foreign policy powers, which often remained unchecked even within their own political systems regardless of the potentially disruptive consequences for others and ultimately for themselves; (c) the possibility of limiting export of capital and checking inward investment; and (d) the facility to control all foreign exchange transactions. But much of this faltered after the eurobond market started to operate in earnest in the 1970s and 1980s as has already been shown in s­ ection 2.1.2 below. International flows of money started to be freed and markets became more interconnected and independent from nations. Competitive devaluations or the right unilaterally to debase the currency were looked down upon and increasingly seen as forms of market manipulation. In these circumstances, after 1973, in practice, the role of the IMF became largely confined to (a) overseeing the internationally agreed rules for monetary and liquidity policy; and particularly to (b) administering a pool of currencies that could be lent to members suffering from foreign exchange crises. In that context, it now commonly sets conditions for its (governmental) borrowers, which in practice often aim at: (i) the free convertibility of the currency; (ii) the freeing of capital flows and financial services to keep access to foreign investors; (iii) necessary budgetary restraints; and (iv) sound monetary controls and banking practices and supervision. In this context, it has often been observed that the IMF now operates de facto as the bank of last resort to states. Crises like the Mexican one in 1994, the Asian one in 1997, the Brazilian one in 1999, and the Argentinean one in 2002 seem to bear this out. Greece in 2010 became the latest example, followed by Ireland, Portugal and Cyprus. This has been criticised, but no less the manner in which the IMF fulfils this function through alleged insufficient separation of its early monitoring, support and execution functions, including the imposition and monitoring of lending conditions. As far as these conditions are concerned, they have been questioned especially for their strong monetarist and deflationary flavour and limited regard for the social consequences. It is often overlooked in this connection that countries in this position without international help would have been forced to balance budgets and deflate a great deal more, which could have had even more undesirable consequences. The problem is invariably poor government with poverty as a result, not as the cause. The IMF conditions have at least contributed to some sense of international discipline without which any bank of last resort could hardly be credible or be sustained.

2.2.3  Cross-border Movement of Services. GATS Like capital movements, the free movement of services also had no place in the formal system that was originally developed after World War II and neither had the free movement of payments in respect of them and of earnings from labour or capital investments. In the area of services, the emphasis was in any event not normally on tariffs but rather on discriminatory trade barriers of a qualitative and quantitative nature as part of regulation.

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Thus licences to provide services could be imposed on foreigners and, where needed, could simply be refused or conditioned upon a restriction in market share. They could be imposed on all, and therefore in a non-discriminatory manner also on local service providers, like licences for banks in the financial services area, but these requirements could be so difficult to fulfil for foreigners that entry was effectively denied to them. The applicable regulatory regime could thus become a substantial barrier in this respect, even for service providers coming from the best-regulated countries. For services that are traditionally regulated, like financial services, there are traditionally further problems as regulation can be seen here as part of the product itself and risks a double regulatory burden: in the home and host country. That by itself is a great handicap in the cross-border flow while full deregulation is here not a viable answer, as it might be in other areas. As far as cross-border services, including those in the financial area, are concerned, the Uruguay Round planned a beginning of liberalisation subject to further negotiations, in which connection the Final Act of the Uruguay Round (1994) made reference to a General Agreement on Trade in Services (GATS).273 In this connection GATS in Article 1 of the Treaty defines what cross-border services are, even if this definition is not complete and overlapping.274 It mentions four delivery methods of services (a) from the territory of one country into another, (b) within the territory of one country to a consumer from another, (c) by a service provider of one country through a commercial presence in the territory of another, and (d) by a service provider of one country through the presence of a natural person from that country in the territory of another. In the liberalisation of financial services in particular, the situation, especially with regard to the initial commitments and market opening, was not clarified when the negotiations ended and they remained the subject of further discussions.275 They ­continued

273  The Marrakesh Agreement creating the WTO included annexes that governed respectively GATT 1994 (Annex 1A), GATS (Annex 1B), TRIPS (trade-related intellectual property rights) (Annex 1C) and TRIMS (traderelated investment measures) (Annex 1D). In fact, originally, the inclusion of services, TRIPS and TRIMS was a trade-off with developing countries under which the industrial countries agreed to include and liberalise the trade in agricultural products and textiles. In the end no straightforward trade-off occurred. 274  It was based on an earlier paper delivered by Gary Sampson and Richard Snape, ‘Identifying the Issues in Trade and Services’ (1985) 8(2) The World Economy 171–82. 275  On the part of the US, there was a fear of free-riders in the financial area. These are countries that did not commit to any substantial liberalisation themselves but, through the MFN clause, would be able to benefit from the liberalisation of others. This fear concerned especially Asian countries, including Japan. Pending a resolution, the US was only willing to preserve (but not to increase) the existing activities in its territory of foreign firms coming from these countries and therefore reserved the right to impose limits on their expansion and on new entries short of reciprocity. It exempted itself also from the MFN principle in this area, as it was entitled to do under Art II(2) GATS (for all services for a period of 10 years), and limited it to countries that were in its view sufficiently open to US service providers, like the EU countries, which obtained MFN treatment from the US in this area in a separate development in July 1995 when 95 WTO members signed an interim agreement, effective 1 September 1996 and promised national treatment and market access on an MFN basis. It lapsed in December 1997. These EU countries themselves were more relaxed on the initial commitments as long as financial services were included in the package from the beginning. Helped by an agreement with the Japanese and by the Asian crisis, the US ultimately obtained the commitments it wanted in December 1997 and 70 countries acceded to the new system. Although only 58 of them had ratified by February 1999, it became effective on 1 March 1999 (Fifth Protocol and Schedules of Commitments). The Fifth Protocol is considered part of the original agreements and became the basis for future negotiations. Many participants in fact went beyond their original commitments and allowed greater access in order to enhance direct and portfolio investment. That applied in particular to

Part II  International Aspects of Financial Services Regulation 737

as part of the present Doha Round.276 There was, however, a special Uruguay Round Annex on Financial Services and Prudential Regulation followed by a special Understanding on Commitments in Financial Services, but it was an optional document merely setting out the regime for making commitments.277 For services generally (including financial services), GATS operates more of an interdependency or negotiation model than the original GATT and depends therefore more on a framework for further negotiations in the service area supported by three principles: (a) a negotiation approach per sector based on effective market access (equality of competitive opportunities) and national treatment (in the sense of non-discriminatory treatment of foreigners also in terms of access to payments, and, where necessary, to clearing systems), always subject to each member’s Schedule of Commitments; (b) the introduction of the MFN clause in respect of past and future concessions to others, for services made subject to a 10-year exception possibility; and (c) a compilation of the domestic regulations concerning market access to create the necessary transparency and ensure a reasonable, objective and impartial application of domestic laws and regulation. National treatment in this connection means that the host country may not treat foreign services or service providers less favourably than ‘like’ domestic services or service providers. It does not mean exactly the same treatment. Here the GATS is more specific than the GATT earlier. The key is that the conditions of competition are not modified in favour of domestic services or service providers. On the other hand, market access and the way in which the service provider chooses to operate in the foreign country (either directly, through a branch or subsidiary) are not defined. In the list of restrictive conditions that should be avoided, the service provider is left free to choose between a branch or a subsidiary. Host-country prudential and other regulatory standards must, however, be met, and it appears that (as previously in the EU) host countries may still insist on the creation of a branch for the foreign activity in their countries subject to their authorisation and other regulatory requirements. As GATS may concern itself with all measures by members affecting trade in services, this includes also legal and regulatory rules, but national policy objectives must

OECD countries under an auxiliary agreement called the Financial Services Understanding (FSU), which could be voluntarily adopted by GATS members. 276  A stalemate was reached, however, at Seattle in 1999 in the Third Ministerial Conference of that year. More problems with the Doha Round, which particularly aimed at the further liberalisation of the trade in services and agricultural and non-agricultural products, emerged at Cancun in September 2003 (which especially considered the so-called Singapore issues: competition policy, investment, trade facilitation and government procurement, subsequently dropped except for trade facilitation). It did not strictly speaking affect financial services, where, however a similar unease developed: see UNCTAD Report of 2004: The WTO Negotiations on Financial Services, Current Issues and Future Directions. It led to a complete collapse of the Doha Round in May 2006 (because of the deadlock between the EU and US on agricultural subsidies and the unwillingness of some large developing countries to increase market access to the manufacturing and service industry). In the meantime, especially within the BIS Group of Ten, the enhancement of co-operation and co-ordination among banking supervisors has become a matter of priority. So has the establishment of strong prudential standards and effective supervision for which the BIS has been issuing guidelines, as will be further discussed below in ss 2.5.1ff. 277  The Understanding of Commitments in Financial Services was covered by the Final Act of the Uruguay Round but was strictly speaking not part of GATS. It was adopted by 31 WTO members at the time.

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be respected. As in trade, a separate Council (for services) was created to monitor the negotiation process and future negotiations. The emphasis on market access besides national treatment meant that national treatment under which foreign service providers could do no more than local ones and were held to the same functional separations (for example, between commercial and investment banking or broad and narrow banking) should not result in greater restrictions than those in the major service-providing countries. As already mentioned, GATS members should apply domestic regulation in a reasonable, objective and impartial manner to avoid undermining commitments to market access as one of the basic three rules. Yet it was always realised that, for example in the financial services industry, the barriers resulting from regulatory differences in terms of permitted activities, the way they could be conducted, and the financial products that could be offered would take a long time to overcome. It would require some deregulation and re-regulation subject to a minimum of regulatory harmonisation, probably also of competition policy. That is not the present aim of GATS but has been achieved within the EU. In fact, for financial services, the GATS contains a so-called prudential ­carve-out to ensure that the liberalisation would not endanger prudential regulation and ­supervision.278 A similar precautionary clause may be found in the North American Free Trade Agreement (NAFTA) and in the aborted OECD Multilateral Agreement on Investment (MAI). GATT rules never had direct effect and GATS rules are unlikely to be interpreted any differently. The EU experience suggests another direction, as we shall see and as has already been summarised in ­section 1.2.1 above. First, it substantially separates financial services from any other and accepts that regulation is here part of the product and not a separate issue that can be solved through transparency and/or liberalisation. Double regulation (by home and host country) is perceived as the true problem to be resolved through harmonisation of the basic regulatory principles and objectives and subsequent supervision of all cross-border services by the home regulator of the service provider only, except in special situations derived from considerations of the general good in the host country. These are, however, sharply curtailed in EU case law to avoid discrimination, duplication, lack of specificity and disproportionality. Subsequent Directives and implementing Regulations further limited the ambit of the general-good exception to home regulation as we shall see. Cross-border activities are here clearly defined and include the establishment of foreign branches, but foreign subsidiaries are always regulated by the host country subject to their rules (regardless of the freedom of establishment).

278  Para 2(a) Annex on Financial Services and Prudential Regulation. It assumes host regulation provided this does not constitute a means of avoiding GATS commitments. It may lead to some balancing of means and ends. See J Trachtman, ‘Trade and … Problems, Cost Benefit Analysis and Subsidiarity’ (1998) 9 European Journal of International Law 32.

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2.2.4  The WTO Calls for reinforcements of the GATT through conversion into an international or multilateral trade organisation as originally planned in the ITO had been frequent and were partly successful in the latter part of the Uruguay Round. As a consequence, as at 1 January 1995, the GATT was transformed into the WTO, of which the successor GATT and GATS became a part. It has modest administrative powers and, most importantly, a uniform dispute settlement procedure in all sectors of its activities with an international legal status for the findings. The old GATT had had at least eight different structures for dispute resolution, each depending on the nature of the dispute. All tended to be handled at fairly junior levels with appointments made exclusively by the GATT Secretariat, which also made the drafts of the decisions. There was much uncertainty and delay in the procedures and the status of these panels was therefore not high. Their underlying ethos was in fact diplomatic rather than judicial. This is notably different in the WTO. In the meantime, the original GATT agreements remained effective between parties not accepting the WTO or refused access thereto because of the lack of agreement on accession. WTO members could technically withdraw from the old GATT 1947 agreement, which the US did as at 1 January 1996, since it did not wish to be subjected to two different sets of rules with different parties. As the WTO only applies to the future, outstanding GATT disputes lost their legal basis for withdrawing parties, the reason why the US agreed to accept these cases for a period of two years after it ceased to be a member. The US also instituted a review panel for decisions of the WTO’s new dispute resolution mechanism and threatened to leave the WTO if in the view of the panel three consecutive cases went against US trading interests in the first five years. In the end, no such action was taken. As was mentioned before, the Final Act of the Uruguay Round embodying the Agreement Establishing the WTO also contained a set of Annexes and Ministerial Decisions and Declarations. These Annexes cover the various agreements on the trade in goods (the GATT as amended in Annex 1A, the GATT 1994 being legally distinct from the GATT 1947 and bringing all members up to the same level of commitment), in services (the GATS in Annex 1B), and in intellectual property rights (the TRIPS in Annex 1C). They also cover the dispute settlement procedure (in Annex 2), the policy review procedure (in Annex 3), and some special trade agreements such as those on civil aircraft and government procurement (in Annex 4, which alone may have a limited membership).279 By 1996, the WTO was accepted by 124 countries and its legal personality was fully recognised. China became its 142nd member in 2001 and Vietnam became its 150th Member in 2006, while Russia remained the main outsider until 2012. The WTO as it now functions is sometimes seen as a way to reduce US influence notwithstanding

279  See for the new dispute settlement system in particular E-U Petersmann, ‘The Dispute Settlement System of the World Trade Organization and the Evolution of the GATT Dispute Settlement System since 1948’ (1994) 31 CMLR 1157.

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the continuing lack of a majority decision-taking process. Yet it established (a) a new legal pattern of conduct, integrating all previous GATT agreements into one system including GATS, TRIPS and even TRIMS; and (b) a new infrastructure for trade relations with its own Ministerial Conference, General Council, Council for Trade in Goods, Council for Trade in Services, Council for TRIPS, Committee on Trade and Development and its own secretariat. Finally, (c) the WTO provides a forum for further negotiations. The WTO agreement complements in several respects the Bretton Woods Agreement and the structure agreed after 1945, although much changed over time. Together they provide a comprehensive system for the cross-border movement of goods, services and related payments and trade-related movement of persons and investments, although capital movements still remain outside the structure but are increasingly subject to their own market-induced globalisation process, originally mainly through the euromarkets (see ­section 2.1.1 above). In fact, it has already been said that the progressive liberalisation of the capital flows played an important propelling role also in other areas, not as an issue therefore of agreement between governments but as an autonomous force in tune with classic economic theory in which market forces favour unilateral liberalisation. The new system as a whole was intended as, and may provide, a reasonably effective basis for the international economic order in the first part of the twenty-first century. The G-7, made up of the most advanced economies, informally rules over it. This process is therefore not without a political component, as of 2009 moving into the direction of the G-20: see for these developments more particularly ­section 1.2.5 above. The EU as well as it members became WTO parties. This duplication was necessary because Member States retain certain powers, particularly in the area of movement of people and establishments across borders and of intellectual property rights, although the EU has sole power to conclude international agreements covering trade in goods.280 Where the EU has exclusive powers, Member States must vote as instructed by it.

2.3  The Creation of the EEC in Europe and its Evolution into the EU 2.3.1  The European Common Market and Monetary Union Since World War II, it has not been uncommon for regional trade pacts to emerge that are in essence deviations from the more global GATT approach and the MFN approach. The regional approach to trade of the EU when it was first created (as the European Economic Community or EEC) in 1958 was an important example and (for goods) in essence went against the MFN clause. It was under US influence allowed to develop (as long as trade barriers were not raised in respect of outsiders) because of its overriding political objectives aiming at reinforcing the peace in Western Europe through

280 See

EU Opinion 1/94 [1994] ECR 1-5276.

Part II  International Aspects of Financial Services Regulation 741

e­conomic integration. Article XXIV of the GATT now authorises and e­ncourages nations to form such regional trade arrangements as customs unions or free trade areas. Within these political objectives and as an expression thereof, the trade paragraphs of the EEC Treaty of 1958 aimed for its area higher than the old GATT. They were later amended by the Maastricht, Amsterdam and Nice Treaties and substantially replaced by the Lisbon Treaties of 2009. It consolidated all earlier ones and the newer ones into two documents or Founding Treaties: the Treaty on European Union (TEU) and the Treaty on the Functioning of the European Union (TFEU). In their key paragraphs on the free movement of goods, services and persons they remained in essence unchanged but there was substantial progression in the area of capital flows. Thus the EU envisages for its area not only the free movement of goods, now Articles 28ff and 34ff TFEU,281 but also of persons (Article 45 TFEU), of services (Article 56 TFEU) including the free right of establishment (Article 49 TFEU), of payments (Article 63(2) TFEU), and of capital (Article 63(1) TFEU). These freedoms together increasingly formed a unitary concept, now mostly referred to as the internal market (see Article 26 TFEU). Article 34 TFEU, which removes all non-fiscal barriers to the movement of goods, Article 49 TFEU, which concerns the right of establishment, and Article 56 TFEU, which introduces the free movement of services,282 and their predecessors were immediately given direct effect, although the latter more like an anti-discrimination measure subject to possible limitations if also applying in a non-discriminatory manner to domestic entities as we shall see below in ­section 2.3.3. Article 34 TFEU prohibiting quantitative restrictions on imports between Member States can also be so explained as we shall see. Also the free movement of persons (workers), established under Article 45 TFEU and, in support of the free right of establishment and the free movement of services, under Articles 49 and 57 TFEU, is cast more in terms of an anti-discrimination measure. Immigration remains a sensitive issue within the EU: see also Articles 21(2) and 114(2) TFEU, which require unanimity for the expansion of citizens’ rights in the area of their free movement. There thus were some differences from the outset between the various freedoms, and they were differently formulated. The freedom to move capital under old Article 67 was separate altogether and not considered to be unfettered—in deference to the Bretton

281  The present Art 34 TFEU in its original version concerned quantitative restrictions and all measures having equivalent effect on the free movement of goods but was extended by case law to include also qualitative restrictions: see Case 8/74 Procureur du Roi v Dassonville [1974] ECR 837, in which all trading rules enacted by Member States which were capable of hindering, actually or potentially, directly or indirectly, intra-Community trade were considered measures having an effect equivalent to quantitative restrictions. This had the effect of potentially evaluating all restrictive domestic rules in terms of legality and proportionality (besides its discriminatory effect), therefore also those applied to national sellers as long as they affected access by sellers of other Member States. Art 34 was in that sense considered an access rather than an anti-discrimination rule: see also text at nn 300–02 below. For interpretative guidance see also Directive 70/50 [1970] OJ L13/29, Art 3, which dealt with the effect of non-discriminatory rules when exerting a restrictive effect on trade that ‘exceeds the effects intrinsic to trade rules’. It tends to outlaw local (mandatory) standardisation rules and gave rise to subsequent Directives introducing EU standards. A good example is electricity sockets and plugs; the different shapes and sizes may, however, still be maintained on public safety grounds under Art 36 TFEU. 282  See for Art 34 TFEU, eg, the fundamental Dassonville case (n 281). See for Art 49 TFEU, Case 2/74 Reyners v Belgian State [1974] ECR 631 and for Art 56 TFEU, Case 33/74 Van Binsbergen v Bedrijfsvereniging Metaalnijverheid [1974] ECR 1299.

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Woods Agreements and international foreign exchange attitudes at the time. It was also denied direct effect (unlike the Bretton Woods Agreements) and could therefore not directly be invoked by EU citizens or entities operating on EU territory. It remained dependent on further implementation through Directives. In a similar vein, even after the end of the initial period in 1970, the free movement of payments under the original Article 106(1) was considered to be liberalised only as a sequel of any ongoing liberalisation in the movement of persons, goods, services and capital and was even then only achieved in the currency of the Member State in which the creditor or the beneficiary resided. This continuing limited direct effect of the original Article 106(1) was confirmed by the European Court as late as 1981.283 In fact, the freedom of movement of capital and payments was only established by the important Directive of 1988, which will be discussed in greater detail in ­2.4.1ff below. It was virtually a precondition for the liberalisation of financial services, even though in principle already freed, as without the free movement of capital and payments cross-border financial services remain practically limited. Yet in this area of the free movement of financial services, there remained important problems connected with the proper supervision of these services and of the entities rendering them cross-border, which, as we shall see, were solved only through a new generation of Directives of which the Second Banking Directive (SBD) (consolidated in the Credit Institutions Directive or CID of 2000 further updated in 2006), the Investment Services Directive (ISD), now replaced by MiFID (effective 2007), and the Third Generation of Insurance Directives were the most important. The CID and MiFID and their successors in the 2013 and 2014 Directives and supporting Regulations (CRD/CCR and MiFID II/MiFIR) will be more extensively discussed below in connection with the so-called European passport for these services.284 In the area of the free movement of goods, the EU operates a so-called customs union: Articles 28ff TFEU. This is an alternative to a free trade area. In the latter, there are no trade barriers, including tariffs and quantitative (and possibly qualitative) restrictions for goods originating in Member States, but not for others,. and there is no common outside customs regime and goods coming from third countries remain subject to the customs restrictions of each Member State, even if these goods have been properly imported into one of them. The origin of goods has therefore to be established in any cross-border traffic between these countries and goods from third countries remain subject to each country’s own customs regime. Internal border checks thus remain in force. This problem is eliminated in customs unions. They have a common outside customs regime and no inside customs restrictions in respect of any goods, once properly imported or produced in any of the Member States. That has been the EU system from the beginning, now reflected in Articles 28 and 29 TFEU. It is supplemented by ­Article 34 TFEU, which eliminates all quantitative restrictions and, importantly, under 283  Case 203/80 Guerino Cassati [1981] ECR 3211 and also in Cases 286/82 and 26/83 Luisi and Carbone [1984] ECR 377. 284  See for a good overview of the old and newer regimes in the EU at the time, E Lomnicka, ‘The Single European Passport in Financial Services’ in BAK Rider and M Andenas (eds), Developments in European Company Law (London, 1996) I, 181. It was in part superseded by the 1998 Action Plan and new Directives flowing therefrom, see ss 3.4 and 3.5 below. See s 3.7 and s 4.1 for the amendments and extensions after the 2008 financial crisis.

Part II  International Aspects of Financial Services Regulation 743

case law interpretation, also all qualitative restrictions as already noted except if justified on grounds of public morality, public policy or public security: Article 36 TFEU. Special rules existed from the beginning in respect of agriculture where the Common Agricultural Policy (CAP) has traditionally been a social policy device for the reorganisation and modernisation of agriculture within the Union over a longer period of time. In this it has been largely successful although at great cost to taxpayers and consumers. Its progressive dismantling has often been demanded, especially by countries like the UK. There is also an increasing demand for it in the WTO. In any event, the cost hardly allowed for the expansion of this agricultural regime eastwards in Europe to its new EU Members and further modification followed although over a longer period. Through the addition of the freedom of movement of persons, services, capital and payments and the related free right of establishment, the EU was from the start meant to be much more than a mere customs union. It wanted to be what economists call a true common market, supplemented by its own competition, dumping, and state aid rules. It envisaged also a monetary union, both to be accomplished by 1970 (Article 2 of the original treaty). In the event, it took the Single European Act 1987 substantially to complete the common market with its basic freedoms of movement (including the financial services) by 1992 and the Maastricht Treaty of 1992 (which entered into force on 1 November 1993) to achieve monetary union. In addition, the Maastricht Treaty envisaged a common currency (for most Member States) by 2002. This common market and monetary union are also referred to as the First Pillar of the EU. In the Maastricht Treaty, this Pillar was given many new facets in the health, safety, consumer, environment, economic and social policy areas. It also introduced a European citizenship concept. At Maastricht, the First Pillar was joined by a Second and a Third Pillar. The Second Pillar considered co-operation in foreign affairs and security matters and could also lead to the eventual inclusion of defence matters. The Third Pillar concerned co-operation in the fields of justice and home affairs. These matters are now dealt with in the TEU. As just mentioned, citizenship of the Union was introduced through the First Pillar. The abolition of all border controls on passports was achieved by all Member States from before the 2004 expansion into Eastern Europe, except for the UK and Ireland through a separate treaty (of Schengen) and was originally outside the EU set-up (even the Third Pillar). This was changed in the Treaty of Amsterdam of May 1999 under which the Schengen acquis was put in the Third Pillar but it did not affect all Members. At the same time, the asylum and immigration policies were moved from the Third to the First Pillar (Title IV of the EC Treaty).285 Neither change affected the UK or Ireland. The EU further distinguishes itself through its organisational structure, which centres around the Commission, the Council of Ministers, the ECJ and the European Parliament, now supplemented by the European Council and in the euro area by the ECB. Although they operate most specifically in the First Pillar, they have a broader but different EU function within the other Pillars. The Commission, Council and Parliament 285  It means that these policies can now be promoted by the established EU institutions like the Council of Ministers and Commission and may (with limitations especially devised for this area) be tested by the European Court of Justice.

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operate through a system of decisions, Directives and Regulations in the areas within their competency (although they may also issue non-binding recommendations and opinions). For the Commission, the promotion of the common market has always been the main objective accompanied by its special powers in agriculture, transportation, competition, dumping and state aid matters. Although from the beginning an ever closer union was envisaged by the Member States, as reaffirmed in the Maastricht Treaty and now also in the Preamble to the TEU, the EU set-up is not tantamount to the structure of a (federal) state. That idea was voted down in referenda in France and the Netherlands in the events leading up to the Lisbon Treaties. In fact, the earlier EU was largely a political framework within which the then existing Communities (the Economic Community, Coal and Steel Community and Euratom) in the First Pillar and the other two Pillars operated. Only these Communities had legal personality (the Coal and Steel Community having in the meantime come to an end in 2002). This created some problems but there was a so-called reflex effect through which common principles from the various Communities were applied to the EU framework as a whole. The European Communities’ own legal order in any event suggested and supported a similar framework for all aspects of the EU and that is now recognised in the Lisbon Treaties: see Articles 228ff TFEU. In all of this, the Member States remain officially sovereign and the EU and the European Communities can operate only in areas delegated to it by its Members. Its jurisdiction is therefore exceptional and based on the relevant treaty law, the interpretation of which is left to the ECJ which, however, traditionally takes a flexible and expansive approach to the EU’s powers. In this connection, it (a) viewed the legal order of the European Communities, even though only of an exceptional and limited nature, as superior to that of the Member States in the areas covered by the various treaties; (b) was accommodating in its interpretation of the Union’s powers in the First Pillar; and (c) accorded in that Pillar citizens direct rights under the various treaty provisions (unless clearly not intended) and even under Directives addressed to Member States but affecting its citizens when remaining unimplemented. The ECJ’s attitudes in these aspects have proved to be of decisive significance in the development of the Union, although it may now be seen as too accommodating for the future: citizens and Member States often feel little protected by it against overweening EU competencies, whether real or imagined. Nobody explains anything. It is true that under Article 5 TEU, the ECJ is like all other EU institutions hemmed in by the principles of conferral, subsidiarity and proportionality. There is now even a Protocol on the application of the principles of subsidiarity and proportionality but these concepts remain undefined. If it is a fact that the ECJ has never taken its constitutional role in these matters very seriously, which—it may be argued—has reached the point where it started to corrode the confidence of the citizenry in the EU institutions, this perceived passivity of the ECJ in defending the citizens and Member States against the Union may itself become a further source of euroscepticism. The borderline between EU and national competences, not being clearly drawn, needs proactive defending. Lack of it may have contributed to Brexit in the aftermath of which indeed the role of the ECJ became a hot issue. In real life, no EU powers are ever given back even if in continually changing circumstances they might on occasion be better

Part II  International Aspects of Financial Services Regulation 745

exercised by Member States.286 Whether the further development of the Union through treaty and case law will eventually lead to a federal structure with its own statehood characterisation remains to be seen. The present limited nature of the EU explains the peculiar structure and powers of the Commission and Council and the role of the European Parliament, as will be further discussed in ­section 2.3.2 below. It has already been said that external autonomous pressures often led to further reinforcement of the community idea. Thus globalisation of the international markets finally allowed the completion of the common market through the Single European Act,287 the creation of the monetary union, and the emergence of the common currency (the euro, as will be discussed in more detail in ­section 2.4 below). The 2008 financial crisis and especially the problem of government debt reinforced the need for more supervision but also created a further source of resentment, not least also in countries that were not in trouble but were nevertheless also asked to surrender sovereignty. Common economic, fiscal and taxation policies, the latter especially in the area of VAT (value added tax), may then also be expanded so that one economic policy structure for the whole Union (or at least the eurozone) may emerge, pushed forward also by the operation of the single currency and its need for policy co-ordination in countries of the eurozone, especially in times of economic stress, as became clear in 2010, when several eurozone Member countries were facing the possibility of default on government bonds. External political and defence pressures, such as, for example, those originating in the Balkans in the 1990s or resulting from international terrorism, had earlier reinforced the role of the Union in the area of security and this is likely to continue. Internally, feelings remain divided on further progress along federal lines. The UK and the Scandinavian countries are traditionally more sceptical than the six founding Members (Germany, France, Italy, the Netherlands, Belgium and Luxembourg). Ultimately the UK opted to leave in 2016. It is a fact that the Union has been allotted ever greater tasks. It has already been mentioned that since the Maastricht Treaty, these tasks also extend into the health, safety, consumer, environmental, employment and

286  By 2005, it became clear that even in founding countries like France and the Netherlands more sceptical views started to prevail and a new Constitution for the EU as proposed in the meantime was rejected in these countries by popular vote, fanned also by extraneous concerns about globalisation and immigration. The project originated in the need to respond to the accession of Eastern European countries, expanding the Membership to 25 nations (followed by Romania, Bulgaria and later Croatia, bringing the number to 28), in order to deal with voting issues. In the event, the project went far beyond this more limited objective and amounted to a rewrite of the fundamental structure of the EU as a whole. Although the earlier Laeken Declaration had promised a rebalancing of the powers of the Union and Member States, the end result was rather perceived as a further power grab by the EU. 287  It followed an intergovernmental conference in Milan in June 1985 and was signed in February 1986. It came into effect on 1 July 1987 and brought together all the actions that were still required to complete the internal market and introduced qualified majority voting in all these areas and Directives or Regulations were subsequently used for the purpose. In the regulatory area, mutual recognition of home rule became the principle, subject to harmonised basic standards. Exceptions remained the areas of public morality, public order and health as long as they did not serve arbitrary discrimination or disguise restrictions. The internal market was to be achieved by 31 December 1992. The earlier history was that in October 1984 the Commission’s President at the time, Jacques Delors, had agreed with the British Prime Minister Margaret Thatcher that Lord Cockfield would be appointed Commission Member for the UK responsible for the internal market. He managed to inventorise the missing pieces and to propose a coherent programme in the 1985 White Paper that served as a guide for the Milan Conference. The programme was to last two Commissions and ended on 31 December 1992.

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social areas where Member States still fulfil more obvious roles. For the moment, the greater and deeper problem appears to be that the peoples of the EU sense more acutely than before that they may have lost their grip on a Union, then increasingly perceived as a self-perpetuating oligarchy with large and undetermined powers, whatever the truth. It is reinforced by suspicion of remote and unimaginative leadership, half-baked political promises, and lots of spin, also in Brussels. Perhaps few citizens in the past realised or cared that they had little say. As long as there were obvious advantages in the EU set-up and its progression, it was clearly not sufficiently problematic. Now it appears to be. It proved a misconception in this connection that improvement and greater legitimacy could come from increasing the powers of the European Parliament. That has long been tried, but the more powers the European Parliament were given, the fewer people came to vote. Its problem was that few could understand what it was doing. This was partly unavoidable, as it deals with complicated structural issues, but the suspicion was also that the parliamentarians had hardly any insight into the processes they were called upon to control and seemed themselves hijacked by the system. There was often no sufficient political acumen, priority, or will to explain. The rejection of an EU Constitution proper and the resistance to the transfer of more powers even after the government debt crises from 2010, are important indications of this attitude, to which, as has already been said, the role of the ECJ and its lack of interest to protect against overweening EU powers may also have contributed. The 2014 Single Supervisory Mechanism (SSM) for eurozone banks, see s­ ection 4.1 below, may be seen as some step forwards but does not affect the EU as a whole. Together with the accompanying Single Resolution Mechanism, it left further serious problems of protection of affected parties, see ­section 4.1.3. For the peoples of Europe to regain a grip and sense of participation, a more radical change may be required and three steps would seem to be necessary. First, a number of powers should be repatriated to the Member States. This was the original idea of the Laeken Declaration, which set the review process in motion and it should be clearly seen to be happening. There should be a precise list. Basically it should cover whatever the EU has taken since the Maastricht Treaty in terms of public health and safety, employment conditions, consumer protection and what is necessary to coordinate national security also needs regular updating. It may be useful if farm and regional support could also be repatriated. Second, the notion of subsidiarity should be defined so as to provide a clear line between EU and Member States’ competencies, and the ECJ should be seen to protect Member States’ rights. Third and most importantly, when: (a) there may be legitimate doubts about the necessity and proportionality of the EU’s measures to promote the internal market; (b) the line imposed by subsidiarity appears to have been crossed;288 or 288  A more attuned ECJ could be the arbiter in these first two points and decide whether referral to national Parliaments is necessary.

Part II  International Aspects of Financial Services Regulation 747

(c) it becomes obvious in clearly identifiable practical issues that the EU in view of its scale and clout could provide a better and more efficient platform for all but has no clear power, the matter should be referred—not to majority voting in Brussels—but to national parliaments,289 which should, in such matters, function as a second chamber, decide on a yes or no basis while the majority of Member States’ Parliaments should prevail. Every year at the same time, a period should be set aside in each national Parliament to decide such issues, therefore in the language and environment of each Member State, but simultaneously, so that one Parliament could learn from arguments in the others. There would be some price to pay for this retrenchment: the EU would no longer be able to figure as a catalyst for often much needed domestic reform. Member States in the past have very willingly used the EU back door to modernise what they could not achieve at home, while subsequently putting the blame on the EU when there was any adverse domestic reaction or consequence. Indeed it may be time that this tactic or facility, which has become another important source of the EU’s bad name, came to an end.290

2.3.2  The EU Institutional Framework and Legislative Instruments At this stage, it may be useful, for those who are not immediately familiar with it, briefly to summarise how the EU works at present. As already mentioned, the major institutions of the Union are the Commission and the Council of Ministers, both operating from Brussels, the European Parliament in Strasbourg (and sometimes Brussels) and the European Court of Justice in Luxembourg. There is also the European Council consisting of the heads of state or government and meeting biannually, at first established informally but recognised since Article D of the Maastricht Treaty of 1992 (after the Treaty of Amsterdam renumbered in Article 4 of the EU Treaty and now in Article 15 TEU and Article 235 TFEU). It is meant to provide the Union with the necessary impetus for its development, and defines general policy through political guidelines, therefore not in a formal institutional manner. It has no legislative powers. Yet its meetings are often of the greatest importance for the further development of the Union. The European Commission can best be seen as the executive branch of the Union but is also responsible for initiating all legislation and for the implementation of this legislation by Member States. Each Member State has one Commissioner, appointed by their governments, all at the same time, for four years. They are, however, supposed to act pursuant to their Union mandate and are not representatives of the government which appoints them.

289  290 

Here the Commission could take the initiative. See JH Dalhuisen, letter to Financial Times (London, 4 June 2005).

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The Council of Ministers represents the Member States’ governments, and their ministers sit on it depending on the particular subject at issue. It does not therefore have a fixed membership at the personal level. It is the decision-making body of the Union and enacts its legislation together with the European Parliament, but only upon the proposals of the Commission as it cannot initiate legislation itself unless specifically given such power under the treaties. Chairmanship of the Council of Ministers rotates among the Member States every six months according to the alphabet. The country holding the chairmanship of the Council of Ministers also has the presidency of the European Council. The Lisbon Treaties of 2009 following the Nice Treaty of 2001 make further provisions among others for the voting system in the context of the enlargement of the EU. The European Parliament is elected directly by the citizens but has a limited legislative function. It cannot initiate legislation, but must approve the Regulations and Directives unless the treaties decide otherwise or where it has delegated this authority.291 The idea remains that national Parliaments should exercise their basic parliamentary functions through their impact on Member State governments and therefore indirectly on the Council of Ministers. There is here a particular issue of national sovereignty against federalism. The European Parliament has, however, the final say on the EU budget and can also veto the appointment of Commissioners and may dismiss the Commission as a whole, the threat of which was sufficient to make the Commission resign in 1999. In most other matters it has a consultative role but its powers are constantly increased as the democratic credibility of the Union is at stake. Often reference is made here to a democratic deficit in the Union, which formally springs from the limited jurisdiction of the European Parliament. On the other hand, broadening the powers of the Parliament and sharpening the use of these powers, especially over the Commission, suggest the beginnings of statehood for the Union in a federal sense. The bigger problem is, however, that the EU citizenry does not sufficiently recognise itself in this Parliament and does not identify with it. The ECJ consists of one judge for each country, and the judges are appointed for a period of six years. The Court ensures observance of the EU treaties and generally deals with issues to which the Commission, Council of Ministers or Member States are party. That is especially so in enforcement actions against Member States concerning their duties under EU law (Articles 258 and 259 TFEU) or in matters of the legality of EU actions (Article 263 TFEU). The court may also be vested with special jurisdiction. It further deals with referrals from national courts on EU issues (Articles 3(b) TEU

291  As regards its legislative powers, the system is that in matters that are subject to a qualified majority decision in the Council of Ministers (rather than unanimity, which for harmonisation measures was abandoned under the Single European Act 1987 except in tax, labour and free movement of people matters), see Art 114(2) TFEU, the Parliament now has the right to two readings, see also Art 294 TFEU. The first is when the Commission sends a proposal to the Council. After comments of the Parliament and the Council, the Commission will then proceed to make a revised proposal or a ‘common position’, which is presented for a second reading to the Parliament. The powers of the Commission, Council and Parliament in the Second and Third Pillar are more limited and incidental.

Part II  International Aspects of Financial Services Regulation 749

and 267 TFEU). These national courts have a duty to refer these issues to the Court unless they are settled law. It should be noted in this connection that individual citizens or legal entities do not usually have direct recourse to the EU Court except when, as in competition matters, the Commission has decided against them or failed to render a decision (­Article 263 TFEU). When their rights under the treaties are curtailed by individual states, their normal recourse is to the competent state courts, which then must refer unsettled principles of European law to the ECJ. This supporting role of the domestic courts in EU matters under the guidance of the ECJ has been of great importance in developing EU law further and securing its impact domestically in each Member State in a coordinated manner. As regards the precise legislative instruments at the disposal of the Union, the basic ones are the various treaties themselves, Regulations and Directives. The treaties may in their various provisions be directly applicable (or self-executing) based on their (presumed) underlying intent. If so they do not need implementation. If not, they will need further measures at EU level. One of the major functions of the Court has been to determine the status in this respect of a great number of treaty provisions, certainly also in the areas of free movement of services, the right of establishment, and the movement of capital and payments as we saw in ­section 2.3.1 above. A Regulation is a piece of legislation of general application that implements the treaties and is directly applicable throughout the Union. It needs no further implementation by Member States. They were relatively rare outside the agricultural field but even there significant. Regulation 17 (now replaced) was probably one of the most important in setting out at an early stage the details of the regime for anti-trust enforcement within the EU. They are now becoming much more frequent also in the financial regulatory area as we shall see in ­section 3.7 below. By contrast, Directives, which must also have their basis in the treaties themselves, are in principle only directed at Member States and require implementation through domestic legislative channels. Member States usually have two years in which to do so. The details of this implementation in national law are left to the Member States and the results may therefore still vary between Member States, especially in the details. No or inadequate implementation may lead to action by the Commission before the ECJ. Under EU case law, a system of direct applicability of Directives has resulted for citizens if their state remains deficient in the implementation of these Directives, and they may in such cases be able to invoke them directly for their protection. The EU may also operate through recommendations and decisions. Recommendations are not binding but are often the precursors of Directives. In the financial services area, there were a number, such as those on Large Exposures (1986), Deposit Guarantee Schemes (1987), and the Code of Conduct for Securities Transactions (1977). Decisions are specific orders of the Commission, as in competition law, and sometimes of the Council (depending on their jurisdiction under European law) binding on the person or entity to which they are addressed. In the financial services area they are not important. Finally, opinions may be issued, which, like recommendations, do not have binding force (Article 288 TFEU).

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2.3.3  The EU Internal Market: Definition of Cross-border Services. Connection with Free Movement of Goods and Persons and with the Right of Establishment As we have seen, the operation of the EU internal market essentially concerns the free movement of persons, goods, services and capital. Together with the related right of establishment, these are considered the essential freedoms within the EU. For the purposes of the application of EU law, it is often crucial to determine whether there is cross-border activity within the EU as the four freedoms concern only crossborder movement. This issue has already been briefly discussed above in s­ ection 1.2.1 and for GATS in ­section 2.2.3 at note 274 above. Especially for services (which are by their nature non-material), this can be a difficult area, relevant in particular when it comes to regulatory restrictions. It should be noted in this connection that the regulatory regime devised by the EU Directives for financial services now applies to all relevant institutions whether or not they engage in transborder services, but host regulators can only get involved if there is trans-border activity. Hence still the importance of determining when this is so. Services may, for example, be solicited by a client from another EU country but effectively be rendered in the country of the service provider. They may also be merely incidental or temporary and then still be considered merely domestic. There is still another issue: the transfer of goods and rendering of services may be so intimately connected that it may be unclear which EU regime applies: that in respect of the transfer of goods or services. When, for example, goods are transported across borders, the transportation and insurance of them may still be a service, but sometimes they can hardly be distinguished, for example when educational books are sent as part of an education course, and both Articles 34 and 56 TFEU could be applied in that case. As already mentioned, in respect of services, the right to free movement was established by the direct effect of Article 56 TFEU. The Directives in the financial area which are based on it apply to all financial and investment services and, as just mentioned, institute a regulatory regime in respect of them whether cross-border or not, but involvement of a host regulator will depend on the cross-border nature of the activity. To better determine whether cross-border services are being rendered and therefore benefit from liberalisation under Article 56, a distinction can be made between a situation:292 (a) where services are rendered cross-border with movement on the part of the provider. This is considered a clear instance of cross-border movement, whether

292  It may be recalled in this connection that Art 1 of the GATS mentioned four partly overlapping delivery methods: (a) provision of services from the territory of one country into another; (b) within the territory of one country to a consumer from another; (c) by a service provider of one country through a commercial presence in the territory of another; and (d) by a service provider of one country through the presence of a natural person from that country in the territory of another.

Part II  International Aspects of Financial Services Regulation 751

the provider establishes in the host country a subsidiary,293 establishment or branch294 or other more than fleeting presence;295 (b) where there is a direct service rendered from abroad even if backed up by a fleeting presence—this is the area of direct services to be distinguished from an activity through a subsidiary, establishment or branch; 293  See the Luisi and Carbone case (n 283). In the case of a subsidiary, there is a new entity incorporated in the host state and regulated by it, it being assumed that the right of establishment does not prevent this or go that far. In the case of a branch or similar arrangement, there is the freedom of establishment to be considered and any limitations that may be put on it in terms of authorisation requirements. More incidental contact without a presence in the host country falls in the category of the freedom to provide services and raises the question what regulatory constraints the host country may still impose. 294  Branches should be understood here in the sense of offices without their own legal personality: see further n 295 below. It is true that especially in common law, bank branches have sometimes been given a status of separateness from the head office for withdrawal of deposits or payment instructions. This is often seen as an implied condition in a banking relationship for the convenience of the bank and its organisation, understandable in the days when bank-wide systems did not exist and each branch tended to operate on its own but it makes much less sense now. However, it never created a separate legal personality in branches and in the event of liquidity shortages of branches, head offices are normally held responsible, but under federal statutory law in the US (12 USC 633, 1828(q) 1994) no longer in the case of bankruptcy of foreign branches whose deposits were not guaranteed by the head office. There had always been doubt about a head office’s liability in this regard in the case of war or expropriation affecting foreign branches. Within most countries, bank branching is free from regulatory constraints, but notably not in the US where, under state law, there were traditionally states that prohibited all bank branching, limited it to the county of the head office or only allowed it state wide. Inter-state, the 1927 McFadden Act reflected and enforced the local restrictions at national level. In the US, there was generally a fear of big banks, which fear could not, however, survive the pressures of business. Since the 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act, bank-holding companies may acquire control of a bank in any state subject to some limitations. Banks may now also merge across state borders and create a joint branch network, although states may opt out of this. States may now also authorise new branches for out-of-state banks. Creating bank branches in other countries has always been subject to the authorisation of the host country (and may also require home-country approval) and often requires the dedication of some branch capital held in the foreign branch and supervision by the country of the branch. In the EU, the regime under the Second Banking Directive, effective since 1992, now consolidated in the Credit Institutions Directive of 2000 and 2006, established, however, for EU-incorporated financial legal entities the right freely to branch out into other EU countries subject to the authorisation and supervision of the (head office or home) regulator only, as will be discussed in more detail below. It is to be noted in this respect that banks may also operate in other countries through so-called representative offices, which do not make loans or take deposits in the host country but only act as originators of business for their head office elsewhere. In the US it is also common to use agencies that may make loans but receive only foreign deposits. Both agencies and representative offices in the banking sense are normally not considered branches but usually also need some type of authorisation in the countries in which they operate although this authorisation customarily falls well short of a banking licence and ordinary banking supervision. 295  What is an establishment or branch as distinguished from activity which is regular but falls short of it (and may therefore be a direct service) is a question of definition and depends on a degree of permanence. The ECJ in Case C-55/94 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165, decided the issue under what is now Art 57 TFEU in the light of duration, regularity, periodicity and continuity. An establishment/branch may therefore be deemed to exist in another country short of the physical appearance of a branch office. From a regulatory point of view, the situation may become identical and give rise to (host-country) authorisation and supervision requirements as if there were an actual branch office (although under modern directives even for such branches there is now basically home-country rule but that used not be the case under older case law as we shall see). See in the area of establishing jurisdiction pursuant to the EU 2002 Regulation on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and Commercial Matters (­Brussels I), Case 14/76 De Bloos [1976] ECR 1497, which required head office direction and control, and Case 139/80 B ­ lanckaert & Willems [1981] ECR 819, excepting an agent who merely negotiates business while basically free to arrange his own work, able to represent several principals, and merely transmitting orders for others. In Case 33/78 Somafer [1978] ECR 2183, the emphasis was on permanence and the possibility of binding the head-office company: see also Case C-439/93 Lloyd’s Register of Shipping v Société Campenon Bernard [1995] ECR 1–1961.

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(c) where the recipient moves to the provider, when the service may not be considered cross-border, especially if the account is held with the foreign provider; and (d) where there is no movement on the part of either the provider or recipient and the service itself moves.296 This situation involves telephone, fax or mail communications when the issue of the initiative and the role of advertising may come in to determine the cross-border nature of the service, but it gives problems with the location of follow-up services. Another idea is to determine (in cases under (d)) the location of the services on the basis of the place where (in each instance) the most characteristic performance under them must take place.297 It may be that (a) initiative, (b) location of account and (c) place of the most characteristic obligation all play a role depending on the facts of the situation.298 Services can thus be rendered by a provider directly from another Member State or through an establishment in the host state. Article 49 TFEU concerns the right of

The EU Commission in its Interpretative Communication on the notion of the general good in the Second Banking Directive (see [1997] OJ C209) highlighted the existence of an exclusive brief from the head office, the ability to negotiate and commit the company, and the permanence of the arrangement, leading together to a genuine extension of the head office. It always presumes that this type of establishment engages in the head office’s activity proper and is not merely a representative office, which often does no more than reconnoitre the market, establish contacts and examine business propositions. 296  Case 76/90 Saeger v Dennemeyer [1991] ECR I-4221; see also the Opinion of the Advocate General in Case C-384/93 Alpine Investment v Minister van Financien [1995] ECR I-1141. 297  In its 1997 Interpretative Communication (see n 295 above), the EU Commission focused on the preliminary question of when there was a direct cross-border service (or an activity within the territory of another Member State) if none of the parties moved. It examined in this connection the possibilities of locating the service at the place of the originator of the initiative, the customer’s place of residence, or the place where the contracts were signed. It found that none of these could satisfactorily apply to all the activities covered by the Second Banking Directive (now Credit Institution Directive). After much discussion the Commission in the end took the position that, where modern communication means were being used rather than actual presence of intermediaries, the place of the service should be considered the place where the characteristic obligation must be performed. This is so at least for the purposes of notification of the trans-border direct service to the home regulator, which became part of the mutual recognition process as we shall see. It may limit the cross-border concept considerably while for direct services it separates it from the whereabouts of the parties: see also s 3.5.2. This concept of ‘the characteristic obligation’ was derived from the 1980 Rome Convention on the Law Applicable to Contractual Obligations (Art 4), now superseded by the 2008 EU Regulation on the same subject and is here used only for the purposes of determining whether the procedure for notification of the home regulator must be used and indirectly whether the host regulators can become affected at all. The reference to the place of characteristic performance of the service seems to take preliminary activity like advertising and cold calling or other ways of seeking clients outside the notification requirement. European case law will eventually have to determine whether this approach connecting the service to the place of the most characteristic performance rather than to the place of the customer is the right one and can also be used outside the area of notification. Initiative and place of account may in this connection also remain relevant, depending on the particular facts of the situation. 298  The question is also of importance in the US in respect of the registration of securities in the US and the operation of foreign brokers there, but as the discussion in s 1.2.3 above showed, the question whether a service is rendered within the US is short-circuited by the definition of certain safe harbours rather than by defining the place of the transaction. The US approach to foreign investments is generally unilateral and translates into exemptions from the 1933 and 1934 Acts. There is no great interest so far in recognising foreign regulatory regimes or in a division of home and host regulator functions. This might be explained partly because of the absence of regulatory standards in many countries, including in the euromarkets. Yet there is a clear (unilateral) drift in leaving the professional investor (even if American) to his own devices when engaging in foreign investments (short of US tax collection in respect of them), increasingly also if these foreign investment are offered directly or indirectly in the US.

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establishment in this connection. As already mentioned, it is mostly considered a nondiscrimination measure and therefore of a somewhat different and less fundamental nature than Article 56 on the free movement of services. In any event, it has more of a support function in respect of the freedom of movement of goods and services, as indeed the movement of persons may also have. It could at least be argued that it is more normal to subject it to host-country rule, just like any other establishment on its territory. Although having direct effect, the freedom of establishment might thus be more readily restricted by a host regulator if locals are similarly limited in their activity, but notably not if the limitation is based on nationality or similar considerations.299 This is indeed the legal approach in which the ECJ continues also to guard against hidden discrimination amounting to the same thing.300 Even discrimination on the basis of differing qualifications is here sometimes treated as an indirect nationality issue.301 In other cases, a legitimate objective was required for discrimination in establishment based on urgent reasons of the general good: see for this concept more particularly ­3.1.1–3.1.2 below,302 thus subjecting the anti-discrimination provision of Article 49, at least in the area of professional qualifications, to the general-good excuses with, as we shall see, further references to the legitimacy of the objective and the discriminatory measures not going beyond achieving that objective while remaining proportionate. Free movement of persons could be similarly treated, at least if it supports the free movement of services or establishments: Articles 49 (paragraph 2) and 57 (­paragraph 3). It is also in Article 45 cast in the nature of an anti-discrimination provision while under Article 114(2) TFEU any expansion of the free movement of persons is subject to unanimity voting. It remains a sensitive area closely related to domestic immigration policies, although the right of EU citizens to move and reside freely within the territories of other Member States is fully recognised in principle (but not for residents that are not EU nationals). The more limited progress that may be expected in this area under the unanimity rule may well induce the ECJ in the meantime to more judicial action viewing free personal movement increasingly as a human right attached to the EU citizenship notion, which is, however, only a sequel (or additional right) to the nationality of the relevant Member State and does not so far replace it.

299 

Case 221/85 Commission v Belgium [1987] ECR 719 and Case 198/86 Conradi [1987] ECR 4469. Case C-1/93 Halliburton [1994] ECR I-1137 and Case C-330/91 Commerzbank [1993] ECR I-4017. 301  Case C-340/89 Vlassopoulou [1991] ECR I-2357. 302  Case C-106/91 Ramrath [1992] ECR I-3351 and Case C-19/92 Kraus [1993] ECR I-1663. In Case C-55/94 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procuratori di Milano [1995] ECR I-4165, para 35, there may be a more general statement included applying to all four freedoms. It was said that ‘national measures liable to hinder or make less attractive the exercise of fundamental freedoms guaranteed by the treaty must fulfil four conditions: they must be applied in a non-discriminatory manner; they must be justified by imperative requirements in the general interests; they must be suitable for securing the attainment of the objectives which they pursue; and they must not go beyond what is necessary in order to attain it’. One may recognise here the modern attitude of the Court towards the general-good exception: see also s 3.1.2 below, which for goods, however, seems not to have been adopted in the earlier Cases C-267/91 and C-268/91 Criminal Proceedings against Keck and Mithouard [1995] ECR I-6097 under Art 28 (ex Art 30), possibly restraining its original tenor under D ­ assonville (n 237), but it was adopted in an Art 39 (ex Art 48) case in respect of the free movement of persons: see Case C-415/93 Union Royale Belge des Sociétés de Football Association ASBL and others v Jean-Marc Bosman [1995] ECR I-4921. 300 

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On the other hand, originally the free movement of persons was not deemed so critical to the internal market (nor the right of establishment) except on a temporary basis. The free movement of goods and services was in fact seen as a substitute for the free movement of people who may produce for export or render services EU-wide from their home base (and were supposed to stay there). However, the free movement of persons may increasingly be considered a natural sequel not only to the EU citizenship but also to the existence of a unitary currency, which requires increased mobility of workers away from depressed regions. In any event, full freedom of movement of people appears a normal ingredient of an ever closer union. This might then also affect the right of establishment. Indeed, while the EU moves forward, the four freedoms are increasingly seen in parallel as a unitary concept, as already suggested in the 1995 Gebhard case, just cited, see also the discussion in ­section 2.3.1. In this approach, anti-discriminatory considerations may well become the essence of all newer case law in this area under which selling practices and behaviour are still subject to host-country rule, but as a matter of the general good (or public policy) of the host state only and subject to its limitations, which include the anti-discrimination concept: see ­section 3.1.2 below.303 Domestic restrictions are based on public policy, public security and public health or on the concept of the general good directly, a test of their legality and proportionality is unavoidable, even if the measures are not discriminatory, and domestic operators are subject to similar limitations, as the effect is still to keep outsiders away and deny them access, even if locals are also restricted. That is therefore also relevant for goods. In short, there will still have to be urgent reasons for any domestic regulation that has the effect of keeping others out. Domestic practices may in any event be outmoded, overly paternalistic or simply based on local attitudes that, as in the German beverages cases (Cassis de Dijon), indeed worked only to stop imports. It is unlikely, however, that the ECJ will be able to draw sharp lines here as has become clear in the area of the movement of goods. What domestic regulation may or may not survive can therefore not always be clearly predicted, although there seems to be more patience with it in the area of the movement of services304 and the freedom of establishment than in the area of the free movement of goods.

303  For goods, the Court in the decision in Keck may have taken a more formal attitude to domestic sales requirements looking at discrimination more legalistically or formally and not necessarily within the context of the general-good exception. This may suggest that there may still be some more room for domestic regulation concerning goods than may be justified on the basis of the general good only. In the case of services, on the other hand, the Court also seems interested in effective market access. It could mean that in the case of services, the Court in essence wants domestic deregulation (until re-regulation at EU level) or at least regulatory competition unless there are clear grounds against it derived from the concept of the general good (and its limitations). It may be more relaxed on this point for goods where it may now be aiming more particularly at the liberalisation of trade between the Member States rather than at liberalisation within these states where domestic regulation would continue to prevail as long as it was not discriminatory. Such could be more particularly justified if domestic regulation were based on considerations that have little to do with intra-Community trade and have only a lateral effect on it. 304  The omnibus Services Directive 2006/123/EC of the European Parliament and of the Council of 12 December 2006 proved a disappointment as it could not overcome (against the original idea) the power of the

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2.3.4  Early Failure of Full Harmonisation of Regulated Financial Services in the EU and the 1985 Breakthrough: Mutual Recognition of Home Regulation. The European Passport in Finance In the EU, before the Third Generation of liberalisation Directives (after 1988—see ­section 3.3 below), the liberalisation of cross-border services in the regulated services area, therefore especially in finance, proved complicated. Regardless of the basic freedoms in the original EEC Treaty, considerations of the general good by the different Member States allowed them, as we have seen, to retain specific regulatory protections against financial services and products coming from other Member States. In fact, local (host-country) circumstances and regulatory standards remained largely determining. In this way, even incidental cross-border services could be made subject to hostcountry rule. More regular services could lead the host country to require the creation of a branch of the foreign service provider on its territory subject to its own rules of authorisation, supervision of conduct of business and product control. This was normally motivated by altogether understandable concerns for the protection of (a) smaller deposit holders against (foreign) bank failures; (b) smaller investors against (foreign) brokers’ breach of fiduciary duties in the conduct of securities business; (c) smaller insured parties against abuse by (foreign) insurers through nonpayment; and (d) similar vulnerable investors in respect of their savings by guarding against unfamiliar or over-complicated life insurance and other investment products. These concerns were not, however, limited to the vulnerable and created altogether a major barrier to the free flow of financial services within the EU, as it led more generally to double regulation (by home and host state). Even though the basic notions of these domestic protections were not always so different, there was nonetheless a great variety in the technical details and sophistication in the various countries. This was so especially in the areas of agency law, as amplified by the local securities and exchange laws, to the extent existing, and the protections thereunder of the principal or investor in security dealings, also referred to as conduct of business rules, and of the local mandatory rules applicable to financial products and their sale. It took a long time before it became clear how to promote liberalisation under these circumstances. Another problem was the whole formal structure of domestic supervision, usually under central banks, ministries of finance, stock exchanges or similar supervisory bodies or insurance supervisory agencies, which was not always transparent and would have to be reconsidered. The approach originally chosen was full harmonisation of domestic regulation in the financial areas, but the progress through harmonisation Directives proved tortuous and the result modest. This was demonstrated by the 1985 White Paper that led in 1987 to the Single European Act, which host regulator and also still contained many exempted areas. In the end, it was not much more than a confirmation of existing EU case law. In fact more progress was made in the financial area where, as we already have seen, home regulation and its recognition is at the centre of policy. In view of many complaints, the Services Directive was ultimately not able to capitalise on this important precedent. The full implementation of the free movement of services in the EU thus awaits further action.

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sought at last fully to implement the internal market also for financial services by the end of 1992 (the 1992 Programme). In fact, it was clear by then that the traditional EU approach of harmonisation of basic principles EU-wide (pursuant to the predecessors of Article 115 TFEU) had basically failed in the area of financial regulation or at least had left too much still to be done. In fact, a purely legalistic attitude proved too complicated, time consuming and inappropriate to achieve fundamental progress while it also became clear that not all differences needed elimination and that there remained a role for local regulation, therefore for regulatory decentralisation in view of the different needs in different markets and in respect of different groups of interested parties. In the end, the EU bit the bullet and adopted a system of recognition of home-country regulation subject to harmonisation of the basic regulatory standards, with a limited area left for host-country rule as we shall see in s­ ection 3.1.1 below. This is now called the European passport for financial services; see further ­section 3.3 below.

2.4  The Effects of Autonomous Globalisation Forces on Financial Activity and its Regulation in the EU 2.4.1  Effects of the Free Flow of Capital in the EU. The 1988 Directive on the Free Movement of Capital The effect of the ever freer flows of capital worldwide—either achieved informally, in which connection the operations of the euromarkets have already been mentioned (see ­section 2.1.1 above) or more formally through government action—was a better allocation of resources internationally, but at the same time it undermined the B ­ retton Woods system of insulated capital markets and fixed exchange rates which, as to the latter, in any event had already collapsed in 1973. At times it also put considerable pressure on other fixed exchange rate (related) regimes as on the European Monetary System in the EU in 1992 and on the Asian and (yet again) South American fixed exchange rates in respect of the US dollar after 1997. The free flow of capital instilled an order of its own. Notably, it compelled governments to adopt a more considered borrowing policy as they lost the monopoly in their own home pool of savings. They must now compete in the international markets where interest rates are easily pushed up and credit ratings easily come down, also for governments, thus increasing the costs. Nevertheless, state borrowings are in aggregate higher than ever before, although substantial declines occasionally occurred, especially in the US and the UK in the latter part of the 1990s, but they acquired unprecedented peacetime proportions by 2009. It is true that the autonomous liberalisation of capital flows in this manner facilitated ever greater offshore capital and money market activity (even though often organised from existing onshore financial centres, especially London, in the case of the euromarkets). It was eventually supported and reinforced by derivative products such as (OTC) swaps (at first parallel loans), futures and options. Domestic capital flow restrictions

Part II  International Aspects of Financial Services Regulation 757

thus became less and less relevant and could in any event easily be circumvented: see also ­section 2.4.4 below. This trend not only opened up the EU, and allowed completion of its internal market and monetary union, but also supported the moves from the original GATT towards the WTO, which, like the Bretton Woods Agreement, never did cover the free movement of capital: see s­ ection 2.2.2 above. In fact, it also forced the EU to formulate a position towards its own continuing limitations on capital flows and ultimately allowed it to overcome its inability to act more decisively in this field and in the related area of cross-border financial services. The liberalisation of the movement of capital happened mainly through the 1988 Directive on the implementation of Article 67 (old) of the EEC Treaty,305 effective as at the middle of 1990, the importance of which can hardly be overestimated. It completed the free movement of capital EU-wide (although it resulted in fact in worldwide liberalisation of the EU currencies) and superseded in this respect a timid first Directive of 1960, amended in 1962, 1985 and 1986, as well as a 1972 Directive on regulating international capital flows and neutralising their undesirable effects on domestic liquidity. It laid the ground work for the liberalisation of the attendant financial services EU-wide.

2.4.2  The 1988 Directive and the Redirection of Savings and Tax Avoidance Issues. The 2003 Savings Tax Directive The 1988 EU Directive liberalised all movements of capital including the important area of current payments306 at the prevailing market rate for the latter (thereby doing away with two-tier foreign exchange rates) and became effective in the richer EU countries in 1990 (1 July). Spain and Ireland had to join by the end of 1992, and Greece and Portugal in 1995.

305  Council Directive 88/361 EEC [1988] OJ L178. Earlier the situation had been that, although under Arts 67(2) and 106(1) on current payments and capital movement, supplemented by separate provisions on exchange rate policy, economic policy, and balance of payments, financial policy had been brought within the framework of EU competency, it was done without undermining the authority of Member States in these areas. It followed that although exchange rate, economic and monetary policy were made matters of ‘common concern’, national sovereignty was preserved in these areas. The Treaty provided for a Monetary Policy Committee but it had no original powers. National currencies and fixed exchange rates remained the norm and Member States were able unilaterally to adjust the value of their currencies. This system became inefficient, however, and increasingly impacted adversely on the movement of goods, services and investments. This created room for the 1988 Directive and later for the completion of the Monetary Union for Member States adopting the euro (on 1 January 2001). 306  Free movement of capital and payments are intimately connected as the free movement of the first necessarily results in payments for imports in terms of money transfers. The freeing of payments creates logistical problems in terms of clearing, settlement and cost which may affect and even destabilise the payment systems. Hence the continuing interest of governments and especially central banks in this aspect of the free movement of capital. This does not strictly result in further regulation or re-regulation at the international level in terms of affecting human behaviour. Rather any governmental involvement is here of a facilitating and streamlining nature and concerns the building and safeguarding of a proper infrastructure, which also needs co-operation between banks (which might still have to be imposed). The Bank of International Settlements (BIS), see s 2.5.1 below, has in fact been busy in this area since the 1980s, see Payment Systems: A Case for Concern (1983) and Security and Reliability in Electronic Systems for Payments (1985). Standards on international cross-border capital transactions were also issued in the Uniform Rules for Foreign Exchange Contracts (1980).

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The free movement of capital and money is now assured within the EU, although in the case of severe strain on the conduct of a Member State’s monetary and foreign exchange rate policy, temporary protective measures may still be reintroduced by the EU Commission. In urgent cases, this may even be done by Member States themselves, subject to the Commission’s amendment or withdrawal of the measure. With the emergence of the euro, these facilities have disappeared for the participating Member States. Outside the EU, the informal internationalisation of capital flows continues unabated. The 1988 Directive created almost immediate anxiety in (some) Member States about the effect on the flow of savings and on the tax avoidance implications, much of which was repeated when the euro came into force at the beginning of 1999.307 Concern had already been expressed in 1989, especially on the tax avoidance subject. It was also clear that the free movement of capital could divert scarce savings to the richest EU countries or to those offering the greatest tax incentives as it became possible for all investors to open bank accounts anywhere in the EU in any currency. A French government report, prepared by Pierre Achard at the beginning of 1988, highlighted in this connection the differences between Member States in taxes on investment products, such as withholding taxes, stock exchange taxes, and stamp duties, which could dramatically affect the place where national savings would be invested.

Subsequently the BIS set up a Group of Experts on an Inter-bank Netting Scheme. That led to two reports: the Angell Report on Netting Schemes (1989), which explained the role of netting in banks in terms of efficiency and allocation of risk, and the Lamfalussy Report on Inter-bank Netting Schemes (1990) (not to be confused with the later 2001 Lamfalussy Report concerning the European Action Plan for a Single European Market for Financial Services, see s 3.4.2 below). The latter report explained that especially multilateral netting schemes would decrease instability and risk and improve efficiency and emphasised the need for a solid legal basis. In turn, the BIS set up a Committee on Payment and Settlement Systems (CPSS) replacing an earlier Group of Experts in that field. It led to Core Principles for Systematically Important Payment Systems (2000), Core Principles for Systematically Important Payment Systems (2001) and Recommendations for Central Counterparties (2004). The CPSS also published several papers on e-money, including multipurpose prepaid card schemes: see its Survey of Electronic Money Developments (2000). Payments and payment systems also became a major concern in the EU, see eg MC Malaguti, The Payments System in the European Union—Law and Practice (London, 1997). Its first practical intervention dated from 1986, in a Commission Communication to the Council entitled Europe Could Play an Ace: The New Payment Cards. The idea was that cards used in one country could all be used in other EU countries in cash machines, which required a form of co-operation between financial institutions. The Commission subsequently issued a European Code of Conduct relating to Electronic Payment 87/598/EEC [1987] OJ L365. It required these electronic payments to be irreversible and that there would be open access to all systems. It also published a paper with Recommendations Concerning Payment Systems and in particular the Relationship between Cardholders and Card Issuers, 88/590/EEC [1988] OJ L317. In 1990, there followed a Green Paper on cross-border payment: Making Payments in the International Market COM (90) 447 final of 26 September 1990 but it took until 1997 before a Directive on Cross-Border Credit Transfers became effective in the context of further implementing the Economic and Monetary Union, Directive 97/5/EC [1997] OJ L043. It imposed minimum standards on the transparency of the conditions for cross-border credit transfers. Following the creation of the euro, Regulation (EC) No 2560/2001 on cross-border payments in euro [2001] OJ L344 was issued. It provides that charges for cross-border payments are to be the same as they are within Member States. 307  See also the December 1998 Proposal for a Council Directive to ensure a minimum of effective taxation of savings income in the form of interest payments within the Community: Community Preparatory Act 598PC0295. It was ultimately followed by the Directive on Taxation of Savings Income in the Form of Interest Payments: Directive 2003/48/EC of the European Parliament and of the Council of 3 June 2003 [2003] OJ L157/38.

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A request by France and Denmark either to institute a system of reporting of all foreign exchange transactions or to harmonise withholding taxes as a precondition to the free movement of capital was nevertheless defeated. The 1988 Directive (Article 5(6)) instead requested proposals from the Commission aimed at eliminating or reducing the risk of distortion, tax evasion or tax avoidance linked to the diversity of national systems for the taxation of savings. It became clear that possible answers were: (a) a uniform withholding tax EU-wide with a possibility of redistributing the proceeds (substantially) to the country of residence of the investor; (b) a reporting system of foreign exchange transactions; or (c) better co-operation between tax authorities by strengthening the 1977 Directive on tax co-operation308 and stopping Member States from using administrative means to frustrate the effect. A proposal followed in 1989309 requesting Member States to remove administrative obstacles to co-operation if there was considerable suspicion that large amounts of capital were being transferred to other Member States (this proposal was blocked by Luxembourg). There is now also a Council of Europe/OECD Convention on mutual administrative assistance in this area, effective since 1 April 1995 after ratification by the US and the four Nordic countries. Other EU countries followed, although as of November 2009, of the larger Members notably Germany and Spain had not so far done so (they only signed). Luxembourg, Austria, Ireland and Switzerland also remain outside the Convention as do the Eastern European countries except Poland. A revision was announced in 2009 of what in the meantime had become a G-20 concern. The Convention covers the exchange of foreseeably relevant information in the area of direct and indirect taxation (except inheritance tax and custom duties while signatories may opt out of any other tax they wish), but does not extend to assistance in criminal prosecutions. Taxpayers retain the typical protections of their own laws while a requested state will respect the due process rights it gives to its own taxpayers. EU efforts along these lines were abandoned at the time because of: (a) technical problems in uniform withholding tax, mainly caused by differences in view on the status of eurobonds, euro deposits and related swaps, and on the position of non-EU debtors generally; (b) bank-secrecy problems with regard to reporting duties; and (c) the expected avalanche of requests in the co-operation area. More importantly, it was feared that further elaboration of these measures would result only in capital flight from the EU as a whole. However, particularly the harmonisation of withholding taxes continued to reappear regularly on the EU agenda, culminating in a proposal for a Directive in December 1998. It put the burden of collection on paying agents, which might leave the EU under those circumstances, as paying agents from outside the EU would not be subject to its jurisdiction. There was no allocation of the taxes collected by Member

308  309 

Council Directive 77/799/EEC [1977] OJ L336. COM (89) 60 final [1989] OJ C141.

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States either. The level of the withholding was put at 20 per cent, which was only to be a credit towards any final tax resulting in respect of this kind of income. The UK originally blocked these proposals while emphasis was put on an exchange of (tax) information. The alternative thus became disclosure by the paying agents of the investors. Pressure was put on non-EU countries to co-operate in a similar approach. This concerned tax havens but also Switzerland. EU countries like Belgium and Luxembourg, on the other hand, preferred a withholding tax. In June 2003 agreement was reached, in the sense that EU Members were given the option of withholding or disclosure. This so-called Savings Tax Directive became effective as of 1 July 2005.310 Co-operation of Switzerland and many tax havens was in the meantime assured, but notably not of countries in the Middle and Far East. The withholding was to increase in three steps, from 15 per cent at first, to 25 per cent after 2008, and 35 per cent in 2011. Countries of the residence of investors were to receive most of this money (75 per cent). Early indications were that not much tax was collected while confidentiality continued. Elsewhere, the repeated taxation feature inherent in all taxation of savings may be better understood. In the US, the tax on dividends was halved in 2003. This does not yet apply to interest income on bonds. It is clear that an ageing population needs greater protection of their savings against tax, most certainly also against any repeated taxation that follows from the annual taxing of income derived from after-tax savings.

2.4.3  The 1988 Directive and the Movement of Financial Products and Services The immediate result of the 1988 Directive was freedom of movement of savings although a further Directive in this connection on the management and flow of pension funds at first ran into serious difficulty in 1994: see ­section 3.6.4 below. The idea was freedom for all types of investment products sold cross-border. In this vein, the scope of UCITS was also extended (see s­ection 3.5.14 below) while efforts were even made to include funds of the closed type. The problem that sophisticated products from elsewhere might reach an unsuspecting public became largely a generalgood concern mentioned in ­sections 3.1.1–3.1.2 below. As noted before, the free movement of money and payments must be distinguished from the free movement of financial products and services and the right of establishment. Yet, the 1988 Directive was a major incentive to promote the free movement of financial products and services as was the globalisation of the financial markets itself. This will be discussed further in ­section 3.3 below in connection with the liberalisation Directives (the SBD and the ISD) concerning the movement of financial services and their supervision in the early 1990s. Under these liberalisation Directives, financial intermediaries may freely operate cross-border subject mainly to home-country regulation, as we shall see.

310  Directive 2003/48/EC of the European Parliament and of the Council of 3 June 2003 [2003] OJ L157/38; see also n 307 above.

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This is only to repeat that they were not merely the result of the political will of the EU countries, but must be seen against the background of a much broader autonomous liberalisation process in the context of the worldwide globalisation impact that affected the capital flows more generally and liberated them, which also made the further liberalisation of the flows in financial services cross-border possible.

2.4.4  The 1988 Directive and Monetary and Exchange Rate Aspects of the Free Flow of Capital. The 1997 Stability Pact Another concern raised by the 1988 Directive was the conduct of future monetary and exchange rate policies in an open system. It was already clear by that time that one of the consequences of the internationalisation of capital flows was that foreign exchange and quantitative restrictions on credit at domestic level could easily be circumvented by loans denominated in foreign currency, swapped back or hedged into domestic currencies, thus indirectly creating liabilities in the latter. Domestic interest rate policy then also runs the risk of becoming ineffectual, as for example an increase in rates to limit the domestic money supply is likely to be neutralised through the free inflow of foreign funds. On the other hand, as governments have long lost the ability to influence longterm interest rates and indirectly the cost of borrowing in their own currency, international monetary discipline appears enhanced but is increasingly exercised through the markets and their interest rates rather than through the monetary authorities. In Europe, these internationalising tendencies require monetary policies to be increasingly conducted at international (EU) levels and possibly even the related economic and fiscal policies. Except for the already mentioned emergency measures in the 1988 Directive, in 1988 these subjects were left to the future and were notably not part of the 1992 plan to complete the common market. They were, however, covered in the 1992 EU Treaty on economic and monetary union (EMU) as part of the Maastricht agreements, which entered into force on 1 November 1993 and introduced also the aim of a single unitary currency (euro) with monetary policy conducted by an independent central bank (ECB) by 1999 at the latest, Member States always retaining, however, a voice in exchange rate policies. In lieu of a uniform economic and fiscal policy, the EMU agreement formulated the notion of convergence in inflation and interest rates, government spending and public borrowings to support the operation of a single currency. It was supported by a so-called Stability Pact as part of the 1998 Amsterdam Treaty, allowing for a system of fines for misbehaving Member States. The political coherence on which this framework may ultimately prove to depend can only be expected in a treaty for greater political union. It was left alone in the Lisbon Treaties of 2009. In the course of 2002 and 2003, the Stability Pact was tested, especially in France, Germany and Italy, which all exceeded its limits at a time of higher domestic unemployment rates in these countries. Many expressed the view that in times of economic decline, the restrictions on government expenditure and borrowing were not suitable. Others noted that the true source of the problems was that in good times government

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debt had often not been sufficiently reduced to allow more governmental borrowing in bad times. The Pact was substantially weakened by agreement in the European ­Council in 2005. It came under much greater pressure after 2008 in view of the measures EU governments had to take to contain the financial crisis. Following the Greek sovereign debt crisis in 2010, this area was being urgently revisited. In the context of the euro, the emergence of the ECB within the European System of Central Banks (ESCB), composed of the ECB and the European central banks, makes a great difference in terms of monetary policy co-ordination, although the old structures remain in place for co-operation with the central banks of non-participating Member States.

2.4.5  The Single European Market for Financial Services and its Relationship to the Euromarkets The 1998 EU Action Plan for a Single European Market for Financial Services was mentioned above in s­ ection 1.2.1. It separates banking and capital markets activity. For the latter, it did not take the deregulated and efficient eurobond market as its point of departure. In fact, neither had the earlier liberalisation Directives already referred to. On the contrary, in so far as operating from EU territory, it tried to bring the international markets ever more into its system. Although it sought to depart from purely domestic regulatory concepts and needs, it did do so without a clear appreciation of what globalisation in this connection had already achieved in terms of deregulation at the local level and re-regulation often on the basis of industry practices as a form of self-regulation at the international one. Under the 2003 Prospectus and Transparency Directives, as well as in MiFID as successor to the ISD, an important key was to determine to what extent some unhealthy concern for domestic (regular) markets and their survival and protection survived or re-emerged, also at the level of the incorporation of the relevant Directives into the laws of the Member States. These developments will be further discussed in ­section 3.5 below.

2.5  Developments in the BIS, IOSCO and IAIS. The International Harmonisation of the Capital Adequacy Regime (Basel I, II and III) 2.5.1  The Functions of the BIS, IOSCO and IAIS In terms of financial liberalisation and the efforts to re-regulate at an international level, the involvement of the BIS, IOSCO and IAIS must be carefully considered. The origin and role of the Bank of International Settlement (BIS) in Basel, ­Switzerland, was briefly discussed above in s­ ection 1.2.4 in connection with the 1983 Basel Concordat concerning supervision of foreign branches of banks. It is the c­ learing

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bank of the central banks, originally created in 1930 to manage German reparation payments, and is directed by the central bank governors of the G-10, which are (or were) economically speaking the most prominent nations. Through its Committee on Banking Supervision, also called the Basel Committee, originally set up by the IMF and which has now 28 Member Countries represented by 45 regulators (see ­section 1.2.5 above), it also serves as a think-tank in the area of banking regulation and it is the author of Basel I, II, and III, through which its role became better known first in the original 1988 Basel Accord for a system of capital adequacy for banks laid down in its document on Convergence of Capital Measurement and Capital Standards, now called Basel I. In 2008, it was replaced by what became known as Basel II, which immediately proved its inadequacy in the financial crisis that ensued at the same time. It was thereafter further amended as Basel III, which is in the process of being implemented, in the EU, substantially in the period up to 2019, see further s­ ection 3.7.2 below. The original Basel Accord (Basel I) was based largely on a joint 1986 UK/US initiative which adopted the risk assets methodology to determine the minimum capital required in banks. This type of co-ordination was itself motivated by the globalisation of the banking industry. We are here primarily concerned with the business and regulation of commercial banking.311 Following Basel I, the BIS produced a number of further communications in the capital adequacy area, leading to a formal amendment in January 1996, while in 1999 it proposed a complete overhaul of the 1988 document, which was followed by further proposals in 2001, ultimately leading to Basel II, which became effective in the midst of the financial crisis of 2008–09. Basel I had often been hailed as rough and ready, but altogether a success although it had never been severely tested. Basel II was an immediate flop, undermining the credibility of Basel I and the Basel Committee at the same time. It remains to be seen whether the amendments following the crisis in 2008 and resulting in Basel III, which essentially retains the structure of Basel II, will fare any better. The essence is that it increased the capital requirements somewhat, introduced a leverage ratio to supplement them, and also introduced a liquidity regime as we shall see. These capital adequacy rules were originally meant to apply only to internationally active commercial banks (and therefore not to purely domestic banks), but this changed in the 2001 proposals. None of these rules had any binding force, but through the 10 central banks most directly involved in the BIS, they have in practice acquired

311  The BIS developed many other initiatives. Thus an early April 1997 BIS consultation paper on ‘The Core Principles of Effective Banking Supervision’ was directed at the supervision practice in developing countries in part in response to the Mexican financial crisis of 1994. It contained a set of 25 basic principles of effective banking supervision developed (unusually) in close co-operation with central banks outside the G-10. It requested supervision without political interference within a clear legal framework with operational independence and adequate resources. This went much beyond mere capital standards and insisted on the need for a proper banking licence and details the prudential requirements, including (besides the need for capital standards and minimum capital) an adequate infrastructure and resources, proper record keeping and information supply. The importance of an exchange of information between banking supervisors in the various countries was also stressed. See for the BIS role in modern cross-border payments and netting facilities, n 306 above and for papers issued after the 2008 financial crisis nn 15 and 155 above.

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the form of an international standard, are soft law in that sense312 but have been widely implemented also outside the G-10, most particularly in a legally binding form in the EU through its system of Directives, as we shall also see. The investment securities business misses a similar potent focus for the international and co-ordination aspects of modern regulation. In the Americas there existed, however, IOSCO, the International Organization of Securities Commissions, as a voluntary organisation of securities regulators based in Montreal. During the 1980s, many other securities regulators joined and this organisation now provides through its regular meetings and various committees a focus for international securities regulation, although not yet of the same standing as the Basel Committee. It often co-operates with the latter, particularly in the area of capital adequacy for universal banks. Efforts since 1989 to provide a worldwide capital adequacy system for other than commercial banks have so far remained unsuccessful. It appeared virtually abandoned by early 1993, although the BIS approach to netting (1994)—see ­section 2.5.5 below—was announced together with IOSCO and is also recommended for investment business. IOSCO’s most important early achievement was probably its 1998 Principles and Objectives of Securities Regulation, which contain a statement of best practices. It particularly seeks to prevent abuses connected with multi-jurisdiction securities activities. In the insurance business, there was even less international co-ordination between supervisors. The International Association of Insurance Supervisors (IAIS) is meant to fill this gap. Like the BIS, it is based in Basel. Its early main achievements were probably in its 1995 Recommendation Concerning Mutual Assistance, Co-operation and Sharing Information and in its 1997 Model Principles for Insurance Supervision. From the beginning, the BIS, IOSCO and IAIS tried to work together. They formed, for example, a Joint Forum of Financial Conglomerates in 1996 following the formation of the Tripartite Group in 1995: see more particularly ­section 1.2.4 above.

2.5.2  The BIS Capital Adequacy Approach for Banks. The Basel I Accord. Criticism. Basel II For reasons mentioned in the previous section, on the capital adequacy front regulation in most countries became largely based on the BIS model (Basel I and later,

312  The issue of soft law and its status are contentious, see for private law and the modern lex mercatoria, Vol 2, ch 1, s 1.6.3, where it was said that it is often the last throw of the legal positivists who do not want to recognise law beyond statist legal texts, but the true question is always whether rules of this nature have become customary or are general principle or reflect fundamental principle when they are law. In public international law, Art 38(1) of the Statute of the ICJ recognises this: if soft law is customary international law or general principle, it is hard law and nothing much otherwise and that is then to be proven. It does not necessarily mean that this law becomes self-executing but at least it puts an obligation on states vis a vis the international community to implement it. It must be doubted whether at this moment the Basel Accords are in the category of customary international law or general principle. They are not therefore law although there may still be some residual meaning, see in this connection AT Guzman and T Meyer, ‘Soft Law’ in E Kontorovich and F Parisi, Economic Analysis of International Law (Elgar Publishing, 2016), UC Berkeley Public Law Research Paper no 2437956, who take a sociological approach and posit that states may prefer this type of law as it is easier and cheaper to negotiate and also to violate.

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as of 2008, also on Basel II at least in more advanced countries, including notably the EU, now amended into Basel III as we shall see). Capital is then seen as the last buffer, especially in respect of credit, market and operational risk, thus when more targeted management of these risks has failed. It had no direct meaning in the area of liquidity risk as explained in ­section 1.1.3 above where the issue is minimum liquidity requirements to which Basel III now responds, although for the time being in an experimental way only. It is the area of asset and liability management (ALM). It was already said in this connection that since the lack of liquidity is the immediate cause of banking demise, capital adequacy requirements were never the direct answer to financial instability. It is the difference between balance sheet and cash flow insolvency, the latter being the more immediate threat to banks. To that extent Basel I and II may always have been improperly focussed. Basel I concentrated foremost on credit or counterparty risk. By requiring adequate capital in banks to cover this risk, it meant to protect the system better, not principally depositors (and not at all the owners or shareholders of banks), but primarily intended to reduce systemic risk which, through the payment system, interbank market and other connected activities as in swaps, CDS, and repos may result in extra dangers for the whole banking system when one of its major participants fails. It is the issue of connectivity discussed in s­ ection 1.1.2 above, which.it was submitted, is not the direct cause of banking instability, but may be an important contributing factor. Importantly, it also meant to create a better level playing field between banks internationally by reducing unequal capital adequacy requirements, which gave a competitive advantage to those banks that have a less strict capital adequacy regime. In the 1980s this was notably perceived to be the case in Japan and to a lesser extent in France. Basel I was considered successful in that it was widely adopted, but it was already noted that its actual effect in preventing bank insolvencies was much less clear as it was never truly tested. However, its method of requiring capital in respect of credit risk on the basis of a weighting of risk assets (in the manner discussed below) was considered sound in principle and has been maintained ever since. This asset approach was taken because asset values (depending on the risk of the borrowers and their capability of repaying their loans) tend to fluctuate more than those of liabilities (funding). All the same, the adopted method became widely contested because of its rough-and-ready approach to the weighting, which, as we shall see, allowed for only a few risk brackets or buckets and did not allow for any differentiation, especially upon the credit ratings of non-governmental debt, or for any diversification within the loan portfolio. Also there was a measure of subjectivity as to the risk classes in which assets fell and it proved easy to shift them to other classes. The result was some considerable subjectivity. Others felt that under Basel I, the banks were too much encouraged to invest in OECD countries’ debt (or bonds, which were zero-rated, meaning that no capital was required in respect of them) rather than in loans to business. The rules could thus easily distort the market. The overall minimum eight per cent capital requirement was also arbitrary, while, as we shall see, what was considered qualifying capital could be and was differently interpreted in different countries. It meant that a level playing field was not always achieved, which was in any event difficult to create in view of the very different emphasis in banking activity in the various countries.

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As a consequence, there resulted increasing pressure from the banking community to allow banks’ own approaches to capital adequacy to prevail subject to some minimum standards and the regulators’ approval for each individual bank, an attitude first accepted in principle under the 1996 BIS amendment, which started to require capital for position or market risk and introduced in this connection alternatively a value at risk or VaR approach: see s­ ection 2.5.5 below. The key is a form of self-assessment operating besides a standard approach, a facility which in Basel II was extended also to credit risk. Basel II also introduced a capital requirement to cover a bank’s operational risk, which is the risk connected with a failure of its organisation and systems. Here again some self-assessment may now take place as an alternative to the standard approach as will be explained below. This structure of self-assessment in respect of all three risks was maintained in Basel III, but notably does not go so far as to allow banks to also determine the capital needed, which remains based on a minimum of qualifying capital (as defined) and more fundamentally reassessed and increased (somewhat) in Basel III as we shall see in ­section 2.5.12 below. Basel II will be discussed in greater detail in s­ ection 2.5.10 below, and some calculations will be presented in ­section 2.5.14. It was not without early criticism either and was believed to have received banking co-operation mainly because it allowed in essence less capital in self-assessing banks (which were the large international banks), for which it became much criticised after the events of 2008–09 especially in respect of market risk for securitised products and off-balance-sheet items. Implementation was always likely to stretch out over several years subject to fine-tuning, especially in the more subjective aspects of risk management. Whatever the subsequent criticisms, the move into the direction of more individual capital adequacy assessments, which was maintained in Basel III, acknowledged, probably correctly, that systemic risk concerns could not be satisfactorily countered by standard capital adequacy rules alone, one system to fit all. It may be repeated in this connection that the great interest in adequate capital and its definition over the last 30 years, whatever the merits (including the early tendency to require ever less capital), was probably misdirected and weakened in any event the interest in liquidity management, which goes to the issue of cash flow insolvency. The lack of liquidity is the true killer of banks, not capital, the adequacy of which depends moreover on valuations. This makes it all the more subjective, especially in crises when asset values may vary greatly, while no regulatory bank capital in the region of eight per cent, as had become the norm, would ever appear to be sufficient to cope with adverse macroeconomic developments and crisis situations. That would require capital at a level that in normal circumstances would undermine the functioning of banks as we know them today in terms of providing liquidity to the economy at large. But it was found in ­sections 1.1.13 and 1.1.14 above that the main problem with this microprudential approach was its hard and fast rules which proved to be pro-cyclical and did not take properly into account the economic cycle, which, it was submitted, is the main task of macro-prudential supervision which remains in its infancy. Other set-ups are conceivable, such as narrow banking as discussed in ­1.3.6 above. It means a different style of banking altogether, which may not be able to ­recycle money (especially deposits) freely to the multitude, including smaller businesses, and

Part II  International Aspects of Financial Services Regulation 767

would therefore likely also have an adverse economic effect. Indeed in 2008–09 it became clear that in practice the present capital adequacy rules, geared to balance sheet insolvency, did not diminish the threat to large banks. Rather, when a liquidity crisis occurs it requires the intervention of lenders of last resort or policy measures of the most directly affected governments using taxpayers’ money. This appears to remain the only way to cope with (perceived) systemic risk. This was borne out in a dramatic way in the Northern Rock bank run in the UK in 2007 and much more generally through the issue in the 2008–09 financial crisis. For the perceived serious moral hazard implications, see ­section 1.1.12 above. Modern banking resolution regimes suggest that banking and government can be separated in such circumstances although that may be seriously questioned, see Part IV below. As already mentioned, Basel III introduced some liquidity rules, provides for a leverage ratio, narrowed the definition of qualifying capital, increased the capital requirements generally, and also required more capital to be held against trading, derivatives and off-balance-sheet products in particular. The short answer was thus more liquid assets and capital, but the real question still is how much more and what was to be the long-term effect on banking activity? The idea was that smaller was more beautiful, but even if one admits that many banks may now be far too large to be properly run, small banks are more risky and cannot provide the liquidity a modern globalised society requires. It has already been said several times that a liquidity squeeze of this nature has an adverse effect on society and is a dangerous idea, especially in times of economic difficulty. It now seems accepted that central banks take over in providing random liquidity to the system in such situations but once the initial panic subsides this hardly proves effective in directing it to the most efficient use. Rather, supported by an artificially low interest rate maintained by the same central banks, bubbles commonly result in real estate and stock markets, making the rich richer but leaving the broader economy behind. It was already suggested that it may have contributed to a low growth environment after 2008, especially in Europe. Regardless of the problems with methodology and their practical impact, the Basel Models became pace setting. Thus in the EU the Second Banking Directive, which was the basis for the completion of the internal market in banking services, was at first supplemented by the EU Own Funds and Solvency Directives,313 both of 1989 and based on Basel I. They entered into force EU-wide on 1 January 1993 and were consolidated in the Credit Institutions Directive or CID in 2000, now superseded by the CID 2006.314 It was joined by the Capital Adequacy for Investment Firms Directive covering investment banks. This new 2006 EU Directive in this area reflected Basel II for

313  Respectively Council Directive 89/229 EEC [1989] OJ L124, as amended (in minor ways) by C ­ ouncil Directive 91/633/EEC [1991] OJ L339 and Council Directive 92/16/EEC [1992] OJ L75; and Council Directive 89/647/EEC [1989] OJ L386, as amended (in a minor way) by Commission Directive 91/31/EEC [1991] OJ L17. 314  In the Capital Adequacy Directive (CAD), the EU also issued capital rules for investment services as a sequel to its ISD, which formed the basis for the completion of the internal market in investment services (1993). The CAD also applied to the securities operations of banks but was not at first directly derived from the BIS, which did not deal with market risk until the amendments of 1996, when the CAD was changed to conform.

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both commercial and investment banking and applied to all banks or investment firms incorporated in the EU.315 In the EU, Basel I and II were therefore not merely soft law. Basel III is also implemented in the EU through a new Directive: see ­3.7.3 and 3.7.4 below.316 In the US, the Federal Reserve System issued Risk-Based Capital Guidelines in 1988, updated in 1997 and again in 2007 to apply to banks and used in their examination and supervision.317 The US followed the Basel Models but maintained in addition a leverage ratio under which (for commercial banks) capital may not be less than 3 per cent of total assets. It is a rough-and-ready rule that was imposed during the 1992 savings and loans crisis, but was not part of Basel I. As we shall see, it was rejected by the Europeans for Basel II, but retained in the US and proved of more than transient interest during the 2008–09 financial crisis when high gearing in banks became a serious issue. It is now part of the revamped Basel III, which, again, also increased capital levels somewhat, while introducing also a liquidity regime as already mentioned, albeit on an experimental basis, it being traditionally the very essence of banking activity, individualised per bank, showing its management’s quality. Regulating it as one system for all may affect banking’s very nature.

2.5.3  Credit Risk, Position Risk, Settlement Risk, and Operational Risk. Liquidity Risk As we have seen, the original Basel Accord (Basel I) was in principle (and certainly initially) based on assessments of credit or counterparty risk only. It concerned the evaluation of the risk in banking assets and in that connection especially of the creditworthiness of bank debtors, basically borrowers, and the likelihood of their default. Risk asset ratios were developed to reflect that risk per asset class. In this connection, it calculated foremost the minimum capital required in respect of each and all balancesheet banking assets, which are assets that are loans or loan related and divided them in classes or risk buckets. This included from the beginning also bonds and other debt instruments held by a bank as investments in their investment book but not other investments. It followed that the sensitivity to credit risk was also considered in respect of other than typical banking assets, notably government and other bonds. The question then is the likelihood of default by the bond issuer or the issuer of any other

315  For the old and new EU regime, see also s 3.5.12 below. See for the amendments after the financial crisis s 3.7.2 below. 316  By the end of 2012, delay was unsuccessfully urged because of the negative effect on liquidity, late but not surprising. It was argued in ss 1.1.12/13 above that in view of the pro-cyclical nature of all banking, there is little point in limiting banks’ activity in bad times. They need to be cut down in good times. Basel III, although introducing a limited facility for counter-cyclical capital increases in good times, as we shall see, proved from the beginning that it was only meant to show action after the complete failure of Basel II, no more. Rather monetary, fiscal and banking policies should all be considered from a counter-cyclical perspective. Doing so for banks aligns macro-prudential policy closely with the monetary or liquidity policies. Thus the flooding of the markets with liquidity as a matter of monetary policy in bad times would acquire a sequel in reducing the capital adequacy and liquidity requirements for banks at the same time. 317  12 Code of Federal Regulations 208 app A.

Part II  International Aspects of Financial Services Regulation 769

debt instrument. Technically, this issue cannot arise in equity or real estate investments, although shares will also reduce in value when the issuer becomes less viable and real estate interests are equally market sensitive (including the value of mortgages held as security for real estate loans as banking assets). In this approach to commercial bank capital adequacy, there was at first no attention given to the position or market risk itself or to the settlement risk related to the transfer of market positions; it was only introduced in the 1996 amendments.318 Again, this concerns more particularly the bond (and share) portfolio or investment book of banks. It must be noted in this connection also that in terms of position risk, variations in the value of the loan book on the basis of prevailing interest rates (a special form therefore of position or market risk) and mismatches (gapping) between assets and liabilities (funding) in terms of maturity, currency or interest rate structures (fixed or floating), which may all be considered other forms of position or market risk, are traditionally not considered nor taken into account for market or position risk capital. On the other hand, the maturity mismatch goes to liquidity risk. Like credit risk, the risk connected with the mismatch between assets and liabilities is considered at the heart of a bank’s business but it was already said that unlike credit risk and now also market and settlement risk and even operational risk, traditionally it did not attract regulatory capital or even minimum liquidity requirements. As already mentioned in the previous section, liquidity management was largely neglected by bank regulators in the run-up to the 2008–09 crisis, and until such time only subject to forms of disclosure. The reason was that liquidity management is considered typical for banking and therefore primarily a matter to be decided by a bank’s management, but it has already been said also that lack of liquidity not capital is the true killer of banks, see s­ ection 1.1.3 above. It was true, therefore, that major factors that could influence a bank’s financial position and especially its stability were not considered in Basel I and its 1996 amendment, nor indeed later in Basel II. As a consequence, the final judgement on a bank’s viability could differ substantially from conclusions that could be drawn merely from its available risk capital. In the meantime, certain countries, like the US, had long required their banks to use other methods as well.319 The result was that banks could technically have quite sufficient capital under the modern capital adequacy test just before they collapsed as especially the liquidity of assets and the way they were funded (short or longer) were not considered. Moreover, while the capital required would itself reflect credit and market risk in general terms, it could as such technically still be adequate because banks did not write down their loan

318  Settlement risk is the securities operator’s type of counterparty risk, the risk therefore that transactions entered into will not settle on the appointed date. Shares are bought, but may not be delivered on the settlement date. Payment may already be sent and it may be difficult, time consuming and costly to retrieve. Equally costly and time consuming may be the enforcement of the claim to the shares, important if they have risen in value in the meantime, so that there is a theoretical loss for the buyer. Alternatively, the latter might have entered into the purchases to hedge some other exposure, which may then remain un-hedged and may show a loss. Settlement risk arises in trading by commercial banks in their investments but also in their trading of foreign exchange, swaps and repos or other products and commodities. 319  See especially the already mentioned leverage ratio, under which core capital must be at least three per cent of the balance sheet total—see s 2.5.2 above, s 2.5.12 below and also n 150 above.

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or investment portfolios sufficiently and therefore showed more qualifying capital than they really had.320 This is an important point and may fatally undermine any capital adequacy test as the capital shown in the balance sheet is in fact not there. In countries like Japan, future tax credits that might not materialise are habitually also taken into account to beef up the qualifying capital, in that case specifically allowed to do so under the prevailing rules,321 but it may also lead to a distorted view of the adequacy of a bank’s capital. To complete the picture, reference should again be made to the regulatory concern with operational risk, further discussed in ­section 2.5.10 below. It remains a contentious issue, in principle covering the inadequacy of systems and management, which is hard to judge in general terms, but since Basel II capital must be set aside against it although the methodology of determining the proper level remains subject to severe doubts.

2.5.4  The Risk Assets Ratio, Risk Weightings, and Qualifying Capital Under Basel I As we have seen, the risk asset ratio is one of the key notions introduced in the original Basel Accord (Basel I) and is now substantially used everywhere as a means of calculating a bank’s capital needs in respect of credit risk per asset class. This methodology requires a specific amount of capital in respect of this risk in respect of all banking or similar assets as defined and distinguished (or for the credit equivalent amounts of lending-related contingent liabilities). It adjusts the total value of the risk assets while using risk asset ratios, determines what capital must be set aside in respect of each of them and also defines what could be qualified as capital for these purposes. Depending on the nature of the credit risk, four basic scales of risk weightings or risk buckets were devised in Basel I (0, 20, 50 or 100 per cent): these so-called risk asset ratios indicated per class how much credit risk was assumed as a basis for the calculation of capital needed in respect of each type of (risk) asset. In this regard, lending to governments or government exposure, especially of OECD members and their agencies, or of international organisations like the World Bank and the European Investment Bank, required the least capital (0 per cent); ordinary commercial loans required the most (100 per cent) except for loans to guaranteed or OECD domestic banks, which attracted 20 per cent risk weighting and therefore covered much of the interbank ­market.322 Mortgage credit required only 50 per cent, being secured lending.

320  In 2017, the ECB issued guidance but no binding rules concerning the identification, management, measurement, and write-off of non-performing loans. An Addendum was issued in October 2017. 321  Earlier, Japan had also allowed industrial holdings to count as core capital, no matter their highly volatile values. 322  The importance is that all capital for credit risk of counterparty banks is thus reduced. That means that if loans attract eight per cent capital, this is reduced to 1.6 per cent if these loans are backed up by a CDS issued by a bank from an OECD country. In Basel II, as we shall see, this is changed: a bank has the credit rating of its country or its own as the basis for capital calculation.

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The values of all risk assets so adjusted were added up to arrive at one total against which capital had to be held. The issue then was how much and what qualified as capital in this regard. From the beginning, there were different categories of qualifying capital identified here, which could count either in whole or in part for these purposes: for example, equity and disclosed reserves qualified in full (Tier One). Undisclosed reserves, asset revaluations, general provisions and subordinated loans (Tier Two) did not qualify in total for more than Tier One capital, while within Tier Two subordinated loans did not qualify if in excess of 50 per cent of Tier One capital. Therefore, there were here two limitations. Deductions were made for goodwill and investments in unconsolidated subsidiaries and (at national discretion) for participations in other banks to arrive at the final qualifying capital. It may be noted at this juncture that some of the most important changes in Basel III were in the area of qualifying capital, notably by reducing the qualifying capital of Tier Two as we shall see. Perpetual bonds became Tier 1 subject to their potential loss of coupon, or conversion into equity upon a crisis (meaning capital falling below 6.125 of risk adjusted assets), or them being written down altogether in such circumstances as would also be the so-called CoCo bonds. Under Basel I, the qualifying capital was never to be less than 8 per cent of the total of the risk (-adjusted) assets. In other words, the total of risk-adjusted assets could not exceed 12.5 times the qualifying capital. It was assumed that central banks or other banking supervisors could increase the minimum capital ratio required per bank, depending on their assessment of its basic strength and the soundness of its business (this was made explicit later in the 2001 proposals and Basel II). This is indeed an important lever by means of which central banks dominate the banking scene besides their regular prudential supervision. See, for a simple calculation of the necessary capital under the 1988 Basel I system and the consequences of a banking supervisor increasing the eight per cent in respect of weakening banks, ­section 2.5.9 below.

2.5.5  1993 BIS Proposals for Netting, Market Risk and Interest Rate Risk. The 1996 Amendment. VaR From 1993, the BIS started to propose a number of amendments to the Basel Accord of 1988 (Basel I). They concerned the prudential supervision of netting (credit risk), of market risk, and of interest rate risk as a form of market risk. In the area of netting, the BIS came up with an agreed amendment in 1994 (formally incorporated in January 1996 together with the later agreed amendments covering market risk), allowing so-called bilateral netting for capital adequacy purposes as a accepted way of reducing credit risk (see also ­chapter 1, ­section 3.2 above). It particularly concerned the netting of all swap and repo positions between the same banks. The condition is 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,

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must accept the netting concept.323 As a consequence, it remains up to each country effectively to incorporate or clarify the notion of netting in its own legal system, 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.324 In the area of market risk, which covers the risk in interest-related instruments and equities in the investment book and the foreign exchange and commodity risk within a bank, the BIS proposal of 1993 suggested specific capital charges to cover open ­positions (including derivatives) in debt and equity instruments as part of a bank’s trading portfolio and in foreign exchange. It was based on a building block approach (see ­section 2.5.6 below) under which each identified risk in respect of each position, for example in respect of credit or market risk, was separated and required its own capital. Under it, a separate capital charge would thus apply to bonds for credit risk if not captured otherwise. The market (or general) risk was defined as the risk pertaining to interest rate-related instruments and equities in the trading book or investment portfolio and to the foreign exchange and commodity risks in a bank (the counterparty risk in these instruments is then called ‘specific’ risk). The proposed standard approach in respect of interest raterelated instruments, like bonds, depended on maturity and interest rates, resulting in standard position risk sensitivity. It led to a so-called haircut, which was the theoretically assumed percentage of a possible loss in market positions (for which qualifying capital would be required as safety margin) applied to ‘mark-to-market’ values of bond or note positions, different per type of product (including also derivatives in these instruments but excepting options for which there was a different methodology) and per currency. Only realised losses and write downs would be entered into the P&L. Offsetting under a hedge was as a matter of right only allowed (for capital adequacy purposes) in identical instruments of the same issuer, coupon, currency and ­maturity. For imperfect hedges, special offsetting rules were devised. For equities, the capital required was also based on a system of haircuts applied to ‘mark-to-market’ values. Under it, capital was equally to be set aside in respect of a certain percentage of loss per type of security based in principle on historical market performance of such securities. Under the 1996 Amendment, the charge for general or market risk in equity positions was put at eight per cent of each net position, irrespective of the type of company or liquidity of the share (and whether or not they were quoted on regular exchanges). A similar figure was used for market risk in interest-related instruments. In the calculation of the capital required for credit and market risk, first the bank’s capital needs were to be determined for credit risk (eight per cent of weighted assets under Basel I and II).

323  This became a vexed question in the meantime and 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 necessary in various countries, see also the discussion in ch 1, s 3.2 above. 324  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.

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It would show how much was left in Tier One and Tier Two to cover market risk under the capital adequacy rules pertaining to that risk, to which the eight per cent capital rule was also applied. A new Tier Three capital (see below) was also introduced in this co-action in the 1996 Amendment, which could only be used in respect of position risk (deleted in Basel III). See for a more detailed calculation ­section 2.5.9 below.325 In respect of market or position risk proper, the Fisher Report accepted for the first time, as an alternative to the just-explained standard approach, each bank’s own internal risk-management system and performance measurement but for market risk only and subject to certain minimum rules or conditions. Following further proposals of April 1995, it became part of the 1996 Amendment, which therefore allowed as an alternative a measure of self-assessment but only for market risk (‘value at risk’ approach or VaR). The aim was to require banks to disclose quantitative information showing their own estimates of their market risk, and the actual performance of their trading portfolio. It encouraged the use of various modelling techniques and was meant to allow a comparison of a bank’s own estimates of its exposures. Potentially, it meant disclosure to regulators of internal sensitivity studies calculating the amounts a bank, according to its own studies, was likely to lose by holding certain positions for some time, usually two weeks, against the actual outcome it had achieved, and thus to gain an insight into the effectiveness of modern risk management of the bank in question. It held out the promise of lower capital requirements for banks with better risk systems.326 In the VaR approach as ultimately agreed, the required capital would not need to be more than three times (the scaling factor) the average daily VaR (loss) during the preceding 60 days or that of the previous day if higher, provided banks could also show that they were not likely to lose more than the predicted amount in 99 out of 100 trading days during an observation period of one year. If it was more, the multiple could go as high as four. Further calculation details may be found in s­ ection 2.5.14 below. The basic problem with VaR is that if markets remain stable ever greater risks can be taken. Bank supervisors were advised to determine which banks would be allowed to use the new system and limit their capital supervision to an assessment of the reliability of in-house predictions over time. Banks with a less reliable record could be punished in terms of needing more regulatory capital. The risk-management systems of banks and their sophistication could thus become a competitive tool. The resulting 1995 Proposals were adopted in January 1996 (Amendment to the Capital Accord to Incorporate Market Risk). In allowing an alternative approach based on self-assessment (if at the time only for market risk), the BIS signalled a fundamental change in attitude. It was followed by the EU in an amendment of the EU Capital Adequacy Directive or CAD (see ­section 3.5.12 below) in respect of securities firms but it also applied to the securities business of commercial banks.

325  Tier Three Capital represented less permanent and more fluid capital to cover losses on trading activities and other market-related risks. It can only be used to meet capital adequacy requirements in respect of market risk and may not be more than 250 per cent of Tier One capital. It was deleted in Basel III. 326  A problem was, however, how to fit the quantitative risk-management information into the traditional accounting principles. This aspect was expressly not covered by the BIS. An altogether updated approach proposed to succeed VaR issued from the BIS in January 2016.

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In the area of interest rate, maturities and currency risk in the banking (loan) book, the BIS accepted from the beginning (1993) that a certain degree of mismatch was a normal feature of banking business but proposed at first to develop a measurement system (rather than an explicit capital charge) so as to identify very large mismatches. Again, this is asset and liability (ALM) or liquidity risk management. Ultimately, it was left to national authorities to determine what, if anything, was to be done. The 1994 BIS Discussion Paper on Public Disclosure of Market and Credit Risk by Financial Intermediaries (Fisher Report) expanded on the idea of disclosure and proposed public disclosure rather than disclosure to regulatory bodies only.

2.5.6  The Building Block Approach Credit and market risk may sometimes be combined in respect of one particular asset, such as bonds. There is also a settlement risk when they are sold or purchased as we have seen. More generally, to handle these risks for capital adequacy purposes, it is not now uncommon to distinguish between the (a) ‘building block’ approach of the BIS, followed in the EU; (b) ‘comprehensive approach’ in the US; and (c) ‘portfolio approach’ used in other countries (and earlier in the UK). In the building block approach, the risk of each product is broken down into credit risk and market risk, most clearly in a bond portfolio, where there is credit risk towards the issuer and interest rate or market risk in holding the bond itself. As already noted, the risks with regard to the issuer are in financial theory often referred to as ‘specific risk’ and the risk derived from market movements or general economic developments as the ‘general risk’ (or Beta),327 terms now also used in the EU in the CAD and its 2006 successor, the Capital Requirements Directive or CRD.328 The specific risk is less obvious in the case of shares than it is in the case of bonds, as share capital is normally not repaid, but shares do go down if an issuer becomes less viable. The Basel system also separates out the settlement risk of trading. This introduces an additional capital requirement depending on the length of any default in delivery or payment. In the meantime, in the US for security firms, the SEC stuck to its traditional comprehensive approach, which was considered too costly to change promptly. It imposes a straight haircut for all types of risks and also requires a minimum of liquid capital in security firms to protect customers against sudden liquidity shocks. In the portfolio approach, the required capital depends on the balance in the portfolio between long and short positions and on the diversification. It is a more academic

327  See E Platen and G Stahl, ‘A Structure for General and Specific Market Risk’, School of Finance and ­Economics, University of Technology (Sydney 2003). 328  For amendments of the CRD following the financial crisis, see ss 3.7.3 and 4 below.

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approach, which was for practical purposes simplified by regulators with some considerable emphasis on a liquidity minimum.

2.5.7  Capital for Derivatives In 1995, the BIS agreed with IOSCO on a Framework for Supervisory Information Supply about Derivatives Activity. This document proposed to create a catalogue for regulators in both the banking and securities industries to facilitate the assessment of derivatives risk and to provide a minimum common regulatory framework for these products. It focused on credit, liquidity, and market or position risk. Derivatives like forwards, futures and swaps were converted into long and short positions in the underlying instruments. For example, an interest rate swap under which the bank is receiving floating and paying fixed is treated as a long position in the floating-rate instrument (until the date of the next fixing) and a short position in the fixedrate instrument (for the remaining life of the swap) and is then made subject to specific (credit) and general (market) risk charges in respect of these positions. Long and short positions in the same underlying assets (same counterparty or issuer, coupon, currency and maturity) could be offset or netted for both credit and market risk. In the proposed methodology, credit risk in swaps was measured according to replacement cost and taken care of in so-called ‘add-ons’ for future exposure already foreseen in the original 1988 BIS Accord, which allowed for certain factors to be applied to the gross outstanding principal swap amounts, based on price volatility of the underlying contracts. Thus if a swap counterparty went bankrupt, the replacement cost of the swap would be considered at that moment and would depend on how much in the money the swap was. Collateral or margin could be deducted depending on quality and marketability. Risk concentrations were to be disclosed and credit ratings could be used to assess creditworthiness. For position or market risk in the underlying values, the VaR approach was suggested as one of the possibilities—see further also the next section. Liquidity risk was broken down into unwinding and funding risk. The 1995 Framework did not go into credit derivatives (CDS) which only developed later, and became an issue under Basel II and especially Basel III.

2.5.8  Contingent Assets and Liabilities. Off-balance-sheet Exposures. Credit Conversion Factors From the beginning (1988), the Basel guidelines also covered so-called off-balancesheet exposures, especially contingent liabilities. Derivatives mentioned in s­ ection 2.5.7 above are off balance sheet (unless in the money). Others, at first more particularly considered in the Basel approach were contingent liabilities (in terms of counterparty or credit risk) resulting under prospective loan or loan-related assets following any maturing funding or payment obligations. Standby lending commitments spring to mind. On the other hand, if a simple write-off resulted under a contingent ­liability,

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as in a lawsuit pending against a bank, it was treated as a loss and valued or provided for accordingly rather than as a contingency. In general, contingent liabilities (or assets) are either lending or investment related: both categories are of interest here and ­distinguished.329 The first ones broadly cover standby lending commitments or standby letters of credit, guarantees, and commitments to make or purchase loans or to participate in acceptances. They were indeed the ones originally contemplated in Basel I and present a form of leveraging, resulting, when taken up or maturing, in credits to customers or banking assets. They are then kept in the banking book, and treated as such for capital adequacy purposes. Investment-related contingencies, on the other hand, include futures and other forward positions, underwriting and other commitments concerning ‘when issued’ securities, standby underwriting facilities, securities borrowed or lent, sale and repurchase agreements, asset sales with recourse, foreign exchange contracts, options, and interest rate and currency swaps, the latter already dealt with in the previous section. These are kept in the trading book. If lending related, the prime concern in respect of these contingent liabilities is credit risk. If investment related, it will be position risk, although in the latter case there may also be a credit risk component, which may still be dealt with differently from other products in the banking book. Note here again a building block approach, see ­section 2.5.6 above. Securitisations present a special picture and pose the question whether the result is indeed that the assets are removed from the balance sheet or whether there are still some connected off-balance sheet obligations remaining, eg to continue to extend credit to borrowers or repurchase lower tranches in the securitisation. They may also be retained from the beginning. To calculate the credit risk capital requirements in respect of lending-related contingencies, specific adjustments depending on the particular nature of the contingency were introduced as of Basel I. They were the credit conversion factors (CCF) producing credit equivalent amounts in respect of these contingencies, all based on statistical models. They reflect the likelihood of these potential exposures maturing and are in the case of standby credits and guarantees applied to the n ­ ominal principal amounts of exposure to produce the credit equivalent amount, which is risk weighted according to the category given to the counterparty. Thus there are here two adjustments to find the risk-weighted asset value. For investment-related contingencies, if concerning derivatives such as futures and swaps, reference is made to the previous section. For other types, the relevant investment positions are commonly marked to market, which means valued at regular intervals, normally daily, on the basis of prevailing market prices or, in the absence of a market, with reference to market prices in related instruments. There was the further possibility of a VaR approach in terms of self-assessment. Any resulting profit will be considered at risk in a counterparty or credit risk sense (as a loan to the loser) and attract the r­ elevant risk asset ratio.330 So will be any other credit risk in these ­contingencies. Half of the 329  Note that contingent liabilities are not defined by the BIS, although lists of items appeared in the Annexes to the EU Solvency Directive (now incorporated in the Credit Institutions Directive of 2000–06). See n 155 above for criticisms after the 2008 crisis. 330  For credit and market risk in the underlying positions, they are broken down into short and long positions as explained in the previous section.

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profit for the time being could be taken into account as capital even if unrealised (as Tier Two). Any loss was immediately recorded in full, but could be reversed. Nominal values are here of no interest.331

2.5.9  Capital Adequacy Calculations Under Basel I. The Level Playing Field for Banks and the Effect of a Change in the Minimum Capital Requirement Many countries still operate on the basis of Basel I or a variation thereof. It is a relatively easy methodology. To demonstrate how the capital adequacy regime works under Basel I, it may be useful to give some simple examples. To calculate the credit risk capital, it is first necessary to look at the asset side of the balance sheet and determine which balance-sheet items are credit risk sensitive, like the loan book and the bond portfolio of a bank. One takes these various balance-sheet items and applies to them the risk asset ratios set by regulation, that is 100 per cent to unsecured corporate and 20 per cent to banking loans (to OECD banks), 50 per cent to mortgage loans, zero per cent to OECD government debt. The total of the risk-adjusted assets is calculated and measured against the qualifying capital, which must not be less than eight per cent of these risk-adjusted assets. To put it another way: a bank may have risk assets totalling 12.5 times its q ­ ualifying capital. So if it has three asset categories—OECD country loans or bonds, m ­ ortgage loans and other loans to corporates, each for US$100 million—its risk-adjusted assets are US$150 million and it needs US$12 million qualifying capital. Assume that it has US$5 million Tier One capital and US$10 million Tier Two capital, it will be US$2 million short, as Tier Two capital for this purpose cannot exceed Tier One capital. The bank must therefore attract another US$1 million in Tier One capital or reduce its loan portfolio in mortgages by US$50 million or in corporate loans by US$25 million. If there are off-balance-sheet exposures, they must (if lending related) be valued and a credit equivalent applied for credit risk purposes—see the previous section. Thus standby lending commitments may have a credit equivalent of 100 per cent applied, standby letters of credit (which are bank guarantees) of 50 per cent, both of their nominal values, and swaps gains (which result in a loan to the loser for the time being under the swap) of 100 per cent of their ‘mark-to-market’ value. Assume that the underlying values are in all three cases US$10 million and that the counterparty for the loan facility and standby letter of credit is a corporate and in the swap an OECD country bank. Applying first the credit equivalents, there result amounts of respectively US$10 million, US$5 million, and US$10 million. Applying

331  As we shall see, if under Basel II off-balance-sheet exposures resulted, eg when SPVs or SIVs were used to remove risk, any remaining exposure or guarantees required credit equivalents to calculate the capital charge while credit risk exposure to any asset class (in terms of large exposure) remained limited to eight per cent of a bank’s own funds. After the 2008 crisis the EU started to require that originators keep at least five per cent of the original loans under CDOs on their books so that these banks would remain concerned about the proper handling of the underlying loans—see n 24 above and s 3.7.3 below.

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the applicable risk weightings of respectively 100 per cent, 100 per cent, and 20 per cent to these amounts, the total risk-weighted assets resulting from these off-balancesheet exposures is US$17 million, for which the bank needs eight per cent or another US$1.36 million in qualifying capital. As mentioned before, one of the original ideas (besides generally reducing credit risk in banks) behind this system of capital adequacy for credit risk (only) was to create a level playing field for banks especially in setting the minimum capital at eight per cent. The other was of course to reduce credit risk in banks. But it has already been mentioned also that there may be other factors that affect the balance so struck. In some countries like the US, mortgage credit may be much more important than in others like Japan. In others, banks rely much more on off-balance-sheet business. The result is that the various risk weightings and credit equivalent amounts may play a very different role in the business of different banks. Also the minimum capital requirement of eight per cent may mean much less in countries with a strong (implied) governmental guarantee than in others where banks do not have it. Therefore, in the latter countries, banks, in order to be safe, may need more capital, which would affect their ability to compete with banks from the former countries. The uniform 8 per cent may therefore itself be a distorting factor. Tax and accounting rules may further distort, as may the risk buckets themselves. Thus a 50 per cent risk weighting for mortgage credit might be alright on the basis of the experiences in Western countries (although hardly for sub-prime mortgages after the 2007 experience) but may be far too little in speculative Asian real estate markets where a 150 per cent or even 200 per cent weighting could be more appropriate in view of past movements in real estate prices and in the value of the collateral they represent. On the other hand, within one country, central banks or other banking supervisors may vary the 8 per cent minimum capital standard and increase it for banks that they do not trust or whose business risk they want to reduce. It means that such banks must move into safer assets like OECD government bonds or reduce their loan portfolios. Even a mild increase in capital requirement can thus have a dramatic effect on a commercial bank, which in its ordinary banking (loan) business may soon become uncompetitive. The following simple calculation may show this for Bank A with a requirement of eight per cent capital and Bank B with a requirement of 10 per cent. Supposing they both want this business, for the same loan portfolio of US$100 million at a risk weighting of 100 per cent, Bank A needs US$8 million in qualifying capital and Bank B $10 million. Assume that both banks, in order to cover this need, issue a perpetual bond at five per cent (assuming further that Bank B with a 10 per cent capital requirement can still attract funding at the same average price of five per cent as Bank A), Bank B will have to issue US$2 million more and has an extra cost of US$100,000 per year. In order to recover this cost in full, it has to charge 0.1 per cent more on its loan portfolio of US$100 million. It is unlikely to be able to do so for competitive reasons, therefore makes less profit on the transaction than Bank A, and loses out further. In real life, Bank B can probably also not attract funding at the same cost as Bank A because it is not as good a bank. It therefore has an extra disadvantage. Moreover,

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Bank A can lend more (12.5 times qualifying capital rather than 10 times by Bank B). It shows that banking is not worth it if one does not belong to the league of best banks.332 To calculate the required capital to cover market risk in the standard approach after the 1996 amendment, a portfolio of, for example, (a) €500 million German government bonds at seven per cent with a remaining maturity of eight years; (b) €75 million corporate bond at eight per cent and a remaining three years’ maturity; (c) an interest rate swap with a notional value of US$100 million where a bank receives floating and pays fixed with a fixing every six months and a residual life of eight years; (d) a short position in a futures contract of six months concerning a €75 million deposit of three years’ maturity (meant to hedge the corporate bond portfolio of €75 million); and (e) a €50 million share portfolio (marked to market) in quoted securities, would be assessed as follows: For the first position, the risk sensitivity or ‘haircut’ is deemed to be 3.75 per cent of the ‘mark-to-market’ value; for the second position, it is 2.25 per cent (in view of the shorter maturity); for the third position, the position will be broken up into a long and short position, in respect of which the risk sensitivity is 0.70 per cent of ‘mark to market’ (six months’ maturity) for the long position and 3.75 per cent for the short position (eight years’ maturity); for the fourth position, the risk sensitivity is 0.70 per cent of the ‘mark-to-market’ value; and for the fifth position it is eight per cent of the ‘markto-market’ value. Assuming that in the above examples the ‘mark-to-market’ values in respect of interest-sensitive instruments are the nominal values, the risk-weighted assets’ value (before set-off) in (a) is €18.75 million, in (b) €1.6875 million, in (c) respectively €0.7 ­million and €3.75 million, in (d) €0.525 million, and in (e) €4 million. One of the more important issues is here, however, the treatment of the hedge and of the swap. They both concern the possibility of set-off for capital adequacy purposes. This is foremost a question of maturities. We have therefore a possibility of set-off between (a) and the short position in (c), resulting in a combined charge of €15 million. We also have a possibility between the long position in (c) and the short position in (d), resulting in a combined charge of €0.175 million.333 However, both set-offs in these imperfect hedges incur an additional charge of 10 per cent of the offsetting amounts, in this case respectively €0.375 million plus €0.0525 million. It follows that the total capital charge is €21.29 million against the total qualifying capital in Tiers One, Two and Three after deduction of the capital required in respect of credit risk in Tiers One and Two.

332  Note in this connection that under Basel II, in the Second Pillar, it was explicitly acknowledged that regulators could increase the capital requirement. This is normally kept confidential and the percentages are not published for any bank but it may now be assumed that if bank balance sheets deteriorate, more capital will be required by regulators. They probably always did but will be very mindful not to disable the bank even further in this manner and will not break the level playing field lightly. This is becoming a major issue where ‘banks too large to fail’ are required to carry more capital under Basel III. 333  Note that as to the offsetting possibilities, here we have to set off long and short positions in different products with the same maturities (or vertically). There are other set-off facilities (horizontal), which will not be further discussed.

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The allowed methods of calculations under the VaR alternative will be shown in their simplest form in ­section 2.5.14 below. It was already mentioned that an altogether updated approach is proposed to succeed VaR and issued from the BIS in January 2016.

2.5.10  Criticism of Basel I. The 1999 BIS Consultation Document and the 2001 BIS Proposals. Inclusion of Operational Risk. Basel II (2008) and the American Shadow Committee The 1988 Basel I Accord came in for much criticism at first in particular because of its rough-and-ready approach to the risk asset ratios, which favoured lending to OECD countries and mortgages but did not otherwise allow for any difference in credit standing, especially of corporate borrowers or bond issuers. Credit ratings were irrelevant in respect of lending related assets; improperly, they were rather considered a market risk issue. Banks’ internal risk-measurement systems were ignored. Largely for these reasons, in 1999 the Basel Committee came with a proposal for a fundamental revamp. Although the benefits for most banks did not seem to outweigh the cost of increased complexity, for larger banks, complexity was believed the unavoidable consequence of their size and a natural reflection of the need for a more risk-sensitive framework. For them this recognition often meant self-assessment and lower capital as a consequence of what was considered greater sophistication. In fact, what became Basel II embodied the realisation that the business of banking was profoundly changing in size as well as techniques while risk management had become an art in itself, giving indeed rise to greater sophistication but, as it turned out, also an opportunity for more excess. Altogether, the drafters of Basel II accepted from the beginning that major financial institutions needed to repackage assets in ever larger transactions and to lay risk off on the international capital markets—also in Europe. That was securitisation, which was seen to be lagging behind the American experience at the time. Another part of this was to put asset-backed securities on a par with other fixed-income products and allow in this manner the connection with capital markets to be made. Banks would thus become originators of loan assets or products that could be transferred as securitised assets.334 This was a policy objective that made sense in principle, but it was soon forgotten that regulators had favoured it once it led to excess in 2005–08; see also the discussion on this excess in ­chapter 1, ­section 2.5.4. Whatever the underlying motivations, the officially declared aims were: (a) (b) (c) (d)

improving safety and soundness in the financial system; promoting competitive equality; establishing a more comprehensive approach to risk; and especially making the system suitable for application to banks of varying levels of complexity and sophistication.

334  The fear was rather that banks would on the one hand reduce their risk weightings but on the other invite new burdens while issuing asset-backed securities. See J Peterson, ‘Basel 2: Mixed Bag for Securitisation’ (2001) 93(9) ABA Banking Journal 59.

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The new scheme was intended to apply to both domestic and international banks, as in fact had already been accepted in most countries. Much of it was implemented after further refined proposals in 2001 and 2006 as we shall see. Indeed, a more sophisticated approach to risk management was proposed under which in respect of credit risk and risk assets, the methodology of risk weighting of Basel I was maintained subject to refinement. Especially the OECD bank and mortgaged loan reductions disappeared (except that the Germans were allowed to retain the mortgage deduction in a market where real estate prices appeared to be less speculative) while external credit ratings could be used for all sovereign lending and also for some bank and corporate lending. The required capital would thus vary per borrower depending on the ratings of senior borrowings and bond issues.335 Obviously not every external rating would be acceptable, and there were a number of eligibility criteria that centred on a methodology that was meant to be more objective, rigorous, systematic and continuous, supported by historical data and ongoing reviews. The relevant agencies had to safeguard their independence and shield themselves from political influence and economic pressure from the assessed entities. The assessment was to be transparent and its outcome publicly available. The criteria were to be disclosed. The agencies had to have sufficient resources to allow ongoing contact with the assessed entities and their credibility should be flawless. Standard and Poor’s was used as a non-exclusive example in this connection. To this effect, the borrowers were divided into three classes (sovereigns, banks and corporates), each with different weightings per rated risk. It meant a variation of the risk weighting according to a fixed table in which triple A government debt was weighted at zero per cent (so was all government debt of the home country of the bank, upon the assumption that printing of money or inflation would always take care of full payment—which proved to be an illusion in the eurozone where these facilities were no longer at the disposition of individual states) and triple A company (senior) debt was to be weighted at only 20 per cent. On the other hand, some risky assets could be risk weighted at as much as 150 per cent. The peculiar aspect here was that lending to unrated borrowers could carry less weight than to the lowest rated (below B–, which carried 150 per cent). This was to accommodate European banks whose clients are less often rated than those in the US but it has the strange effect that giving up one’s ratings could make it easier to attract loans from banks.336 In this standard approach to credit risk, the system of rigid risk buckets (after eliminating the special ones for OECD government loans or bonds and mortgage lending) remained otherwise intact, with the extra one of 150 per cent being added. Interbank

335  Note in this connection that the rating does not primarily concern issuers or borrowers, although they may in addition also be rated as such, but the type of bonds they issue or borrowings they negotiate. Subordinated loans will thus be rated much lower than senior ones, it is a matter of credit risk in these borrowings. 336  To be more precise, the end result was that if the borrower was a sovereign state or central bank with a credit rating AAA to AA- (the highest credit ratings) the credit risk weight remained zero per cent. A loan to a company with the same credit rating was weighted at 20 per cent. A loan to a company with BB+ to B- rating was weighted at 150 per cent (rather than 100 per cent) as was a loan to a sovereign state, central bank or bank rated below B-. This meant that a loan to such a company, state, central bank or bank of £100 million under Basel I would have required the bank to hold £8 million capital and under Basel II it needs to hold £12 million.

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lending was to attract the rating either of the borrowing bank’s country or of its own. In either option, more capital would be required against these short-term loans. Further rules were developed for credit risk-reducing techniques through collateralisation, netting and use of guarantees and credit derivatives. In this connection, haircuts could be used to determine the value of collateral; netting had to have a sound basis in law and the net effect had to be capable of assessment and monitoring; for guarantees and credit derivatives, the quality needed to be constantly assessed in terms of the protection being direct, explicit, irrevocable and unconditional. When SPVs or SIVs were used to remove credit risk, any remaining exposure, eg in terms of further funding obligations, or guarantees required credit equivalents to be determined to calculate the capital charge.337 Again, regardless of the later criticisms, securitisation did receive substantial attention at the time but the details of the credit risk regime were substantially left to credit rating agencies.338 That also concerned credit derivatives. For market risk, the standard approach remained substantially as before (see ­section 2.5.5 above) although for interest-related instruments there was now a duration or maturity method.339 The VaR approach was maintained as a self-assessment alternative for qualifying institutions, also for these interest-related instruments. Risk models and systems needed to be considered and operational risk became here also an issue. In times of stress, its importance may even exceed that of market risk itself.340 The professed concern at the time was, however, not to stifle market-based innovation in relation to risk management, which, like credit default swaps or CDSs, was still considered to be at an early stage.341 Other problems remained maturity and currency mismatches in terms of asset and liability or liquidity management and the effect of hedges in respect of them. A conservative approach was demanded in assessing the underlying exposure and the hedge. In the currency mismatch, a contingency risk was implied to which a haircut was applied. In the new proposals, operational risk was to be covered as a new risk category and a large standard charge was suggested in this connection although in the original proposals not yet fixed. The common industry definition was used to define operational risk in terms of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. It was also deemed to include

337  In practice, banks were likely to keep some slice of the risk but were much criticised for not retaining any at all—see also nn 24 and 331 above. 338  See Basel Committee on Banking Supervision, Changes to the Securitisation Framework (BIS, January 2004). 339  For both, the capital charge in respect of market risk is the sum of four components: the net short and long positions in the trading book, a small fraction for matched positions in each time band, a larger fraction for matched positions across time bands, and a net charge for positions in options. The maturity method is the more normal method and based on a maturity ladder for different time bands in which debt maturities are positioned. These positions are then weighted by a factor that reflects price sensitivity. In the duration method, each position is considered for its price sensitivity. It is more accurate but also more burdensome and requires prior regulatory approval. 340  L Bielski, ‘The Great Risk Debate: Basel Committee Proposals and a Tough Business Climate Push Operational Risk to the Fore. The Question Remains How to Manage It Best’ (2002) 94(2) ABA Banking Journal. 341  Hence also the idea to bring them under operational risk that would then be moved to the second pillar, in the event not implemented; cf also L Meyer, Remarks by Governor Laurence H Meyer at the Annual Washington Conference of the Institute of International Bankers (Washington DC, 5 March 2001).

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legal risk but excluded strategic and reputational risk. In truth it was a catch-all for employee errors, systems failure, the impact of fires and floods, fraud, and criminal activity, and concerns incidents that are unlikely to happen but that, if they do, have a great impact. It means, however, that no rational calculation appears possible of the capital required to cover these risks (of black swans). Many argued that it is implicit in the other risks and that capital covering them also covers operational risk so that there is here a doubling of capital requirements. In respect of all these three risks, besides standard approaches, there was introduced a self-assessment method depending on the sophistication of a bank, which since 1996 had already been used in the VaR approach to market risk as we have seen in ­section 2.5.5 above. In respect of credit risk, the alternative approach allowed banks to rely on their own internal ratings, leading to the internal ratings based approach (IRB), further explained in ­section 2.5.14 below, joined by an internal measurement approach (IMA) as a new self-assessment facility in respect of operational risk. In the original 1999 IRB proposals for credit risk, it remained unclear how and when the choice for self-assessment was to be made and which banks would qualify. As a practical matter, any bank was assumed to operate some form of risk management in such a way as to maintain its own (desired) credit rating. That was considered the external check on the adopted approach and potentially a most important self-correcting factor. In the area of qualifying capital, there was no fundamental change proposed, therefore no sharper definitions, while the Japanese were able to retain their Tier I capital definition advantages, especially allowing them to include future tax credits. In the new alternative self-assessment approaches, banks continued to be held to a minimum of eight per cent of risk assets, which was not entirely logical as the consequence of a self-assessment system would be that a bank would also determine the capital it needs and its different tiers. On the other hand, bank regulators could require more than eight per cent minimum capital for the weaker ones, a facility that had only been implicit in the 1988 Accord. This approach (of minimum capital requirements in respect of credit, market and operational risk) was called the First Pillar. There were two others which could indirectly also cover other risks. The Second Pillar concerned itself with the supervisory review of the capital adequacy requirements and stressed the importance for banks of developing an internal assessment process and targets for capital that reflected the bank’s particular risk profile, therefore all its risks, and risk-control environment.342 342 

Basel II identified in the Second Pillar four key principles of supervisory review: ‘Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.’ This was the Internal Capital Adequacy Assessment Process (ICAAP). Such a process was thought to have five main features: i) board and senior management oversight; ii) sound capital assessment, including processes that ensure the bank identifies and reports all material risks, holds capital appropriate for that level of risk, and has a process of internal controls, reviews and audits to ensure the integrity of the management process, iii) comprehensive assessment of all risks and not only those considered dion Pillar I, iv) monitoring and reporting risk exposures and assessing the effect of the bank’s changing risk profile on its capital needs, v) internal control review process that regularly verifies its risk management process through both internal and external reviews.

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It suggested a close dialogue between bank and regulator for which the latter might not always be equipped. The Third Pillar was concerned with market discipline and aimed at disclosure that allowed market participants better to assess the bank’s risk profile and capitalisation. Again, Pillar II and III may go beyond credit, market and operational risk. Indeed, the Second and Third Pillars were both meant to underpin and expand on the operation of the First Pillar but did not in effect amount to an approach in which the risk-management systems of banks opting for self-assessment were tested and given a competitive advantage or disadvantage. Although lower risk weightings would lead to a lesser need for capital in total (but in the proposed system not to a lower capital requirement for totality of risk assets so calculated), it appeared that the introduction of capital to cover operational risk was meant to counter any substantial reduction in the required total capital for all banks, including the best organised. As already mentioned, the use of operational risk in this manner was much criticised. In January 2001 the Basel Committee released a great number of refinements as a result of the extensive comments that were received and discussions that had taken place in the meantime and issued the text of a new Basel Capital Accord for further comments. In essence, the 1999 proposals were maintained. There were the three pillars, the eight per cent capital requirement, and the alternative of self-assessment methods for credit risk, market risk, and operational risk. However, there was further refinement, especially in the self-assessment methods (for the IRB now divided into a foundation and an advanced approach). For market risk, a new definition of the trading book was introduced, allowing for three different valuation methods covering also illiquid investments, which are difficult to ‘mark to market’. Capital for operational risk continued to be a special problem. The Basel Committee assumed in this connection that in practice banks always kept a buffer of about 20 per cent of their capital to cover systems failures and management mistakes (‘risk of direct or indirect losses resulting from inadequate or failed internal processes, people and systems or from external events’).343 In line with the general approach, both a standard and a self-assessment facility concerning this operational risk continued to be offered. The standard proposal attempted to link the operational risk either to a bank’s size, mix of business, or its track record.

‘Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.’ ‘Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.’ The incentive might be better credit ratings. ‘Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored’. 343  Andreas A Jobst, ‘The Regulation of Operational Risk under the New Basel Capital Accord—Critical Issues’ (2007) 22(5) Journal of International Banking Law and Regulation 249; V Dejesus-Rueff, JS Jordan and E Rosengren, ‘Capital and Risk: New Evidence on the Implications of Large Operational Losses’ (2006) 38(7) Journal of Money, Credit and Banking 1819.

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The major practical problem remained, however, the suggested large charge. The final amount was left to local regulators but the committee suggested 15 per cent (the alpha factor) of the average annual gross income over the previous three years. An alternative standard approach divides banks’ businesses into eight types to which gross income standard loss factors (or betas) are applied, varying between 12 per cent and 18 per cent. There were no further rules but banks were encouraged to comply with the Committee’s guidance.344 As to the self-assessment approach in respect of operational risk (the Internal Measurement Approach or IMA/Advanced Measurement Approach or AMA), Basel II had little to say on the substance, although it had a lot to say on who might qualify for self-assessment (see also the calculations in ­section 2.5.14 below). In all of this, the major tactical problem was that the operational risk charge was seen to have been introduced mainly to maintain capital requirements at more or less the levels under the old Accord. The main conceptual problem was that it did not concern an external or business risk nor indeed a rationally quantifiable risk. If the idea behind operational risk capital was to check on existing risk management by introducing yet another (operational) risk manager who goes into the adequacy of risk management, its methods and systems, it would still not protect against a rogue manager or trader or even against bad management decisions. To immobilise capital against such a risk in a random way seemed to be questionable. In any event, who was to check the operational risk manager?345 It has already been said that operational risk may not be an independent risk category at all and may be covered in the other risks (credit, market and settlement risk) and the capital set aside for them. Indeed, it could be asked what guarantee there was that operational risk was any better assessed than the other risks with the assessment of which operational risk is primarily concerned. The layering of risk management through the board, the asset and liability committee, the internal auditor, the external auditors, the risk management group, and now the operational risk manager, who was supposed to be separated from the other risk managers, not only created further costs, but could also result in a greater lack of co-ordination.

344  See the BIS paper: Sound Practices for the Management and Supervision of Operational Risk, February 2003. See for the 2003 update of the Basel Committee on Banking Supervision, The New Basel Accord (Consultation Paper 3) and for the ultimate revised Report, International Convergence of Capital Measurement and Capital Standards—A Revised Framework, June 2006. See further HS Scott, International Finance: Law and Regulation (London, 2004); HS Scott (ed), Capital Adequacy Beyond Basel: Banking, Securities and Insurance (Oxford, 2004); R Sappideen, ‘The Regulation of Credit, Market and Operational Risk Management under the Basel Accords’ [2004] Journal of Business Law 59. 345  It may make more sense to treat operational risk under the Second Pillar (in terms of supervisory review) rather than the First, since the charge defeats logical calculation. As the events requiring it have a low probability while the impact may be substantial, the capital charge may never be enough but weighs heavily on the business in normal times; see also J Rodriguez, ‘Banking Stability and the Basel Capital Standards’ (2003) 23(1) The Cato Journal 115. The FSA in London published a paper from the Prudential Standards Dept to the Operational Risk Standing Group of 30 June 2008 on Operational Risk: The ‘use’ test. The BIS released two papers in July 2009 relating to operational risk: Results from the 2008 Loss Data Collection Exercise for Operational Risk and Observed Range of Practices in Key Elements of Advanced Measurements Approaches (AMA).

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2.5.11  Continuing Criticism and the 2008 Crisis Even apart from the operational risk complication, the overall view of Basel II was not entirely positive. Clearly there was a wish to retain the basic structure regardless of the self-assessment, which was in any event not to affect the overall requirement of eight per cent capital and its composition. In fact, the internal systems and their sophistication were not accepted as a competitive tool (subject to an objective regulatory evaluation). Notably, the Second Pillar did not function in that manner but suggested a more superficial checking system. The reason may be that it would have favoured the strongest banks unduly, in itself a justified concern, but the approach was not logical while the strongest banks with the best systems did benefit anyway. The market discipline and disclosure regime of the Third Pillar—in principle to be greatly welcomed— would not seem to make a great difference here either. It was so complicated that it was unlikely to be of great help to the untrained eye. On the other hand, it was feared that the detail of the disclosures could make banks as a whole more vulnerable to nonbank competitors. It is a well-known excuse of banks commonly used at the expense of proper information of the public and of bank clients and depositors.346 Another (well known) problem was that the innate riskiness of products varied per country. For example, the way mortgages were structured and limited in Scandinavian countries could differ from attitudes in common law countries so that this business was innately more risky there without finding proper expression in the capital requirements. This can also be seen as a form of legal risk for which normally no capital is set aside (except perhaps again in terms of operational risk). In short, the danger was that upon a proper analysis, the new capital adequacy system remained unconvincing in reducing banking risk and continued to distort banking business. This was entirely borne out in the crisis of 2008–09 in respect of credit and position risk for securitised products including CDSs.347 Capital adequacy’s contribution to preventing bank insolvencies hardly seemed enhanced. In any event, self-assessment may profoundly disturb any level playing field. In truth, the problem is that no externally imposed capital adequacy system is likely to be of great help here, especially because the eight per cent capital standard is far too low to be meaningful in adversity and may in any event not protect all banks similarly. The Germans, notwithstanding the earlier concession on mortgage credit, remained unconvinced and were in particular worried that in the proposed new system of Basel II smaller companies would find it increasingly difficult to obtain bank credit as larger companies with better credit ratings could crowd them out. In fact, there is a broader problem here as servicing smaller companies is both riskier and more costly for banks. It is often not good business. Yet there is a strong public interest in these companies having access to liquidity as they are often seen as the more likely entities to reduce unemployment.

346  347 

See also n 138 above. See also the footnotes with references to articles and comments in ss 1.1.1–1.1.3. and 1.3.1–1.3.6 above.

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By the middle of 2003 the US had already indicated that only some of its largest banks, about 26 in number, would be allowed to move to the new system, while bank regulators wished in any event to retain the so-called leverage ratio, introduced in the US after 1991 in the wake of the savings and loans disaster, which also imposed the duty on regulators to take ‘prompt corrective action’ (see also s­ection 2.5.2 above). As already mentioned, it required banks to hold as (qualifying) capital at least three per cent of their balance-sheet total, which is rigorously enforced.348 For the rest of the US banks, there would be a kind of Basel 1A system, which introduced only some of Basel II while also retaining the leverage ratio for them. China opted to stay with the old system for the time being but encouraged its banks to empower their risks management along the lines suggested by Basel II. The EU, on the other hand, fully assumed the new system in its new Credit Institution Directive and CAD for Investment Firms in 2006: see s­ ection 3.5.12 below. It may thus be seen that the unity in world standards was threatened. It is clear that (a) regulators, (b) rating agencies and (c) banks themselves may hold different views of what is prudent and that in practice the most cautious approach prevails. As that of the rating agencies is likely to be the most conservative, it puts them in a dominant position even though they are merely private companies whose practices remain unsupervised and often un-transparent, while their ratings may not always coincide or convince. The consequence is nevertheless that regulatory capital in the standard approaches is likely to become less relevant even if such approaches continue to be used. It is a classic argument to leave everything to the rating agencies, whatever present criticisms, and avoid the enormous complications of the capital adequacy regime, which are in any event likely to result in un-transparent capital requirements and will pay lip service only to regulatory level playing fields. Here risk management becomes the key, and those banks that can show themselves (for the time being) to be best at it will then also be best at reducing the necessary capital and increasing their business accordingly. Again, they would likely be the bigger banks. In the US, the entire approach to capital adequacy in banks has been the subject of a more fundamental rethink (see also ­section 1.3.8 above).349 An informal Shadow Committee has been conducting studies for the last 15 years in this area and proposed an alternative to the new framework. It is less interested in capital and accepts that debt may be as good a cushion, if not better, against bank failures. It proposes a system in which public subordinated debt is issued and traded, so that its holders will become the risk disciplinarians of banks by pricing this type of debt on a continuing basis, thus determining its yield, which becomes in this manner the yardstick of a bank’s safety. It may lead to public discipline: the lower the yield, the better the bank. The higher the yield, the more supervision and regulatory intervention may be warranted. 348  In 2006, at the Basel Committee, the US put this ratio unsuccessfully on the agenda as it became clear that Basel II could reduce regulatory capital for the better banks by as much as 30 per cent. The rejection of this proposal may have played a role in the crisis of 2007–09 after which it was reconsidered and introduced by countries like Switzerland. It was included in Basel III. 349  See also HP Tarbert, ‘Rethinking Capital Adequacy: The Basel Accord and the New Framework’ (2001) 56 The Business Lawyer 767, 824. See for an important contribution to the subject also K Alexander, R Dhumale and J Eatwell, Global Governance of Financial Systems: The International Regulation of Systemic Risk (Oxford, 2006).

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Subordinated debt is here debt that ranks lower than the position of common creditors, including depositors. It is therefore extra sensitive to the bank’s fate as the position of the subordinated debt creditors is almost as low as that of shareholders. In the proposal, it would cover two per cent of non-cash assets. This debt must not be subject to any direct or indirect guarantee, either through deposit insurance schemes or government bailout. For the rest, the 1988 Basel I approach was to be maintained except that the capital requirement would be lifted from 8 per cent to 10 per cent of risk assets while eliminating the risk buckets and introducing a uniform 100 per cent risk weight for all non-cash items in order to avoid distortions in banking response. The two-tiered capital system would also be reformed and made into one.

2.5.12  The Situation After Basel II. Basel III. Increased Capital, the Leverage Ratio, and a Regulatory Approach to Liquidity Risk Basel II came in the middle of the banking crisis of 2008–09. Taking into account recent experiences, it is perhaps not unfair to summarise the situation following Basel II as follows. The key to all commercial banking regulation was found in the capital adequacy regime, which had become the essence of all financial regulation. In this approach, other risk-management techniques and their quality took second place. That also applied to liquidity policy and leverage or gearing practices as we have seen. It became clear, however, that capital adequacy is not the sole remedy. It goes primarily to the problem of balance sheet insolvency, not cash flow insolvency. In any event, the regime of capital adequacy in respect of market risk for derivatives and more advanced securitised products and in respect of (residual) off-balance-sheet exposures (of originators) proved inadequate. Applying the common IRB standard for credit risk and VaR for position risk also proved insufficient, while adequate system back-up was caught only indirectly under operational risk. Nevertheless, the Basel II regime enhanced risk-management awareness and practices in banks, probably also in smaller ones (although many had to stay with the standard approaches as they were not similarly sophisticated in risk management, nor might they need it). Yet in order not to discourage smaller and less sophisticated banks, newcomers and territorial diversity, the general regulatory regime was always likely to be less stringent than the approach notably of rating agencies and also that of the more sophisticated banks internally. The true test of a bank’s viability thus remained the credit rating of its senior bond issues and not its meeting of regulatory capital. This presents a strong argument that only the market itself can act as the proper guide to a bank’s standing and that regulation does not add much except cost. The American Shadow Committee also took this attitude and wants to use the price movement in subordinated debt as flashpoint for regulatory intervention as we have seen in the previous section. Eight per cent (qualifying) capital was by itself never likely to avoid major trouble in the banking industry, either resulting from management or system lapses or macroeconomic events. It is an arbitrary figure that is historically very low. When, after 2008,

Part II  International Aspects of Financial Services Regulation 789

reference was made to irresponsible deregulation, it must have meant that, although the volume of regulation had increased considerably and compliance departments mushroomed, the capital requirements became de facto ever lower, largely to encourage more lending to the multitude as a political desirability, a facet of the social welfare state and an element in growth theories, under which what could not be provided by government should be obtained from banks, whose liquidity-providing function operated then also as a social policy and growth elixir, see the discussion in ­section 1.1.3 above. Hence also poor enforcement of regulation. The absence of an international safety net for banks aggravated the situation: see s­ ection 1.3.11 above. It was submitted before that these circumstances were at the origin of the banking crisis that unfolded in 2008, soon followed by a government funding crisis and a second banking crisis when government bond portfolios also became of dubious value in many countries while it became clear that governments were probably less likely to be in a position to save banks when necessary. While officially a level playing field was maintained under Basel II, it was also under pressure because of the self-assessment facilities in respect of the major risks in bigger more sophisticated banks. There also was still considerable subjectivity in the allocation of risk assets to the proper risk bucket, which allows banks to play around considerably with their asset structure, looking for the best risk categorisation for them. As to management or system lapses, the Basel II regime for operational risk also seemed arbitrary and was not strictly rational. Again, it sought to quantify a risk, which cannot be quantified generally or in advance, and is at least to some extent already discounted in the credit and market risk calculations. It may well serve to keep more capital in banks generally and then acts as a disguised leverage ratio, the introduction of which was otherwise rejected (over US objections), but it is part of Basel III as we shall see. Indeed, over and again it is proven that regulation of this nature does not prevent major financial shocks as the banking crisis of 2008–09 only confirmed, but an argument can be made that by dividing or limiting banking power it is better used. Hence also the regulatory insistence in the EU in 2009 that at least the large but weaker banks were to be broken up. In this connection, it may have to be reconsidered whether the more speculative activities of banks should not be parked in a different entity in a holding company structure. However, it has already been said the idea that the large international flows on which we depend can adequately be served by small local banks is irrational. Substantial banking risk must thus be taken to make the money-recycling function work properly. It was the earlier thesis in this book (see s­ ection 1.1.14 above) that banks should be curtailed at the top of the economic cycle through countercyclical capital adequacy, liquidity and leverage ratio measures, but making them smaller generally (or imposing more capital on their activities overall) is no answer and may well increase the banking risk. It makes banking in any case less efficient and likely more expensive. Besides liquidity, the lack of which was earlier considered the true killer of banks (see ­section 1.1.3 above) and lack of capital, banking is often (more fundamentally) threatened by other factors, like macroeconomic woes or imbalances everywhere, governmental meddling in bank lending not only in countries like China, cultural attitudes

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which require continued lending to established clients regardless of credit risk in countries like Japan, or a political desire for greater democratisation of credit and the consequent moral hazard in Western countries, especially the US and UK, where cultural aspirations often put consumer demands for credit at the pinnacle. In s­ ection 1.1.2 the issue of stability was more fundamentally discussed, especially in the aspect of societal leverage. It may explain why in practice, micro-prudential regulation including its capital adequacy requirements do not seem to have any major preventive impact. It has been said several times before that for modern banking and its scale, the true insights into what is happening and what is needed may be missing. There may be a new paradigm altogether, see ­section 1.3.7 above. It was also said that modern economic models, be they neoclassical or Keynesian or something else, hardly explain and they predict very little. In this atmosphere, financial regulation including the capital adequacy requirements often function as fig leaves for the public, suggesting sound banking practices under the prudential supervision of capital standards and risk-management practices that may prove barely relevant and often do not bear on the cause of a modern bank’s true problems and potential failure. It is also clear that regulatory supervisors are hardly able to evaluate the impact and risk of newer products, which can usually only be determined upon experience, so ex post. It may even be doubted whether regulatory supervisors are able adequately to understand and handle the complications resulting from the more refined system that results under Basel II itself. What else may need to be done has already been discussed in ­section 1.3.10 above and needs no repeating, but it is of great interest to note the shape regulation has been taking after the 2008 crisis—see also s­ ections 1.3.8ff above and in the EU ­sections 3.7 and 4.1ff below. All in all, financial regulation and especially capital standards, even liquidity requirements in the form of Basel III, are unlikely to prove a panacea in terms of the protection of the public against commercial banking risk either. Basel II proved an instant failure as the events in 2008–09 unfolded. Basel I was often lauded but it was already said that it was never tested in any big crisis. We shall see whether Basel III fares any better.350 Its impact may be the constraining of the liquidity-providing function at the bottom of economic cycle when liquidity is needed most to regenerate some growth. Again, it may well have contributed to the low growth, especially in the EU, for many years after the financial crisis. Banking regulation remains a most imperfect art and banking a dangerous business. Again, part of it is that we seem not to be able to analyse the underlying processes and their consequences adequately, and can in any event not predict with any certainty when a danger zone is reached nor the timing of collapse. Neither can we decide what we really want: financial stability or cheap credit for virtually all. As we have seen, after the crisis, the initial reaction was a call for smaller banks and also a form of de-­globalisation, with local regulators taking the driving seat. But it threatens international liquidity and the level playing field for banks internationally. It also had an important impact on the minimum capital that we want banks to have, which again may start to differ considerably. Swiss banks in particular were held to a 19 per cent 350 See Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010, revised June 2011, BIS 2011.

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capital adequacy ratio, Switzerland as a small country not wanting to face bank bankruptcies again when an international safety net is still missing. It was submitted that the true issue is the impact on growth, which was already anaemic in Europe even before the crisis. Cutting down banks means cutting down liquidity, which is the oil in the economic machine. If globalisation is so beneficial, then limiting its liquidity-providing arm internationally would seem irrational, but that is the uncertain new regulatory environment in which modern banks must now operate, the paradoxes of which the banking industry increasingly shows in its appearance and behaviour. Basel III was a quick fix to meet political demands for action, again probably without much deeper insight.351 What causes the problems, and especially when, remains an enigma beyond assuming that banks are simply too big and that we should go back to an older form of banking, never mind the effect on growth.352 Some argument can be made that Basel III tried to combine (better) the bank specific regulatory regime of Basel II with a systemic risk-based framework.353 More capital was required, generally to limit activity, also through a redefinition of qualifying capital, both in Tier I and Tier II. Tier III, which only had a meaning for market risk, was deleted. After Basel III, regulatory capital in Tier I exists of common equity, retained earnings, reserves and share premium accounts. Additional Tier I capital consists of capital instruments that satisfy certain criteria: Perpetual and CoCo Bonds are in this category. Tier II capital is limited largely to subordinated loans. Some deductions are made: cash-flow hedge reserves if positive are deducted from Tier I, if negative they are added. The fair value of derivatives may figure subject to gains and losses due to valuation adjustments but not the changes in fair value of future cash flow hedges. Intangible assets like goodwill are also deducted. So are foreseeable tax liabilities and current year losses as well as banks’ investments in their own shares. It has already been said that in all of this, it was never considered what millions more Chinese and Indians requiring liquidity would mean to the system in the years to come. Fundamental questions were thus largely avoided and fears for limiting growth, although largely ignored at the formal level, accounted for the fact that it was hoped and expected that banking would still go on much as before. The discussion on an international safety net was largely postponed also, although it started in euro c­ ountries in 2012, but only for their banks in the context of the emergence of the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) for banks in the eurozone of the EU (see ­section 4.1 below). The risk is ultimately the pursuit of financial stability at too low a level of activity. If the deleveraging of society is more truly the objective, this should be openly discussed and its consequences better understood. It is unlikely to be popular.

351  EH Lee, ‘Basel III and its New Capital Requirements as Distinguished from Basel II’ (2014) January, The Banking Law Journal, 131. 352  E Pentz, ‘Third Time’s the Charm: Will Basel III Have a Measurable Effect on Limiting Future Financial Turmoil?’ (2014) 3 Penn State Journal of Law & International Affairs 287; see also E Goyfman, ‘Let’s Be Frank: Are the Proposed US Rules Based on Basel II an Adequate Response to the Financial Debacle’ (2013) 36 Fordham International Law Journal 1099. 353  H Hannoun, The Basel III Capital Framework: A Decisive Breakthrough (2010) www.borg/speeches/ sp101125a.pdf is.

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The idea is now that a bank should have at least six per cent Tier I capital and within it 4.5 per cent of core Tier I capital (common equity and retained earnings) by 2015. Tier II capital may be used to reach the total requirement of eight per cent. The 4.5 per cent core capital is extended by 2.5 per cent to reach seven per cent by 2019 as an extra conservation buffer that may be reduced in times of stress. There is also added (by 2019) a counter-cyclical capital buffer within a range of 0–2.5 per cent of Tier I capital depending on national circumstances.354 Its main feature is that it is built up regardless of the cycle, to help when problems arise. That is not truly counter-cyclicity, which was earlier identified as the key in terms of financial stability: see s­ ection 1.1.14 above. It was also suggested that this system breaks with the level playing field notion in the EU. Not meeting these levels would, on the other hand, reduce the earnings distribution, including share buy-backs. A number of amendments followed in December 2017.355 The essence was the introduction of output floors, refinement of the leverage ratio requirement, and a new approach to operational risk. Output flows meant a limit on the advantages selfassessment could bring for the various types of risk: the required capital should be no less than 72.5 per cent of the standard approach. The leverage ratios were made more flexible allowing for different types of activities. For operational risk the advanced measurement approach (AMA) based on the bank’s internal models and the standard approaches were replaced with a single risk-sensitive standard approach for all banks. Hence forth there were two components (i) a measure of a bank’s income and (ii) a measure of the bank’s historical losses. The assumption was that a bank’s operational risk increases with its income and that its past performance was indicative of its future operational risk exposure. A new formula was proposed that was still subject to national adjustment in the sense that the national regulator could eliminate the historical component for all banks on its territory although there would still be disclosure of historical losses. Systemically important banks are subject to a further capital charge.356 Following proposals in 2011, the exact amount of the surcharge depends on a bank’s placement in one of five ‘buckets’ (requiring a one per cent, 1.5 per cent, two per cent, 2.5 per cent and 3.5 per cent surcharge, respectively) based on the bank’s global systemic importance. For all banks, more capital is required for securitised and trading products short of central counterparty (CCP) clearing, see also the next section. They also have to retain five per cent of collateral debt obligations (CDOs) that they originated. This may make more sense: see in the EU also ­section 3.7.3 below. Proprietary trading is proposed to be curtailed and short selling immediately restricted, at least in the EU; a new Directive to that effect was put in place: see ­section 3.7.9 below. In addition, a non-risk-based leverage ratio was introduced to supplement and serve as a backstop for the risk-based capital adequacy rules. The capital measure for the leverage ratio is Tier I capital and the total exposure measure is the sum of (a) onbalance-sheet exposures, (b) derivative exposures, (c) securities financing transaction 354  B McDonnald, ‘Designing Countercyclical Capital Buffers’, Legal Studies Research Paper No 14-16 (2014) http://ssrn.com. 355  Basel Committee on Banking Supervison, High Level Summary of Basel III Reforms (Dec 2017). 356  In the EU, Art 131 CRD 4 defines these banks, see s 3.7.4 below.

Part II  International Aspects of Financial Services Regulation 793

exposures, and (d) off-balance-sheet exposures. The total of these exposures may not exceed three per cent of Tier I capital at all times. The idea behind LCR is that banks have sufficient high-quality liquid assets (HQLA), easily convertible into cash to exceed the net cash outflows for 30 days. The ratio must be maintained at all times except in times of stress (as described eg in the case of increased margin calls) when banks may use their HQLA. These have been given a set of criteria (including their being unencumbered and listed on developed and recognised markets that are active and sizeable), allowing in such a situation a fall below 100 per cent of the sum of cash inflows and outflows. The 2008 banking crisis serves here as basic scenario and hypothetical situation and example of high stress in the system around which banks should take further individualised action, discounting the bank’s sensitivity to significant downgrades, deposit runs, cessation of unsecured wholesale funding, accessibility to secured funding following downgrades of existing assets, collateral or margin calls, and demands for further liquidity by clients.357 The NSFR is available stable funding (ASF) over required stable funding (RSF) and is intended as an incentive to finance longer-term assets with longer-term liabilities. Long term means here more than one year and the idea is to reduce refinancing risk on and off-balance sheet. The result is that the fraction of assets that are or may become illiquid, especially in the investment book, and that are reliant on short-term funding, is to be reduced. The implementation period for the new system was eight years until 2019. The idea was that any reduction in growth, which could be the result, would be stretched out over that period. The longer-term effect is thus expected to be less palpable, hidden in what is hoped to be a solid economic upturn. If this does not materialise, it may be assumed that capital requirements will again be reduced or poorly enforced, that is to say that circumvention will increasingly be condoned. The hope was that a one per cent increase in capital requirements over four years would reduce GDP only by 0.2 per cent while a 25 per cent increase in liquidity is thought to have only half that effect. History will tell. When it came to the crunch in 2012, the introduction of Basel III in the EU was widely asked to be postponed exactly because of the consequences for liquidity and growth. This was not at all surprising; its introduction should have waited until better days when maybe there would also have been greater clarity. It demonstrates that for Basel III to be truly responsive, its rules should have been counter-cyclical, which at the moment they hardly are.

2.5.13  Derivatives, Contingencies and Other Off-balance-sheet Exposures After Basel III The way financial derivatives, securitisations and other off-balance-sheet exposures were treated for capital adequacy and liquidity purposes was considered one of the major contributory factors to the 2008 banking crisis and therefore obtained special 357  See S Gleeson, International Regulation of Banking: Capital and Risk Requirements, 2nd edn (Oxford, 2012) 51.

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attention in Basel III.358 One important innovation is the separate treatment of derivatives and other off-balance-sheet exposures for each of the capital adequacy, leverage ratio, and liquidity requirements. However, for capital adequacy purposes, the basic methodology outlined in ­sections 2.5.7 and 2.5.8 above was not changed although the credit conversion factors (CCFs), where applicable, were clarified. The Basel Committee also asked the International Accounting Standards Board (IASB) to clarify the contingency rules in IAS 39. The new methodology relies on expected losses rather than incurred losses to allow for a better insight in risk and its management.359 On the other hand, it allows for simpler hedging rules and also recognises the problems with markto-market or fair value in illiquid markets, to which effect all relevant credit information is now taken into account earlier. The new rules also allow for expert opinion and establish other guidelines. There may, however, be a special credit valuation adjustment (CVA) in respect of derivative transactions. This is an extra charge for potential mark-to-market losses connected with the loss of creditworthiness of counterparties and is the difference between the hypothetical value of a derivative transaction with a risk-free counterparty and the possibility of changes in creditworthiness of the present counterparty. Clearing of derivatives through a CCP is further encouraged, a complicated issue more extensively dealt with in ­chapter 1, ­section 2.6.5 above and for the EU in ­section 3.6.14 below, resulting in a capital adequacy reduction to two per cent of the exposure amount as determined.

2.5.14  Capital Adequacy Calculations Under Basel II and Basel III From a calculation point of view, the system of Basel II and its impact cannot be ­summarised in a similarly simple manner as that of Basel I (see ­section 2.5.9 above) mainly because of the self-assessment elements. In the EU, the supplementing Regulation (EU) No 575/2013 to the Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of (both) credit institutions and investment firms goes into great detail. Although the standard approach for credit and market risk was methodologically unchanged since Basel I (and the earlier EU Directives), there was much refinement also for credit risk achieved in particular through the repeal of the existing risk ratings, especially in respect of OECD country debt and mortgage loans as we have seen, and differentiation according to official credit ratings. Diversification within the loan portfolio was also taken into account, but again more important was the fundamental acceptance of self-assessment in all three risk categories (credit, market and operational risk). For credit risk there is the IRB approach, for market risk the VaR approach (already introduced in 1996 and not fundamentally changed), and for operational risk the 358  See Lynn Stout, ‘Derivatives and the Legal Origin of the 2008 Credit Crisis’ [2011] Harvard Business Law Review 1 and H Hannoun, ‘The Basel III Capital Framework’, BoJ-BIS High Level Seminar on Financial Regulatory Reform: Implications for Asia and the Pacific (Hong Kong 2010). 359  See Richard Barfield (ed), A Practitioner’s Guide to Basel III and Beyond (London, 2011) 200 and the BIS Guiding Principles for the Replacement of IAS 39 (2009).

Part II  International Aspects of Financial Services Regulation 795

IMA or Internal Measurements Approach, sometimes also called the Advanced Measurement Approach or AMA. Still some calculations may be useful and demonstrate what has been said so far. For the purposes of calculating the capital requirements under the standard IRB approach to credit risk, the banking book is divided into six exposure classes: (a) ­corporate; (b) ­sovereigns; (c) banks; (d) retail; (e) project finance; and (f) equity. For each of these exposure classes, the IRB treatment concentrates on three so-called ‘credit risk components’: (a) probability of default (PD);360 (b) the loss given default (LGD);361 and (c) the exposure at default (EAD).362 360  PD or default risk is the probability of an event of default. Several events qualify as ‘default’, eg missing a payment obligation for a few days or for more than 90 days, a bankruptcy filing, breaking a covenant, triggering a cross-default, etc. The definition of default is critical for calculating the default probability and measures historical default frequencies. The Accord sets the minimum requirements for banks to be allowed to calculate PD on the basis of their own internal ratings. In practice, banks using their internal ratings will frequently use a Moody’s or S&P table for the PDs corresponding to each rating: AAA, AA etc. This is the simplest way for them to arrive at the PDs. But banks may make their own calculations. There are different ways of calculating the PD. Among different techniques, the more popular one in respect of public companies is the Option theoretic approach to default (the updated Merton model of default), which considers that equity holders have the option to sell the firm’s assets rather than repay the debt if the asset value falls below the debt value. This approach sees equity as a put option on the underlying assets of the firm sold to the lender with a striking price equal to the debt amount. It illustrates the expected default probability since equity prices look forward, unlike historical default statistics mostly used by the rating agencies. In this approach, the default is an economic rather than a legal event and probabilities depend on the asset value, the debt value and the asset volatility. To provide a simple example of this calculation of PD, we may assume that the asset value of a borrower over a particular period of time is 100 and the debt value (its borrowings) is 50. We need to take into consideration the volatility of asset prices. Let us assume it is 21.46 (all volatility figures are complex). In the present example, the probability of economic default arises when the asset value drops below the debt value of 50. The PD is in that case 50:21.46 = 2.33. This number is subsequently transformed through so-called deviations, which in this case arrives at a figure of one per cent. Most PDs are lower, especially of higher-rated companies. Rating agencies will often use this approach, but for private companies other formulae are maintained. 361  This is the estimated amount at risk at the moment of default less recoveries. In the foundation model, the LGD numbers are imposed by the Accord, which also provides that some protections decrease the LGD number such as collateral, third-party guarantees and covenants in the loan agreement. Senior claims on corporates, sovereigns, and banks not secured by recognised collateral are assigned a 50 per cent LGD, subordinated claims a 75 per cent LGD, etc. They are standard but based on modelling techniques discussed below. For using a bank’s own estimate of LGD in the advanced approach, the estimate must be based on the average economic loss of all observed defaults in its loan book within the data source of the bank and should not be the average of annual loss rates. In its analysis, the bank must consider the extent of any relationship between the risks of the borrower and collateral provider. In connection with protections, the Accord adopts a definition of eligible collateral. In general, banks may recognise as collateral cash, a restricted range of debt securities issued by sovereigns, public-sector entities, banks, securities firms and corporates, certain equity securities traded on recognised exchanges, and gold. It is necessary to account for the time changes of exposure and collateral values. ‘Haircuts’ denote here: (a) the required excess collateral over exposure to ensure effective credit risk protection; (b) given time periods necessary for readjusting the collateral level (re-margining); (c) recognising the counterparty’s failure to pay or to deliver the margin; and (d) the bank’s ability to liquidate collateral for cash. Two sets of haircuts have been developed for a comprehensive approach for collateral: those established by the Accord (ie, standard supervisory haircuts), others based on a bank’s own estimates of collateral volatility subject to minimum requirements. There is a capital floor, denoted ‘v’, the purpose of which is to encourage banks to focus on the monitoring of credit quality of the borrower in collateralised transactions. To reflect the fact that irrespective of the extent of over-collateralisation a collateralised transaction can never be totally without risk, the normal v value is 0.15. As for PD estimates, the measurement techniques of LGD are different under various risk-modelling methodologies. The option approach mentioned in the previous footnote also provides a facility to calculate the LGD. To reach the LGD number, the Merton model calculates the put and call option value on the assets of the borrower, then calculates the expected recovery under the given PD × LGD = value of the assets minus expected recovery of debt. 362  See further the EU implementing Regulation No 575/13 accompanying the recast of the EU Credit Institution Directive (2013/36/EU) of the same year. EAD for an on-balance-sheet or off-balance-sheet item is defined as

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The last one is not relevant to the basic calculation: in on-balance-sheet exposure it equals the nominal outstanding amount; in off-balance-sheet exposure, it has some meaning in special situations which will not be further discussed here. So the key is PD and LGD. A risk weight (RW) subsequently uses these risk components to arrive at the risk-weighted assets. Maturity (M) affects the RW also. The BIS proposes here a Benchmark Risk Weight (BRW) assigned to all PD grades.363 In retail borrowing, the notion of ‘expected loss’ (EL) is used as an alternative to PD and LGD because there are unlikely to exist credit ratings which are commonly used to determine PD. Expected loss is the product of a retail exposure (say US$100) and the PD of a borrower (say two per cent) and the LGD (say 50 per cent) in any specific credit risk facility. In this example, EL is $100 × (0.02) × (0.50) = $1. Thus as the first step for calculating the capital charges in the IRB approach, a bank must normally arrive at the PD estimate. The calculation of PD is the common element of the two alternative approaches under IRB: foundation and advanced. As already mentioned, banks will normally borrow their PDs for their credit ratings from Moody’s or S&P. The difference starts at the next stage when a bank has to calculate the LGD risk component. Under the advanced approach, the bank is allowed to calculate the LGD number according to its internal methodologies, which may give rise to subjectivity, however, and can become manipulative. In the foundation approach, on the other hand, LGD is either given under the rules or has to be calculated according to the regulator’s instructions. The disadvantage is here that it may still give rise to different standards per country when it becomes a level playing field issue. The calculation formula for risk-weighted assets is RW times the nominal value of the loan in which RW = (LGD:50) × BRW (in respect of the relevant PD), or LGD × 12.5, whichever is smaller. The eight per cent capital requirement is subsequently applied to this number to arrive at the necessary capital charge.364 the expected exposure of the facility upon default of the obligor. In practice, this comes down to the recovery possibility in a bankruptcy, which can hardly be predicted in advance. In contingent claims, there is another variable. 363  See ‘New Accord’, para 173. The result is a percentage that will be applied to the nominal amount of the loan. In this formula, BRW is the benchmark risk weight, which derives from the PD figure and catches also the maturity, which should be no more than 3 years. If it is more, there are different formulae. The BRW for PD 0.03 per cent is 14; BRW for PD 0.05 per cent is 19, and so on. See ‘New Accord’, para 176. 364  The IRB approach may be advantageous to banks investing in better credits: see the Quantitative Impact Study (QIS3) of the Accord itself, which allows a comparison as follows:

Standard Approach Rating

Foundation IRB

Risk Weight

Equivalent PD%

Approx risk weight

AAA

20%

0.00

14.75%

AA

20%

0.01

14.75%

A

50%

0.05

20.03%

BBB

100%

0.26

51.60%

BB

100%

1.20

104.35%

B

150%

5.93

192.70%

CCC

150%

24.64

394.50%

Part II  International Aspects of Financial Services Regulation 797

In the foundation IRB approach, a loan portfolio of €500 million AAA ­government bonds of a remaining three years’ maturity, €100 million AA corporate loans of two years’ maturity, and €300 million of single A interbank loans of six months’ maturity is treated as follows. As maturity is less than three years in all cases, we may apply the standard foundation formula, which is RW = (LGD:50) × BRW, in which LGD is always 50. Assuming that AAA generates a PD of 0.00 per cent, the RW is 1 × BRW, or 14 per cent, for AA it is 0.01 per cent, corresponding with a BRW of also 14 per cent, and for single A it will be 0.05 per cent, corresponding to a BRW of 19 per cent. The result is therefore a total risk-weighted amount of €141 million, attracting a minimum capital charge of €11.28 million in terms of qualifying capital under Tier One and Tier Two. For market risk the standard approach of 1996 remains in place: see for the calculation ­section 2.5.9 above in fine and for the refinement in respect of debt securities, ­section 2.5.10 above, with special rules also for commodity and foreign exchange positions. For the self-assessment or VaR approach to market risk, the 1996 Basel I amendment also largely continued in force.365 The market risks subject to capital adequacy requirements are defined as the risks pertaining to interest rate-related instruments and equities in the trading book and beyond this book to foreign exchange and commodity holdings. This measure is meant to be prospective, not historical, but applies only to assets that can be marked to market, therefore to liquid assets, not, for example, to real estate or art. The focus is the determination of the maximum loss in a given time period assuming only a one per cent probability that it will be larger. That represents a confidence level of 99 per cent. If we say that a position has a VaR of €1 million at a 99 per cent confidence level (as imposed by the 1996 Amendment to Basel I), we mean that any daily loss will on average not be higher than €1 million except on only one day in every 100 trading days (therefore only on two-and-a-half days each year, a year for these purposes having 250 trading days).366 In the VaR approach to capital adequacy, a bank may use its own VaR models to determine the VaR figure in respect of its ‘mark-to-market’ positions (in this case resulting in the €1 million figure). All VaR models require (a) the selection of the relevant risk factors, and (b) a prediction of their impact. This could be done on the basis of historical data or under more advanced models which are not further discussed here.367

365  The VaR model is now commonly used, also outside the area of capital calculation. But academic research into its effectiveness has always been hampered by lack of data due to the proprietary nature of much of the necessary information: see J Berkowitz and J O’Brien, ‘How Accurate are Value-at-Risk Models at Commercial Banks?’ (2002) 58 Journal of Finance 1093. How good these models were for recognising portfolio risk thus remained in some doubt. 366  This leaves room for the so-called ‘black swan’, which may thus be rare but can create the greatest havoc: see n 156 above. 367  There are commonly three approaches between which banks may choose: the analytical variance-­ covariance approach, the Monte Carlo approach, and the more traditional historical simulation approach. The last one is the most simple. It involves (a) the selection of the relevant daily risk factors in a given period, say 100 subsequent trading days; (b) the application of them to the VaR and the revaluation of the current portfolio as many times as the number of days chosen in the sample; and (c) the construction of a diagram (histogram) of

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Once the VaR is established, it will be multiplied by three (the ‘multiplier’) to arrive at the capital charge. The regulator may increase this multiplier if it becomes clear that the bank’s own risk-management systems are unreliable.368 In general, the standard approach to market risk is likely to produce a larger capital charge than any VaR-based model, but the saving depends also on the diversification in the portfolio.369 It may be repeated that as of 2016 the Basel Committee started to propose a new approach to VAR altogether. Finally, the capital necessary to cover operational risk may also require complicated calculations which can only be summarised here. As we have seen, in a first approximation in developing minimum capital charges, the Basel Committee estimated the operational risk at 20 per cent of minimum regulatory capital, later reduced to 12 per cent, but it subsequently proposed three increasingly sophisticated approaches to capital requirements for operational risk: basic indicator, the standard approach, and the internal measurement approach or IMA. The ‘basic indicator approach’ links the capital charge for operational risk to a single indicator that serves as a proxy for the bank’s overall operational risk exposure. As we have already seen, that indicator is the gross income370 and each bank should hold capital for operational risk equal to a fixed percentage (‘alpha factor’) of its gross income (15 per cent was proposed). The ‘standard approach’ builds on the basic indicator approach by dividing a bank’s activities into a number of standard business lines (eg corporate finance and retail banking). With each business line, the capital charge is a selected indicator of operational risk multiplied by a fixed percentage (‘beta factor’). Both the indicator and the beta factors may differ across business lines. The beta factor is set and serves as a rough proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the indicator for that business line. The total capital charge is calculated as the simple summation of the regulatory capital charges across each of the business lines.

portfolio values and identification of the VaR that isolates the first percentile of the distribution compatible with a 99 per cent confidence level. There are here issues of consistency and transparency. Some banks report quarterly, others annually, some differently per type of regulator. It makes comparing banks’ exposure quite difficult and supports the charge that the whole system of Basel is too subjective. 368 

See for further details, M Crouhy, D Galai and R Mark, Risk Management (New York, 2000) 177ff. For example, if we consider the portfolio consisting of a long US$100m 10-year government bond with 6.50 per cent annual coupon and a US$100m 10-year swap, bank paying fixed against three months Libor, assuming that the counterparty is a corporation, the capital charge under the standardised approach will be US$635,000 and the internal model approach using the VaR method will produce the charge of US$240,000 and the bank will be capable of making a 62 per cent saving. This figure is taken from Crouhy et al (n 368) 221. On the contrary, if we consider the US$100 million 10-year swap where the bank receives fixed against three months Libor and the counterparty is a corporation, then the capital charge for this position under the VaR model would be higher, viz US$8,854,294 as against US$3,810,000 under the standard approach. This illustrates the benefits of the Internal Models Approach when the bank’s position is well diversified across maturities, countries (ie currencies) and products. The more sophisticated the portfolio is, the greater benefit the bank receives from using internal models rather than the standard approach. 370  ‘New Accord’, para 552. Gross income = Net Interest Income + Net Non-interest income. It is intended that this measure should reflect income before deduction of operational losses. 369 

Part II  International Aspects of Financial Services Regulation 799

The self-assessment or IMA finally allows individual banks to rely on internal data for regulatory capital calculation in respect of operational risk. The self-assessment of their own systems and management capabilities is obviously a delicate matter and strict guidance is necessary. The adopted technique necessitates three inputs for specific sets of business lines and risk types: an operational risk exposure indicator, the probability that a loss event will occur, and the anticipated losses given such events. Together, these components make for a loss distribution for operational risks. The IMA allows the capital charge to be driven by a bank’s own operational loss experience371 within a supervisory assessment framework, which becomes a key issue here. In the future, a loss distribution approach in which the bank specifies its own loss distributions, business lines and risk types may become available. Now that self-assessment is an alternative also in this area of operational risk and capital must be set aside for it, banks have been doing much more work to get to grips with quantifying the operational risk. Contingencies of this nature are often thought to fall into two categories: those that occur frequently and entail modest losses and those that occur occasionally but may lead to large losses (black swans). Qualitative and quantitative techniques must thus be used in any modelling. It assumes some uniformity in both areas (which may not be the case in the occurrence of acts of t­ errorism, natural disasters and fraud, which therefore render modelling unreliable in respect of these risks). Correlations must then be found between some specific risk indicators and rates of loss so that elevated operational risk can be identified and the cost calculated as long as it lasts. Here as well, risk reduction might have to be taken into account and may occur through avoiding some risks, moving to others that can be better mitigated, and accepting the rest as simply part of the business. Special risk-reducing techniques are in recruiting higher-quality staff, providing more employee training, better oversight of them, better systems, insurance etc. Implicit in these choices is also a responsible cost/benefit analysis.

2.5.15 Evaluation The calculations in the previous s­ ection were a necessary exercise to show the s­ tudent some of the very considerable complications in the details of the new regulatory approach to capital adequacy and in the underlying modern risk-management techniques. The CRD 4 and Regulation (EU) No 575/2013, see s­ection 3.7.4 below, give the details in the EU. In the detail, they are largely an accounting exercise, complicated but not beyond all understanding. A certain amount of detail is necessary to get a feel for the picture and also to appreciate that the system and its methodology are by no means perfect. It has already been noted and it should never be forgotten that in practice the credit rating of credit agencies in respect of a bank’s senior debt, however

371  Some studies show that if a bank relies on the available data, then the charge for operational risk under Basel II could exceed the charge for market risk. See, eg, Using Loss Data to Quantify the Operational Risk (Federal Reserve Bank of Boston, April 2003).

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much criticised, will determine a bank’s fate sooner than the bank’s regulatory capital requirements. The capital calculations of the rating agencies will therefore be the more important and the final assessment of a bank’s balance-sheet solvency will be determined in the first instance by these outsiders; regulatory and internal systems are secondary to their findings. It puts the whole discussion on regulatory capital adequacy in perspective. Squeezed between the rating agencies and the banks’ internal systems, regulatory capital requirements are probably only of minor importance. As mentioned above, they are also losing their transparency and, through self-assessment, their objectivity, defying their original objective of creating a level playing field in respect of the necessary capital between banks. Basel III does not change this, but by introducing a wholesale increase in capital requirements—even though they will never be enough in a crisis—and also a leverage ratio and liquidity requirements, banking and its liquidity-providing function to society may be seriously cramped and the effects socially and economically detrimental especially in bad times. It was already said that it may have been conducive to the lack of growth in the EU for a prolonged period after 2008. For these various reasons, the whole exercise of Basel II (as of Basel I), its approach, result and use could be seriously questioned with regard to its focus, effectiveness and efficiency. The worst part is probably its pro-cyclicity, see also section 1.1.13 above, but in more practical terms, we seem not to be able to cope with what many would consider an overleveraged society, see section 1.3.6 above. The 2008–09 financial crisis showed it in abundance. It is no less true for Basel III. To repeat, regulatory capital adequacy requirements of this nature are not the key to financial stability; liquidity is. In any event, present capital adequacy levels are too low to prevent crises. They may never have saved a bank and probably never will, but they discharge regulators if the requirements, however modest, are formally met. There is no shortage of regulatory power in regulators to do more but, beyond measuring regulatory capital, and now also leverage ratios and liquidity requirements, they often do not know what to do and must fear the charge of meddling, which makes them liable for the result even if after 2008 there was more enthusiasm among regulators to do so and, in support, probably even more so among politicians but to micro-manage banks through regulation in this manner was always a dubious proposition, aggravated by what is now called in the UK a judgement-based approach (see s­ ection 1.1.14 above). For financial stability, it was proposed that this micro-prudential approach be eclipsed by macro-prudential supervision, which is policy oriented and takes a more dynamic attitude to capital adequacy, including leverage ratios, and liquidity requirements, depending on where we are in the economic cycle—see again ­section 1.1.14 above. If properly handled that may make more sense and should, as has been submitted all along, concentrate on countercyclical measures as a matter of policy, not of regulation. This raises the important question whether the considerable extra expense of implementation of micro-prudential supervision for the industry is justified (except for conduct of business and market integrity where it is also failing), as there is no guarantee whatever that banking will become a less dangerous activity as a consequence unless much more capital were required and activities curtailed, which no-one wants. It has already been said several times that in that case they would hardly be able to

Part II  International Aspects of Financial Services Regulation 801

assume the modern liquidity-providing function for all that is politically required from them and also believed to underpin economic growth. This supports the continuation of existing business in which invariably high leverage figures as an important factor. There is here a fine line where the G-20 did not give guidance except to ask banks to restart lending and regenerate growth as soon as possible. Others would say that this was exactly at the heart of the banking problem. Again, the truth is that the social and economic consequences of doing otherwise are not acceptable, at least not in the West. Whatever the clamour for banks to be punished, what was the problem (high leverage) is then at the same time considered the solution. It demonstrates that in a modern economy there is no true way back; see also the discussion in ­section 1.3 above. Banking is inherently unstable because of the liquidity problems that are built into it, compounded by the modern credit demands that tend to lead to excessive leverage or gearing of society in good times and which we would like to see continued in the bad times that invariably follow. This is the conundrum in a banking system that has grown out of all proportion but without which we can no longer live. In a more rational world, banks need to be supervised, especially in good times, and curtailed. They should then build capital but be deregulated in bad times (except for conduct of business and market integrity). That may mean zero capital and no liquidity requirements or leverage ratios. That is macro-prudential supervision but the problem is that nobody is able to spot with certainty what good times are except in retrospect, although it is in fact not different in determining anti-cyclical monetary or fiscal policies. There is always want of some sort and nobody likes to cut. Rather, leverage appears to have become an inalienable right for all, supported by politicians who have come to the point of guaranteeing this kind of lifestyle for the multitude. That is where the votes are but it also suggests a higher risk of bankruptcy for all, banks and governments included, and a baked-in financial instability by which we choose to live. It was already said that banking as we now know it is a reflection of ourselves. In this environment, policy seems unable to see much coming. The result is that modern democracies are brought to their senses (but also their knees) mainly by crises. This was discussed in s­ ection 1.3.5 above and it continues unabated and nobody really seems truly to want it differently. In any event, deeper insights fail us and academic models fall short in ever-moving risk environments. Again, much regulatory effort as we know and practice it as a rule-based system is wishful thinking and doomed to be not much more than window dressing. One may well ask whether with present insights and intent, it ever could be otherwise.

802

Part III  The EU Regulations and Directives Concerning the Internal Market in Financial Services: Early Action, the European Passport, the 1998 EU Action Plan for a Single Market in Financial Services, and Further Action Following the 2008 Financial Crisis 3.1  Early EU Concerns and Action in the Regulated Financial Service Industries 3.1.1  Regulatory Restrictions on the Operation of the Internal Market. The Effect of Home and Host Regulation. The Concept of the General Good It was shown above in s­ection 2.3 that the slow opening of the market for financial services within the EU was partly due to the prospect of double regulation (different in home and host country) and further to the limited progress in the closely related area of the freedom of capital flows. The Founding Treaties themselves saw them indeed as connected (now in Article 58(2) TFEU), but by 1988 the freedom of capital flows was achieved in only three EU countries (Germany, the Netherlands and the UK) and this outside the EU framework. In these countries, this free movement operated in respect of all currencies worldwide. In the EU, only after the fundamental 1988 Directive freeing these capital movements within the EU by the middle of 1990s,372 did the freeing of the regulated financial services become a true priority—see further s­ ections 3.3 and 3.4 below. It was achieved by accepting home-country regulation of activities throughout the EU under minimum harmonised standards but still subject to g­ eneral-good exceptions which could reactivate host-country rule, in the event especially (and rightly) to protect smaller depositors and investors per country. However, the exceptions were increasingly limited under case law and better described in subsequent Directives, as we shall see, exactly to promote these free flows of financial services and products EU-wide. In ­2.3.1ff above, the subject of the operation of the EU internal market was introduced and also the relevant case law concerning the definition of cross-border movement and its promotion in order to understand the impact of regulation. It is clear that the threat of double regulation was a serious impediment to trans-border activity of regulated industries or services, in particular in finance. It should be repeated in this connection that in the EU approach, the free movement of persons, goods and services as well as the right of establishment under the direct applicability of the relevant treaty 372 

See s 2.4.1 above.

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articles are (together with the freedom to move capital and make payments) of a fundamental nature but have always been subject to a limited number of restrictions, which therefore may still limit these free flows. They are notably those concerned with public security, health and safety: see Articles 36, 52 and 62 TFEU.373 As already mentioned in ­section 2.3.3 above, the general-good exception was here introduced by case law as a similar overarching notion that proved relevant in trans-border finance, although not used in the Treaty but explored and ultimately also confined as we shall see by the ECJ. In appropriate cases, it may still lead to host-country restrictions on the free movement of goods, services and money. That may then still lead to dual regulation and remains as such a serious impediment to the free flows and an important EU preoccupation. It should also be remembered that the EU jurisdiction in this area is limited and does not go beyond what the free flow of financial services and products requires in this connection. The basic rule remains that Member States regulate the financial institutions and their activity in their own territory. Given here the initiative to the home regulator to regulate the activities of its own financial institutions EU-wide, is then the exception. That also applies to the passport as we shall see To step back, within the EU, the free movement of goods and the liberalisation of their transportation were substantially achieved by 1992 under what are now Articles 28ff TFEU on the implementation of the programme for the completion of the Common Market set into motion by the Single European Act 1987 (largely through the introduction of majority voting except in the areas of tax, labour and free movement of persons)—see also ­section 2.3.1 above.374 The Single European Act also initiated full liberalisation of capital flows and payments, completed through the highly important free movement of capital and money 1988 Directive, already mentioned.375 Services were liberated under Article 56 and the right of establishment under Article 49 in the ways explained in ­sections 2.3.1 and 2.3.4 above. So it was largely with the movement of persons where further Directives on professional services were still forthcoming. But as we have seen, they also left special problems in the traditionally regulated industries, therefore also in the financial services. As was noted before, towards the end of the 1980s, the EU was helped in this integration process by the internationalisation or horizontalisation of production worldwide and by the globalisation of the capital markets,376 both autonomous developments which ultimately also facilitated further progress in GATT and the creation of the WTO, including GATS (see s­ ection 2.2 above). In the EU, any remaining restrictions on the freeing of goods were eventually reduced to VAT and excise duty problems in the sense of compensatory charges still being levied at each border within the EU. Their elimination through harmonisation was finally agreed in 1992 (even though technically outside the 1992 Programme).377 373  Although not especially repeated in the context of the free movement of persons and services, these freedoms are closely connected with the freedom of establishment where they were again spelled out (Art 52). 374  It always remained subject to the special rules for agriculture within the Common Agricultural Policy (CAP). 375  See s 2.4.1 above. 376  See s 2.1.1 above. 377  See for this programme s 2.3.4 above.

Part III  The EU Regulations and Directives Concerning the Internal Market 805

Even then, the problem and danger of dual regulation (in home and host country) as a bar particularly to the free movement of financial services still had to be overcome. Again, this was a problem in all the service industries that were traditionally regulated and supervised, especially relevant for banks and investment securities and insurance companies. Article 57 of the original EEC Treaty, now Article 53 TFEU, provided for a system of Directives to facilitate the activities of intermediaries generally (self-employed legal or natural persons) in terms of removing legal and administrative impediments. Regulation remained, however, in essence purely domestic and the free movement of these services was under prevailing case law only considered liberalised, that is to say not subject to host-country regulation, to the extent that this movement was incidental—see ­section 2.3.4 above. This meant that any other movement of financial services crossborder remained potentially subject to regulation not only in the home country (therefore the country of the service provider), but could also be subjected to that of the host country. The already noted result was double regulation, which in practice constituted a serious bar to the free flow of these services. In fact, also incidental cross-border financial services coming from other Member States and, all the more so, more regular cross-border financial services even short of establishing formal branches or agencies (which were all the more vulnerable to dual regulation) could still be curtailed in the host country by considerations of the general good, which played a particularly strong and persistent role in this area, if only to protect smaller local depositors and investors. Pursuant to EU case law at the time,378 it allowed Member States as host regulators to insist on the creation of local branches subject to full host country authorisation requirements, although objectively only if indispensable as proper protection for host country clients. Alternatively, they could apply their regulation directly to services delivered from another Member State, especially if there was some regular presence in the host state or there was substantial targeting of this host country from elsewhere. As in the case of a branch, this could imply a need for full authorisation, but it could also be limited to conduct of business or product supervision only. Especially consumer or small-investor protection could thus continue to provide a strong base for (a) full hostcountry authorisation and supervision of service providers from other Member States, (b) host-country supervision of their conduct of business, and (c) host-country review

378  See Case 205/84 Commission v Germany [1986] ECR 3755, in which a German statutory requirement that a branch be established or implied in Germany to do direct (life) insurance business from another EU Member State was, however, rejected as generally disproportionate, although an authorisation requirement could still be imposed on the rendering of insurance services from another Member State while a permanent presence in ­Germany or these services being entirely or principally targeted at Germany from another Member State could still imply the existence of a branch properly subject to German authorisation. See on the notion of the general good, W van Gerven and J Wouters, ‘Free Movement of Financial Services and the European Contracts Convention’ in M Andenas and S Kenyon Slade (eds), EC Financial Market Regulation and Company Law (London, 1993) 55ff, and more particularly the Commission Communication referred to in n 295 above. See further also SE Katz, ‘The Second Banking Directive’ (1992) 12 Yearbook of European Law 249, 266; M Tison, ‘What is “General Good” in EU Financial Services Law?’ (1997) 2 Legal Issues of European ­Integration 1; and M Bjorkland, ‘The Scope of the General Good Notion in the Second EC Banking Directive According to Recent Case Law’ [1998] European Business Law Review 227; GA Walker, European Banking Law (London, 2007) 95ff.

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of their products while applying their own mandatory standards to the (foreign) financial or insurance products sold on their territory. At first, the insurance industry proved here a particularly sensitive industry, especially for the ‘mass risks’ normally insured by consumers such as fire and theft, the risks connected with the ownership or use of a car, and subsequently also risk to life itself. Local regulation continued here under the general-good idea as least in so far as some basic (insurance) protections were concerned. The concept of the general good was subsequently also used for other regulated services like in the cross-border banking and securities business. In case law within the EU, it became clear, however, that the general-good limitations on the free flow of financial services (as in other areas) would not only have to be reasonable, but had to be justified by pressing, even imperative, considerations. Restrictive local measures based on it could notably not be discriminatory nor lead to unnecessary duplication or disproportionate action (the principles of equivalency, proportionality and non-discrimination). These measures had to be objectively necessary and needed to be limited to areas not specifically harmonised by the EU379 and a public interest had to be served. To avoid home-country rule,380 which became the normal regulatory standard, the measures taken by host states pursuant to the notion of the general good also had to be suitable and capable of achieving the protection objective381 and should not go beyond it.382 Nationality could also not enter into it.383 Nevertheless, the effect of these limitations on the concept of the general good, even though important, was always modest. At least until the new generation of liberalisation Directives in the financial services area were enacted after 1988, which essentially opted for recognition of home-country regulation (subject to some harmonised minimum standards), the general-good exception to the free flow of financial services continued to serve as a substantial barrier to a common market operating in these services. Only subsequently, relevant Directives tried to push back the concept by defining (narrowly and more precisely) the room for host country protections

379  See for a summary of these criteria in particular see Case C-76/90 Saeger v Dennemeyer [1991] ECR I-4221. See also the Commission Communication referred to in n 295 above for the observation that the principle of proportionality may lead to greater restrictions where the cross-border service is permanent rather than temporary or incidental. Katz (n 378) suggests that the purpose of the general-good exception to home-country rule is to protect the users of financial services from unqualified, unethical, inexperienced or financially irresponsible service providers. After the Second Banking Directive and the Investment Services Directive, this was too broad an approach if service providers were authorised in another EU Member State. It left too much room for opinion and for host-country discretion. 380  cf Case C-55/94 Reinhard Gebhard v Consiglio dell’Ordine degli Avvocati e Procurati di Milano [1995] ECR I-4165. 381  cf Case C-362/88 GB-Inno-BM [1990] ECR I-667. 382  cf Case C-101/94 Commission v Italy [1996] ECR I-2691. 383  Thus Italy was not allowed to require all securities companies operating in Italy to be incorporated on its territory and to keep their registered offices there, which was in truth a nationality requirement: see Case C-101/94 (n 382); cf also M Andenas, ‘Italian Nationality Requirement and Community Law’ (1996) 17 Company Lawyer 219.

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3.1.2  Case Law Concerning the Notion of the General Good in Support of Host-country Financial Regulation As a general background observation, it may be repeated that the general-good exception had already started to operate in the EU in a broader area than that of the financial services industry to support, at least to some extent, domestic regulation, even if it intruded on the free flow of goods and services. It was first formulated in the EU through case law in 1979,384 and became important in financial services pursuant to the German insurance cases in 1986. It has since been used in the area of consumer protection,385 the protection of workers,386 the protection of creditors and the proper administration of justice.387 It is has also been used for social protection,388 to retain the cohesion of local tax regimes,389 to preserve the good standing of an industry,390 to prevent fraud,391 and in certain other areas not directly related to the service i­ ndustries.392 In fact, in this manner it became a general and overarching concept, which could even be deemed to include the public policy, security, safety and health exceptions to the free movement of goods and the freedom of establishment, which the treaties themselves had formulated and earlier as exceptions. The concept of the general good itself is not outrageous if it serves to fit the liberalisation measures better into the domestic environments of the various Member States, to avoid undue stress in the liberalisation process, to achieve better co-operation, or to deal promptly with emergencies, pressing conduct of business issues, market manipulation or fraud. In those situations, the liberalisation could even be served and made more effective by the use of the notion of the general good in favour of host country regulation, while the credibility of all regulation in this area could be enhanced. If used, however, mainly to protect overriding local interests in the host state, it is reminiscent of the concept and operation of public policy in private international law. In any event, in the EU this is subject to the freedoms guaranteed in the founding treaties promoting the free flows of persons, goods, services and money as the higher policy objective. This implies limitations on host-country protections which do not obtain between freely operating sovereign states. Although this still allows the general-good concept to be used, particularly for host-state protection of overriding consumer interests, it follows that its use is mostly unsuitable, especially in the professional area, and always exceptional.

384 

In Joined Cases 110/78 and 111/78 Van Wesemael [1979] ECR 35. See for the consumer protection aspect, Case 205/84 Commission v Germany [1986] ECR 755. 386  Case 279/80 Webb [1981] ECR 3305. 387  Case C-3/95 Reisebüro Broede v Gerd Sandker [1996] ECR I-6511. 388  Case C-272/94 Guiot [1996] ECR I-1095. 389  Case C-204/90 Bachman [1992] ECR 249. 390  Case C-384/93 Alpine Investments BV v Minister van Financien [1995] ECR I-1141. 391  Case C-275/92 Schindler [1995] ECR I-1039. 392  See Case 62/70 Coditel [1980] ECR 881 in connection with the protection of intellectual property; Case C-180/89 Commission v Italy [1991] ECR 709 in connection with the preservation of the national heritage; Case C-353/89 Mediawet [1991] ECR I-4069 in connection with cultural policy; Case 55/93 Van Schaik [1994] ECR I-4837 in connection with road safety extendable to environmental matters generally. 385 

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As just mentioned, in financial services, it became in any event a more limited concept after the generation of liberalisation Directives since 1988, therefore especially after the SBD (now consolidated in the Credit Institutions Directive of 2000, recast in 2006 and 2013), the ISD (in 2007 succeeded by the MiFID of 2004 and MiFID II in 2014), and the Third Generation of Insurance Directives. It was already said that much of the subsequent concern of the EU was to do away with the concept in financial services altogether and replace it with a system of hard rules indicating more precisely where host-country rule was still allowed. As we shall see in ­section 3.3 below, under these Directives, importantly, branches of EU-based banks in other Member States also became subject to home regulation, at least for authorisation and prudential supervision and no host-state authorisation could be imposed any longer. It did not fully eliminate the possibility of imposing host-state rules of conduct of business or product supervision in respect of retail customers, but again only within the general-good concept and its limitations, which basically reduced it to small depositors’, borrowers and investors’ protection. In commercial banking it never meant much and in MiFID the concept of the general good is virtually eliminated, at least in the text, although there may still be residual importance of the concept through case law, especially where it may be considered of a fundamental nature.

3.2  The Early EU Achievements in the Regulation of Financial Services 3.2.1 Banking As we have seen more particularly in s­ection 2.3.4 above, at first the EU tried a full harmonisation approach of all financial regulation in Member States, but it proved too legalistic and complicated and hence failed. Some modest progress was nevertheless made, especially in the banking field, on the basis of a number of early Directives, most of them, however, with limited objectives. To better understand what followed, it may be useful briefly to summarise the earlier steps. By 1987, the sum total of EU endeavours in the banking field was largely the First Banking Directive of 1977 aiming at the harmonisation of the conditions for establishing branches or agencies EU-wide. It still allowed endowment capital for branches of banks from other EU countries. It did not aim at one single supervisory regime but implicitly continued to accept the concept of market fragmentation under host regulation as we shall see. Yet it narrowed the differences in regulation pertaining to the creation of branches in other Member States. It was followed by the Consolidated Supervision Directive of 1983 and the Consolidated Accounts Directive of 1986. Thereafter followed the Large Exposure and Deposit Guarantee Scheme Recommendations of 1986 and 1987, see also the next section. In the field of mortgage credit, an early effort to make a special Directive in this area was abandoned. This service was only liberalised together with other banking services through the much later Second Banking Directive (SBD), which liberalised the field

Part III  The EU Regulations and Directives Concerning the Internal Market 809

by first adopting the European passport in this area. As we shall see, much of the substance of these Directives to the extent still relevant, is now subsumed in the Credit Institutions Directives, first of 2000, superseded by a new text in 2006 and 2013 (see ­sections 3.5.1ff and s­ ection 4.1.2 below). By 2010 there was also the reconsideration of a separate Directive in the area of mortgage credit: see more particularly ­sections 3.2.3 and 3.6.11 below.

3.2.2  Details of the Early Banking Directives and Recommendations The First Banking Directive393 was preceded by a Directive of 1973 on the abolition of the restrictions on the freedom of establishment and on the freedom to provide services in respect of self-employed activities of banks and other financial institutions,394 which followed an even earlier 1964 Directive concerning the freedom of establishment and the freedom to provide services more generally, which had excluded banking and other financial institutions from its coverage. As already mentioned, the aim of the First Banking Directive was more particularly for each Member State to create a non-discriminatory authorisation regime for all credit institutions operating on its territory, whether or not based in other Member States. It thus considered the rights and conditions of establishing branches or agencies in the Member States for EU-based entities on a non-discriminatory basis. Branch activities remained otherwise subject to supervision by the host country, however, each with its own authorisation regime. For banks, they were only subject to a few harmonised rules on prudential supervision (such as the requirement of a minimum of two managers of good standing and a proper business plan) and capital protection (designated capital). For insurance branches, there was some harmonisation on formalities, scheme of operation, technical reserves and solvency margins. The essence was, however, that there were no single-licence, shared-supervision, or even harmonised regulatory standards. However, any discrimination in favour of nationals was forbidden. On the other hand, branches from entities outside the EU could not be given better treatment. The idea was therefore non-discrimination under host-country rule. Importantly for the longer term, the First Banking Directive instituted a system of co-operation between the EU Commission and the supervisory authorities of the Member States. The Directive, although now substantially superseded, remains of importance in this latter aspect (as the relevant Advisory Committee proved very instrumental in the further progress of liberalisation in the banking sector) and for the definitions of financial institutions and their activities. The Consolidated Supervision Directive of 1983395 followed the Banco Ambrosiano affair and introduced the notion of consolidated supervision of banking activities

393  Council Directive 77/80/EEC [1977] OJ L322 as amended by Council Directive 86/524/EEC [1986] OJ L309. 394  Council Directive 73/183/EEC [1973] OJ L194. 395  Council Directive 83/350/EEC [1983] OJ L193.

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by the regulator of the head office of a bank established in the EU (home regulator), although this did not by itself preclude supervision by the host state. It tracked the BIS Basel Concordat: see also ­section 1.2.4 above. Included in the consolidation were also (more than 50 per cent) controlled companies that granted credits or guarantees, acquired participations or made investments, but not yet other sectors of the financial services industry such as insurance. For banks within the EU operating in other Member States this is now substantially superseded by the EU Banking Directives, which incorporated this Directive. The Consolidated Accounts Directive396 harmonised in 1986 the accounting rules for banks, largely following (except for some terminology, layout and valuation aspects) the Fourth Company Law Directive (1978), which had exempted banks and other financial institutions from its accounting and disclosure requirements. Amendments were added from time to time on the basis of the recommendations of the Accounting Consultative Committee. The Seventh Company Law Directive (1983) on consolidated accounts was also relevant in this connection. Contrary to the principles of the Company Law Directives, the Consolidated Accounts Directive notably allowed prudential undisclosed reserves and eliminated the need for separate accounting for branches of credit institutions incorporated in other EU countries. Branches of non-EU banks were covered for their annual accounts by another Directive.397 In the field of large exposures, there followed a Recommendation in 1986.398 It suggested regular reporting of large exposures of banks to one single client (equivalent to 15 per cent of a bank’s capital), which should not exceed 40 per cent of its capital, while all large exposures together should not exceed 800 per cent of its capital. It was followed by a Directive in 1992 (see s­ ection 3.3.1 below). The Deposit Guarantee Scheme Recommendation of 1987399 set out some principles for all Member States in terms of the protection of depositors in the event of bankruptcy of a bank. It also covered deposits in branches in other EU countries under host-country rule and was followed much later by a Directive effective since 1995: see ­section 3.6.2 below.

3.2.3  Mortgage Credit An early proposal on the free establishment and supply of services in the area of mortgage credit,400 already mentioned, was meant to supplement the First Banking Directive. It intended to allow mortgage institutions incorporated in a Member State to undertake mortgage business throughout the EU, either through local branches or directly, even using the financial techniques of their home countries. The result would have been that, for example, English endowment mortgages or German mortgage bonds

396 

Council Directive 86/635/EEC [1986] OJ L372. Council Directive 89/117/EEC [1989] OJ L44. 398  Recommendation 87/62/EEC [1987] OJ L33. 399  Recommendation 87/63/EEC [1987] OJ L33. 400  COM (84) 730 final [1985] OJ C42 and COM (87) 255 final [1987] OJ C161. 397 

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could in this manner be marketed EU-wide while domestic institutions would have been allowed to adopt similar techniques in their own country even if their own law had not so far allowed them to do so. The ultimate responsibility for the supervision of intermediaries was split: if there were branches, they were subject to host-country rule; direct services were subject to home-country rule, subject to consideration of the general good. The later SBD leading to the European banking passport under home-country rule (see ­section 3.3.1 below) superseded this approach, at least in the areas of authorisation and supervision, and also covered mortgage credit: see its Annex 1, footnote 1. Although it did not so specify, under the general rules, the question of the mutual recognition of the financial techniques and products in this area could still be subject to the notion of the general good in the host country, however, especially relevant to the selling methods used and the products offered. It could therefore still lead to hostcountry intervention, especially to protect consumers who are largely the customers for mortgage products. The 1997 Commission Interpretative Communication concerning the general good,401 did not cover the question of mortgage products nor the aspect of conduct of business, including the sales techniques concerning these products, see generally for the approach to the general good ­sections 2.2.3 and 3.1.2 above. Further progress in this area of mortgage credit appeared not to have a high priority. Because of the mostly domestic nature of mortgage products, creating subsidiaries or acquisition of mortgage companies in host Member States remained the more normal approach for service providers from other Member States in this business. However, by 2005, there was further movement, the European Parliament adopting in 2006 a report on mortgage credit following a 2005 Green Paper on the subject.402 It concerned itself with pre-contractual information supply, a single funding market, the entry of non-deposit-taking institutions into this market (which is a matter of freedom of services and establishment, the use of the general good as a bar, and private-law limitations on the transfer of loans and mortgages cross-border), and the systemic risk and macroeconomic and prudential effects. An EU Directive has now been adopted in this area.403

3.2.4  The Early Securities and Investments Recommendations and Directives In the area of regulation of investment security products and services sold or rendered cross-border within the EU, there was no early activity of the EU and the subject remained largely overlooked even in the 1987 White Paper leading up to the Single European Act 1992. Instead, the EU at first concentrated largely on stock exchange operations and co-operation and only later started to focus on broader areas of fi ­ nancial

401  402  403 

See n 295 above. See for the Green Paper COM (2005) 0327 and for the Parliament’s Report Final A6-0370/2006. See s 3.6.11 below.

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stability, and more especially on investor protection as a matter of conduct of business as we have seen and on the operation of the capital markets cross-border. Under the earlier approach, in 1977, there was agreement on the Admission, Listing, Interim Reporting, Mutual Recognition and Public Offer Prospectus Directives, and finally the important UCITS Directive, which first introduced the home-country supervision approach in the supervision of the cross-border unit trust business and is as such of fundamental historical importance. As we shall see in s­ ection 3.2.5 below, the UCITS Directive, which addressed the issue of the selling of (open-ended) mutual fund products cross-border in the EU, foreshadowed the home/host regulatory supervision system, which was to become the prevailing one later in the supervision of all crossborder financial activity in the EU under the Third Generation of EU Directives in this area after 1988, leading to a system of passporting of these services, since 2003 also adopted for the so-called issuer’s passport as will also be discussed shortly. Of further historical importance in these developments was the Recommendation concerning a Code of Conduct for Securities Transactions of 1977.404 Although only a Recommendation, it laid down a programme of what amounted to harmonisation of some stock exchange practices and some better investor protection. It did not envisage one coherent approach, nor did it present a clear vision, but it was nevertheless of interest as it led to the just mentioned Directives concerning Admission, Listing, Interim Reporting, Mutual Recognition and the Public Offer Prospectus—see the Admission Directive (1979), the Listing Particulars Directive (1980), the Interim Reporting Directive (1982) and the Mutual Recognition Directive (1987).405 The first four clearly focused on domestic stock exchange operations and were eventually consolidated in the Consolidated Admission and Reporting Directive (or CARD) in 2001 (2001/34/ EC), see further s­ection 3.5.10 below. Only the Public Offer Prospectus Directive of 1989406 had a broader scope and applied to all public securities offerings (except eurosecurities as defined) on- or off-exchange. It was superseded by the Prospectus Directive of 2003, see ­section 3.5.10 below, in turn superseded by the 2018 Regulation see ­section 3.7.14 below The 1979 Admission Directive was partly directed at a situation in which, especially in southern Europe, considerable discretion was exercised in the matter of the listing of security issues on the regular exchanges. It continued to allow, in Article 5, local restrictions, but within a clear legal framework. If investors’ protection was the motive, there could be greater flexibility in this respect (Article 10). The Directive only set a number of minimum conditions for admission of security issuers and their issues to exchanges (which remained undefined). These concerned notably the legal formation and operation of the issuer, size of capital (at least ECU 1,000,000 including retained earnings), and the minimum period (at least three years) of existence of the company listing

404 

Recommendation 77/534/EEC [1977] OJ L212. Respectively Council Directive 79/279/EEC [1979] OJ L66; Council Directive 80/390/EEC [1980] OJ L100 as amended, and Council Directive 90/211/EEC allowing for mutual recognition [1990] OJ L112 and by Council Directive 94/18/EEC [1994] OJ L135; Council Directive 82/121/EEC [1982] OJ L48; Council Directive 87/345/ EEC [1987] OJ L185. 406  Council Directive 89/298 EEC [1989] OJ L124, containing a mutual recognition regime in Art 21. 405 

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its issues. For shares, it insisted on a satisfactory legal framework, their full transferability, the existence of a sufficient number of them, and on their adequate physical form. Bond issues had to have a minimum outstanding value of ECU 200,000. Convertible or exchangeable bonds or bonds with warrants could be listed only if the related shares were already listed or were being listed at the same time, unless the competent authorities were satisfied that all information necessary to form an opinion concerning their value was available. Refusals of admission to listing were made subject to proper appeal possibilities (Article 15). Prior issue and listings of shares of the same class or of pari passu bonds should have been properly handled. Subsequent to listing (but always under the Admission Directive), issuers had a number of obligations, mainly concerning the publication of annual accounts, of material new developments concerning the company, and of any change in the rights of security holders. In the information supply, there had to be equal treatment per class and the information had to be made available to all markets on which there was a listing of the relevant issue in equivalent form (and supposedly simultaneously). Any amendment to the instrument of incorporation of the company concerned had to be disclosed to the competent authorities of the state where the securities were listed. The language of the communications had to be that of the relevant exchanges except where the competent authorities accepted another language customarily used in financial affairs. The language of the admission prospectus could be decided by the local authorities. It had to be published in an official gazette or similar means of communication. The 1980 Listing Particulars Directive concerned especially this prospectus as it covered the initial disclosure requirements for the listing of shares, bonds and certificates representing shares such as depositary receipts.407 The 1982 Regular Financial Reporting of Listed Companies Directive built on the notions of investor protection and ongoing disclosure of financial information to all investors at the same time. It assumed a full report on the listed companies’ activities under applicable company law at least once a year pursuant to the Fourth and Seventh Company Law Harmonisation Directives and concentrated therefore particularly on

407  The concern of this Directive was the great difference under domestic laws in the layout and contents and in the efficacy, method and time of any supervision of the information provided in this connection. The prospectus had to provide all information necessary to enable investors and their advisors to make an informed assessment of the financial health of the issuer and of its prospects. It had to contain the names and functions of the persons responsible for them, a declaration that to the best of their knowledge the particulars that were given were in accordance with the facts and contained no material omissions as supported by the findings of the auditors concerning the annual accounts. The basic information concerning the issuer related to capital structure, principal activities, assets and liabilities, profits and losses, and recent developments in the business and its prospects. The prospectus also had to contain the relevant information of the issue itself, notably its form and conditions, whether the investment securities had already been marketed, the rights attached to them, the tax arrangements concerning them (like withholding taxes), date of dividend or coupon payments, name and whereabouts of paying agents, etc. It needed approval of the competent authorities as part of the listing process. This Directive was amended in 1987 (as part of the 1992 EC programme) to provide for a system of mutual recognition where listing was requested in more than one Member State. A compulsory recognition regime was provided in the Mutual Recognition Directive of that year under which the recognising State could impose only minimum extra requirements concerning the additional market on which listing was sought, the relevant tax regime, paying agents and the publication method of notices. The mutual recognition of admission prospectuses was further strengthened in an amendment of 1990, following the 1989 Public Offer Prospectus Directive, which already contained a better regime in this connection.

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interim reporting after the first six months of each financial year. It set standards for it, aiming only at a disclosure of the essentials of the financial position and the general progress of the business. It did not need to contain an interim balance sheet and profit and loss account (even in unaudited form). Incidental developments must be reported under the Admission Directive itself. The 1989 Public Offer Directive was meant for all unlisted public offerings (it may at the same time be used for listing subject to an equivalence test under the conditions of the Listing Particulars Directive). Euro-securities were lifted out of the draft as it was accepted that they were often issued in response to rapidly changing market conditions. They did not always allow for the issue of a prospectus before placement while they were generally issued internationally to professionals only (and the definition of euro-securities reflected this). In any event this Directive applied only to issues with denominations smaller than ECU 40,000 and was therefore directed towards information for and protection of the smaller investor.408 Again, much of this in now consolidated into CARD as we shall see in ­section 3.5.10 below, but also superseded by the 2003 Prospectus and Transparency Directives.

3.2.5 UCITS Separate from this limited programme pursuant to the 1977 Recommendation, the EU agreed in 1985 a Directive on Undertakings for Collective Investments in Transferable Securities (UCITS), allowing their products to be marketed EU-wide.409 Among the earlier Directives, the UCITS remains of particular relevance. It concerns the operation of open-ended funds EU-wide. It was already said that it proved of much greater importance, especially because it introduced for the first time the notion of a ­European passport for financial services. A further 1993 proposal sought to include money market funds and funds investing in units of other UCITS and allowed a UCITS freely to choose depositories in other Member States if properly supervised in that state.410 It also proposed to allow the use of standard derivatives to better manage risk. This proposal was amended in certain aspects on 20 July 1994,411 but encountered problems. Further amendments were proposed in 1998, the one expanding the number 408  The Directive sought a genuine information supply in all public issues, including if no listing was intended, and required that even in such cases a prospectus was prepared and communicated to the relevant authorities in Member States where the securities were offered. It had to be made public in such states (Arts 14 and 15). There was no need for prior approval of the prospectus by such authorities as there was in the case of the listing prospectus. In that case it was easy to enforce, as listing will be withheld without it. The requirements of the prospectus were very similar to those for the listing prospectus. If its information was equivalent to that of a listing prospectus, it could be used as such (within three months) in countries where listing was requested. Upon a first approval of such listing, it had then to be recognised in other Member States (subject to proper translations) where additional listings were required (Arts 20 and 21); see also Art 24b of the 1982 Listing Particulars Directive as amended. The Public Offer Prospectus itself could be used in other EU countries pursuant to the necessary communication to the competent authorities and publication under Arts 14 and 15. 409  Council Directives 85/611/EEC and 85/612/EEC [1985] OJ L375, as amended by Council Directive 88/220/ EEC [1988] OJ L100 increasing the maximum ceiling of investment in a single issuer from 10 per cent to 25 per cent. 410  COM (93) 37 final [1993] OJ C59. 411  [1994] OJ C242.

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of products in which UCITS could invest, which was therefore a follow-up to the 1993 proposal, the other concerning management companies and their authorisation and supervision.412 Only pursuant to the 1998 EU Financial Services Action Plan were these problems resolved in two Directives in 2001.413 The more direct aim of the UCITS Directive was to allow marketing of collective investment schemes of the open-ended type in all Member States under certain minimum standards as regards structure, activity and disclosure. These funds may now be marketed in all EU countries subject to home-country authorisation and supervision (per individual scheme), although some minimum requirements are laid down in these areas (Article 4), and always provided that the scheme’s operator produces a home regulator certificate that home rules have been observed before the operations can start in another Member State and has organised payment facilities there. Host-country rule was allowed and remains effective, however, in the area of advertising and marketing (and also outside the aspects specifically covered by UCITS Articles 44 and 45). The general-good exceptions are in this way embedded in a more formalised structure, later on followed more generally in MiFID as we shall see. Interestingly, the EU Commission did not directly attempt to erode restrictive sales practices in this area (see third Recital). Pursuant to the 1998 EU Financial Services Action Plan, the original UCITS Directive was extended in 2001 by the two new Directives, already mentioned. The first Directive concentrated on management, giving the same facilities as investment firms under the ISD to operate in other EU countries. The second one concentrated on products and expanded the range to include money market instruments, units of funds that did not themselves qualify for UCITS status, bank deposits and financial derivatives. By 2010 further action was taken in this area— see ­section 3.5.14 below. There is a legitimate question, however, whether Directives of this nature are still necessary in the fund management area or whether funds could now function transborder in the EU under the more general regime for all financial services resulting from the Third Generation of EU Directives in this area and their progeny. This is, however, not the direction and for other types of investment funds, the Alternative Investment Fund Management Directive (AIFMD) was later on enacted as part of the post financial regulatory activity, see ­section 3.7.7 below.

3.3  The European Passport for the Financial Services Industry 3.3.1  The Third Generation of EU Directives. The Development of the Passport In s­ection 2.4.1 above, it was shown that the liberalisation of capital flows and payments through the 1988 EU Directive proved of major importance. It made the further 412 

COM (98) 0449 final and COM (98) 0451 final. EU Directives 2001/107/EC and 2001/108/EC, both of 21 January 2002, of the European Parliament and of the Council [2002] OJ L41/20 and L41/35. 413 

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liberalisation of the financial services sector within the EU more urgent, and accelerated the pace. This liberalisation was in fact forced on the EU at the risk of its being overtaken by events which could have affected the viability of the financial services industry in the EU, particularly in countries other than the UK. In other words, most major financial business could have moved to London if it was not doing so already, at least for the wholesale financial business. The technique chosen was to abandon the idea of progressive harmonisation of regulatory standards. As already mentioned, it accepted instead: (a) mutual recognition of home-country rule with only minor exceptions; and (b) a small number of uniform rules notably as regards: (i) the authorisation requirement itself and its basic conditions, notably the required capital; (ii) prudential supervision; and (iii) some aspects of the conduct of business, especially in the securities and insurance sectors. The key was therefore regulatory competition under a system of mutual recognition of home-country standards of authorisation, capital, and supervision for cross-border activities EU-wide, including any branches elsewhere, which could be freely set up. It resulted in the European passport for financial service providers who are incorporated in the EU and are subject to proper authorisation and supervision in their home state (state of incorporation and principal business—it is suggested that these places should be the same). As we have seen, this approach was foreshadowed in the UCITS Directive of 1985 (see ­section 3.2.5 above)414 and was first formulated as a more general policy in the June 1985 White Paper on the Completion of the Internal Market (page 27). It happened in partial reliance on the Cassis de Dijon case (see ­section 2.3.3 above), which, however, concerned the free movement of only (dangerous or unhealthy) goods under the old Article 30 of the EEC Treaty (now Article 34 TFEU).415 The essence was that goods sold in the home market subject to home-country rule would be able to circulate EU-wide unless there were justified concerns (besides public health) of the host states in the context of the general-good exception (to home-country rule). Through the White Paper this basic approach of mutual recognition of home-country rule was

414  It was, in fact, also foreshadowed in the First Banking Directive of 1977 (10th Recital). The First Banking Directive itself, see ss 3.2.1/2 above, although setting out some common regulatory standards for authorisation and requiring some branch capital, did not yet provide, however, a sufficient basis for home-country authorisation and supervision, as admitted in its Art 4(1). 415  Case 120/78 Rewe-Zentral AG v Bundesmonopolverwaltung für Branntwein [1979] ECR 649, in which it was decided that, under Art 30, in the absence of common EC rules, Member States still remain competent to regulate the production and use of goods. They may do so even if this results in restrictions on their importation from elsewhere in the EU through the imposition of mandatory rules concerning health, fairness or the protection of the consumer, provided that it can be shown by the relevant authorities that the restrictions were necessary while the measures taken were proportionate and did not duplicate. Limitations could thus result from Art 30 on the basis of public morality, safety and health. In the area of regulated services, this amounts to the general-good exception: see also s 3.1.2 above. In the Rewe case, it was decided, however, that the French (home) regulation for the spirits shipped to Germany was sufficient and that there was therefore insufficient justification for duplicatory German (host) regulation, although quite different.

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extended to services under Article 59 EEC Treaty (now Article 56 TFEU)416—see also ­section 2.3.1 above. For financial services too, mutual recognition of home-country regulation remained subject to the notion of the general good, as we have seen. It could thus still provide an exception to home-country rule, but only in exceptional cases (see s­ection 3.3.2 below) although the objective of Directives in this area became to limit the reach of this exception, now, for investment services, more particularly in the MiFID, effective since 2007 (see ­3.5.3ff below). To repeat, the consequence of this new approach was regulatory competition between various home-country rules operating side by side depending on the origin of the service provider involved. To repeat, important areas of host-country rule remained, however, in the areas of conduct of business and product control, especially to protect smaller investors. The general good notion was then used in support. For banks, this liberalisation was first reflected in the 1988 Second Banking Directive (SBD) (effective on 1 January 1993), consolidated in the Credit Institutions Directive (CID) in 2000, itself superseded in 2006 by a new CID Directive and again in 2013.417 For the securities industry, it was covered by the 1993 ISD (effective on 31 ­December 1995), now superseded by MiFID, effective since 2007,418 followed by MiFID II in 2014,419 and for the insurance business by the Third Insurance Directives for the life and non-life business, agreed in 1991 and effective since 1 July 1994.420 The totality of EU Directives at the time was also referred to as the Third Generation or Liberalisation Directives. They incorporated the idea of mutual recognition of home-country rule, subject to some harmonised rules for the authorisation and supervision requirements. In this connection, the substantial harmonisation of the capital adequacy standards (subject to local implementation) as a major part of the authorisation and supervision (prudential) regime was for banks achieved in the Own Funds and Solvency Directives of 1989 (effective on 31 December 1992),421 following Basel I and consolidated into the CID 2000 and 2006, the latter also covering the effect of Basel II, followed later by amendments under Basel III (see ­3.7.3/4 below). For the securities industry

416  In the event not fundamentally pursued in the 2006 Services Directive, see n 304 above, which proved a disappointment because of much political resistance in some Member States and it was not able to do much more than restate existing case law. This area will probably be revisited in due course as trans-border services remain much hobbled by host-state regulation. 417  See the Second Banking Directive, Council Directive 89/646/EEC [1989] OJ L386, the Credit Institutions Directive, Directive 2000/12/EC of the European Parliament and of the Council of 20 March 2000 [2000] OJ L126, and the Credit Institutions Directive, Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006. Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of [both] credit institutions and investment firms, amended Directive 2002/87/EC and repealed Directives 2006/48/EC and 2006/49/EC [2006] OJ L176/338. It was supplemented for the capital and liquidity requirement by Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms at the same time (CRR) [2013] OJ L176/1, see s 3.7.4 below. 418  Council Directive 93/22/EEC [1993] OJ L141. 419  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments amending Directive 2002/92/EC and Directive 2011/61/EU [2014] OJ L173/349 supplemented by MiFIR, Regulation (EU) No 600 of the European Parliament and of the Council of 12 June 2014 [2014] OJ L173/84, see s 3.7.5 below. 420  Respectively Council Directives 92/49/EEC [1992] OJ L228 and 92/96/EEC [1992] OJ L360. 421  Respectively Council Directives 89/229/EEC [1989] OJ L241 and 89/647/EEC [1989] OJ L386.

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(including the securities activities of universal banks) the Capital Adequacy Directive of 1993 (effective on 31 December 1995)422 covered capital, now superseded (since 2006) by the Capital Adequacy of Investment Firms Directive, covering also a further revamp to provide for Basel III. As already mentioned, the capital requirements for both commercial banks or credit institutions and investment firms are now consolidated in Regulation (EU) No 575/2013, see ­section 3.7.4 below.

3.3.2  The Reduction of the Role of the General Good Supporting Host-country Rule in the Third Generation Directives The Third Generation of liberalisation Directives in the EU as from 1988 reduced the impact of the general good in support of host-country rule by making the notion subject to more specific rules, thereby reducing its more general overarching nature. However, as we have seen, the notion was not eliminated and under case law could still lead to some form of fragmentation of regulation and supervision along national host-country lines and particularly allow host-country interference in sales methods and products, especially to protect consumers and small investors on their territory. This became therefore largely a conduct of business issue, although as just mentioned the possibility of host regulation in this connection was further pushed back through more precise rules in MiFID of 2004, effective in 2007 and in MiFID II effective in 2014. In fact, in the Third Generation Directives, notably in the Investment Services Directive (ISD), and contrary to the original proposals, the conduct of business rules were largely left to the host country while the concept of the general good still served to amplify the host-country rules in this connection. Nevertheless, the concept could no longer be used for host-country intervention where the newer Directives provided a clear home-country rule. Thus, under these Directives, host countries could in particular no longer require the establishment of a branch subject to their own authorisation and regulation. Where a branch was established by a service provider from another Member State, it was explicitly made subject to home-country rule, at least in the areas of authorisation and prudential supervision. Even after these Directives, the concept of the general good continued as an unsettling element in the provision of cross-border financial services423 and could give rise 422 

Council Directive 93/6/EEC [1993] OJ L141. It still meant limitation of host-country rule in the areas of the conduct of business and product control to consumer business only. For professional dealings home-country rule was probably applicable. In any event, home-country rule in the area of conduct of business and product control was not to be ousted and the home regulator could still set standards in this area for its own service providers when operating at home or abroad, if only to protect the reputation of its own financial system: see the Alpine Investments case (n 390). We are concerned here with market access, with behaviour of service providers in the foreign market, eg their selling (particularly cold calling and advertising) techniques, and with the nature of the products they try to sell in that market, their suitability, eg in the case of insurance products, their legal characteristics, for example in the case of mortgage credit, and their proper settlement or unwinding facility, eg in the case of OTC swaps, but also the possibility of their proper protection through segregation between assets of clients and service providers, eg for investment securities bought and held by brokers in their own name but on their clients’ behalf. Clearly there may here be regulatory but also private law concerns, even though the ECJ has so far hardly ever dealt with the latter. 423 

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to abuse through self-serving action of host regulators,424 which action could subsequently be undone by the ECJ, however, although it was a costly and long-winded procedure.425 The balance reached in the earlier Directives between home and host regulation (with emphasis on the former), could thus still be upset. The European Commission already in its 1997 Interpretative Communication on the notion of the general good426

What does not seem possible, however, is to keep foreign services and products out on the basis that they have never been offered in host states in the manner proposed by foreign service providers, cannot be accommodated by the host country’s legal system, or can only be offered in the manner customary in the host state simply to protect local operators or even wholesale (professional) customers, certainly if these practices and products are normal and currently offered in the home state or more generally in countries with an advanced financial system. 424  In practice, claims to host regulation gave rise to problems mainly in four areas. First, under cover of monetary policy, statistical information gathering or more generally the general good, host countries continued to require the issuing of eurobonds in their currencies to take place in their own financial centres. Yet the issuing itself is no monetary matter, statistical information on it can be gathered separately and the general good seems not to be involved (only the interests of local underwriting banks). It was clearly untenable. Another difficulty was that host regulators attempted to require foreign service providers to register fully with them to share in their costs (and not only those directly related to conduct of business supervision). For statistical information gathering, local systems compatible with those of the host regulator have been required, which can be very costly for the foreign service provider. Finally, the issue has arisen whether, as part of its conduct of business and product control, a host regulator may insist that its own law applies to these products and that they be dealt in its own local markets. For securities, that last point has largely been resolved by the anti-concentration principle of the Investment Services Directive and the new approach in MiFID: see also s 3.5.7 below. The general-good exception to home-country rule also played a role where host regulators continue to insist on prospectus requirements for public issues emanating from other Member States or on some form of local registration of primary issues that may be placed in the host country. This may be especially relevant when they are meant to reach consumer investors. Although eurobonds were exempted from the relevant EU Prospectus Directive at the time (see s 2.1.2 above) some Member States still took a more restrictive attitude here. The mutual recognition of prospectuses was a bar to this requirement but did not affect government bonds, which were exempted from the relevant EU Directives at the time. The prospectus or registration requirements did not affect secondary trading either where, in the consumer area, host-country rule in any event prevailed under the relevant Investment Services Directive or under the notion of the general good. Sales restrictions imposed by the issuer on eurobond sales, particularly into the US and UK, also often reflected host-country regulation. Within the EU, such regulation appeared to be justified only on the basis of the general good or on the basis of the monetary-policy exemption to home-country rule. If, nevertheless, the issuer imposed them also on bondholders, this was another matter and an issue of contract law. 425  In emergency situations, the host regulator could still have a role to play but, where it had not been given original powers of co-operation, only as ad hoc representative of the home regulator and until the latter can act, especially relevant to prevent market manipulation and fraud. An example may help. Assume a foreign bank operates or wants to operate a number of ATM machines in another EU country. Regardless of whether the activity were incidental or maintained through an official branch, authorisation and supervision would be home-country matters. Even if conduct of business and product supervision had a host-country bias under the ISD this was not so under the Banking Directives. Leaving monetary and liquidity policy considerations to one side (and also the question as to which currencies could be distributed in this manner), any intervention of the host state would have to be based on general-good considerations. They are severely limited by case law, as we have seen above in s 3.1.2. The customer’s protection would have to be paramount and require it. The concern ought to be specific, but it could focus on the proper mechanical functioning of these machines (fraud would also be a legitimate hostcountry concern), but probably not much more. European case law may suggest host-country powers on the basis of the general good, also to protect more generally the integrity of the host-country financial system and its supervision. The coherence of the host-country tax system and the effectiveness of tax collection have also been issues. They may become so more particularly in connection with the free movement of capital and the movement of investments. Short of EU action in these areas, which in its harmonisation and interpretative efforts is motivated by the importance of integrity of the financial system as a whole, host-country intervention to protect national financial and tax set up at the expense of the free flow of financial services hardly seems appropriate. 426  See n 295 above.

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showed its concern and wariness in this connection. In MiFID, which succeeded the ISD effective since 2007, there were few references to it left, and the idea was to capture the notion in more precise home/host regulation terms in a so-called maximum Directive. This is followed in MiFID II as from 2014. Yet the concept remains important and a strong underlying idea that may resurface through case law at any time. The limitations on the concept of the general good introduced by case law may, on the other hand, also become relevant for the small number of instances of host-country rule specifically introduced by the Directives, as in monetary and liquidity policy for banks, and underline its exceptional nature.427 Finally, the consequence of the Third Generation Directives was that the whole financial regulatory scene in the EU was substantially pre-empted by it. Even regulation in respect of purely domestic financial transactions was covered by the implementation of the EU Directives in Member States. However, where transactions remained purely domestic, there was no intervention of host regulators in the limited areas where they still had power, notably under the general-good concept. So the definition of crossborder activities discussed in s­ ection 2.3.3 above remained quite relevant in some cases, especially where the contact was electronic or by telephone and host regulators could not reach.

3.3.3  Division of Tasks. No Single EU Regulator. Regulatory Competition The end result of the Third Generation EU regime, essentially completed by 1993, was a division of roles and labour between home and host regulator, with strong emphasis on the former, although with residual powers for the latter, especially in the area of conduct of business and product control for the more sophisticated products, if sold to consumers, and in some other limited areas specifically made subject to host-country regulation and supervision, such as monetary policy and statistical information gathering as we have seen. Although complete harmonisation was thus no longer the objective, a considerable approximation of regulatory regimes resulted within the EU under the new regime. It did not, however, lead to a single regulator, even on the banking side, although the emergence of the European Central Bank (ECB) within the framework of the ESCB (European System of Central Banks), is making a significant difference in the countries that have adopted the euro as we shall see in ­section 4.1 below. It also acquired the main role in banking supervison. In these countries the ECB now determines monetary policy and thereby acquired a major say in the provision of liquidity with a natural

427  The principle of subsidiarity has also been mentioned in this context in the wake of Joined Cases C-267 and C-268/91 Keck and Mithouard [1993] ECR I-6097, concerning the free movement of goods under Art 30 EEC Treaty after de Cassis de Dijon case, see n 415 above. In Keck, see also n 302 above, the emphasis seemed to switch to equal treatment of national and imported goods. See on this subject M Andenas, ‘Rules of Conduct and the Principle of Subsidiarity’ (1994) 15 The Company Lawyer 60. Yet in Case C-384/93, Alpine Investments, n 390 above, this approach was not extended to Art 59 EEC Treaty for services, now Art 56 TFEU: see further M Andenas, ‘Cross-border Cold Calling and the Right to Provide Services’ (1995) 16 The Company Lawyer 249.

Part III  The EU Regulations and Directives Concerning the Internal Market 821

concern for systemic risk and financial stability. Nevertheless, the EU always rejected an approach in which there would be one single supranational banking or other financial supervisor with a unitary supervision regime at EU level by industry. Only under the 2012 proposals did the ECB become the sole regulator in the eurozone, at least for the larger banks, even though financial regulation itself still remained a Member State issue, demonstrated by their formal power solely to grant banking licences. More contentiously, the new role of the ECB was also believed to entail a broader notion of lender of last resort, extended to becoming a safety net for these banks in times of stress. At first, this led to the idea that not all banks might qualify to enter this system, and that there was at least a need for conditions and greater supervision, see further the discussion on the Single Supervisory Mechanism (SSM) and Single Resolution Mechanism (SRM) in s­ ection 4.1 below, but much of this was overtaken by the continuing effects of the 2008 financial crisis. The original diversified approach to authorisation and supervision, accepting in essence the idea of one licence for the whole EU area in most service sectors on the basis of home-country authorisation, not formally changed by the SSM regime, led to the interesting consequence that different regulatory regimes could operate side by side within one EU country depending on the origin of the relevant institution within the EU. This is the essence of the already mentioned regulatory competition, meaning that domestic regulators may be forced to amend their own standards so as to create a level playing field between their own houses and foreign supervised houses on their territory. It shows the dynamics of internationalisation even in regulated areas. It may have suggested a race to the bottom, but this did not take place. The minimum of common standards seems so far to have prevented it, although some home regulators may be more lax in enforcing the rules abroad than others. In its harmonisation efforts, albeit limited, this approach shows the traditional micro-prudential regulatory concerns, especially for proper authorisation, capitalisation and prudential supervision to underpin the health of the financial system as a whole, thus meaning to reduce systemic risk and promoting in this way financial stability, and in its approach to the general good concern for the special needs of the consumer and small investors. In this newer approach there was less concern, therefore, for professionals and their dealings among themselves, even though this differentiation is often still poorly expressed. The filling out of the details and the supervision remain mostly domestic affairs. So does combating fraud, although there are now also Directives in the area of insider dealing and money laundering,428 as we shall see, but they function largely outside the above home and host-country system of regulation.

3.3.4  Interaction with GATS In the meantime, globalisation induced the GATT in its Uruguay Round also to look at services, extending its basic approach to a proposal for a General Agreement on Tariffs 428  Respectively Council Directive 89/592/EEC [1989] OJ L334 and Council Directive 91/308/EEC [1991] OJ L166. See for market abuse also s 1.1.20 above and for money laundering ch 1, s 3.4.

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and Services (GATS): see s­ ection 2.2.3 above. The idea was to give access and rights of establishment to foreign service companies on equal terms with domestic institutions under the national treatment principle, supported by the MFN principle, provided that (depending on the type of service) some basic minimum standards of liberalisation for all are met from the beginning. It is the essence of the negotiation process that is taking place in this area. As noted before, also under GATS, progress creates a need for a balance between home and host regulation worldwide to make the free supply of cross-border services meaningful for those services that are traditionally regulated, such as financial services, most efficiently probably in ways similar to those already adopted in the EU, with emphasis therefore on home regulation, provided there is a minimum standard of regulation among members. To bring this standard up is then the more immediate concern. It would have to be followed by co-operation among regulators to establish some basic confidence in the effective supervision of home regulators elsewhere in host countries, although it is also conceivable that host regulators will act here as agents for home regulators under the latter’s regimes, at least in the areas of prudential supervision. As things now stand, when a foreign bank comes into the EU, there will be national treatment but still regulatory control by the country of entrance. It is possible therefore that the regulator of the country of entrance may not like the broad activity of the foreign bank and it may still attempt to use regulatory means to undermine national treatment and limit the activity as part of the authorisation process.

3.3.5  The Early EU Reciprocity Requirements. Relation with Third Countries. National Treatment and Effective Market Access Pending the further development of GATS, a particular aspect the EU had to face was its relationship with third countries in view of the charge that it was creating a ‘Fortress Europe’, not only in goods but also in services, by excluding non-EU-based institutions from the benefits of its ‘passport’, even though the EU approach in this area appeared initially mostly inspired by the desire to preserve bargaining power within the Uruguay Round of the GATT. For commercial banking and investment business, the original solution was found in the introduction of a reciprocity regime based on national treatment—compare Article 9 of the SBD (later Article 23 of the CID) and Article 7 of the ISD (later Article 15 of MiFID). This is to say that countries which gave EU institutions entry and operation rights on a non-discriminatory basis compared to their own entities (national treatment) would be allowed to incorporate their own subsidiaries in the EU. These could subsequently use the EU passport in order to render services or branch out into other EU countries. The system was that, failing national treatment, the Commission could intervene with Member States to prevent a foreign entity from gaining access through a subsidiary in the EU (thereby obtaining the passport). It signified that strictly speaking no mirror-image reciprocity was necessary aiming at the granting of similar benefits to EU entities in the relevant foreign country as the

Part III  The EU Regulations and Directives Concerning the Internal Market 823

EU would give to foreign service providers of that country within the EU, although the southern European countries and the European Parliament had wanted to go further in this direction. This notably meant that the Americans and Japanese could continue to apply a measure of separation between banking, investment and insurance businesses to foreign financial entities as they do to locals without these limitations impinging on the right of US and Japanese banks to create universal banking subsidiaries in the EU, thus benefiting there from the absence of any such division or limitation. However, the EU required a certain equivalence in business opportunity (effective market access). If there was a problem in this area, the Council of Ministers could act to start the necessary negotiations, for which it was then likely to instruct the Commission to take the necessary action. In such situations, the Commission did not have original powers, however, to request Member States to refuse a licence to a subsidiary of a third-country service provider wanting to obtain a passport in this manner. As the matter of effective market access was more difficult to establish and a political question, the Council of Ministers reserved the policy to itself. If US and Japanese (or other third-country) service providers wished only to establish a branch in an EU country or wanted only to do direct business there, that was a matter entirely for the host country under its own rules. As such a branch was never entitled to a European passport, which could only be given to an entity incorporated in a Member State under its rules of authorisation—EU law did not get involved. Thus, under the Third Generation Directives, such branches could operate in other Member States only to the extent that the national law of such states allowed it. In fact, also the creation of a subsidiary was, except for the power of the EU to prevent it if there was no sufficient reciprocity, itself entirely a matter of the host country under its own rules as supplemented by that country’s obligations under GATS. To the extent that GATS succeeds in the area of financial services, the EU would have to abandon the reciprocity policy, which primarily affected the creation of subsidiaries within the EU. This was the effect of the 1 March 1999 GATS Agreement: see ­section 2.2.3 above. In the meantime, and perhaps as a consequence, the EU adapted its stand in the Credit Institutions Directive of 2013 (Articles 47 and 48) and also in MiFID II of 2014, which came into force in 2018 (Preamble 109 and Articles 39ff, cf also Preamble 42 and Article 46(1) MiFIR), in which context the notion of equivalence was developed instead in certain areas, see more in particular ­section 3.7.17 below.

3.4  The 1998 EU Action Plan for Financial Services 3.4.1  The Main Features As explained above, after the June 1985 White Book and as part of the programme for the Single European Act 1988 entering into force in 1992, there emerged what is called the Third Generation of Directives in the area of financial services, substantially completed by 1993, of which the Second Banking Directive (SBD) and the Investment Services Directive (ISD) were the most important in the area of commercial banking

824 VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

and investment services respectively.429 In 1998 it was followed by a new EU Financial Services Action Plan. It ultimately led to a substantial review of all earlier Directives in this area although the SBD and ISD approach continued and set the tone of all that followed in terms of refinement and replacement still, which all adheres to their original pattern, but the whole effort became increasingly based on the idea of a single European market for financial services, which had always been implicit in the free movement of services. Although through the SBD and the ISD a breakthrough had been achieved, especially by introducing the division of regulatory labour between the home and host state with emphasis on the former, as we have seen, it was felt that more needed to be done and in 1998, the European Council at Cardiff requested the EU Commission to present a framework for action to complete the single European market for financial services in the light of the emerging euro and the considerable benefits which further integration in this area was believed to bring. Subsequently, the Commission published a Financial Services Action Plan in 1999 for implementation by 2005, and saw its task at first mainly in filling in gaps in the EU measures presented until then, and started to present lists of pending Directives or Directives that needed updating. The prime role of financial regulation was not reconsidered, notably in terms of financial stability and protection of depositors or investors. But it soon became clear that there was no coherent view of what was further needed as the European Council had left the Commission without any (­political) ­roadmap. It had notably omitted to give guidance in important areas such as (a) to what extent wholesale services needed regulation, (b) how the international bond market (or euromarket) was to be treated, and (c) what to do about consolidated regulation of trans-border financial activities. Importantly, there was no concept of the role of market forces in the area of regulation either, although implicitly it appeared to be respected and, within (undefined) limits, favoured. In particular, the unavoidable friction between the key EU freedoms of movement of services and capital on the one hand and the impact of regulation on the other, and the question how far regulation was still allowed to impede these free flows, especially in wholesale or professional dealings, in the capital market area concentrated especially in the euromarkets, were not fundamentally addressed. The framework of the SBD and the ISD, with their emphasis on the mutual recognition of home regulation, was apparently believed to have been adequate.430

429  See for the Second Banking Directive (SBD), Council Directive 89/646/EEC [1989] OJ L386, consolidated in the 2000 Credit Institutions Directive (CID), Directive 2000/12/EC of the European Parliament and of the Council of 20 March 2000 [2000] OJ L126. This consolidation had already been in progress before the 1998 Action Plan under the so-called Simpler Legislation for the Internal Market (SLIM) scheme dating from 1994. In the banking area, the objective was to consolidate 7 Directives and 12 amending measures. Under the 1998 Action Plan, the 2000 consolidating Credit Institutions Directive was replaced by the 2006 Credit Institution Directive, Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 [2006] OJ L177, replaced again in 2013 as we shall see in ss 3.7.3/4 below. See for the Investment Services Directive (ISD), Council Directive 93/22/EEC [1993] OJ L141, pursuant to the 1998 Action Plan replaced by Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on Markets in Financial Instruments (MiFID) [2004] OJ L145/1, replaced in 2014 by MiFID II, see s 3.7.5 below. 430  See for the problems that even then had emerged, n 424 above.

Part III  The EU Regulations and Directives Concerning the Internal Market 825

The view presented in this book is that in the area of regulation for wholesale business, (local) deregulation needs to precede (re)regulation at EU level or through EU harmonisation at Member State level, see ­section 1.1.9 above. That means that financial regulation in this area must in each case be demonstrated (a) to be dictated by overriding financial stability or systemic risk concerns or (b) to be justified in the interest of participants, especially investors and depositors as a matter of conduct of business, (c) pass in all areas a proper cost-benefit analysis, or (d) promote the integrity of the financial markets. Even then, as for banking, the emphasis should be on more control and capital formation in good times and on less in bad—that was perceived to be at the heart of macro-prudential supervision, see the discussion in ­1.1.13/14 above. Regulation should at the same time leave the necessary room for innovation and efficiency considerations (and low cost) and maximum room for the freedom of movement of capital and services (including the right of establishment).431 Thus, apart from stability concerns, which have surfaced less in capital market activity, regulation of underwriting, market-making, clearing and settlement, for example, might well prove unhelpful and often unnecessary, especially shown in the large euromarkets that have proven to be well able to look after themselves and have been greatly beneficial without doing anybody much harm. All the same, in the EU, often led by countries like France and Germany, which have a strong regulation culture, this attitude was always likely to spill over at EU level and from there into the euromarkets. Regulation then becomes a purpose in itself. The Action Plan and its implementation did not avoid these pitfalls. Whatever the results, they proved unable to make much difference in the 2008–09 financial crisis. The reason is the lack of any coherent view of what financial regulation is and how it is to operate and an absence of a proper perspective, see also the discussion in ­1.1.10, 1.1.11 and 1.3.8 above. This resulted in a largely prescriptive approach, often still dominated by retail protection needs432 while the BIS capital adequacy requirements were left to take care of stability issues. The financial crisis in 2008–09 confirmed that there had been no superior insights into the workings of the financial markets, their services and dangers. Nothing suggested either that there was much more of a view thereafter. Nevertheless, initiatives emerged as after any other crisis but again without much direction, the EU awaiting at first guidance from the US and G-20. This being said, even after the crisis, the market may not have allowed itself to be alerted sufficiently and early enough to create a proper forum for consultation about any new direction. An important example of where it was caught out was the 2009 EU draft proposal

431  See RS Krozner, ‘Can the Financial Markets Privately Regulate Risk? The Development of Derivative Clearing Houses and Recent Over-the-Counter Innovations’ (November 1999) Journal of Money, Credit and Banking; J Niemeyer, ‘An Economic Analysis of Securities Market Regulation and Supervision: Where to Go after the Lamfalussy Report?’, SSE/EFI Working Paper Series in Economics and Finance, No 482, 14 December 2001; DC Langevoort, ‘Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation’, Law and Economics Seminar, Boalt Hall, UC Berkeley, 15 April 2002; JD Fox, ‘The Death of the Securities Regulator’, Globalisation, Law and Economics Seminar, Boalt Hall, UC Berkeley, 1 April 1 2002; JH Dalhuisen, ‘Towards a Single European Capital Market and a Workable System of Regulation’ in M Andenas and Y Avgerinos (eds), Financial Markets in Europe, Towards a Single Regulator? (The Hague, 2003) 35. 432  This was also the view of market experts: see eg the Wicks Report of November 2003.

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for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers (AIFM), amending also the Pension Directive of 2003 and covering in particular hedge fund and private equity activity. In the event, regulatory zeal required much softening and amendment later: see ­chapter 1, ­section 2.7.4 above and ­section 3.7.7 below. On the other hand, earlier, industry input had been forthcoming notably in respect of the 2003 Prospectus Directive and 2004 MiFID. It remains true, however, that in legal and regulatory matters, the financial services industry often acts after the fact and then depends on financial structuring or innovation to get itself out of the woods or it moves to more congenial places to get around burdensome or unacceptable impediments which may serve little purpose. This may, however, not always be efficient and might in any event prove to be more difficult in the equities market than it is in the bond, derivative or funds markets. In fact, again apart from stability concerns, in the investment industry, more important than regulation at every level433 may be the access given to issuers and investors to all markets and exchanges, formal and informal, and to clearing and settlement institutions subject to these institutions’ own standards in a competitive environment. It may easily improve conditions all round, as business will go to the institutions that offer better service, lower cost, greater reliability and transparency, and greater liquidity. Short of stability and liquidity considerations, at least in wholesale, it is in principle for the markets themselves to sort these matters out in a competitive environment. Again, the international debt market or euromarket, as the largest capital market in the world, traditionally largely unregulated, offers the best example. It suggests that except for these stability issues, which may be less urgent in this area, the regulatory concern should be largely limited to retail or small investor protection and to market integrity issues and perhaps to better standards and supervision in the issuing activity, even though, at least for institutional investors, this could also be left to competition. It should give the issuer with the best disclosure probably the greatest benefit in terms of the pricing of new issues. One key factor is indeed access of issuers to all formal and informal exchanges and other markets in the EU. This would indicate a further separation of prospectus and regular reporting requirements from admission and listing on regular exchanges. It may also suggest a separate supervision of the issuing activity in order to make a passport into all markets possible. That lifts this issue out of the competition between markets, which would all have to accept the disclosure that took place initially in one of them under common rules. It might be a price worth paying. It became the preferred approach in the new Prospectus Directive in 2003 as part of the Action Plan, as we shall see and was maintained in the April 2017 proposals for new prospectus rules in a new EU Prospectus Regulation, see ­section 3.7.14 below. 433  Another approach may be that of regulatory competition in which participants (for example issuers) may choose the regulatory regime they prefer. There is an increasing literature on this subject. This research points to free markets and competition leading to higher voluntary disclosure (and even increased cost) with the prospect of greater proceeds. See the literature cited in n 261 above, but see especially also J Fried, ‘Should Corporate Disclosure be Deregulated? Lessons from the US’, Law and Economics Workshop Paper 4 (UC Berkeley, 2007), who argues against the market function in this area on the basis of the American experience.

Part III  The EU Regulations and Directives Concerning the Internal Market 827

In this connection, there was some confusion from the beginning on whether the prime objective of the Action Plan was the creation of a single liquid capital ­market (following the emergence of the euro after 1999) or was more limited to a Single Market for Financial Services, which would also cover banking services and be in any event less market focused. It would immediately have posed the question of its relation to the eurobond market and would also have raised the position of domestic stock exchanges.434 In the event, the latter remained the more initial focus, but market issues were never far below the surface and the issue of regular and OTC markets came to a head in the early discussions concerning the redrafting of the 2003 Prospectus Directive (see s­ection 3.5.10 below) and subsequently more so in the discussions of the amendments to the ISD, which ultimately led to a complete overhaul in the 2004 MiFID. It faced in particular the operation of Alternative Trading Systems or ATSs (called Multilateral Trading Facilities or MTFs in MiFID—see also s­ ection 1.5.6 above) and the need for similar investor protections in these informal trading environments; see further s­ection 3.5.7 below. In the meantime, the earlier Listing and Admission Directives (see s­ection 3.2.4 above) were consolidated into CARD as we shall see in ­section 3.5.10 below. In fact, the main objectives identified in the original Action Plan were expressed as follows: (a) to create a single wholesale market to enable corporate issuers to raise finance on competitive terms on an EU-wide basis and provide investors and intermediaries with access to all (formal and informal) markets from a single point of entry; (b) to allow investment service providers to offer their services cross-border without encountering unnecessary barriers; (c) to achieve an open and secure retail market with information and safeguards to participate in a single financial market; and (d) to formulate state-of-the-art prudential rules and supervision. Again, one may note here the absence of any reference to systemic risk or stability and liquidity considerations.435 Eventually, it led to an issuing or recasting of 42 EU Directives, although not all were intimately related to financial markets operations, such as the Insolvency Directives for banks and insurance companies, the EU Company Statute (introduced by Regulation in October 2001), the Fair Value Accounting Directive of 2001 (concerning valuations other than at purchase price or cost), the Regulation of July 2002 on International Accounting Standards for all listed companies (after 2005), the Accounting

434  The Commission wanted integrated wholesale markets and recommended in this context easy access, which eventually resulted in the issuers’ passport, but investment service providers were also to be given access throughout the EU without overlapping legal and administrative formalities: see Commission Communication, Financial Services: Building a Framework for Action COM (1998) 625 final 28 October 1998, paras 18–20. 435  Only in the subsequent Lamfalussy Report, see s 3.4.2 below, were general principles of securities regulation identified. Eight overarching principles were mentioned: maintaining confidence in the European securities markets, maintaining high levels of prudential supervision, contributing to systemic stability, ensuring adequate levels of consumer protection, respecting subsidiarity and proportionality, promoting competition, ensuring regulatory efficiency and encouraging innovation, and taking into account the international dimensions.

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­ odernisation Directive of 2003 amending the Fourth and Seventh Company DirecM tives (after 2005), proposals for a Tenth and Fourteenth Company Law Directive, the Settlement Finality Directive, and the Collateral Directive (on the cross-border use of collateral in financial dealings). The Commission flagged, however, two (interrelated) issues from the start: it did not opt for a single regulatory system but proved more interested in a procedure that would speed up the amendment and implementation of Community law in this area into national laws. As we have seen, beyond this, it did not express clear ideas. To obtain more of a roadmap, the EU’s Economic and Finance Ministers in Ecofin appointed in 2000 a Committee of Wise Men under the Chairmanship of Mr Lamfalussy, which was to focus also on these two issues. It presented its report in February 2002 (called the Lamfalussy Report), confirmed the preference for financial regulation and regulators at the Member State level, and suggested a procedure to speed up EU legislation and its incorporation in what came to be called the Lamfalussy Process, which is an example of so-called EU comitology. It felt that only if this Process did not adequately function would the idea of a single regulatory framework have to be revisited.

3.4.2  The Lamfalussy Report and its Implementation. The Role of Comitology The procedure or process proposed by the Lamfalussy Report to speed up the amendment and implementation of EU legislation in Member States envisaged four levels. In Level 1 (framework level), primary Community legislation is envisaged based on framework principles. This could involve Directives or Regulations, the latter having the advantage of being directly applicable in Member States and achieving speed and uniformity. This is important and the Lamfalussy Report encouraged their use. However, the EU is not entirely free in the choice between Directives and Regulations as it must respect domestic cultures and allow for variations in implementation where dictated by the local legal environment. That is the reason why Directives are often more opportune and remain important also at the implementation stage although both in respect of the Prospectus Directive and MiFID (see below) there are now also implementation Regulations. Both are adopted through the ‘co-decision’ procedure between the Council and the European Parliament. The European Securities Committee (ESC), which was formed pursuant to the Lamfalussy proposals and consists of permanent representatives of Member States, fulfils only an advisory function here. It cannot exercise any authority at this level and does not operate here as a regulatory committee.436 436  This Committee as well as the Committee of European Securities Regulators (CESR) were set up by Decisions of 6 June 2001, 2001/527/EC and 2001/528/EC [2001] OJ L191, 43. The CESR was the successor to FESCO and later transformed into ESMA, see s 3.7.2. The ECB could become involved under Art 105(4) EC Treaty, now Art 127(4) TFEU since it needed to be consulted ‘on any proposed Community Act in its field of competence’. Under Council Decision 98/415/EC [1998] OJ L189/42, this role was interpreted to include all measures materially influencing the stability of financial institutions and markets. Thus, early on, the ECB was consulted on the newer UCITS proposals, see [1999] OJ L285/9. Under Art 105(6), now Art 127(6) TFEU, the ECB could even be given special tasks in this connection.

Part III  The EU Regulations and Directives Concerning the Internal Market 829

In Level 2 (implementation level), the Commission adopts Community legislation concerning the technical details of the framework principles. Here the ESC may be given regulatory powers within new Directives and then operates as a proper regulatory committee437 but only in assisting the Commission in its implementation powers pursuant to Articles 16 and 17 TEU and Articles 290 and 291 TFEU. It takes a vote with a qualified majority whereupon the measures will be sent to the European Parliament for approval. At this Level, technical advice may also be given by the Committee of European Securities Regulators (CESR) and the Committee of European Banking Supervisors (CEBS), which were also formed pursuant to the Lamfalussy proposals and represent the regulators of the Member States. They may be further mandated in this connection by the ESC. The danger of both committees is that they may retain a purely domestic perspective and act as a pressure group of domestic regulators while favouring, in case of investment securities, also the position of domestic exchanges (the concentration principle: see ­section 3.5.7 below) to the detriment of the international OTC markets or trade internalisation or other more rational market evolutions, like ATSs now called Multilateral Trading Facilities or MTFs in the EU: see also s­ ection 3.5.7 below. In Level 3, the implementation or transposition process in Member States is considered, in which connection the CESR and CEBS play a role in obtaining consistency. They may issue guidelines or common, non-binding, standards. They will also compare and review national regulatory practices in the light of EU legislation. In Level 4, the Commission resumes its normal responsibility for enforcing EU legislation (under Article 17(1) TEU and Article 258 TFEU),438 and for compliance by Member States, where necessary, initiating compliance action before the ECJ. At both Levels 2 and 3, three other standing committees function: one for commercial banking, one for investment business including UCITS, and one for insurance including pensions. A fourth committee operates at Level 2 for financial c­ onglomerates.

There was therefore always some basis in the Treaty for a supervisory role of the ECB in banking or even more generally where the stability of financial institutions and markets is concerned; see also M Andenas, ‘Banking Supervision, the Internal Market and European Economic and Monetary Union’ in M Andenas et al (eds), European Economic and Monetary Union: The Institutional Framework (London, 1997) 402. It would seem to be geared, however, to prudential supervision and to the operation of the financial system as a whole rather than to individual investors’ protection and therefore would appear to play a role largely in the area of financial stability and systemic risk, see s 1.1.2 above. There is no equivalent for securities regulators or for an EU committee operating in their stead. The unstable relationship between domestic financial regulators who remain basically in charge and the EU institutions, particularly in the area of investment services, had earlier been noted by W Bratton, S Picciotto and J McCahery (eds), International Regulatory Competition and Co-ordination (Oxford, 1996) 38. If the thesis of this book that domestic liberalisation in this area is to precede re-regulation at EU level, at least for professional dealings, and that retail protection is better exercised at local levels is correct, this state of affairs cannot be considered immediately disturbing or in need of reform. It means that there is little room at present for any real power for the ESC. 437  Under the 28 June 1999 Decision on Comitology, Decision 1999/468/EC [1999] OJ L184/23. See for the committee structure, Commission Decision 2004/5/EC [2004] OJ L3/28, and 2009/78/EC [2009] OJ L25/23 and its later reform and expansion, s 3.7.2 below. 438  In this connection, it was stated at the Stockholm European Council in 2001, which considered the Lamfalussy Report, that the Commission in its enforcement powers in the financial area should not go against ‘predominant views’ which might emerge in the Council and which as such could derive from national considerations.

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Ecofin has set up a Financial Services Committee of its own (FSC). The whole set-up was reviewed in 2004.439 The Prospectus and Market Abuse Directives were the first ones to emerge under the new regime, followed by the Transparency Directive and the revision of the ISD into MiFID. The amendments to this structure following the 2008 banking crisis are discussed below in ­section 3.7.2. A 2015 Action Plan on Building a Capital Markets Union was meant to help businesses further to tap into more diverse sources of capital, see ­section 3.7.15 below, and necessitated changes in the 2003 Prospectus Directive.

3.4.3  The 2005 White Paper on Financial Services In its 2005 White Paper440 the EU Commission reviewed the progress of the Action Plan and restated its objectives. It mentioned consolidation, better regulation, supervisory convergence, competition and global contribution. More open consultation and impact assessments were promised with a shift to a more risk- and principle-driven approach leading to simplification with only minimum legislative intervention. The idea, now more clearly expressed, was to make regulation market, cost and effect driven rather than seek mere intervention. Harmonisation of rules at all levels and in all areas was no longer the objective.441 It was a recognition of the fact that neither regulation nor its fine-tuning, but ultimately only market forces could create the single market. It was considered the task of regulation to make this possible within a minimum framework of rules necessary to protect the public interest in terms of financial stability and of the protection of participants, especially depositors and investors. No more. Even here trade-offs needed to be made: perfect stability may come at a level of banking activity that is too low for a modern economy while the protection of participants is only one aspect to be considered and may well be eclipsed by others: see also ­section 1.1.11 above.

439  See also Y Avgerinos, ‘Essential and Non-essential Measures: Delegation of Powers in EU Securities Regulation’ (2002) 8 European Law Journal 269. 440  White Paper on Financial Services Policy (2005–2010) COM (2005). It followed an earlier Green Paper of the same year. 441  Walker (n 378) provides on pp 276ff an interesting catalogue of areas where differences between Member States subsisted: suitability assessment procedures, supporting documentation and practices on authorisation, specific requirements with regard to internal controls, record and decision-taking procedures as well as detailed rules on capital adequacy in respect of credit risk (including eg country or sovereign risk, industry risk, geographic risk, transfer risk, default risk and event risk), market risk (including basis risk, interest rate risk, commodity risk, yield spread risk, transaction risk, translation risk, availability risk, quantity risk, inventory risk, inflation risk, extension risk, performance risk, repayment risk, discontinuity or ‘jump’ risk, timing risk, forced sale risk and underwriting risk), currency or foreign exchange risk, settlement and delivery risk, operational risk, more complex financial products risks as well as legal risk and environmental risks. Related are the liquidity rules. Significant inconsistencies could also arise with regard to local supervisory practices and may also affect consolidated supervision, notably inclusion of ‘significant business units’ (in addition to subsidiaries). The nature of reporting, number, content and filing of returns, nature and timing of meetings with management may also still differ widely.

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The issue of one regulator EU-wide to come to greater regulatory bite, consistency and efficiency was reviewed after the financial crisis, and started in earnest only in the eurozone for banking in 2012: see ­section 4.1 below. This posed the question whether a system of mutual recognition was to be replaced by one based on substantive uniform rules and mutualisation of banking exposure. Given the notions of subsidiarity and proportionality, such an approach could only be warranted if there was a better prospect of it providing greater financial stability and preventing major financial crises. There is no indication that it would be the result or that the crisis was due to or aggravated by the regulatory set-up in Europe. It is the insight into what is needed in terms of liquidity for all and especially the political will to accept the consequences of any reduced leverage and a retrenching financial system (if that is what was meant) on growth that appeared to be lacking. The structure of regulation proved secondary. Particularly macro-prudential supervision remained underdeveloped as a concept, as we have seen in ­1.1.13/14 above, so providing a better international safety net could to help calm the waters—see s­ection 1.3.11 above—even if it increases moral hazard.442

3.5  The Details of the Third Generation Directives and Their Revamping Under the 1998 Action Plan. The Period up to the 2008 Financial Crisis and the Continuation of the Basic Framework 3.5.1  The Second Banking Directive/Credit Institution Directives (SBD/CIDs): Home Country Rule Reach. Residual Host-country Powers Returning to the free flow of financial services and the right of establishment in the EU, in commercial banking the fundamental idea of the Third generation of Directives was to accept home-country regulation subject to harmonisation of the most important rules. That was first expressed in the 1993 SBD as we have seen. This home-country rule principle in essence concerned itself with: (a) authorisation, which is substantially a question of a review of (i) reputation, (ii) capital, (iii) organisation and systems, and (iv) business profile and activities plan (Articles 6ff CID 2006); and (b) supervision, in which connection there are usually prudential rules (Article 40). It could also concern itself with (c) conduct of business, and (d) product control, but not exclusively. Even the CID 2006 (following the SBD and CID 2000) did not contain substantial rules in these latter two respects (regardless of the heading of Title II). It followed that there was home-country rule in principle, but conduct of business and product control could

442  An important issue here may still be that the ECJ is not fully neutralised by a system of Directives and implementing Regulations and may still revive or leave room for domestic (host) regulation on the basis of the general good or even subsidiarity, see s 3.1.2 above. Another issue is that although the need for regulation in the financial sector is generally accepted, the ECJ will protect the internal market even at the cost of otherwise perfectly accepted regulatory principle if proving obstructive to the free flow of financial services, capital and investments.

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still be of some concern to host states under the notion of the general good. This could be so exactly because the Directive did not deal with them (but only to that extent). The 2006 CID’s essentially home-country regulatory approach expressly reserved in Article 27 to the host regulation all matters of liquidity and monetary policy pending further co-ordination, now the activity of the European Monetary Union (EMU).443 In statistical matters the host country could also continue to require reporting (Article 29 CID), which was not defined and could still impose substantial burdens in terms of maintaining adequate systems geared to the accounting principles of the host country. These host-country powers were not restrained by the limitations attached to the general-good exception, which is a more limited concept subject to certain safeguards as we have seen in s­ ection 3.1.1 above. On the other hand, Recitals 17 and 18 of the Preamble and Articles 26(1), 31 and 37 CID 2006 still referred to this host-country’s power under the general good also, without defining the term. It was, as mentioned before, primarily thought to relate to consumer protection and could then have a special meaning in terms of conduct of business and advertising or product control, to the extent not specifically dealt with in the Directive itself as already mentioned. It was in the context of the SBD/CID more likely to relate to the protection of deposits, the sale of foreign mortgage credit products, the preservation of the good reputation of the banking industry as a whole in the host country and the prevention of fraud and other irregularities, the latter certainly on an emergency basis (Article 33 CID 2006), in that case always subject to the EU Commission’s power to amend or abolish these host-country measures.444 As noted above, measures taken on the ground of the general good could, according to case law,445 not duplicate, become disproportionate to the ends to which they are directed nor discriminate, in which connection reference was sometimes also made to the principles of equivalence, proportionality and non-discrimination. The measures must have a public-policy motive and be suitable for the desired end and not overshoot. It is clear, however, that under the Second Banking, Investment Services, and Third Insurance Directives the general-good notion could not interfere with the authorisation and supervision or prudential process as harmonised areas. In the product sphere, banking activities, being largely confined to deposit-­taking, were not greatly affected by special protections for the public derived from the general good and the SBD and its successors did not evince a particular concern in this area, as already mentioned several times, which also went for local banking Acts. Conduct of business was not traditionally a particular bank regulatory concern. As mentioned before, it is more typically for the securities and insurance industries.

443  This was created by the 1992 Maastricht Treaty under which the European Council of Heads of States or Government of all Member States sets the main economic and fiscal policy objectives and also rules for the eurozone, which is considered the third stage of EMU to which all Member States are committed except the UK and Denmark. The Council co-ordinates and Member States align their own policies. The EURO Group co-ordinates the policies for the eurozone where the ECB determines the monetary policy. 444  See for the special concerns about long-distance selling of banking services to consumers, the EU regime discussed in s 3.6.8 below. 445  See cases cited in s 3.1.2 above.

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Nevertheless, specialised products like derivatives and mortgage credit may elicit special consumer protection concerns for banks too, and their cross-border sale may then give rise to special general-good considerations in the recipient country. Mandatory rules of applicable local law in the recipient country may also have this effect as long as not contravening EU rules. Within the EU, short of transnationalisation by the EU or otherwise, this applicable law, to the extent that it is contractual, which may especially concern investors’ obligations under the products bought, could be determined in EU courts under the 2008 Regulation on the Law Applicable to Contractual Obligations accepted by all EU countries (Rome I). As already mentioned above in another context,446 it has special consumer protection rules in Article 6, leading mostly to applicability of the (mandatory) law of the country of the habitual residence of the consumer. As, however, EU law prevails over this Convention (Article 23), any restrictions of this nature still had to pass the EU general-good test limitations, where applicable.447 Host governments could take punitive action against foreign bank branches violating host-country rules issued in accordance with the provisions of the Directives. To facilitate co-operation, memoranda of understanding could be agreed between the various central banks or other banking supervisors on a bilateral basis further to clarify the role of each and the type of assistance to be given. This was largely confined to pure banking (prudential) supervision and often did not reach the stage of ancillary activities, like the securities business.

3.5.2  Scope of the Banking Passport. Universal Banking and the Procedure for Obtaining the Passport. Home- and Host-country Communications Under the SBD/CID 2006, which continues to provide the basic framework up to today, a bank could receive its passport for all banking activities in a universal banking sense. The passport (covering also subsidiary financial institutions: Article 24 CID 2006) was tied in principle to the deposit-taking and lending function (Article 23) but could also cover, according to the Annex, mortgage products and securities activities (the original English text erroneously referred only to shares, later corrected), investment management and custody functions, but notably not insurance. The idea was that the scope of the passport basically depends on the scope of the authorisation in the home country. Yet, since the entering into force of the Investment Services Directive (ISD) in 1995, the securities business of banks, as covered by that Directive because of its functional rather than institutional approach and banking supervisors, were to take a step back and allow for the operation of security supervisors. The relationship between both became a matter of regulatory co-operation and division of tasks in which connection there was also the concept of lead regulator, especially for capital adequacy, which was then usually the banking regulator, see further the discussion in s­ ection 1.1.16 above. 446  447 

See s 3.1.2 above. See on this aspect also the Commission’s Interpretative Communication referred to in n 295 above.

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As far as the procedure for obtaining the passport was concerned, interested parties had to inform their relevant home regulators of their intention to branch out or engage in cross-border services in other EU countries and this had to be agreed by their home regulator. In the case of branching out, the home regulator then had a period of three months in which to inform the host regulator concerned. If it did not do so, the petitioning entity may appeal. The host country had two months in which to make its own (limited) supervisory arrangements and also explain what rules would be applied in respect of the general good. It could not object to the passport itself and had no blocking powers (Article 25(2) and (3) CID 2006). They were reserved to the home regulator. Explaining the rules concerning the general good was an option of the host regulator and in view of the multifaceted and undefined nature of the general-good exception not a duty, although the foreign service provider should be able to solicit more information: Article 26.448 When only direct cross-border services were considered rather than a branch elsewhere, the procedure was simplified (Article 28 CID 2006) and the home regulator had only one month to send on the file to the host regulator while no further period was set for the host regulator to make its own arrangements and give any indication of general-good exceptions. The Commission’s Interpretative Communication of 1997 had made it clear that the notification itself was not a customer protection measure and its absence has no effect on any contracts concluded. As mentioned above, prior (legal) cross-border activity would excuse a bank from giving notification.

3.5.3  ISD/MiFID: Basic Structure. Background and Scope The 1993 Investment Services Directive (ISD), covering the passport for intermediaries in the securities industry, was not originally part of the 1992 EU programme as the question of a European passport for securities services was largely overlooked at the time of the Single European Act, while progress towards the insurance passport was considered premature at the time. The securities passport was subsequently requested by the securities industry to give it the same facilities as universal banks and denoted true further progress in this field. It is unlikely that the securities industry understood at the time what it was asking for, especially in the area of capital adequacy and other types of supervision. As far as the ISD was concerned, the structure of the Second Banking Directive (SBD) was followed. Yet there was an important difference: the SBD in principle adopted an institutional approach to the subject and focused on banks (credit institutions and subsidiary financial institutions). The ISD took a functional approach and focused on investment services activity (Article 1(1)) and then defined investment firms in terms of legal (or similar) entities engaged in this activity (Article 1(2)). Most importantly, because of this approach, it also covered the securities business of banks for prudential and conduct of business aspects, including the capital required for their investment 448 

See ibid.

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­business, but not for the authorisation and acquisition of the passport (Article 2(1)). It did not apply to insurance undertakings and their various products either (Article 2(2)). The 2004 MiFID,449 now often referred to as MiFID I, was the successor to the ISD and became effective on 1 November 2007. It continued the same functional approach. As before, it roughly divided into authorisation requirements, conduct of business requirements and transaction reporting requirements. It was implemented by a further Directive in the area of conduct of business and by a Regulation in the area of market transparency. Unlike the ISD, it also covered official markets and MTFs, hence its name. MiFID I stated in Article 1 its scope, which concerned investment firms for their various activities as defined and then covered also the investment activities of commercial banks. In this connection, it defined investment firms in Article 4(1) and investment services in Article 4(2) where reference was made to the activities listed in ­section A of Annex I relating to the instruments listed in ­section C of the same Annex. These activities concerned underwriting, placing, trading, brokerage and investment management activities in transferable securities, units in collective investment undertakings,450 and money market instruments and futures, options and swaps that could be settled in kind or cash in respect of securities, currencies, interest rates or yields, commodities and climatic variables (since MiFID I) and credit derivatives (also since MiFID I), to which there may be added certain undefined non-core activities or ancillary services, like related lending, foreign exchange activity and advice, mergers and acquisition services, and safe custody. These services benefit from the passport, provided they are included in the authorisation (Article 31 MiFID I). Prime brokerage may be another. MTF activity is here a main service activity. It has already been said that banks get the passport for all their businesses from the home banking regulator. Some concern was expressed at the time about the scope of the ISD as defined in the Annexes.451 The definitional terminology (in all regulated services Directives) was not always stable or comprehensive and between the ISD and SBD, later followed by MiFID I and the CID 2006, not even always compatible. Implementation by the Member States also showed some divergences when industry practices also came into the equation. In any event, they evolve all the time and are in some EU countries more advanced than in others. Certain terms like ‘instrument’ remained altogether undefined and had then to be understood in their common meaning. That probably also went for many of the semi-defined terms. In fact, it was probably unwise to read too much into any of them but to concentrate on what was excluded. In Article 2 ISD, later Article 2 MiFID I, there was a long list of excluded intermediaries, in particular insurance businesses, collective investment undertakings and pension funds, investments incidental to professional activity of lawyers and accountants, and commodity trading.452 449  Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on Markets in Financial Instruments [2004] OJ L145/1. 450  For trans-border activity in open-ended fund activity, there is UCITS: see s 3.2.5 above. 451  See G Ferrarini, ‘Towards a European Law of Investment Services and Institutions’ (1994) 31 CMLR 1283, 1287ff. 452  According to Recital 39 of the Preamble to MiFID I (following the ISD) Member States should not grant a licence if it is requested merely to avoid the stricter conditions of other Member States. The use of a foreign branch solely for spot or forward exchange transactions other than as an investment service may thus constitute misuse of the Directive.

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The key was always authorisation, therefore the licensing requirement, set out in Articles 5–15. Again, the authorisation provisions (except the rules on investor compensation schemes, on organisational requirements and on the trading processes in an MTF—see Articles 11, 13 and 14) were not applicable to banks and nor were the rules concerning the obtaining of an investment services passport, which remain governed by the CID 2006 (see Article 1(2)), but banks were otherwise subject to MiFID I in their investment intermediary activities. The coverage of regulated markets was new in MiFID I and indeed was the reason for the full replacement rather than amendment of the ISD, and MiFID I applied directly to regulated markets (Article 1(1)) in terms therefore of authorisation, capital and prudential supervision. A fundamental distinction was being made here between regulated markets on the one hand and MTFs on the other, which were defined in Article 4(15) as multilateral systems, operated by investment firms or a market operator, which bring together multiple third-party buying and selling interests in financial instruments in a way that results in a contract (in accordance with non-discretionary rules). These MTFs became a major embodiment of OTC markets in the EU and also comprise electronic markets and telephone markets: see further ­section 3.5.7 below and earlier ­section 1.5.6 above. They remained in principle unregulated (see Article 5(2)) and were as such outside the scope of the MiFID I Directive but they could be caught indirectly, either as an investment service of an investment firm or as an activity of a regulated market. Notably the investment compensation scheme requirements and the provisions concerning the relationship with third countries did not apply (Articles 11 and 15), but they did benefit from the passport. Under Article 13, MTFs further had to comply with some minimum organisational requirements and transparent and nondiscretionary rules and procedures for fair and orderly trading and the establishment of objective criteria for the efficient execution of orders (Article 14(1)). Pre- and posttrading information was an important aspect of this in terms of market efficiency or smooth operation of markets and market integrity. Importantly, MiFID I also started to deal with systematic internalisers, defined in Article 4(1)(7) as investment firms which on an organised, frequent and systematic basis dealt on their own account by executing client orders outside a regulated market or an MTF. As such they compete with the formal and MTF markets. In fact, systematic internalisers deal from their own inventory but may also engage in setting off client orders, which obviously raises the question at what prices they do so. Especially for this reason, they are subject to strict regulation, notably in terms of best execution. This is even the case when they are market-makers,453 at least if they have previously agreed to act as broker for a retail client at the same time (Article 24(1)). Finally, at the formal level, MiFID I distinguished technically between investment services and investment activities. The first were rendered for a client, the latter concerned activities for the firm’s own risk and account. They were therefore less regulated. 453  They are not necessarily market makers, which under Art 4(1)(8) are defined as persons who hold themselves out on the financial markets on a continuous basis as being willing to deal on their own account by buying and selling financial instruments against their proprietary capital at prices defined by them. Here pre- and posttrading price transparency is again important.

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Ancillary activities were mainly custody, giving credit for investments, advice on capital structures including merger and acquisition activity, and related foreign exchange services. These were not themselves subject to a licensing requirement but were included in the licence of investment services and activities.

3.5.4  Home-country Rule, Authorisation, Capital, Prudential Rules. Procedure for Obtaining the Passport. The Concept of the General Good Revisited Following the SBD model, the home country issued the basic authorisation, taking into account the reputation, capital and business profile of the applicant (Article 3(3) and (4) ISD), followed in Articles 9, 12 and 13 MiFID, which specifically excluded MTFs from this process in Article 5(2) except for the general organisational and specific trade-processing rules of, respectively, Articles 13, 14, 29 and 30, as already mentioned in the previous section.454 As for the procedure for obtaining the passport, the system compared (and still does) to that of banks (see ­section 3.5.2 above), but since MiFID I the language became different but a distinction continued to be made between the freedom of establishment of a branch (see Article 32 MiFID I) and the direct provision of services (see Article 31 MiFID I), with some doubt remaining about whether incidental services remained fully liberalised or were still subject to the notification requirement. The use of brokers (tied agents) in the host country was now also to be notified to its regulators (­Article 31(2) MiFID I). The possibility for the host country to explain its general-good restrictions was deleted. This was in line with the general approach of MiFID I, which tried to define home/host-country rule, especially the latter, more precisely thus seeking to eliminate reliance on general-good notions and their exceptions to home-country rule. This was further supported in Article 4 of the Implementation Directive. It has already been asked, however, whether the general ECJ case law concerning the host country’s general-good exception could be completely superseded by the new text. In the case of doubt on the host countries’ powers, especially to protect smaller investors or its markets and their operations, it could still resurface even if this was not the idea. Under MiFID I, the passport was extended to investment advice, operating an MTF, systemic internalisation and investment activities in commodity derivatives as we have seen. Articles 33, 34 and 35 further provided that foreign firms, if properly authorised by their home regulator, had direct access to host-country regulated markets, if necessary by becoming members, and to all relevant clearing and settlement systems in the host country, including CCPs.

454  It was of interest in this connection that Art 3 ISD did not refer to proper infrastructure and system support, which were only mentioned in the context of prudential supervision in Art 10 (and more indirectly also in Art 3(7)(e)), where it referred to sound administrative and accounting procedures, arrangements for electronic data processing and adequate internal controls.

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3.5.5  ISD/MiFID I: Conduct of Business Rules of conduct (subject to a list of minimum principles) appeared first in Article 11 ISD and remained mostly a matter for each host country—see Article 11(2)—at least for retail protection. As such they were elaborations of the general-good notion and, except where clearly going beyond them, were considered limited thereby. No specific provisions existed in Article 11 as regards cold calling, more especially relevant if foreign products were on offer, but it could be caught within the general provisions on ‘know your customer’ or under the residual general-good powers, especially in the consumer area.455 Strictly speaking, there were no provisions on suitability either. Confidentiality was also not covered and the audit trail was considered a matter of prudential supervision in Article 10 ISD rather than a matter of investor protection under Article 11.456 It was therefore tied to the licence. The question of conflicts of interest was covered in both Articles 10 and 11 in the sense that, from a prudential or licensing point of view, a firm had to be structured to avoid them while under Article 11 conflicts had to be avoided and, if impossible, clients were to be fairly treated. That could lead to a claim for damages by individual investors, but there was no principle of postponement of the firm’s interests more generally.457 The aspect of product supervision and control by the host

455  In the area of cold calling, eg, the general-good notion clearly allowed host-country restrictions to protect investor confidence, particularly with regard to more complicated financial products like OTC commodity futures: see Case C-384/93 Alpine Investments BV v Minister van Financiën [1995] ECR I-1141. These products might not have been covered by the ISD so that their trans-border sale was not further liberalised, especially relevant when the sale was made through establishments in the host country as these remained then subject to host-country authorisation and supervision, at least in respect of this activity. It may be asked whether this is now different under MiFID. Already on 16 November 2000, the Commission issued a Communication on the Application of Conduct of Business Rules under Art 11 of the Investment Services Directive 93/22/EEC asking for greater convergence to make host regulation less of a barrier. 456  In the ISD, the Articles on conduct of business came in late in the drafting process. There was not much of a harmonisation effort, but Art 11 made clear that the new standards need not necessarily amount to the standards required to comply with fiduciary duties in a common law sense, although securities houses should try to avoid conflicts of interest, besides being professional, honest and fair, knowing their customers and providing adequate disclosure of their dealings. A distinction between types of investors could also be made in this regard (Art 11(3)), but it proved less effective in practice. A further Directive in the area of conduct of business was apparently contemplated to achieve further harmonisation, which at the same time could have allowed more fully home-country rule, at least for wholesale business, but it was never produced. Thus, pending further harmonisation of the conduct of business rules and much more so than in the approach of the SBD where it is less relevant (except for specialised banking products), host regulators retained considerable power in the area of conduct of business under the ISD: cf Art 11(3), confirmed by the further elaboration of the principle of the general good, Recitals 33 and 41 and Arts 13, 17(4), 18(2) and 19(6) and (11), which also went to the nature of the products sold. The host regulator had to assist the home regulator (Art 24), but could also demand the latter’s co-operation (Art 19(4)), especially in areas of supervision reserved to itself (Art 19(2) and (6)). This might also have meant enforcing extra (fiduciary) duties to protect small investors in host countries. It was thus clear that in the ISD, under UK influence, much more was made of the host regulator role, especially in the area of conduct of business (Art 11(2)). See also M Blair, Financial Services. The New Rules (London, 1991), elaborating on the UK core rules and also on the IOSCO Resolution on the International Conduct of Business of December 1990, reproduced in that book. 457  Through Art 10 ISD, a firm was subject in this respect to home regulation but in the host country also to the conflict of interest regulation of that country under Art 11 ISD. Treatment of client assets and money was viewed as a prudential matter, as were probably custody and settlement arrangements, where, however, under the third indent of Art 11, the host country could also claim an interest. In any event, in practice, monitoring was still

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country remained conditioned by the general-good exception to home-country rule without further refinement. In the meantime, it remained doubtful whether foreign firms could be required under this general-good exception to submit to membership of host-state regulatory bodies, such as the FSA in the UK, and to their registration requirements and rules in respect of direct services from abroad.458 The 2004 MiFID, effective 2007,459 was intended to progress from this scenario and was, as already mentioned, specific first in defining more clearly the remaining hostcountry powers, especially in the area of conduct of business, thus reducing any remaining impact of the general-good notion, references to which were deleted (see also the previous ­section and ­section 3.5.7 below). Second, it defined more clearly the conduct of business rules, and third, it became more deeply concerned with the operation of official and unofficial markets—see for this aspect, the previous and next sections. At least for retail, in terms of conduct of business, the key was now the best-execution rule, especially because of the MTFs and internalisation possibilities that were being allowed (see next section). Again, the principle of best execution (and its market unifying effect) had not appeared in the ISD, although it was deemed implied in its Article 11 and could be found in the implementation legislation in several Member States. MiFID I dealt more particularly with the meaning of best execution now that many more markets or trading platforms had to be considered. First, while holding itself out as a broker to the public, a broker should not be able to hide behind an unusually small number of trading platforms that it customarily checked for best prices, even if it could be accepted that it was not able to check all at all times. A good effort had to be made and there had to be a broad range. Second, for retail, Articles 44(3)ff of the Implementing Directive

an important host-country concern. It could also be delegated by the home regulator to the latter under Art 24 and was otherwise likely to be raised with the home regulator under Art 19(4) if the investment firm failed to take the necessary steps. These double (home and host) safeguards could give the foreign firm an advantage when its own home regulation as regards treatment of conflicts and client assets was more precise than that of the host country. Indeed, classification under either Art 10 or Art 11 made the difference in regulatory jurisdiction of the home or host state and there could be some doubling up. There would also be a difference in recourse. Again, the one under Art 10 was administrative, the one under Art 11 could give rise to private investors’ action. More important was, however, that both Articles were so vague that in the implementation legislation there could be great differences and that modern minimum standards of investor protection, particularly in the area of postponement of brokers’ interests, segregation of client assets, suitability of the investments and best execution of deals might still not be met. It would in civil law probably mean a more fundamental adaptation of the agency notion in its obligatory and proprietary aspects or a further elaboration of good-faith notions than was commonly developed in case law in this area. It was pointed out before that conduct of business rules are more important in the investment services industry than in banking and were therefore more specifically dealt with in the ISD, and somewhat better separated from the prudential rules, which are essentially home-country matters. But as may be clear from the above, there remained ambiguity and perhaps too much shadowing of the regulatory approach to commercial banks, which is traditionally not strong in conduct of business. It is also more of a retail than professional investors’ issue. 458  In the meantime, the EU also became concerned about long-distance selling to consumer investors. What we are concerned with is the interface between financial regulation and supervision and the protection of long distance recipients of financial services: see more particularly s 3.6.8 below. 459  Followed in 2006 by implementing Directive 2006/73/EC of 1 August 2006 [2006] OJ L241 largely dealing with organisational requirements and operating conditions within an investment firm and implementing Commission Regulation (EC) No 1287/2006 of 10 August 2006 [2006] OJ L241 largely dealing with the operation of markets.

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established total consideration as the dominant factor, a dubious and dangerous concept for clients however. In this connection, it should be asked whether, in considering best execution, besides the market price, other elements like order size, efficiency in trading, the time factor, the cost of clearing and settlement, and custody could also be considered. In other words, did we mean here best price or a total package? It was the last in general, but best price for retail. Indeed, if too many factors other than price slip in, it may be expected that the concept soon loses its meaning and protection. In any event, where brokers charge a commission, the cost of efficient execution would seem to be theirs and should not enter the best-execution equation. Price is then the sole factor and in such cases it remains the broker’s duty to execute at the best price available in the market and, through the brokerage fee or commission the broker is paid, the latter should get there and not subsequently use excuses why it could not comply (which is for the broker normally a question of its higher cost and greater effort).460 This may well all be different if the client agrees or asks to be treated on a net price basis, which may suggest an abandonment of the best-price principle and might only be available for professional clients. Naturally, if the broker itself goes into the market and deals at its own initiative against net prices, the client would still have the benefit of best execution (price) over all. Under MiFID I, it could be said that at least firms had to adopt an execution policy and could not use a trade-by-trade test: see Article 21(2) and Articles 45(5) and 46(1) Implementing Directive. The firm was expected in this manner to obtain the best possible results on a consistent basis. Clients had to be informed of this policy but would seldom be in a position to do much about it, although advance consent was required. It is in truth a regulatory supervision issue. Again, the most important feature to understand is that all kinds of market efficiency-related excuses may easily make a mockery of the best-execution principle and serve only to make some savings for the broker. There are here innate conflicts of interest in which the client’s interest should prevail. This raised a related further point. Once a broker agrees to make a trade, he should not be able to refuse to do so at the best price in the market (because it may be more costly for him) referring the client instead directly to the best deal offered by others. It is not possible for a retail client to set up accounts at once with any securities’ offeree, and in any event the moment would have passed and this would therefore appear to be a breach of the best-execution notion as the client here gets no execution at all for reasons internal to its broker. Special problems arise here in any event in dealer markets and in the world of bespoke products, but at least these are normally professional dealings. Another important point in this connection is whether client limits have to be shown to all markets for the best price (which for larger deals would at the same time warn the market and could have the opposite effect but could nevertheless be justified from the broader perspective of efficient price formation), or whether systematic internalisers (in any event for retail) would as a minimum have to signal their bid-offer prices 460  In this regard the French Autorité des Marches Financiers (AMF) issued an important Consultation paper on enforcing the best execution principles in MiFID and its implementing Directive in July 2006. So did the FSA in the UK in May 2006 in Consultation Paper 06/3 on Implementing MiFID’s best execution requirement; see also its October 2006 Consultation Paper 06/19 on Reforming Conduct of Business Regulation, 90ff.

Part III  The EU Regulations and Directives Concerning the Internal Market 841

(effectively the prices at which they debit and credit their clients’ securities accounts) to the broader market, at least in shares admitted to regular exchanges that are sufficiently liquid and dealt in up to standard market size.461 This latter alternative became the way forward under MiFID I (Article 27). The issue here was pre-trade transparency. The quotes must reflect and are compared to prevailing market conditions. The benchmark is therefore the price in the regular ­markets but that does not relieve the broker from the best-execution duty (Recital 44). That is the key issue, as discussed in the previous section. They are followed by a posttrade transparency requirement that tracks the one for regular exchanges/MTFs (Article 28). It also needs to apply when brokers set off their various orders, another form of internalisation.

3.5.6  Home or Host-country Authority in Matters of Conduct of Business We have seen that in cross-border financial dealings, it is the policy of the EU to encourage home regulation at the expense of host regulation even to the point that claims to host regulation under the general good are now ignored and deemed subsumed in the division of labour under the newer Directives. This applied in particular to MiFID I, also in the area of conduct of business in respect of retail clients. It has already been mentioned that the ECJ may or may not agree with this approach. At least retail clients may still have a legitimate interest in being able to pursue their protection in their own country, especially in their own language before any simplified complaints bodies that may exist there. It would then also follow that rules of protection as formulated by the host regulator may apply. In practice, host regulators may have further concerns in respect of this class of investors and how they are treated by foreign intermediaries or firms. However, it was already noted that, if the clients keep accounts with brokers abroad, or when the place of the characteristic performance of the broker is elsewhere, no cross-border activity proper may result, so that no host-country concern may be legitimate, see ­section 2.3.3 above. Nevertheless, even in respect of activity of the foreign broker in the host country, MiFID limited considerably the host-country jurisdiction also in respect of retail activity. The corollary was that the home regulator must take over this function even in respect of foreign activities of its regulated brokers or other financial intermediaries like fund managers. MiFID I did not, however, exclude all host-country rule but wanted to be specific. The approach in MiFID I was explained in Recital 32 of the Preamble as follows: By way of derogation of the home country authorisation, supervision and enforcement of obligations in respect of operations of branches, it is appropriate for the competent authority of the host Member State to assume responsibility for enforcing certain obligations specified in this Directive in relation to business conducted through a branch within the territory

461  In respect of liquidity and standard market size, there is some quantification in the implementation legislation. CSER suggested a similar approach to the requirement of ‘frequency’, but that was rejected.

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where the branch is located, since that authority is closest to the branch and is better placed to detect and intervene in respect of infringements of rules concerning the operations of the branch.

It is to be noted in this connection that such a statement was not made in respect of more incidental activity of a foreign firm in the host country. The definition of what is or amounted to a branch was here important (see summarily Article 4(1)(26)), the real dividing line between a branch and direct services being left to case law—see also ­section 2.3.3 above. Another point is that no distinction is here made in principle between wholesale and retail clients. Article 32(7) picked up the theme and gave responsibility to the host regulator of a branch in matters dealt with in Articles 19, 21, 22, 25, 27 and 28. They concern foremost the supervision of the duty of firms to act honestly, fairly and professionally in accordance with the best interests of clients, and further the supervision of best execution, client order handling, market integrity and transaction reporting, as well as pre- and post-trading information supply in respect of activity on its territory. Articles 61 and 62 provided two other instances of home regulation: we are here concerned with gathering statistical information and emergency measures when the investment form is in breach of its regulatory duties, both already contained in the ISD.

3.5.7  Regulated Markets, Concentration Principle and Stock Exchange Membership. The Competition of Modern Informal Markets or MTFs. Best Execution and Internalisation Within the context of the deliberations on the ISD, there arose at an early stage the question of competition between the formal domestic stock exchanges and the formal or regulated exchanges (as defined in Article 1(13) ISD) in other Member States or the (often offshore) informal or OTC markets. The most important discussions in this connection ultimately centred on the host countries’ right to request (a) local transactions in respect of (b) local securities to be exclusively carried out on their own (c) ‘regulated’ markets (this is the concentration principle as reflected in principle in Article 14(3) ISD and under the reporting requirements of Article 21 ISD), as against OTC or telephone trading in or from other financial centres in the EU under their own transparency or price-reporting requirements (to which Article 21 ISD did not apply). It appeared largely a rearguard action to protect domestic exchanges of the order-driven type. The controversies on this subject were resolved in the sense that even habitually resident investors could opt out of such constraints,462 probably in advance, especially important for euro-securities and large professional trades: see Article 14(4) ISD.463 462  Nevertheless, it was reported at the time of the recasting into MiFID that concentration was still favoured and that particularly internalisation of trading remained forbidden in Italy, France, Spain and Greece. The reason was likely to be the support of local exchanges but there may also have been a justified concern about transparency and proper investors’ protection. 463  Price reporting on regular exchanges (Art 21) was for continuous markets in any event only required at the end of each hour in weighted averages over the previous six-hour period, allowing two hours’ trading before

Part III  The EU Regulations and Directives Concerning the Internal Market 843

All securities houses, including universal banks, were in the meantime allowed under their passport to become members of or have access to domestic regular exchanges as of the end of 1996 (in Spain, Portugal and Greece by the end of 1999: Article 15 ISD). These markets themselves remained domestically regulated, subject, however, to the possibility of mutual recognition EU-wide (Article 16 ISD).464 It has already been said that a revision of the ISD was at first proposed in November 2002 but in the end new trading environments motivated its complete replacement by MiFID (I) (see Recital 5). Recital 44 referred in this connection in particular to the integration of Member States’ equity markets, the promotion of efficiency of the overall price information for equity instruments, and the effective operation of best execution. The idea was that official exchanges would no longer remain purely domestic but were to be exposed to competition with one another and with the informal markets.465 In this connection, the sharp rise in OTC electronic communication networks or ATSs, not only in the US,466 substantially added to the variety. MiFID here introduced the term multilateral trading facility or MTF: see s­ ection 3.5.4 above for the definition. Regular exchanges now needed authorisation, subject to harmonised standards, and thereby received the passport. No authorisation proper was required for MTF activity, which was normally covered by the licences of investment firms or regulated markets operating them. Market operators who were not investment firms or regulated markets but only operated an MTF needed no authorisation or licence for doing so either, as we have seen, and were exempt (see Article 5(2) MiFID) but were subject to prior verification by their home regulators of their compliance with the provisions of ­chapter I MiFID I excluding Articles 11 (compensation schemes) and 15 (relationship with third countries). As such, MTFs benefited also from the passport, subject to Article 31(5) and (6), which instituted for them the now traditional system of home-country control and notice to the host country. They were all subject to the organisational

publication. Every 20 minutes, weighted averages were published and highest and lowest prices for the previous two-hour period allowing one hour’s trading before publication. The delays were particularly important to protect market makers in a price-driven system against early disclosure of their positions with any resulting difficulty in unwinding them. The competent authorities could also delay or suspend publication if justified by exceptional market conditions to preserve the anonymity of a trade (eg in small markets), when there were large transactions, or when highly illiquid securities or dealings in bonds or other forms of securitised debt were involved (Art 21(2)). Art 20 imposed, however, a more general duty on investment firms to provide the competent authorities with transaction information on or off the regulated markets, but this reporting was then directed towards the homecountry authorities and only in respect of instruments more commonly dealt with on regulated markets. It was meant to prevent market manipulation and insider dealing in such instruments. See for MiFID I the CESR Level 3 Guidelines on MiFID Transactions Reporting of February 2007 and its Level 3 Guidelines and Recommendations on Publication and Consolidation of MiFID Market Transparency Data, also of February 2007. 464  Art 15(4) ISD was indeed interpreted in the sense that regulated markets benefited from a European passport and access, which allowed eg screen trading in other Member States. Art 15(3) was not considered to apply to this access. There was no such rule for OTC markets, their functioning, activities, transactions, participation and price reporting. Market makers could, however, rely on their passports as service providers. Parties from abroad with ambitions to bring new trading mechanisms could not use the ISD either, but had to rely on the general principles of ‘free movement’ and ‘non-discrimination’ as enshrined in the EC Treaty as such. 465  As between official markets, competition is likely to come from fee structures and from access to their clearing and settlement operations, in which connection competition authorities may also have a say. 466  See for electronic trading s 1.5.6 above and for US regulation s 1.5.9 above.

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requirements of Articles 13 and 14. The market function itself required some levelling of the playing field between official or regulated exchanges and the OTC ones, including these ATSs or MTFs, which remained otherwise unregulated in their operations. Thus pre-trade transparency requirements became the same for all, at least in shares admitted to regular markets (Articles 29 and 44). Post trade, all had to publish details of their transactions as close to real time as possible (price and size), with a possible deferment for block trades (Articles 30 and 45).467 Due to the nature of the service provided, for MTFs, cross-border service meant in practice appropriate arrangements to provide access to the use of MTF systems in other Member States. MiFID I did not go into these arrangements themselves. The CESR (see ­section 3.4.2 above)—in the meantime transformed into ESMA—at one stage tried to come up with some ‘connectivity test’ covering the placement of screens, delivery of software to support access, physical infrastructure and establishment of the platform and access via the internet in the host country. It is clear that in the case of MTFs the provision of cross-border services was primarily done by placing trading screens and providing other trade-facilitating infrastructure in other Member States, leading also to secure internet access there. The mere establishment of technology elsewhere in the EU did not constitute an investment service per se, however. It has already been said that it was not always clear what amounted to a crossborder service in this connection, especially if a client accessed an MTF platform at his own initiative from abroad while all services were rendered at the place of the supplier, including clearing and settlement. Whether the MTF facilitating such access safely and securely (eg through the internet) was itself a cross-border service could then still be doubted. Another important issue was that in practice brokers might wish internally to match trades away from all types of exchanges. It could be very efficient for them to net out concurrent buy and sell orders at the same or similar prices. That is internalisation, already mentioned in ­section 3.5.4 above, which may be particularly efficient for trades that must otherwise be done on foreign exchanges and may involve an additional (correspondent) broker and its costs.468 To repeat, MiFID introduced here the concept of systematic internaliser. In this area of internalisation, investment banks and brokers were asked to provide transparency (especially in trade matching), guarantee best

467  In this connection, there was felt to be a particular need to report done prices if there was a regular market in respect of the underlying instruments so that these prices could figure in the overall trade reporting and help to provide a more accurate price information system in regular exchanges. There is a separate reporting requirement to regulators (home competent authorities besides authorities of the most liquid market in the relevant instrument) to allow them to monitor abuse. It covers all financial instruments admitted to trading. Under MiFID pre- and post-trade price transparency is dealt with in Arts 22 and 27. Proper price reporting of all done prices and their time is a major safeguard for investors. So is the role of independent brokers even if a division of the same institution that internalises the deal or engages in market-making in the relevant security. Special attention would appear warranted when there are combinations of activities (see Recital 26 of the implementing Directive). Pre- and post-trade price transparency become all important here and it is the broker’s task to check for his client best execution in self-dealing by the same institution. The more internalisation or self-dealing the more this becomes necessary. 468  It was reported at the time that this internalisation could well amount to 25 per cent of all trades.

Part III  The EU Regulations and Directives Concerning the Internal Market 845

execution (see Recital 44) and guard against conflicts of interest. The notion of best execution was discussed in ­section 3.5.5 above. The essence is to provide the same protection across the board, especially for retail investors.469 A special form of internalisation emerges, as also already mentioned, when a broker is also a market-maker. It is a form of self-dealing especially relevant in OTC products like eurobonds and off-market derivatives, including swaps. Investment firms here become counterparties and the investor does not then have normal investor protection. Under MiFID I, Article 24, this facility was therefore limited to eligible counterparties who are professionals. They could, however, be brokers for private clients. It meant that if internalisers were at the same time retail brokers, their retail clients retained their right to best execution. This highlights the need for the independence of the brokerage function in conglomerates. Where a broker is in house, that function should be split out so that the broker is not beholden to the products and services, crediting and debiting methods or custodial policies of his own firm. It should allow the broker to go outside for the best deals. It remains a concern whether that is also happening in practice. The full acceptance in MiFID I of MTFs, internalisation or self-dealing even as market-maker concluded for the time being the battle fought earlier on the concentration principle.470

3.5.8  Clearing and Settlement, CCP Access After MiFID Clearing was discussed in s­ ection 1.5.7 above and earlier in c­ hapter 1, s­ ections 2.6.4 and 4.1.4 above. From an EU perspective, the key is to make sure that all barriers to cross-border clearing and settlement are eliminated. This brings costs down and provides safety. The search for this goal led to an EU Communication in 2002 in which an overall policy was announced. Other measures were foreseen in this direction in 2004;471 see further the more extensive discussion in ­section 3.6.14 below. MiFID I in the meantime gave firms from other EU countries the right of access, also to CCPs: see Article 34 and ­section 3.5.4 above. The matter received renewed attention after the 2008–09 financial crisis, especially in respect of derivative markets, but the precise way forward may still remain less clear—see also ­section 3.7.6 below on EMIR.

469  It could even be said that in as much as in a modern book-entry system the brokers only make security debits and credits at best prices at the time of the order or as soon as possible thereafter, there is always internalisation. The broker only has a subsequent asset maintenance obligation, which he fills out (promptly) in his own manner. He might take a market risk. That is his part of the circuit. Certainly for smaller retail orders this seems increasingly to be what happens. 470  Regulators may ask MTFs and internalisers to invalidate transactions in order to protect investors or orderly markets. It is also possible to exclude certain financial instruments from these facilities altogether but such a drastic step requires intervention of the courts. 471  Communication of the Commission to the Council and the European Parliament ‘Clearing and Settlement in the European Union—The Way Forward’ COM [2004] 312 final.

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3.5.9  ISD/MiFID: Member States’ Committee Finally, the ISD according to its Preamble aimed at setting up a Committee of Representatives of Member States to assist in further progress in this area, in the same manner as the Contact Committee for banking matters under the First Banking Directive. Although the role of these committees of Member States’ representatives and the EU Commission remains largely undefined, they tend to provide an important forum for the discussion of new developments and needs, but are not intended to assume the role of EU-wide regulators. They may, however, advise where the Commission is given authority to implement and sometimes change the details of the regulatory regimes. See for the Lamfalussy process and the committee set up thereunder s­ ection 3.4.2 above and for the amendment of the committee structure after the financial crisis, ­section 3.7.2 below.

3.5.10  CARD and the 2003 Prospectus Directive. The Issuer’s Passport A number of early Directives concerning regulated markets, the admission thereto, and operations thereon were discussed in ­section 3.2.4 above. They were the Admission, Listing Particulars, Regular Reporting, and Mutual Recognition Directives, since 2001 consolidated in the Consolidated Admission and Reporting Directive (CARD), which covered the admission of securities to official stock exchanges, listing and the information to be published on these securities.472 It did not consolidate the Public Offer Directive of 1989. The 2003 Prospectus Directive (PD)473 amended CARD and also replaced the Public Offer Directive (Articles 28 and 29). The text was adopted in July 2003. Implementation was required by 1 July 2005. The principal objectives of the PD, to be replaced in 2018 by a Regulation were, according to its Preamble (Recitals 10 and 18), the promotion of investor protection and market efficiency in the capital markets in accordance with international standards. It made the prospectus its centrepiece. A new important objective was the promotion of a single passport for issuers who met the prospectus requirements in another EU country. The consequence was that the securities could then be placed and sold in any other market in the EU. In fact, the new Directive was partially a response to earlier criticism concerning CARD, which centred on the lack of (a) a definition of what was a ‘public offer’, which led to different implementations in the different Member States; (b) mutual recognition which, although foreseen, seemed not to develop sufficiently under the old Directives; and (c) a common and clear private placement exception, so that legal advice in every Member State was no longer required if an EU-wide private placement was intended. 472 

Directive 2001/34/EC [2001] OJ L184/1. Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 [2003] OJ L345/64, implemented by Commission Regulation (EC) No 809/2004 of 29 April 2004 [2004] OJ L215/3. 473 

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Together with MiFID I, the PD became one of the major new measures in the whole 1998 Action Plan. It was intended to create common and enhanced standards for the issuance of securities throughout the EU. It continues to distinguish in this connection between (a) offers made to the public and (b) admission to trading on regulated markets, but relates them closely for transparency purposes and mutual recognition. Under the Directive, both activities require a prospectus but with identical conditions EU-wide. The Directive now promotes the notion of mutual recognition of prospectuses in the form of the issuer’s passport. The key provision of the PD was that a prospectus must be published (a) when an offer for securities is made to the public, or (b) where they are admitted to a regulated market (Article 3).474 The offer to the public was defined (especially through the exemptions) and was any communication presenting sufficient information on the terms of the offer and the securities offered to enable investors to purchase or to subscribe to securities (Article 2(1)(d)).475 Under Article 3(2), a prospectus in the required form was not necessary (unless admission on regulated markets is also sought) if the offer is made (a) to qualified investors; (b) for small issues (not exceeding EUR 100,000); or (c) for offers in excess of EUR 50,000 per investor or expressed in denominations of at least EUR 50,000). Qualified investors are here distinguished from wholesale or professional investors and concern a defined narrow class of investors including banks, insurance companies, governments and governmental agencies, but also other legal entities with the exception of small and medium-sized enterprises (Article 2(1)(c)(iii)). In this sense, private persons or partnerships could never be qualified investors.476 Following its uniform approach, the EU eliminated an important competitive tool among regular and informal markets and limited regulatory competition in matters of disclosure. In doing so, it ignored the improvement of standards that could flow from it. The benefit was the passport into all markets. This trade-off has already been signalled in ­section 3.5.1 above and is perfectly defensible if one believes in prospectuses for all types of products regardless of whether they are targeted to wholesale or retail in whatever official or unofficial market. In its sweeping prospectus requirements, the EU nevertheless betrays an innate suspicion of all that is not regulated and an aversion to open competition. There is here no notion that regulation should be the exception, not the objective, nor an appreciation of the modest impact that prospectuses in their present form have in terms of investor protection. 474  The concept of regulated markets was redefined in MiFID (see s 3.5.7 above) and was removed in CARD, see s 3.2.4 above. A list approach is being used. Admission to such markets is not the same as admission to listing, which is a matter for host authorities under Art 8 CARD, although the relationship between admission to a regulated market and listing and the consequent regulation is still not straightforward. 475  This concept is not meant to constrain unduly the distribution of promotional materials before an offer in these terms is made, but there may often be justified doubt on the borderline. One would further assume that all offers that are not offers to the public are private placements but this does not seem to follow as the definition of public placements is broad and clearly used for other reasons than distinguishing between public and private placements. The term ‘private placement’ is not used. The essence is the exemption from the prospectus requirement, not the absence of a public offer. 476  The earlier exemptions for conversion offers, takeovers and mergers, bonus issuers and employee offers are maintained (Art 4(1) and (2)). One may expect that these exemptions will lead to new structures devised around them, especially for the international (eurobond) markets.

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As to the details, the prospectus had to contain all information necessary to enable investors to make an informed assessment of the assets and liabilities, financial position, profits and losses and financial prospects of the issuer and of any guarantor. It also had to give the necessary information on the rights attached to the securities (Article 5(1)). Much of the detail was left to implementation (and CESR, now ESMA, guidance). This may now be done by Commission Regulations.477 Accounting standards are the International Accounting Standards (IAS). The newer standards are called International Financial Regulatory Standards (IFRS) and EU Regulation requires these standards to be observed to the extent endorsed by the EU. Again, no distinction was made between issues targeted at wholesale and retail investors (except for the exemptions) and not much room was left for new products that might require an altogether different treatment. High denominations are here considered a proxy for wholesale/sophisticated investors and made subject to a lighter regime. Beyond this, Article 7(2)(e) allows some flexibility only in respect of small and medium-sized issuers. But there had to be a summary of the prospectus (Article 5(2)), considered especially important for retail. This raised the important issue of prospectus liability for inaccurate, inconsistent or incomplete information. Article 5(2)(d) dealt with this matter and imposed liability only if these defects appeared in the summary when read together with the text of the prospectus itself. Problems could increase when the full prospectus was in another language. Otherwise, prospectus liability was left to local laws and was not harmonised. According to the Directive, primarily responsible were the issuer, offeror, the person asking for admission to regulated markets or any guarantor. It would seem to exclude investment banks, lawyers and accounting firms, but the inclusion of ‘offerors’ might still catch them in certain circumstances. The prospectus could be in three parts (tripartite), consisting of a registration document, a securities note and the summary (Article 5(3)). Short of any closing, it remained valid for 12 months (Article 9(1)) and achieved in this manner the facility of a shelf registration. A supplement was necessary whenever significant new factors arose or a material inaccuracy was noticed between the approval of the prospectus and the closing of the issue (Article 16(1)). A base prospectus could be presented in respect of MTN programmes (Article 5(4)). In order to avoid time constraints, further terms could be filled out later (without approval) unless they were inconsistent and formed a supplement in terms of Article 16(1). Current market practices could also bring enlightenment here but have historically been confused and inconsistent as to what must be included or covered.

477  The Lamfalussy Process was made applicable to the Directive—see Art 24—and was relevant in respect of Arts 2(4), 5(5), 7, 10(4), 11(3), 14(8), 15(7) and 20(3). An important implementation Regulation (EC) 809/2004 [2004] OJ L215/3, was issued by the Commission on 29 April 2004. It concerned the information contained in prospectuses as well as the format, incorporation by reference and publication of prospectuses and dissemination of advertisements. The powers of implementation were limited as reflected in Recital 41, which encouraged in particular market innovation, efficiency and the international competitiveness of the Community’s financial markets. This Recital suggested a number of underlying policies. They were, however, not reproduced in the text of the Directive itself, which seemed at times to be at odds with them.

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Approval was through the relevant competent authority of the ‘home’ Member State (Article 13(1)). The time limit was 10 days, unless the relevant competent authority requires more information. The ‘home’ Member State was here the Member State where the issuer had its registered office (Article 2(1)(m)), except for non-equity securities with denominations of more than EUR 1,000. A choice is then allowed and the authority of the market in which the offer is made (regulated or not) could thus become alternatively competent (it became the ‘home’ authority). This was done to alleviate the problems when the primary listing is in another country than that of the issuer. It is an important facility as especially a bond issue may not take place at all in the country where the issuer is registered. For non-EU issuers, the competent authority was the one of the Member State in which the security was first offered or sought to be admitted to trading. It could thus be seen that non-EU issuers had more flexibility than EU issuers, even though the place where the issue was first offered to the public (as distinguished from admitted to a regulated market) may be wholly unclear if the issue is targeted to all of the EU. Upon approval by home states, the prospectus and any supplements had to be published a reasonable time in advance of the offer (Article 14(1)). Home states had to issue certificates of approval to host Member States within one day of the request. The latter would have to accept the validity of approved prospectuses and any supplements for public offers or admission in their state upon simple notification of the approval (Article 17(1)). In that case, the language had to be that acceptable to the host state or had to be ‘customary in the sphere of international finance’. This was to be English. The host country could, however, always require the summary to be translated into its own language (Article 19(2) and (3)). Unlike many other Directives in the past, including MiFID I, the PD set complete rather than minimum standards, which cannot be exceeded by Member States. It was a so-called maximum Directive.478 A truly uniform regime was foreseen, which would perhaps have justified a Regulation, as used in its implementation, although national competent authorities retained some flexibility in that they could require issuers to include some (limited) additional information and could also elaborate on listing requirements, which were not fully dealt with in the Directive, but the former probably only on an ad hoc basis (Article 21(3)(a)). The proposed replacement instrument will be a Regulation which became effective in 2018, see s­ ection 3.7.14 below. In any event, host states remained in charge of listing requirements (see Article 8 CARD), but could not in that context impose new prospectus or approval requirements either. Nor would the system appear any longer to allow any exceptions for host countries on the basis of the EU notion of the ‘general good’. Yet, as in the case of MiFID, earlier case law in this area remains fundamental and may not be entirely superseded, although the detail of the harmonisation leaves less room for it. It is of interest to see how the euromarkets and especially the international bond markets reacted. Under the earlier Public Offer Prospectus Directive, the eurobond market had been exempt. The key was always whether the flexibility and the exemptions the 478  It may be noted that MiFID is for most practical purposes also striving for maximum harmonisation in that it leaves much less room than the ISD for variation in implementation.

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new Directive provided would be sufficient for this market to largely continue to operate within the EU, especially from London. As mentioned before, it has restructured around the exemptions and other facilities the new Directive presented for wholesale market dealings. Most offerings became in fact private placements. Large international equity placements might, however, be forced to go offshore. Here one could still see the protection by the Directive (supported by CESR) of formal exchanges and similar domestic backwaters. Internationalisation and globalisation thus appeared to come to an end, even for professional investors regardless of the fact that the concentration principle had been abandoned, see ­section 3.5.7 above.

3.5.11  The 2003 Transparency Directive The Transparency Directive (TD),479 first proposed in March 2003, continues to cover much of the ground of the earlier Regular Financial Reporting Directive (of Listed Companies) of 1982 (see s­ ection 3.2.4 above) and also entailed further amendments to CARD, see ­section 3.5.10 above, which consolidated the earlier Listing, Admission and Reporting Directives. The TD’s aim was to impose a continuing obligation on all issuers to disclose financial information and new developments. It covered in particular annual and biannual financial reporting and the publication of interim statements. Like the PD, it used the IAS, now followed by IFRS, see previous section, to the extent endorsed by the EU. Excesses thought to be inherent in the Sarbanes-Oxley Act in the US were believed to have been avoided. The TD became effective on 20 January 2007. As in the PD, the definition of the home state was crucial (Article 2(1)(i)), but did not track the PD entirely. For all issuers issuing shares or bonds with a denomination of less than EUR 1,000, it is the Member State of the registered office of the issuer. Otherwise, the Member State where the issue was admitted to a regular market could be chosen. In practice it was mainly issuers of bonds with higher denominations who benefited, but share issues were not excluded altogether. Foreign issuers filed in accordance with Article 10 CARD, their home state being determined by the PD. So the confusion under the PD where, in the event securities were offered to the public the offer itself had to be located for regulatory purposes, did not arise here. The idea was that each home Member State maintains a filing mechanism where investors can go for information on issuers. There is one filing system per Member State and no single all-EU filing system, although the intention was to create one at some time in the future. Liability of (outside) directors, lawyers and auditors to the general public throughout the EU for errors in published financial information was also another important issue here. Unlike the PD, which was introduced at the same time, the TD remained a minimum harmonisation Directive so that Member States could still impose a stricter regime. 479  See for the final version, Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the Harmonisation of Transparency Requirements in Relation to Information about Issuers whose Securities are Admitted to Trading on a Regular Market and Amending Directive 2001/34/EC (CARD) [2004], OJ L390/38.

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3.5.12  The EU Approach to Capital Adequacy The BIS capital adequacy guidelines (Basel I), which had, as we have seen, no binding force of their own (­section 2.5.2 above) were generally followed by the G-10 countries who were originally constituting the BIS banking committee, six of which were EU Members. This became reflected in the EU capital adequacy rules for banks (Own Funds and Solvency Directives, later consolidated in the Credit Institutions Directives (CID) of 2000 and 2006).480 For investment firms there was a separate Capital Adequacy Directive (CAD) of 1993.481 When Basel II became a reality, see s­ ection 2.5.10 above, it was necessary to reflect it in new EU Directives which superseded the earlier ones in this area.482 In 2006 the capital adequacy regimes for banks and investment firms were adjusted pursuant to Basel II, implemented by 2008. The result was in fact an entirely new CID (of 2006),483 which replaced in full the earlier consolidating Directive of 2000 as we have seen and also covered the regime of own funds and solvency ratios for commercial banks. For investment firms (and commercial banks for their investment activity), there was a replacement of the CAD by the Capital Adequacy of Investment Firms and Credit Institutions Directive (also of 2006, later called the CRD 1, see also ­3.7.3/4 below), in respect of the latter, in particular, the capital required for market, settlement and currency risk.484 For the details of Basel II see ­2.5.10–2.5.12 above. The financial crisis led to further amendment of the Basel Accord in Basel III as we have seen. See for its implementation in the EU ­sections 3.7.3/4 below. The essence was a new Directive covering credit institutions in 2013, now encapsulated in CRD 4,485 which covered much more than capital adequacy for banks and covers also the prudential regime concerning investment firms, meaning its capital adequacy and liquidity

480  See for references s.3.3.1 above. Annex 2 to the Solvency Directive was amended to adopt the policy of netting for capital adequacy purposes as proposed by the BIS in 1996: see s 2.5.5 above. 481  Council Directive 93/6/EEC of 15 March 1993 [1993] OJ L141. 482  The EU capital adequacy rules for banks applied to all banks on EU territory without consolidation and deviated from the Basel I approach also in a number of other aspects: they restrict external elements (Second Tier) capital to 50 per cent of Tier One capital; they accepted on the other hand undisclosed reserves in Tier One as well as revaluation reserves, general provisions and some subordinated capital; they did not require goodwill to be deducted from qualifying capital or investments in unconsolidated subsidiaries or in other banks. There were also some minor differences in risk weightings and in credit conversion factors. The EU notably accepted all Member States as zero risks even if not OECD countries. Repos were given a 100 per cent weighting (Basel I: 50 per cent), while the EU, unlike Basel I, did not make reductions in weightings for foreign exchange swaps with non-banks. The 1993 CAD for investment activity in the meantime covered capital for securities firms and for the securities businesses (trading books and portfolios) of commercial banks. It accompanied the ISD. The approach to minimum capital requirements was essentially different. The CAD adhered from the beginning to the building block approach (see s 2.5.6 above) and differentiated between specific risk and general risk. Specific risk is connected with issuer (therefore counterparty risk) and general risk with market developments. Beyond an absolute minimum and a fixed overhead charge, the specific risk exposure tracked the banks’ credit risk regime under the Solvency Directive. 483  Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 [2006] OJ L177/1. 484  Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 [2006] OJ L177/201. 485  Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L176/338.

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requirements, the details of which were set out in an accompanying Regulation of the same year (CRR 2013).486

3.5.13  The Market Abuse Directive (MAD) and 2014 Regulation (MAR) The Market Abuse Directive of January 2003, supported by two implementation ­Directives,487 harmonised the rules on insider dealing and market manipulation in regulated and OTC markets: see s­ection 1.1.20 above. Its implementation date was October 2004. By 2011, proposals were forthcoming for a replacement by an EU Regulation and a new Directive, notably extending the reach to newer trading platforms (MTFs) and other trading venues. They were approved in 2014.488

3.5.14  UCITS and Fund Management As we have seen in s­ection 3.2.5, the UCITS Directive of 1985 was updated by two Directives of January 2002,489 which broadened the types of assets in which UCITS can invest, regulated management companies, and allowed simplified prospectuses. These Directives had to be implemented by February 2004 and were consolidated in 2009 in UCITS IV.490 Updates were proposed as of 2010 leading to UCITS V.491 The aim on the part of the EU Commission was to approximate the UCITS regime to the one for Alternative Investment Funds (see for the AIFMD ­section 3.7.7 below) but increase the liability of depositories possibly beyond it (following the Madoff affair) and align the remuneration structure of managers to the one for banking. It should be appreciated that UCITS only covers the cross-border activity in certain open-ended funds within the EU. It presupposes home-country approval and authorisation on the basis of which a certificate is issued. For general supervision of fund management, MiFID applies, although not to collective investment undertakings proper. The Directive on Alternative Investment Fund Managers now deals with funds not under UCITS, especially hedge and private equity funds, see again ­section 3.7.7 below.

486  See for Capital Requirement Regulation (CRR), (EU) No 575/2013 on prudential requirements for credit institutions and investment firms [2013] OJ L176/1 followed by the Commission Implementing Regulation (EU) 2016/892 OJL 151/4 (2016) and the Commission Delegated Directive (EU) 2017/593 OJL 87 (2017). 487  Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 [2003] OJ L96/16; Implementing Directive 2003/124/EC of 22 December 2003 [2003] OJ L339/70; Implementing Directive 2004/72/ EC of 29 April 2004 [2004] OJ L162/70. 488  Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on Market Abuse [2014] OJ L173/1 and Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014 [2014] OJ L 173/179. 489  EU Directives 2001/107/EC and 2001/108/EC, both of 21 January 2002, of the European Parliament and of the Council [2002] OJ L41/20 and L41/35. 490  Directive 2009/65/EC of the European Parliament and of the Council [2009] OJ L302/32. 491  Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 [2014] OJ L257/186.

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As in so much financial regulation in Europe, these later proposals were much inspired by suspicion of financial activities more generally, particularly in France and Germany, heightened after the 2008 banking crisis, but they met with a great deal of criticism from the beginning, it being clear that fund-management activities had not been at the heart of the crisis. Again, the danger simply was that a crisis atmosphere was used to extend the coverage of all regulation even of activities that were poorly understood and thus risked to become poorly regulated, inducing them to leave the EU altogether. On the other hand, there was a danger, as we shall see, that pursuant to this type of regulation other bona fide foreign funds became unable to access the EU markets.

3.6  Other EU Regulatory Initiatives in the Financial Area 3.6.1  Large Exposures There are other EU initiatives in the area of supervised financial services. One was concerned with the large-exposure regime for banks, in which connection there was an early 1986 Recommendation (see s­ ection 2.3.2 above), converted into a Directive in 1992, effective on 1 January 1994.492 The Directive provided for certain transitory flexibility until 2001 (Article 6). The 15 per cent notification and 40 per cent prohibition rule of the Recommendation were reduced to respectively 10 and 25 per cent, while the allowed total of all large exposures together remained unchanged at 800 per cent. In the CAD for securities business there was also a large-exposure regime for securities activities as a matter of counterparty risk, in the same manner as foreseen in the Large Exposure Directive, any excesses of the limits in respect of securities activities requiring extra capital. Neither the Large Exposure Directive nor the CAD covered large concentrations in (similar) positions notwithstanding the greater difficulty in unwinding these (liquidity risk). This regime was retained in the CIDs of 2000 and 2006 as well as in the Capital Requirements Directive (CRD), also of 2006, which applied to investment firms (and credit institutions for position, settlement and currency risk). The regime for large exposures may therefore be changed through the amendment of these Directives as was done in the CRD 2 of 16 September 2009 (Article 1(21)) following the financial crisis of 2008;493 see further ­section 3.7.3 below.

3.6.2  Deposit Protection and Investor Compensation In 1995, the EU also agreed a Deposit Protection Directive494 guaranteeing a minimum of protection for depositors EU-wide, following a 1987 Recommendation in this area. 492 

Council Directive 92/121 EEC [1993] OJ L29. Directive 2009/111/EC of the European Parliament and of the Council [2009] OJ L302/97. It was an omnibus Directive covering a number of items as a first response to the financial crisis. 494  Council Directive 94/19 EEC [1994] OJ L135; see for the earlier Recommendation s 2.3.2 above. ­Germany unsuccessfully attacked the new Directive before the ECJ on the ground that the host-country limitations on the 493 

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It was replaced in 2014495 after many amendments in order to promote clarity, but was not fundamentally changed and remains based on home-country schemes, but bank branches elsewhere in the EU may participate in host-country facilities to top up home protection. Until 1999, they could not, however, exceed host-country limits. The issue of compensation and the implied mutualisation of deposit debt became an issue in the euro banking union, see ­section 4.1.4 below. During the 2008–09 financial crisis, many Member States took additional emergency measures reassuring depositors in the face of the threat of severe bank runs. For investors in securities there is a parallel Investors Compensation Directive,496 aiming at a similar protection for small investors.

3.6.3  Winding up of Credit Institutions. The Alternative of an EU Resolution Regime in the Eurozone As regards cross-border insolvencies, the Winding-up of Credit Institutions Directive, already proposed in the early 1980s, was revived in 1993.497 It relied for jurisdiction and applicable law in essence on the home country of the entity, leading in principle to a system of unity and universality, the practical consequences of which required a much more detailed regime, however. In corporate insolvency there is now the Insolvency Regulation of 2002.498 After the 2008–09 financial crisis, the issue of bank insolvency was more particularly considered and studied, for which the term ‘resolution’ was then used. One of the objectives was to sever, in so far as possible, the taxpayer and the banks in times of financial crises; see also ­section 3.7.16 below. It led to a new proposal in 2012 and a special regime for the eurozone banks in the context of the banking union or single supervisory mechanism—see ­section 4.1.3 below.499 The true issue in these matters is who makes the concessions and necessary contributions if governments or tax payers do not, or no longer want to get involved. The view in this book is that to keep banks and governments separate in financial downturns is wholly unrealistic, although this is not to say that there is no need for a more robust reorganisation regime for banks or other financial institutions in times of crises, in which in particular certain classes

protection (until 31 December 1999) prevented free competition, Germany having the highest level of protection and being willing to extend it to all German bank customers EU-wide, although it objected at the same time to foreign EU institutions having automatic access to membership of the German scheme without necessarily adhering to the strict German preconditions. See on deposit guarantees D Schoenmaker, ‘A Note on the Proposal for a Council Directive on Deposit Guarantee Schemes’, Special Paper No 48, LSE Financial Markets Group, August 1992, and RS Dale, ‘Deposit Insurance: Policy Clash over EC and US Reforms’, Special Paper No 53, LSE Financial Markets Group 1993. 495 

Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 [2014] OJ L173/149. Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997 [1997] OJ L084. 497  COM (88) 4 final [1988] OJ C36. 498  Council Regulation 1346/2000, effective in 2002, only excluding Denmark. See also J Israel, European Cross-Border Insolvency Regulation (Antwerp, 2005) and M Veder, Cross-Border Insolvency Proceedings and Security Rights (Utrecht, 2004), and Dicey, Morris and Collins, The Conflict of Laws, 14th edn (London, 2006) 1526. 499  Proposal for a Directive establishing a framework for the recovery and resolution of credit institutions and investment firms, COM (2012) 280/3 of 6 June 2012. 496 

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of creditors may be converted into shareholders. This may even apply to depositors beyond their guaranteed deposit protection, but the problem is always that such rules may well contribute to bank runs at the most sensitive moments for banks. An alternative or addition has proven to be the split up of these banks into good and bad ones, the problem being, however, that in such cases the decision which assets and large deposits are being transferred to these bad banks becomes contentious, whilst rules are difficult to devise, as the situation is often very case specific. As we shall see in ­section 4.1.3 below, there is so far little protection for affected parties and a shortage in due process. In emergencies, all appears to become policy and substantially discretion. The danger is that whatever rule system there may be, it starts failing under these pressures and discretions and protection of interested parties becomes political. In the EU this is becoming a highly litigious area as we shall see.

3.6.4  Pension Funds In the pension area, there was an early proposal of 1991 for a Directive on the freedom of management and investment of pension funds.500 It allowed authorised managers from other Member States to manage funds, guaranteeing in this manner a free choice of professional advice and expertise, and in principle accepted investment freedom, subject to a number of general principles concerning liquidity. Member States could no longer request more than 80 per cent matched funding and could also no longer insist on investment in particular assets or localise it in particular Member States. The proposal did not, however, cover cross-border pension fund membership, as earlier there had been much concern about the taxation of pensions earned on the basis of tax relief but paid to beneficiaries who had left the country.501 Mutual recognition of supervisory systems was therefore less relevant and harmonisation of prudential rules was mainly of interest in the context of any exchange of information. In the meantime, this project ran into considerable difficulty, on the one hand because the 80 per cent limit was thought contrary to the Maastricht provisions (Article 56, ex Article 73(b) and (d) EEC Treaty, as amended), while other countries wanted greater powers to localise the investments of their own funds. It was as a consequence withdrawn by the Commission, which then issued a Communication on the Freedom of Management and Investment of Funds held by Institutions for Retirement Provision.502 The Commission especially insisted on proper diversification facilities, also in terms of currency (considering as a first step 60 per cent of matched funding the maximum), and on free access to foreign advice and management expertise to improve income and reduce risk (including also a restriction on investment in connected enterprises). The Commission did not, however, wish to affect

500 

COM (91) 301 final [1991] OJ C312, amended by COM (93) 237 [1993] OJ C171. GS Zavvos, ‘Pension Fund Liberalisation and the Future of Retirement Financing in Europe’ (1994) 31 CMLR 609. 502  [1994] OJ C360. 501 

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the manner of pension funding (or absence thereof), the level of benefit, or the combination of pension protection through private pension, insurance or state schemes, and also excluded cross-border membership from its consideration for the time being (so that there was no question of a pension fund passport at this stage with mutual recognition of regulatory regimes, which created a basic difference from the Life Insurance Directives). Nevertheless the Commission intended to clarify the restrictions, which, in its view, could be imposed on prudential grounds or for reasons of the general good, if only to assist Member States in interpretation of the EEC Treaty in this area and to provide some uniformity to help service providers when asked to provide information to regulators from other EU countries. The substitution of the original proposals by the Commission Communication ran into further trouble and the legality of this approach was successfully attacked by France (1997) before the ECJ, because it was found to be more than a clarifying document.503 However, a Directive on the Activities and Supervision of Institutions for Occupational Retirement Provision was agreed in May 2003504 and covered the operation of employment-related pension schemes across borders in the EU. There is mutual recognition of home-state supervision. Investments must meet the standard of a ‘prudent person’ so that the proper investment policy can be followed for members per country. It had to be implemented by 2005. Further proposals for occupational pension funds were forthcoming in March 2014 aiming at improving governance and transparency of these funds, promoting access of SMEs at reasonable cost, facilitating cross-border activity, supporting long-term investment, and promoting financial stability. A Regulation on a Pan-European Personal Pension Product (PEPP) was proposed in 2017. It provides a uniform framework alongside national regimes for complementary voluntary pension schemes on the one hand to enable providers to offer personal pension products on a pan-European scale and on the other to make consumers fully aware of the key features of these products.

3.6.5  International Banking Supervision. Basel Concordat, EU Implementation Another issue is international banking supervision, which, after the 1993 amendment of the 1983 revised Basel Concordat of the BIS (pursuant to the original paper of 1975 after the Herstatt case) is now accepted in principle, see ­section 1.2.4 above. The EU followed the original approach of supervision at the head office of a bank (home regulator) in its 1983 Directive (see s­ection 3.2.2 above). A second Directive in this area was enacted effective 1 January 1993505 repealing the earlier one and covering also banks’ non-banking parents (if holding at least one credit institution as a subsidiary, a concept extended to holding one investment services firm as at 1 January 1996, see Article 14) and all its financial subsidiaries in the consolidation (Article 6).

503  504  505 

France v Commission [1997] ECR I-1627. EU Directive 2003/41/EC of the European Parliament and of the Council [2003] OJ L235/10. Council Directive 92/30/EEC [1992] OJ L110.

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They must provide the information requested by the supervisory authorities of the financial entity in the group. This happened after the BIS, in a 1992 paper (Minimum Standards for the Supervision of International Banking Groups and their Cross-border Establishments), further elaborated on its approach to international supervision as a consequence of the BCCI affair, applying its rules to the ultimate parent of a banking group but setting out the host country’s right and duty to make sure that the home regulator was capable of consolidated supervision, particularly where the group structure proved insufficiently transparent. It proposed that the setting up of cross-border banking activities (or branches) needed the approval of both home- and host-country regulators, while host countries might take the necessary action if they remained unsatisfied with the supervisory role of the home regulator. It may be seen that this overrides to some extent the home regulator principle of the EU Directives, which, however, already accepted (in the Preamble to the SBD and in the text of the ISD) the desirability of combining the registered and head offices within the same jurisdiction so as better to focus supervision and avoid confusion. It is also likely that the EU will increasingly ease its strict rules on the passing of confidential information between regulators in this context, while insisting on sufficient transparency of the transactions of the group as a whole. In fact, in the summer of 1993 the Commission agreed in principle to reinforcing prudential supervision along these lines. This regime was incorporated as part of the Credit Institutions Directive (CID), which in 2000 consolidated this approach, replaced by a new CID in 2006. The same applied to security firms in MiFID and the Capital Adequacy of Investment Firms and Credit Institution Directive 2006: see ­section 3.5.12 above. The regime was further amended for significant branches of security firms in the 2009 Capital Requirements Directive (CRD 2) as a first reaction to the financial crisis of 2008;506 see further ­section 3.7.3 below. More changes resulted under the succeeding Directive of 2013 (CRD 4) and its supporting Regulation, which also cover investment firms in these aspects, see s­ ection 3.7.4 below.

3.6.6  Consolidated Supervision. International Co-operation and the 2011 Amendments Conglomerate supervision is another issue and arises when a group has activities which are regulated by several different authorities, such as banking, securities and insurance operations. Especially in the area of regulated capital supervision, it may be efficient to have a so-called lead regulator in order to prevent too much capital being tied up separately in different activities. The quality of connected lending may then also be more properly assessed, while the lead regulator will supervise the necessary movement of capital within the group. A preliminary aspect here is the capital allocation 506  Directive 2009/111/EC of the European Parliament and of the Council (Arts 1(4)ff CRD 2) [2009] OJ L302/97.

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to the different businesses. It may raise in particular the so-called double gearing (or funding mismatch) issue, under which the parent borrows in the capital markets funds, which could not qualify as capital for it, but invests these funds as equity in its financial subsidiaries where it so qualifies. Default of the parent in these circumstances would, however, endanger the (financial) subsidiaries. This also raises the question whether the same capital may be used twice for very different risks, an issue in fact already arising between banking and securities activities, and under what circumstances. On a daily basis, the simplest approach is, first, to calculate the capital needed for securities and insurance activities, deduct this from total capital, and subsequently ascertain whether the remaining capital is sufficient for the banking activities. The situation may become more complicated when the bank is in one country, the insurance or securities company in others, or when risks are parked in offshore havens. The lead regulator is then fully dependent on effective information co-ordination, which will become the essence of its task. In December 2002 the EU issued a Directive on the Supplementary Supervision of Credit Institutions, Insurance Undertakings and Investment Firms in Financial Conglomerates, implemented in 2004.507 It is also called the Financial Conglomerate Directive. Review of this Directive has been pending since 2009 and resulted in an amending Directive in 2011.508 In 2014, the EU also adopted a delegated Regulation with regard to the regulatory technical standards for the calculation methods of capital adequacy requirements for financial conglomerates.509 Risk of contagion, management complexity and conflicts of interest may also arise where large financial groups operate, even more if operating trans-border. No leadregulator concept has emerged as yet in areas other than capital (such as supervision of internal operations and the conduct of business of different activities within one group or company).510 Co-operation between the pertinent regulators, including central banks as lenders of last resort for banks and Treasury departments representing the taxpayer, may also be needed from this perspective and will primarily depend on an active exchange of information as traditionally promoted in the UK by so-called memoranda of understanding (MOUs). This is naturally more complicated across borders. International co-operation is itself increasingly achieved through bilateral ad hoc arrangements, often also by means of MOUs, now between regulators and other relevant agencies in different countries, not only in the monitoring of capital, but also in enforcement. In the banking area this is supported by the BIS. The turbulence in the financial markets and the possibility that large international banks might go bankrupt intensified discussions during 2008 at EU level on how such crises could be better handled, at least in Europe.

507  Directive 2002/87/EC of 16 December 2002 of the European Parliament and of the Council [2003] OJ L35/1. 508  Directive 2011/89/EU of 16 November 2011 of the European Parliament and of the Council [2011] OJ L326/113. 509  Commission Delegated Regulation (EU) No 342/2014 of 21 January 2014 supplementing Directive 2002/87/EC and Regulation (EU) No 575/2013, [2014] OJ L100/1, see s 3.7.2 below. 510  See also CC Lichtenstein, ‘International Standards for Consolidated Supervision of Financial Conglomerates: Controlling Systemic Risk’ (1993) 19 Brooklyn Journal of International Law 137.

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One main problem arose from the differences in the sector-specific Directives and the Financial Conglomerate Directive of 2002 in the area of definitions and competences. The definitions of banking, securities activities and insurance in the sectorspecific Directives and for mixed holdings in the Financial Conglomerate Directive could be mutually exclusive, so that either supervision under the sector-specific Directives or supplementary supervision under the Financial Conglomerate Directive had to be chosen. This was an unintended consequence which the new amending Directive of 2011 sought to address. It at the same time amended the relevant ­sections in the Credit Institution and Capital Requirement Directives of 2006, ultimately replaced in 2013 by a new Directive (CRD 4) also amending the Directive of 2002, see s­ ection 3.7.4 below.

3.6.7  The E-commerce Directive In the EU, the 2000 E-commerce Directive511 deals with information society services generally. Implicitly it also covers security trading on the internet although this is clearly not its main focus, which was to give legitimacy to any type of contract concluded by electronic means (Recital 38). In this connection, e-commerce and internet trading are legally synonymous. Under Article 3, the supervision of the country of origin of the accessed service provider applies to these services. There is an exception only if consumer protection, which also includes investors (presumably only the smaller inexperienced ones), is the issue—see Article 3(4)(a)(iii)—and there is a great risk of impairment, but any host regulator measures (here the regulator of the small investor) must remain proportionate after the regulator of the service provider has been asked to take adequate measures but fails to take them. The EU Commission must be informed and will examine the compatibility of the measures with Community law (and in the event the measures are not so compatible they will have to be abandoned).512 This is in fact an indirect expression of the general-good notion, which for financial services through e-commerce now falls outside the home/host regulatory system of the Investment Services Directive (ISD), succeeded in the meantime by MiFID. It follows from the location of the service at the place of the service provider, which therefore assumes no movement of this service and opts for the regulation of the latter. A similar result would likely have been obtained if, while accepting the movement of the service, the regulation of the party providing the most characteristic performance had prevailed. It accommodates the EU’s fear of double regulation and suspicion of host-country intervention. Yet Article 3(4) is also an acknowledgement of the fact that the general-good notion cannot be entirely suppressed in view of the European Court’s case law. Also, while cast in terms of consumer protection, there is the general policy of

511  Directive on Certain Legal Aspects of Electronic Commerce in the Internal Market, 2000/31/EC [2000] OJ L178, adopted on 8 June 2000 to be transposed into national laws not later than 17 January 2002. 512  In the insurance area, the service provider’s regime will not, however, impact on the regime concerning consumer contracts, in particular the limitations on the freedom of parties to choose the applicable law: see the Annex.

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the EC Treaty since the 1992 Maastricht amendments, which sees this protection as a major EC objective (Articles 3(t) and 153(3)(b)), although never extended by the treaty to (small) investors. They are therefore especially mentioned in this Directive and given a similar protection (in language reminiscent of the general good, including the reference to proportionality). In this system, the regulator of the customer remains relevant in respect of active marketing of the service provider into retail in other Member States, in which area further E-commerce Directives were contemplated.513 This approach is thus different from that of Article 11 of the ISD at the time and of its 2004 MiFID successor, which favoured a unitary regulatory regime and opted more fundamentally for that of the service provider. Another difference is that, unlike under these Directives, the E-commerce Directive does not require notification by the service provider to its home regulator, followed by the latter’s contact with the host regulator. There is no EU passport either, which means that EU branches of non-EU service providers may also be accessed from other EU countries. Again, the service provider is not assumed to move.

3.6.8  Long-distance Selling of Financial Products to Consumers The emphasis was again different in the 1998 EU proposal for long-distance selling of consumer financial products, approved in 2002.514 It was meant to extend the basic protections of the Consumer Directive of 1997, which covered non-financial goods and services,515 to financial services, but there was also the desire to use modern communication methods in a manner that further promotes the internal market. Consumers were defined in the traditional way as persons acting outside their trade, business or profession. There was no consideration of expertise in the consumer, as is more normal, at least in respect of the regulatory aspects of investment transactions. The 2002 Directive limited itself to the method of selling financial products (particularly through modern electronic means such as the internet, telephone, fax or email) only and was not concerned with the type of financial service or the financial product involved. It was limited to the opening of the relationship and does not cover follow-up transactions. A new Directive, the EU Consumer Rights Directive of 2011, repealing the 1997 Directive and becoming effective in 2014, provides for a single set of rules for distance selling and contracts formed away from a business’s premise anywhere in the EU.516

513  In fact, two further measures were being contemplated from the beginning: one on marketing of financial services online (see Working Document 6 October 2000) and one on liability of service providers. Earlier, IOSCO had formulated Principles of Regulation in Securities Activities on the Internet, Report by the Technical Committee (September 1998). 514  Directive 2002/65/EC of the European Parliament and the Council of Sept 23 2002, [2002] OJL 271. 515  Directive 97/7/EC of the European Parliament and the Council of 20 May 1997 on the protection of consumers in respect of distance contracts [1997] OJ L144/19. It is supplemented by the Directive 98/06/EC of 16 February 1998 on consumer protection in the indication of prices of products offered to consumers and by ­Directive 98/44/EC of March 25 1998 on the Sale of Consumer Goods and Associated Guarantees, [1998] OJL 171/12. 516  Directive 2011/83/EU of the European Parliament and the Council of 25 October 2011 [2011] OJ L304/64.

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The basic protection given to consumers was since 1997 the right of reflection (upon the supplier’s offer) and withdrawal (if the contract was concluded instantaneously at the consumer’s request or unfairly induced by the supplier), although other aspects are the confirmation of the contract terms in writing (or through a durable accessible medium), the impossibility of construing silence as consent, and the outlawing of cold calling (unsolicited communications); follow-up transactions may be suggested by the supplier. Another concern is a proper complaints and redress procedure. The idea in the 2002 Directive is that the opening of bank accounts, loan agreements, brokerage relationships and the entering into of insurance contracts with entities in other Member States are all subject to a possibility of reflection or withdrawal during a certain period. Many of these, like bank and brokerage accounts, may in any event be abandoned at will. As already mentioned, follow-up action is not so protected, therefore the subsequent movement in current accounts or use of credit cards is excluded, as are follow-up transactions in investment services themselves, which are in any event not covered because of their market-related speculative nature. Customers may have to pay for temporary coverage, for example under an insurance contract which is later rejected. Contracts must be in writing but may, like insurance contracts, be concluded without documentation but subject to written confirmation, important for obtaining instant protection. The burden of proof is put on the consumer in respect of the supplier’s obligations to inform the consumer, obtain his consent and performance. The provisions of the 2002 Directive are mandatory and cannot be set aside by choosing the law of a third country if the consumer is a resident of a Member State and the contract has a close connection with the EU. The relationship between this Directive and the others existing in connection with the European passport for financial services and aiming at harmonisation, for investment services particularly of the conduct of business, is not considered. These are not affected although they may overlap, particularly in the area of unfair inducement and cold calling. See for the Consumer Credit Directive section 3.6.13 below.

3.6.9  The Takeover Bids Directive A Takeover Bids Directive was proposed in October 2002 and replaced an earlier proposal of 1989 updated in 1990, which had largely tracked the UK City Takeover Code. After having been suspended in 1991 and revived in amended form in 1996 along the lines of general principles, it was ultimately rejected in 2001 by the European Parliament under German pressure following the hostile cross-border tender for Mannesmann AG by Vodafone Plc of the UK in 1999. The idea remained, however, that a minimum common framework was to be achieved for the national approval of cross-border takeovers including the applicable law, the protection of shareholders, and type and extent of disclosure. Mandatory bids when a certain minimum control is reached, the right to buy out minorities of less than 10 per cent (the squeeze-out), and minority protection allowing any remaining 10 per cent or less to force bidders to buy them out (the sell-out) are other important issues in this regard. But the key contentious issue was the protection of a target

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c­ ompany against any bid, either through restrictions in its by-laws or through ad hoc takeover defences. A regime for a so-called breakthrough by the offeror company allowing a free vote of shareholders of the target, regardless of any voting restrictions in by-laws, is a common answer. A compromise was reached in November 2003 after the EU Commission had wanted to forbid all takeover defences without shareholders’ backing.517 The prevailing view remained that this could expose European companies to predatory (especially) US practices through contested takeovers. The compromise allowed Member States the ultimate say in banning poison pills and multiple voting structures, or in relaxing any such bans in each instance where the bidding company itself benefited from similar protections. So no harmonisation resulted and the Directive left a widespread feeling of disappointment, although companies may still opt for EU neutrality and breakthrough rules. Article 4 makes the supervisor of the regulated market on which the shares of the target were first listed competent unless the target company is listed also in the country in which it has its registered office when the regulator of that market is competent. Article 5 introduces the mandatory tender offer but leaves the percentage of control triggering such an offer to Member States. Any increase in price must be paid to all. Article 6 requires full disclosure of all relevant information (also to employees, see further Recital 23) and Article 7 limits the term of the offer to 10 weeks (with a minimum of two weeks). Article 8 deals with false markets. Article 15 and 16 introduce squeeze-out and sell-out rights. Article 11 prohibits any restrictions on the transfer designed during the tender period and lifts any restrictions on voting rights in respect of such offers. Any takeover restrictions in by-laws, shareholders agreements and the like are also ineffective. However, Article 12 allows Member States not to apply Article 11 in respect of listed public companies that have their registered office within their state but these companies, when targeted, may themselves still opt to apply ­Article 11 and have the last word.

3.6.10  Other Parts of the 1998 Action Plan: Electronic Money, Money Laundering, Settlement Finality, Cross-border Use of Collateral, and Taxation of Savings Income In the area of electronic money and commerce, the E-Money Directive of September 2000 defined electronic money and governed capital and authorisation requirements for new electronic money institutions. It primarily covered pre-paid cards, therefore relatively small amounts, the e-money within them normally having a short life. The implementation date was April 2002. It was replaced in 2009.518

517  Directive 2004/25/EC of the European Parliament and of the Council of 21 April 2004 [2004] OJ L142/12. In 2012 The EU Commission adopted a report on the application of the Directive, COM (2012) 347 final. 518  Directive 2009/110/EC of the European Parliament and of the Council of 16 September 2009 on the taking up, pursuit and prudential supervision of the business of electronic money institutions amending Directives 2005/60/EC and 2006/48/EC and repealing Directive 2000/46/EC.

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Money laundering was discussed in ­chapter 1, ­section 3.4 above, including the EU measures in this area. The First Directive dated from 1991, see s­ ection 3.4.4 above. The Second Money Laundering Directive dates from December 2001, extends the scope of the offences for reporting purposes and includes professions like those of lawyers and accountants and the activities of casinos. The Third Directive dates from the end of 2004 and especially deals with terrorist financing. It consolidates the first two ­Directives.519 The Fourth Directive dates from June 2015, effective in 2017,520 and deals with new customer due diligence checking requirements together with new obligations to report suspicious movements and maintain records of payments. It applies to a range of banks, financial institutions, auditors and accountants. Gambling operators may also be made subject to the new rules depending on implementation legislation in each Member State subject to providing a justification for doing so to the EU Commission. The EU Settlement Finality Directive was discussed in c­ hapter 1, s­ ection 4.1.5 above and the Collateral Directive in ­chapter 1, ­section 1.1.8 above and Volume 2, ­chapter 2, ­section  3.2.4. The taxation of savings income also proved an important issue, already discussed in ­section 2.4.2 above. The Taxation of Savings Income Directive was ultimately agreed in June 2003.521 Under it Member States must exchange information on interest income payments to non-residents or, in Austria, Belgium and Luxembourg, tax that income at source. Switzerland agreed to a similar regime. It became effective as from July 2005. So far the tax income collected under this measure has been disappointing, suggesting that money is moving elsewhere.

3.6.11  Mortgage Credit New proposals for a Mortgage Credit Directive (MCD) were outside the 1998 Action Plan but revived an old idea (see s­ ection 3.2.3 above) although the emphasis appeared to have shifted to irresponsible lending and borrowing practices creating different regulatory responses in Member States impeding the trans-border flows of capital.522 The MCD was agreed in 2014, effective in 2016.523

3.6.12  Payment Services Directive: SEPA In 2007 agreement was reached on a Single European Payments Area (SEPA), therefore a single market in payment services, which as of 2010 provides especially consumers 519  Directive 2005/60/EC of 26 October 2005 of the European Parliament and of the Council [2005] OJ L309/12. 520  Directive 2015/849/EU of the European Parliament and of the Council of 20 May 2015 [2015] OJ L141/73. 521  Directive 2003/48/EC of the European Parliament and of the Council of 3 June 2003 [2003] OJ L157/38. 522  See the Commission Staff Working Paper of 31 March 2011 SEC (2011) 355 final, accompanying the Proposal for a Directive of the EU Parliament and of the Council on credit agreements relating to residential property. 523  Directive 2014/17/EU of the European Parliament and of the Council of 4 February 2014 [2014] OJ L60/34.

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with a legal framework to obtain cross-border payment services, including credit cards services and the borrowing facility inherent in them.524 This was the Payment Services Directive (later called PSD1). We are here concerned with the legal framework covering payment service providers whose main activity consists in the provision of payment services to payment service users. These providers may be banks or others; all must now be licensed, but access to common payment systems was given to all subject to appropriate requirements to ensure integrity and stability of their systems. Non-banks need to segregate client funds. Differences in the capital adequacy requirements applying especially to non-bank credit card companies were overcome in the sense that a large discretion was awarded to domestic (home) regulators. Importantly some rules concerning payment finality and correct payment execution were also introduced, as well as a cost-effective, out-of-court, conflict resolution facility. SEPA was updated by Regulation in 2012.525 This new Regulation defines the mandatory deadlines for compliance of euro credit transfer and direct debit schemes. In the euro area, this was 1 February 2014. Effectively, this means that as of that date, existing national euro credit transfer and direct debit schemes are replaced by SEPA Credit Transfer (SCT) and SEPA Direct Debit (SDD). In July 2013 the EU announced an overhaul and revised Payments Services Directive (PSD2) replacing PSD1 and a Regulation on Multilateral Interchange Fees (MIFs).526 One important issue was here the access to payment account information by third parties. The new approach is that third parties that have a licence to provide payment services must be given access to this information provided the customer has given explicit consent. PSD2 was adopted in 2015.527 The Regulation was approved in May 2015.528

3.6.13  The Consumer Credit Directive The Consumer Credit Directive529 became effective in the EU in June 2010. It was not directly related to the financial crisis and should not be seen as the EU counterpart of the US Dodd-Frank Act and its consumer protection measures, although it is quite conceivable that this Directive will eventually be tightened in a similar manner. Its objective was to promote the single market for consumer credit and to create a level playing field for consumer credit providers. It applies to all credit to consumers such

524  Directive 2007/64/EC of the European Parliament and of the Council of 13 November 2007 [2007] OJ L319. 525  Regulation (EU) No 260/2012 Establishing Technical Requirements for Credit Transfers and Direct Debits in Euro. It amended the earlier implementing Regulation (EC) No 924/2009 in this area. 526  It was a response to the Commission’s Green Paper ‘Towards an integrated European market for card, internet and mobile payments’ of 2012. 527  Directive 2015/2366 EU of the European Parliament and of the Council of Nov. 25 2015 [2015] OJ L 337/35. 528  Regulation (EU) 2015/751 of the European Parliament and of the Council of 29 April 2015 [2015] OJ L123/1. 529  Directive 2008/48/EC of the European Parliament and of the Council of 23 April 2008 on credit agreements for consumers and repealing Council Directive 87/102/EEC [2008] OJ L133/66.

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as that given by banks and similar institutions and all credit intermediaries including mortgage brokers. It is limited to amounts between EUR 200 and 75,000. The emphasis is on information supply in the pre-contractual phase and there is a right to withdraw for 14 days after signature. There is also a right to early repayment without excessive penalties.

3.6.14  EU Activities in the Field of Clearing and Settlement The issue of clearing and settlement of investment transactions was introduced in ­section 1.5.7 above and also mentioned in ­section 3.5.8 above, see further section 3.7.6 below on EMIR. It became an important issue, with which the EU had struggled for quite some time. The perception at EU level was originally that in matters of clearing and settlement530 the situation was not what it should be, but it was not clear what the alternative was. According to some, part of the problem was that this area of financial activity had remained largely unregulated. On the other hand, it is true that for a long time no major problems relating to investors’ protection surfaced in this area. There were inefficiencies, a lack of competition and relatively high cost. It was often said that clearing and settlement in Europe was five times as expensive as in the US, but that this was primarily a matter for the competition authorities to handle. Part of the problem was the complications innate in trans-border settlement. How to better interconnect a structure which remains largely fragmented along national (or stock exchange) lines, then becomes the true issue. Although Euroclear and Clearstream, on the other hand, had long experience in cross-border dealings in the eurobond market, that did not eliminate an extra layer of cost and potential exploitation of international inefficiencies. It could also present a lack of transparency. What may be wrong with cross-border clearing and settlement in the more technical sense became the subject of some important studies in Europe and elsewhere. In November 2001 IOSCO presented its Recommendations for Security Settlement Systems. In January 2003, the Group of Thirty (G-30) published its Plan of Action for Global Clearing and Settlement, closely aligned to the IOSCO findings. In the meantime, the EU Commission was relying on the knowledge and experience of the Giovannini Group, which had functioned as an advisory committee to the Commission since 1996,531 and was asked to prepare a study on an efficient clearing and settlement system in the EU and released a first report in November 2001 on Cross-Border Clearing and Settlement Arrangements in the EU. In the event, the Group noted that the EU financial market could not be considered to be an integrated entity, but remained a juxtaposition of domestic markets. It did not propose an altogether new system or approach nor proved

530 

See for the international ramifications also Vol 1, ch 2, s 3.1.6. In this capacity, it produced three reports: the first focused on the impact of the introduction of the euro on capital markets and especially on the redenomination of public debt (1997); the second on the EU repo markets, their differences in infrastructure, practices and tax treatment (1999); and the third on the euro-denominated government bond markets and their efficiency (2000). 531 

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to be inspired by the transnationalisation in the euromarkets, but concerned itself foremost with greater efficiency and certainty in the existing fragmented system. In this connection, technical issues arose first and policy issues later. The Group identified 15 barriers and recognised the practical but also legal problems deriving from insufficient transnationalisation (page 54) in which connection a difference between shares and bonds was (rightly) identified, the latter being more easily capable of transnationalisation: see Volume 1, c­ hapter 1, s­ ection 3.2.2. The Report proposed specific action and a timetable (two to three years) to remove these barriers. It identified the responsible actors in terms of public authorities such as regulators, central banks or legislators, or private bodies such as the European Central Securities Depositories Association (ECSDA), SWIFT and the International Primary Market Association (IPMA—now ICMA since 2005) and proposed co-ordinators where several were involved. Subsequently the EU issued a First Commission Communication on Clearing and Settlement in the EU (May 2002), which was followed by a Second Giovannini Report in 2003 and a Second Commission Communication in April 2004. Ultimately the ECB and the CESR published their Standards for Securities Clearing and Settlement in the European Union in September 2004. It produced 19 standards to increase the safety, soundness and efficiency of securities clearing and settlement systems in the EU. In connection with clearing and settlement, the most important issues were identified as follows: (a) the effective operation of national book-entry entitlement systems in respect of immobilised and dematerialised securities; (b) the problems connected with the access to and interconnection of these systems and the technicalities of international clearing and settlement; (c) pricing of the various services and anti-competitive practices; (d) legal risk, in particular the protection of investors against claims of creditors of the intermediaries/custodians in their bankruptcy, and the international dimensions of such protections; (e) the issue of finality of instructions and settlement; (f) the recognition of bilateral netting; (g) simplification of the collateral regime; (h) the impact of legal fragmentation and its effect on cross-border dealings; (i) the impact of different regulatory regimes; and (j) the impact of different tax treatment. The tendency of the EU Commission remained to leave the technical aspects to the market and evolving market practices subject to competition review. All the same, the accent shifted to the legal issues and to the impact of legal fragmentation. The Commission saw a need for a framework Directive in this area to guarantee access and choice, identifying also the need for a proper legal and regulatory framework. To leave action solely to national legislators and regulators was henceforth thought to lead to inadequate progress. A functional rather than institutional approach was to concentrate on risk and its proper management. In order specially to remove the barriers identified earlier in the Giovannini Reports, a Clearing and Settlement Advisory and Monitoring

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Expert Group (CESAME) was established by the EU in July 2004. It was chaired by the Commission, with the Giovannini group acting as policy adviser. In a legal sense, the EU looked for a unitary, therefore implicitly transnationalised system and proposed to address eight issues in particular: the nature of the bookentitlement, its transfer, the finality of the transfer, the treatment of the upper-tier attachments, investor protection against insolvency of intermediaries, the position of the bona fide purchaser, corporate action processing in respect of entitlement holders (and the exact moment as of which they may be so considered, eg for dividend payments), and an issuer’s ability to choose the location of its securities (and their listing in any particular market). To deal with these issues, a Legal Certainty Group was established in January 2005. It was also chaired by the Commission. In its subsequent work, this Group was also faced with the potential impact of its recommendations on the system of property, company and insolvency laws in each Member State, but its success was foremost believed to depend on a proper understanding and recognition of the transnationalising forces that operate in this area to the benefit of all so as not to get lost in and between parochial perceptions and rule systems. The Legal Certainty Group in its Second Advice on solutions to legal barriers related to post-trading within the EU of August 2008, identified as one of the key areas of concern ‘the absence of an EU-wide framework regarding the treatment of “book-entry ­securities”’ and, like the Giovannini Report earlier, considered it the single most important legal obstacle to a legally sound cross-border framework for post-trading arrangements. It issued 11 Recommendations, taking into account existing Community legislation, notably the Financial Collateral, the Settlement Finality and the MiFID Directives—see c­ hapter 1, ­section 4.1.5 above and for MiFID ­section 3.5.8 above. Yet progress on the legal front proved very slow and much was lost in descriptive analysis of disparate local differences which led nowhere. There was no sufficiently abstract academic thinking that could simplify. Sensitivity to and respect for transnationalised practices, perceptions and expectations proved modest, however. The Hague Convention of 2005 (see Volume 2, c­ hapter 2, ­section 3.2.2) was only a private international law treaty identifying an applicable domestic legal system. The Geneva Convention of 2009 (Volume 2, ­chapter 2, ­section 3.2.4) proved to be an academic effort at unification that did not convince the marketplace. In the meantime in 2006, the EU Commission threatened action through Directives if the industry itself could not come up with a more efficient system. This entire area of clearing and settlement subsequently became caught up in the financial crisis of 2008–09 and the need to restructure financial regulation more generally. In preparation of a Securities Law Directive (SLD), see also s­ ection 3.7.8 below, a further report was prepared for the EU Directorate General for Internal Policies, Economic and Monetary Affairs in 2011. It noted again the legal fragmentation and contained an unclear reference to conflict of laws principles, therefore ignoring transnationalisation tendencies in the marketplace in favour of national laws, which conceivably made things only worse.532 It referred to public consultation in favour of action but stated also 532  P Paech, Cross-border Issues of Securities Law: European Efforts to Support Securities Markets with a Coherent Legal Framework (2011). A similar regressive flight into conflict of laws doctrine followed in

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that Member States still had an interest in defending their current domestic concepts. The differences become apparent especially in insolvency situations. In a nutshell, in cross-border investment securities transactions, it may be that the client may replace the bankrupt broker in the security account, but how far the back-up moves also may depend on the law of other countries. Outside a bankruptcy situation, the worry is that the back-up in other countries may fail for other reasons. In that case the broker or account provider in the first country is short of back-up vis-à-vis its own clients. The matter of adequate back-up of security entitlements (in other countries), which became a serious issue in the financial crisis of 2008, the EU AIFMD Directive (see ­section 3.7.7 below) followed by UCITS V Directive (see s­ection 3.5.14 above) now make the intermediary or account provider, who maintains the entitlement system, a guarantor of the back-up so that short of the intermediary’s bankruptcy, the security account holder is protected. This is comparable to a ‘strict liability’ approach533 and means that an intermediary must take risk in respect of assets not on its books,534 even though this does not provide relief in a bankruptcy of the intermediary when it matters most. Reasonable excuses of the intermediary are of no avail with the consequence that it incurs extra risks in this activity and must hold capital against it. In ­section 3.7.6 below the matter will be dealt with further in connection with the European Market Infrastructure Regulation (EMIR).

3.7  The EU During and After the 2008 Financial Storm 3.7.1  The General Scene Much was said in s­ ection 1.1.2 and s­ ection 1.3 of this c­ hapter about the causes of the financial crisis that hit after 2008. It seemed at first to be a severe banking crisis but it soon became evident that there were other problems. The reality was that, in the West, society as a whole had become highly indebted: governments, banks and private citizens alike all facing bankruptcy, the banks together being the big spider in this web, from whom stability could hardly be expected under the circumstances. This was policy and proved a typical Western problem: the world as a whole kept on thriving. Yet the West still accounted for more than half of the world’s GDP and its travails could therefore hardly be ignored. They continue and there is now even more debt promoted, by articially low interest years during many years.

‘­Capital Markets Union, Investment Securities and the Tradition of Casting Liquidity into the Law’, LSE Law, Society and Economy Working Papers 20/2015. Rather the transnational operation of the eurobond market and of the swap market under the ISDA Master should have been used as examples and analogies, see Vol 1, ch 1, s 3.2. 533  The origin is thought to be in the approach of the French Regulator (Autorité des Marches Financiers or AMF) whose orders to RBC Dexia and Société Générale to return to investors assets held as collateral with Lehman Brothers International Europe were upheld by the Court of Appeal in Paris in 2008. 534  In its UCITS V Impact Assessment of 2012 p 40, fn 49, the EU Commission considered that it was a ‘low probability/high impact’ contingent exposure and saw it as an operational risk. It did not expect a major effect on the capital charge. But it is conceivably a black swan in financial crises.

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The way back is difficult to find. As usual, growth was considered the answer but especially in Europe it was unclear where it could come from on the scale required, which also posed environmental issues, while ingenuity was threatened by excess regulation, which, however laudable in each instance, could have the overall effect of societal sclerosis and had hardly worked in the financial sector. The essence was probably that the middle classes had difficulty maintaining their lifestyle without a high level of debt and high expectations of social benefits or support in health and education, while the lower part of society risked drifting back into poverty, often leading to or compounded by a lack of education and social mobility. Safety nets for them started to prove not strong enough or became more difficult to afford. Their ranks were joined by the elderly who wanted to live to a hundred with 35 years of free pensions and care. Nobody knew where that money could come from even if growth itself continued. On the other hand, the small band of the rich, after an initial jolt, got again richer, much helped by central banks printing money, but could hardly carry the rest. Longer term robotisation and artificial intelligence (AI) produced vistas of large unemployable parts of society. Even though one could envisage some type of social support, what were people going to do with themselves? In truth, the problems of banks became a sideshow, although they were closely connected: whatever governments could not provide was to be borrowed from them. Given this preference, capital standards had been lowered ever since Basel I, liquidity requirements were ignored, leverage ratios rejected (except in the US) and financial regulation had not been sufficiently enforced. Bankers took advantage, no doubt, but were not the cause of the problem, which was irresponsible government that did not dare to say no or did not have the wherewithal to figure out when limits were reached. Of course, it had special facilities: it could raise taxes, borrow more, print money and try to inflate itself out of its debt. It cannot formally go bankrupt. Through monetary policies, it can manipulate interest rates. Indeed, as a temporary measure, an accommodating monetary policy, even more borrowing or printing money, could be very necessary to provide the necessary kick-start, but as a way of life it barely has a clear future. In any event, nothing comes without a price. Bubbles were created serving the rich a great deal more than the poor, for the middle classes savings were eroded either through low interest rates or higher inflation, or both. It is probably a fair expectation that a society living in this manner may become unhinged. Worse, governments become mainly debt managers and may lose the normal levers of power to steer and when no more money can be borrowed and hardly any more printed, the markets take over and the law of the strongest starts to prevail. That was the scenario that was tested in many countries after 2008, even in advanced economies. Unavoidably, in this climate there resulted serious differences of opinion as to whether the crisis was temporary and could be ridden out by infusing ever more liquidity, therefore taking on more debt or by central banks printing more money, or whether deeper structural reforms were necessary, including the lowering of expectations, the favouring of initiative, and the promotion of higher-quality work, meaning more money for the successful. In this latter view, it was noted, only crises of this nature re-establish some sense of order, see also the discussion in ­section 1.3.8 above. Whatever the answer, it confirmed that modern banking became only part of a bigger problem. In either view it was unclear what its future direction was supposed to be and even less

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what the direction of financial regulation should become. Banks were used as handy scapegoats and had to become smaller—at least that was at first the idea. Thus in Basel III, capital was increased accordingly and even liquidity management prescribed and leverage ratios introduced, but it eventually became clearer that the reduction in the liquidity-providing function of banks—which always results in times of financial crisis because of the highly pro-cyclical nature of banking, see s­ection 1.1.13 above—was seriously detrimental to the revival of the economy and growth. Banks in Europe in particular had difficulty escaping the malaise. In fact, there was a danger of Balkanisation of the liquidity-providing function worldwide, which posed a threat to the globalisation of the economy and the large benefits it had brought. This may have been reminiscent of the collapse of the international order in the 1930s, now driven by the retrenchment of the banking industry behind national borders and domestic regulation. Keeping interest rates artificially low for years also limited the banks in recovering through adequate profits, evident especially in Europe. Pension funds became similarly threatened, but normalisation of the interest rates proved difficult and central banks became and remained the main liquidity providers for society for a long time. There was even a cry that the implementation of Basel III should be postponed until better times given the depressed nature of banking and the pro-cyclical nature of its attitudes in this regard, but what needed truly doing became ever more obscure. In fact, the G-20 soon ran out of ideas. They wanted to punish the banks and then asked what to do about growth. Why did the banks not lend more? This was not an unreasonable question in a downturn given the procyclicity of all banking activity, but it remained a fact that what had been the problem in banks, was then paraded as the solution at the same time. It was said before that what were considered the errand ways of banks was rather the result of the way we wish to live and they mirror the type of society we have and it is politically supported. Indeed, our financial system is a reflection of ourselves, not the invention of dark spirits or the manifestation of the evil empire. In the discussion in ­section 1.3 above, it was shown that so far there are no clear and ready policy tools or proper models or answers at hand to explain and guide this new world and there is here also academic failure. In the EU, there were other considerations: especially the free movement of capital and services within the common market could not be threatened, must even be promoted. On the other hand, financial regulation remains in principle a Member State affair, although subject to the demands of the internal market. State aid, however, is an EU issue, which was used after 2008 as an important initial response as we shall see, especially to curtail EU banks’ international activities, that is their activities outside the EU. However, this led to confusion coupled with the romantic idea and irrational desire to make banks smaller because small was considered beautiful and safe. But it can only be repeated that stress tests show over and again that smaller banks were much more dangerous because they could not properly spread risk, even though of course a big bank in trouble presents a much greater headache. At first, G-20 provided some roadmap in its Declaration of November 2009 as we have seen. In the US, the Dodd-Frank Act was meant to give more guidance, perhaps also to the international community, and the EU followed, see s­ection 1.3.10 above, but everywhere it was tinkering at the edges only where the law of unintended

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consequences was also to be feared, especially in the effects on liquidity and growth. In the meantime, in the EU, seven years after the beginning of the crisis, there was further experimentation with printing money, now called quantitative easing (QE), which indeed can tide society over a bad spell but risked becoming institutionalised. Lack of inflation or even deflationary pressures were cited by its promoters, but its causes remained obscure. Rather, there were the international flows of cheaper and better products and the retirement of a larger older generation as deflationary impulses. In seriously indebted countries there was further a need to get back to a competitive wage and lower benefits structure which had often been inflated by public largesse and cheap funding, no matter how laudable the intent. Much seemed to be engineered to save the Southern European banking system. In the event, printing money was considered a better way to provide liquidity than to encourage banks to provide it. The idea for banks was rather to micro-manage them through more regulation to make sure that the crisis could not recur. What else might be needed and whether perhaps the whole paradigm of modern banking had shifted and needed a new approach in regulation, see the discussion in s­ ection 1.3.7 above, was beyond most people’s imagination. In the circumstances, even in the US, Dodd-Frank became a vague omnibus piece of legislation that depended on implementation and offered less guidance than might have been hoped for. It was more a list of worries. Micro-management of banks through rule-based regulation still seemed to be the idea, but it was submitted all along that regulation in order to be effective can hardly be of that type alone. At least in the UK it became supplemented by a so-called judgement approach (see s­ ections 1.1.13/14 above), moving from a rule-based regulatory system to more policy-driven regulatory intervention. On top of this, stability boards were created everywhere to formulate policy in respect of systemic risk/financial stability and probably to see problems in this area coming. But nothing suggested that there was any better insight and the whole idea of macro-prudential supervision remained vague, see again the discussion in s­ ection 1.1.14 above. The approach in this book is radically different and requires taking account of the fundamental pro-cyclical nature of all banking and its role in a highly leveraged society. It rejects the idea that small is beautiful. We do not have that option. Experimentation with new products and risk management will also continue to be needed to deal with an ever changing world with ever greater liquidity demands and different risk patterns now that billions more people will join the fray and become consumers. Except for market abuse, fraud or other forms of manipulation and conduct of business shortcomings, the proposition is that banks should be deregulated in bad times and capital potentially reduced to zero; they might even be nationalised. Whatever happens or is done, managements should be given much room to dig themselves out of the holes in which these banks fell, and continue the liquidity-providing function to society, in which connection liquidity management is also better left to chastised banks. Microprudential regulation as we know it today is very unlikely to achieve this and has over and again proven to be inadequate. It is in fact pro-cyclical. In this connection, it can only be repeated that the true danger of banking surfaces in good times, when the sky appears the limit. That is when banks are at their most dangerous, not at the bottom of the cycle. New banking activity needs to be severely curtailed in situations of hubris

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and capital adequacy requirements aggressively increased for all new business. Liquidity management should then also be supervised, notably new long-term assets should not be funded by short-term deposits. Leverage ratios should be increased, perhaps by product or activity. That is here considered what macro-prudential supervision means and is all about. There are three problems with this: (a) who is calling a halt to the bonanza when all seems to be going marvellously while there is (b) also the problem of the level playing field internationally? This may require calling a halt for all at the same time and therefore an international agency to do so. That is the nub and may be inconvenient, especially to large countries like the US and China. When it comes to liquidity management, and regulation, the further issue is (c) what are liquid assets and if becoming illiquid, may they still be funded through deposits? To determine when we have reached the top or most sense danger remains judgemental, but it is not different in monetary and fiscal policy when conducted on an anti-cyclical basis. We further need an international safety-net structure for international banking and a resolution regime as demanded by G-20 is secondary, see further the discussion in ­section 1.3.11 above and 3.7.16 below and for the eurozone ­section 4.1.3 below. To avoid panic, a ‘bail-in’ requiring bond holders and depositors alike to contribute is hardly the right tactic in a financial crisis; banks will have to be saved by the public purse. This is perceived in this book to be quite normal and a typical government function now that banks are asked commonly to finance all and sundry, including municipalities and governments themselves. It is considered by many to be also a healthy growth elixir (never mind how the money is being used). Banks are never stronger than their clients and we very much need them to survive, especially in an economic crisis. So they must be saved (or nationalised, later to be resold possibly for a profit), but there must be an international framework for this to work now that the largest 25 banks appear to have more than 70 per cent of all banking assets worldwide. This will get worse as globalisation on the scale that may be needed to create more growth will require ever larger banks. Further banking consolidation was an important feature of the 2008 crisis and is likely to continue. The result is ever fewer and larger banks. New entrants, although highly desirable, are unlikely to appear on any massive scale. The shadow banking industry may help but is unlikely to take over and to the extent it does may well prove more unstable. It is at least as pro-cyclical as banking always was. The conclusion was that banking policy should be perceived as a macro-economic subject and steering vehicle rather than a micro-economic regulatory facility. As such it is closely connected with monetary and fiscal policies, see ­section 1.1.9 in fine. The key is that banks should be forced in good times to build capital and retain it and create industry safety nets rather than expanding their business even further while excessively rewarding shareholders, managers and the taxman alike. Only that will make them less vulnerable in bad times and reduce the need for wholesale rescues, thus making the system generally more stable. This cannot be expected, it is submitted, from micromanaging banks through a ragbag of regulatory rules that barely have a clear focus but only mean to be remedial in certain aspects, activities or products. In this macroeconomic approach, curtailment of excess needs to start at the macro-economic level, supported by a global safety net.

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In fact, short of some clearer view of what modern banking is and does, in finance in the present approach we hardly appear to know what we are regulating, and for or against what. We talk endlessly about financial stability, but what does it mean and do we really want it? Can we afford it if it means less liquidity and a smaller economy? Does stability of this type crystallise at too low a level of activity? All the while, we must preserve the savings of the old as states may no longer be able to provide adequate pensions. That goes not only to the health of banks, but no less to the issue of a hard and a lasting currency, something in practice most people want: the savers because of the safety of their savings, the others because of lower interest rates. We also must provide for the poor, even if we know that whatever we subsidise we get more of and they do not want their support to be withered away. It requires discipline and the constant restructuring of society up front, something that was at first conveniently forgotten by many newcomers to a hard currency in the eurozone while the soundness of that currency and especially the benefit of cheap funding was greatly enjoyed by all. The bonanza came to an end only when no more could be provided at these favourable rates, while printing money had become impossible in eurozone countries except centrally by the ECB, which was by treaty law restricted in so doing even if it found ways around it. More importantly, much of this new money proved poorly invested; booms in real estate and stock markets followed, but in the countries most affected everyone was running out of money. Obviously, banks were in the forefront. In the eurozone, deeper down, it may have to be established whether its outer regions can aspire to German standards of activity and management to be able to afford and improve their social stability and safety nets.535 If that is the future,

535  Germany also has a different approach to leverage. This was already mentioned in s 1.3.8 in fine above and should be repeated. As a consequence, the Germans have an idea of modern banking very different from the English or even the Dutch, which are traditional trading nations; the same applies in the US. Their banking scene is much more used to risk, even a boom-and-bust culture. These countries also look with favour on the internationalisation of financial services as good business. It is quite different in the German perception. The German lives in rented accommodation, has no mortgage, does not speculate in property, is unlikely to have a credit card, and saves before he/she buys a car. It follows that banking is a bad business in Germany and German banks have a chequered history. To demonstrate the point, Deutsche Bank, being the largest, always had a low percentage of the German domestic banking market and now operates much of its large international business from London, often badly managed and subject to severe agency problems. Domestic banking is stable at this low level, at least in the loan business, but often of low profitability, the added problem being a high savings rate in Germany so that a great deal of excess money is parked in banks, needs some return, and may then be invested in the investment portfolio of banks rather than in their loan portfolio in order to achieve a higher returns. Hence their propensity for buying Greek bonds over German ones in good times. Hence also the propensity of German banks to buy all kinds of repackaged, higher-yielding, securitised products. For them that is where the problems usually start in bad times and where they go off the rails. The result of these different attitudes is that from a regulation point of view, there is in Germany a very different perception of banking safety and stability. Italian banks traditionally operate in a similar way but invest in Italian government bonds, which have a higher yield. Their problem is overleverage of smaller companies, resulting in an excess of non-performing loans in bad times. The major Spanish and French banks may be somewhere in between. These different attitudes provide for very different approaches to financial regulation that need to be bridged if this regulation is to move forward at the EU level. To this must be added the general attitude, particularly in France and Germany, that regulation is in essence a good thing. The UK was always more uncomfortable with this attitude and with the EU regulatory response in finance even though or perhaps because some of its largest banks still fared badly in the crisis. It also wants order and discipline but expects it not from regulation but foremost from market forces.

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it may mean serious trouble for the whole of the EU. Seen from this perspective, the euro is only a thermometer measuring the temperature in all of Western Europe and a harbinger of its economic prospects. A collapse of the euro would thus be the signal, not the cause, of the worst scenario, especially for the leavers. Renewed growth on the tail of it in the exiting countries would likely be some chimera: where will countries like Portugal, Greece and Cyprus find the product quality and inspiration to make and do anything useful beyond attending to a floundering domestic scene? Italy, Spain and even France might not be far behind.536 Where did this leave the banking scene in the EU and its regulation, which had been deemed complete in 2005 at the end of the 1998 Action Plan for Financial Services? See ­section 3.4 above. Exactly because of this sense of completion, the EU was slow to pick up the pieces after 2008 and it proved difficult promptly to find another gear. This meant, as it eventually transpired, in particular abandoning a generally softer or lighter-touch regulatory approach, borrowed in the 1998 Action Plan from the English tradition,537 regardless of the major effort at re-regulation which had already led to a massive overall increase in rules issued by the EU and locally implemented: hence

At least Germans still listen to their government and are confident doing so. In the eurozone, that poses a true challenge for the other members. If they cannot meet this challenge of discipline, the euro must fall apart, meaning that these outer countries will be poorer for a long time to come, preferring devaluation to restructuring or reform, while borrowing in the international markets to preserve their lifestyles can only continue at punitive rates. This being said, Germany also suffered high unemployment after the oil shocks of the 1970s and again after unification in the 1990s while it is often forgotten that its household wealth is lower than in many southern European countries (because Germans do not own their houses and pay their taxes). But they overcome these difficulties with confidence and like a project. 536  It is often argued, although it is not at all true, that a single currency like the euro requires a unified state or at least a common fiscal policy. The gold standard never did and survived perfectly well in normal times. Currency unions as previously between Belgium and Luxembourg did not do so either. What the gold standard required and did impose was a minimum of discipline and order in each Member State. If in the eurozone it would now have to be imposed from the centre it will only be resented and could be a sign of deepening instability. It was the hope that the introduction of the euro would itself reinforce this discipline. If it did not work out that way in the short term after 10 years of a cheap funding bonanza for many, it only meant that the froth so generated had to be blown off first in order to do better. Austerity was not the answer but the consequence and means. Once countries get back into shape, a kind of Marshall plan at EU level is not beyond contemplation for the weaker Members in their endeavour to build stronger economies—a European Monetary Fund (EMF) may be a weaker substitute or be part of it—but such a plan cannot be requested simply in order to continue an unreformed entitlement society through a system of transfers from richer countries. The EU is not a state and transfer union, nor does it behave like one and EU solidarity could hardly mean the support of a lifestyle that cannot be afforded by individual Member States. If that were now to become the idea, it would require a very different set-up which would indeed resemble much more that of a state but was not on the cards. See, however, for the Intergovernmental Treaty on Stability, Coordination and Governance in the Economic and Monetary Union signed in March 2012, the text below. 537  It could be said that earlier the EU had been much influenced by the UK approach to regulation, which largely derived from the US example. After the crisis, the reinforcement and centralisation or Europeanisation of financial regulation was at first also supported in the UK, at least by the local regulator, the SFA, primarily to fight contagion following the Iceland crisis, see A Turner, The Turner Review (London, 2009) 96ff. In practice, the need to offer the same compensation scheme for depositors in all EU countries imposed itself immediately to avoid depositors moving their accounts to other countries. Subsequently, the UK and Germany remained united but mainly negatively in not wanting to transfer too much regulatory supervision to Brussels or to its new committee structure, see also s 3.7.2 below. France was more willing. On the other hand, as mentioned earlier, both France and Germany had always been more regulation oriented and they prevailed in this aspect, the Commission’s earlier more market friendly approach having been found wanting when the crisis blew up. It became increasingly clear that the UK government was not happy with this approach and it created tension.

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the explosive rise of compliance departments, although it had left some areas still unregulated (such as clearing and settlement, hedge funds, rating agencies, and shadow ­banking). In the event the EU waited largely for US guidance in G-20 rather than taking the initiative. In fact, the EU’s energy in the regulatory area revived at first mainly because of the problems with state aid that had become widely necessary for banks during the crisis, in particular in the UK, Belgium and the Netherlands. Non-EU financial business was then soon thought to be redundant, ready to be sold off in order to reinforce the EU base—that became very much the focus of the conditions under which state aid of this nature was to continue. But there was much copying of the US beyond the activities of the Basel Committee with regard to capital adequacy and liquidity risk (Basel III). For the rest, there was hardly any clear policy; the impact on future growth of much stricter banking regulation was barely considered,538 or was conveniently thought to be minimal. Indeed, the longer-term dangers for the EU shown in the crisis were pushed aside. Another aspect was institutional: the EU and the Commission in particular were not to waste an opportunity to centralise power even if there was no clear direction in anything very much. One sign of this was the increasing use of Regulations rather than Directives. Eventually, an EU response was formulated in three policy documents of 2009 and 2010. Bolstering the safety, soundness and responsibility of the financial system became the not-unexpected (bland) focus.539 It provided a beginning for some newer longerterm thinking. The main initiative was in the meantime taken at the level of a new Intergovernmental Treaty on Stability, Coordination and Governance in the Economic and Monetary Union signed in March 2012 by 25 of the then 27 Member States (the TSCG or Fiscal Stability Treaty, excluding, at their request, the UK and Czech ­Republic). It focused not on financial regulation but on a ‘European fiscal compact’, meaning Commission oversight of national budgets with automatic consequences for breaches of agreed limits. That was fiscal policy. There would thus be much stronger supervision of economic policy. A particular new feature was that the ECJ would verify the transposition of the balanced budget rule in Member States. As of 2016, there was talk that the European stability mechanism, another intergovernmental treaty, see section 4.11 below and especially the associated fund540 were eventually to be transformed in a kind of IMF for the EU. That was to be the EMF. In banking proper, the key policy idea and initiative became a banking union for the eurozone and emerged also in 2012. It would make the ECB the central banking regulator—an idea that received its final shape (for the time being) at the end of 2013: see ­section 4.1 below, although formally regulation itself remained a Member State

538  This is somewhat different in the US where this danger was better understood, especially in connection with the need for society to renovate, see E Tafara, ‘Observations About the Crisis and Reform’ in Ferran et al (n 196) xxv. 539  European Commission, Driving European Recovery (COM (2009) 114), European Financial Supervision (COM (2009) 252), and Regulating Financial Services for Sustainable Growth (COM (2010) 301). Probably of greater importance was the Report of the High Level Group on Financial Supervision in the EU (also called the ‘de Larosiere Report’) (Brussels, 2009). See for the ensuing Fiscal Compact also n 630 below. 540  See also n 630 below.

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jurisdiction subject to EU harmonisation.541 But it was unclear why all of a sudden this project became all-absorbing and even less clear why the ECB should become the central regulator for these banks unless it also intended to expand its role of lender of last resort to provide a guarantee for the solvency of any of them with all the moral hazard consequences that this would entail, whether or not helped by a special stabilisation fund or facility. For such a scheme to be fully effective, it would likely require more fundamental treaty changes. Another initiative already mentioned was the setting up of a new committee structure through the creation of the so-called European Supervisory Authorities or ESAs (see ­section 3.7.2 below). It recast regulation at the level of the regulator very considerably and undoubtedly meant the institutionalisation of greater power of the EU in this area regardless of the fact that banking regulation remained in essence a Member State competency even in the eurozone. It could also be called the (post G-20) stability agenda, embellished by some other ideas mainly derived from the concept that all finance activity in the EU was essentially to be regulated—hence more in particular the AIFMD and the expansion of MiFID to cover most areas of organised trading in bonds and derivatives as we shall see. Other areas under review were the shadow banking system and proprietary trading. The result was a wave of activity geared towards greater market efficiency on the basis of greater intervention in the market mechanism itself. This may go beyond greater transparency, often invoking the needs and rights of (older) savers and consumers, all perhaps laudable but in reality much inspired by an interfering mentality without many clear ideas. The AIFMD and the expansion into MiFID II and MiFIR testified to this mentality, see s­ ections 3.7.7 and 3.7.5 below, which was politically inspired. In this vein, the Short Selling Regulation (SSR) was also being recast, see ­section 3.7.9 below and the new committee set-up in ESA, see s­ ection 3.7.2 below, made subject to further review, especially ESMA, an Authority particularly active in SSR, EMIR, the Market Abuse Regulation (MAR) and the supervision of credit rating agencies (under Credit Rating Agency Regulation (CRAR)). The Prospectus Directive and Transparency Directive were further streamlined also and so was the related accounting regime.542 By 2018 a replacement of the Prospectus Directive by Regulation was envisaged, see ­section 3.7.14 below. In 2013, the market abuse regime543 and UCITS544 were also reformed as we have already seen. It was perhaps only in SEPA (see s­ ection 3.6.12 above) that the EU established a more lasting framework. At issue is here the system of payments throughout the EU, although the rise of Bitcoin and similar payment regimes (see ­section 1.4.11 above) might well eclipse it. With all this activity, the hope was for the best.

541  A Council Regulation (EU) No 1024/2013 conferring specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions was agreed on 15 Oct 2013, [2013] OJL 287/63. 542  See the Prospectus Directive 2010/73 [2010] OJ L327/1, the Transparency Directive 2013/50/EU [2013] OJ L294/13 and the Accounting Regime Directive 2013/34/EU [2013] OJ L182/19. 543  See s 3.5.13 above. 544  See for UCITS V, s 3.5.14 while for UCITS VI a wide-ranging reform is being contemplated, see EU Commission, UCITS, Product Rules, Liquidity Management, Depositary, Money Market Funds and Long Term Investments (2012).

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3.7.2  The New Committee Structure: The European System of Financial Supervisors (ESFS). The Single Rule Book In s­ection 3.4.2 above the EU committee structure of financial supervisors and the powers of these committees were explained pursuant to the 1998 Action Plan following proposals in the Lamfalussy Report of 2000 as a matter of comitology. The essence was that a European Securities Committee (ESC) was formed, representing Member States (often at Ministry of Finance level) with powers to implement EU Level 1 framework legislation in the financial area.545 It takes a majority vote whereupon the measures will be sent to the EU Parliament for approval. This is Level 2, at which level advice may also be given by other committees which may be further mandated by the ESC. These were for banking the Committee of European Banking Supervisors (CEBS) in London and for securities the Committee of European Securities Regulators (CESR) in Paris. They represented the regulators in Member States and in that sense still local interests. In the implementation or Level 3 stage in these Member States, the CEBS and CESR played a role in obtaining consistency and could issue guidelines or non-binding standards. At both Levels 2 and 3, there were three other standing committees: one for commercial banking, one for investment business including UCITS, and one for insurance, including pensions. A fourth committee operated at Level 2 for financial conglomerates. Ecofin set up a Financial Services Committee of its own (FSC). The whole set-up was reviewed in 2004 and then again in 2011.546 The Committee structure that emerged after 2008 is now referred to as the E ­ uropean System of Financial Supervision (ESFS).547 Within it, the ESC remained in place but the CEBS was replaced by the European Banking Authority (EBA) in London and the CESR by the European Securities and Markets Authority (ESMA) in Paris. For life insurance and occupational pensions, there is now the European Insurance and Occupational Pensions Authority (EIOPA) in Frankfurt, replacing the earlier Committee of European Insurance and Occupational Pension Supervisors. These agencies are more independent from local regulators and are meant to play a greater supervisory role at the EU level in the implementation of new Directives and Regulations, although still short of becoming EU regulatory bodies themselves, financial regulation ­remaining

545  A European Banking Committee (EBC) was also set up, by Commission Decision of Nov 2003. It advises the Commission on policy issues in the banking area and further assists it in adopting implementation measures as a matter of comitology. Like the ESC, it is composed of high-level representatives for EU countries normally the ministries of finance and is run by the Commission itself which also provides its secretariat. This Committee usually meets four times per year and, like the EBC, continued after the reforms. 546  See E Ferran, ‘Understanding the Shape of the New Institutional Architecture of EU Financial M ­ arket Supervision’ in G Ferrarini et al (eds), Rethinking Financial Regulation and Supervision in Times of Crisis (Oxford, 2012). 547  The ESFS is based on four EU Regulations of 24 November 2010, one Directive, and one Council Regulation. Regulation (EU) No 1092/2010 created the European Systemic Risk Board (ESRB); Regulation (EU) No 1093/2010 the European Banking Authority (EBA); Regulation (EU) No 1094/2010 the European Insurance and Occupational Pension Authority; and Regulation (EU) No 1095/2010 the European Securities and Market Authority (ESMA). Directive 2010/78/EU of the same date amended earlier Directives to reflect the changes in the committee structure, while Council Regulation (EU) No 1096/2010 of 17 November 2010 conferred specific tasks upon the ECB concerning the functioning of the ESRB.

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in principle a Member State jurisdiction (see for the European Banking Union in the eurozone ­section 4.1 below). It also raises the question of delegation, particularly to ESMA, which acquired an important role under EMIR, CRAR, MAR and SSR as we have seen. Under Article 18 of the ESMA Regulation, the EU Council may further declare an emergency, empowering ESMA to demand action from national authorities or impose immediate adequate measures in respect of market participants.548 At the initiative of the European Parliament, this framework is supplemented by the European Systemic Risk Board or ESRB, which operates (for the first five years, subsequently to be reviewed) under the ECB.549 See for these macro-prudential initia­ tives also ­sections 1.1.13/14 above. It is meant to monitor the risk build-up in the EU financial system as a whole and may issue recommendations (not decisions), especially whenever it detects risk concentrations and bubbles. It is the European version of a stability board. The first chairman was Mario Draghi, now President of the ECB. Again, in the eurozone, it may be substantially eclipsed by the European Banking Union or Single Supervisory Mechanism (SSM)—see ­section 4.1.2 below. The new set-up was the result of much political debate and wrangling and was a compromise. The UK in particular was not keen on surrendering more regulatory power to the EU. There are as a consequence many veto possibilities for Member States. One key objective was that the first three new authorities are given power within their areas to settle disputes among national supervisors if they cannot agree on cross-border issues, especially relevant in the resolution of banking collapses cross-border (the ESRB only issues recommendations in recognition of the fact that financial regulation and capital adequacy standards in particular remain domestic, even if harmonised through Directives, last in the CRD 4 as we shall see). They may also issue temporary bans on risky financial products, see s­ ection 3.7.10 below, and trading and may set up uniform technical standards. As we shall see in ­section 4.1 below, in the euro banking union, there is a possibility of conflict of these Authorities with the new supervisory mechanism (SSM) under which the ECB cannot, however, ignore these bodies, notably the European Banking Authority (EBA) in its task to create a Single Rule Book for banks in all of the EU, while the ECB as banking regulator has also to deal with the fact that much financial regulation in the EU, even if harmonised through Directives, remains geared to the whole EU or is local. So are in fact the banking licences. In this, the Single Rule Book has become an important further support for all EU banking regulations, not linked to the eurozone, and is an instrument of uniformity

548  On 26 April 2013, the EU Commission launched a new consultation paper on the ESFS, proposing to make a number of adjustments for improvement. The main role remains the upgrading of the quality and consistency of national supervision, the strengthening of the oversight of cross-border groups, the establishment of a single European rule book applicable to all financial institutions, as well as the prevention and mitigation of systemic risk. The ESRB conducts the macro-prudential oversight of the financial system. This set-up is increasingly seen as a first step towards banking union in all of the EU, in which the ECB closely co-operates with the EBA in particular within the framework of the ESFS. 549  Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on the European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board.

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and knowledge supporting host country reliance on the home country regulator. It follows a European Council Recommendation of 2009 and has the capital requirements, depositors’ protections and resolution regime at its core (CRD 4 and CRR, DGS and BRRD), but also includes the corresponding technical standards developed by the EBA as well as EBA guidance and related questions and answers. It is seen as an important step in completing the Single Market in banking services. It was already said that further EU Directives or Regulations may give these Committees or Authorities additional powers, but any jurisdiction to supervise banks and other financial institutions directly was notably withheld and indeed it remained established that this continued to be the preserve of national regulators, although the situation was to be reviewed after three years (in 2014). The operation of the SSM starting in 2014 was an incentive to more centralisation but only covers banking in the eurozone. An attempt to move all three Authorities to Frankfurt, close to the ECB, was shelved at the time but may be revived after Brexit, the EBA moving rather from London to Paris.

3.7.3  The Amended Capital Adequacy and Liquidity Regime (CRD 2–3) In the EU, the financial crisis led to a number of early amendments of the applicable capital adequacy regime for financial institutions.550 This concerned in particular the Capital Requirements Directive of 2006 (later called CRD 1), see s­ ection 3.5.12 above, which applied to investment firms and credit institutions, in the case of the latter, however, only for position, settlement and currency risk. The major capital adequacy regime for banks was still covered in the Credit Institutions Directive (CID), recast also in 2006, see ­section 3.5.2, largely to take care of Basel II as did CRD 1 for investment activity. In September 2009, there followed a kind of omnibus Directive (CRD 2)551 as a first response to the crisis. It amended foremost the regime of consolidated supervision for significant branch activity in other EU countries by forcing more co-ordination and creating better co-operation structure between host and home regulators. It also revisited the regime of large exposures, see s­ ection 3.6.1 above, which had been incorporated in CDR 1 and imposed a duty on banks engaging in securitisation to retain five per cent of the securitised products, as already mentioned.552 CRD 3 of 2010553 concentrated more in particular on the capital requirements for trading books and securitisation products, disclosure of securitisation exposure, and remuneration policies. The latter were treated as a function of financial risk and risk management. Hence their unexpected coverage in a capital adequacy Directive.

550 

See s 3.5.12 above for the regime established for banks and investment firms after Basel II. Directive 2009/111/EC of the European Parliament and of the Council of 16 September 2009 (CRD 2) [2009] OJ L302/97. 552  See also n 24 above. 553  Directive 2010/76/EC of the European Parliament and of the Council of 24 November 2010 (CRD 3) [2010] OJ L329/3. 551 

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3.7.4  The New Credit Institutions Directive and the Consolidation of the Capital Requirements for Banks and Investment Firms (CCR and CRD 4) CRD 4 of 2013,554 supported by the Capital Requirement or CR Regulation (CRR)555 of the same year was a more in-depth effort and replaced the CID 2006 and the 2006 Capital Requirements Directive for Investment Firms (subsequently called CRD 1), see also ­section 3.5.12 above. The title CRD 4 is therefore a misnomer especially for credit institutions, it covered much more than capital adequacy which itself was largely taken over by the CRR. The relevant parts of CID 2006 were fully incorporated in the new text which covered henceforth both the capital adequacy requirements of banks and investment firms. MiFID remained unaffected for the other licensing and operating requirements of investment firms but was replaced by MiFID II in 2014, see ­section 3.7.5 below. The aim was more capital, and Tier One and Tier Two capital are redefined, downgrading the latter and introducing at the same time the Basel III experimental system of liquidity risk control—see further ­section 2.5.12 above. In view of what has already been said, it was not surprising that by the latter part of 2012 the cry went out to postpone the introduction of this new regime until later in the cycle when decent growth could be shown. That could have taken much longer than people expected but was a back-handed acknowledgment of the fact that the essence of banking regulation must be and is becoming its anti-cyclical nature, only modestly reflected in Basel III, see further the discussion in ­1.1.13/14 above, and the worry that more microprudential supervision of this nature was not the right answer to the crisis and its aftermath. Nevertheless, the measure was approved on 16 April 2013 for introduction on 1 January 2014.

3.7.5  The 2014 Amendments to MiFID. MiFID II and MiFIR and the 2016 Commission Delegated Directive The implementation of Basel III in the 2013 CRD 4, also covering investment firms, is at the heart of the EU response to the financial crisis, but in other areas there were regulatory changes as well. Thus the 2004 MiFID, which covered the passporting of security firms (see ­3.5.3ff above), was replaced and extended in 2014 by MiFID II to cover also custody of financial instruments, which so far had been an ancillary activity only and OTC products. It required especially bonds and derivative products increasingly to be traded on exchanges or on electronic trading platforms (and is then co-ordinated with EMIR, see s­ection 3.7.6 below). The possibility for 554  Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L176/338. 555  Capital Requirement Regulation (CRR), (EU) No 575/2013 on prudential requirements for credit institutions and investment firms [2013] OJ L176/1 followed by the Commission Implementing Regulation (EU) 2016/892 OJL 151/4 (2016) and the Commission Delegated Directive (EU) 2017/593 OJL 87 (2017).

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firms to deal on their own account (internalisation) was narrowed. The exception of execution-only business to the ‘know your customer’ requirement was also recast and henceforth only applied to qualifying instruments. Corporate governance was reinforced: senior management must be sufficiently experienced and able to devote sufficient time to the firm. Other main themes in the revamped MiFID II were: (a) access of regulators to information must be presented in more accessible form, and there is a stronger connection with the regime of the Market Abuse Regulation; (b) extension of the pre- and post-trading reporting requirements from regulated market products (and MTFs or systemic internalisation) to similar identified instruments, such as exchange traded funds (ETFs), fixed income, structured finance, CDS and other OTC products, although large-scale transactions may still be handled differently; (c) regulators being able to demand the reduction in size of derivative positions and prohibit or restrict the marketing, sale and distribution of particular financial instruments or financial activity, this probably being the most contentious part of the new regime (see ­section 5.1.1 below); (d) passporting rights for branches of non-EU entities under a single branch authorisation procedure for wholesale activity, this being a major structural change (so far the passport could only be obtained by EU subsidiaries of non-EU entities), see further ­section 3.7.17 below; (e) a system of payment for research and information supply amongst intermediaries requiring the separation of costs and fees; (f) a more comprehensive regime for emergency measures, see s­ ection 3.7.10 below; and (g) clearing and settlement open to all unless it threatened the smooth or orderly function of markets, see further ­section 3.7.6 below (EMIR). The provisions dealing with pre- and post-trade transparency, exchange trading of derivatives, and product intervention by national authorities were the more particular subject of a new Regulation called MiFIR556 and apply therefore directly without the need for incorporation into the laws of Member States (as Directives require). Everything that dealt with passporting (including authorisation and supervision), conduct of business (including investor protection and powers of national authorities, host/home regulator issues, and the incorporation in the system of markets), trading platforms and clearing facilities continued to be contained in a Directive, hence MiFID II,557 which paralleled CRD 4 covering credit institutions in the passporting aspects. Article 24 deals with and summarises the basic investor protections, see also section 3.7.19 below.

556  Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 [2012] OJ L201/1, amended by Regulation (EU) No 600 of the European Parliament and of the Council of 12 June 2014 [2014] OJ L173/84. 557  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments amending Directive 2002/92/EC and Directive 2011/61/EU [20vo14] OJ L173/349.

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Agreement was also reached between the European Parliament and Council re-emphasising the policy of pushing trades to regulated venues if not also regular markets. This concerned equities, bonds and derivatives but also commodities. Dark pool exemptions, where participants trade large volumes without pre-trading transparency and disclosure of names and size (which disclosure takes place only when the deals are done), were in some instances forbidden, forcing these trades into the light, while there were limits set for traders on the size of their positions and on these being financed by their own capital (only 4% of a comnpany’s equity could be traded in these pools over a 12 months period and only 8% of te total volume could be traded across all dark pools). Opponents had always argued that darkpools prevented smaller investors from getting best prices. Yet there is no evidence that trading reverted to regular exchanges, large trades having always been exempted whilst the alternative became periodic auctions on exchanges which orders are not made public, resulting in “greyish” pools. It is an example of the market readjusting immediately to regulatory interference. High-frequency computerised trading systems were also regulated in the sense that operating firms were no longer allowed to suddenly shut them down. The policy to prevent exchanges and traders from requiring participants also to use their clearing was further strengthened. A particular feature was the regime concerning research and the separation of their costs from fees, already mentioned. Except for the latter and the emergency measures, see s­ ection 3.7.10 and the summary in s­ ection 5.1.1 below, much of this was no longer truly contentious but because of its detail the regulatory burden and cost increased substantially. It created quite an implementation squeeze before 2018 whilst the necessity of much of the detail could be questioned. But once it was done and the cost assumed, there was little insistence on review, which would lead to further cost. It showed that MiFID II represented a consensus with which the industry could live.

3.7.6  The European Market Infrastructure Regulation (EMIR) EMIR primarily followed and facilitated within the EU the commitment made by G-20 leaders in Pittsburgh in September 2009, that: All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.

Similar objectives were also formulated in the 2010 Dodd-Frank Act in the US. The idea is that information on certain OTC derivative contracts should be reported to trade repositories and be accessible to supervisory authorities. They included interest rate, foreign exchange, equity, credit and commodity derivatives. It also identified ­categories

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of counterparties to who a clearing obligation was to apply. One consequence was that more information could then also be made available to market participants in these products. This also goes to the issue of pre- and post-trade (price and volume) information and reporting. The issue is not, however, merely sourcing data, but rather their processing, interpretation and organisation. There is here also operational risk, not only connected with IT capabilities and reliability of systems. Ultimately the issue is one of transparency in activity, risk management and oversight. Another important issue in this regard is that OTC derivative contracts when sufficiently standardised may be cleared through central counterparties (CCPs). This is meant to reduce counterparty or credit risk, ie the risk that one party to the contract defaults. This was the inheritance of the Lehman debacle and also went to the matter of proper records and margin calls, the adequacy of the margin, the segregation of the margin accounts for centrally cleared products and the adequacy of the amount of collateral used to mitigate counterparty risk, and proper marking to market for noncentrally cleared products. The assumption was that CCPs would want to do this business even short of much greater standardisation: see also the discussion in ­1.5.7, 3.5.8 and 3.6.14 above, and further the discussion above in ­chapter 1, ­section 2.6.5, but it could put them seriously at risk as we have seen. EMIR foremost sought to (a) impose mandatory central clearing obligations on outstanding OTC derivatives of the types covered in respect of the relevant counterparties, (b) introduce risk limitation techniques for OTC derivatives that are traded bilaterally, and (c) impose a reporting requirement on all derivatives to a trade repository. One key issue was what business would be taken from the OTC markets, which are effectively the swap warehousing desks and trading facilities in the large commercial banks. Another was what products would be deemed sufficiently standardised in this connection to allow for or even demand regular clearing and what that concept meant: is the accent on standardised documentation, which goes to form and reporting, or on standardised risk, which goes to the issue of notional values/maturity and set-off/ netting? See again the discussion in ­chapter 1, ­section 2.6.5 above. Interest rate swaps may have to be specially tailored, as may be CDSs. This raises also the issue of their hedging and replacement or their liquidity. It is of interest that in Title IV, Article 34, CCPs are required to maintain a business continuity policy and disaster recovery plan aiming at preserving and recovering operations in the event of disruption. It does not cover, however, the event of CCPs being themselves in financial trouble, but they must have a minimum capital of Euro 7,5 million, more in proportion to the risk they take (without any further details) and maintain a fund that covers losses resulting from failed margin calls. Credit Default Swaps (CDSs) were the more direct cause of concern in this connection arising from the precipitous collapse of AIG. The margin that was or could be sought, especially when the credit rating of the protection giver went down, became an important issue, but broader questions were also raised concerning operational risk, including the proper amount and calculation of the collateral (usually cash collected under the margin arrangements or otherwise government securities) and the proper management, assessment (and quality of the risk model, including the mark-to-market valuations) and ready collection of margin. It requires a great deal of costly ad hoc and

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often manual intervention, which becomes especially difficult when there is high volatility accompanied by large volumes. What can the CCP handle and how? All the same, bespoke (non-centrally cleared) derivative transactions of the CDS or interest rate swap types remain necessary if only as hedge instruments and EMIR accepts this, devising a special regime here. To this effect, it distinguishes between three types of parties: (a) financial counterparties, (b) systemically important non-financial counterparties and (c) non-financial counterparties of limited systemic importance. The latter may include SMEs engaged in managing their own exposures to commodity price or interest rate fluctuations. Larger companies, such as airlines or oil trading companies, may be in the second category. In respect of OTC derivatives, EMIR maintains a different set of requirements for each category.558 Transactions between the first and second category are subject to clearing through the CCP system if they are sufficiently standardised. In particular there must be sufficient liquidity and the possibility for the CCP to value the derivative and easily work out the amount of collateral or margin to be demanded. EMIR sets guidelines in this respect. The importance is that CCPs are not defenceless here and may refuse to clear on good grounds. The consequence for financial intermediaries is that there are higher capital requirements. This is a safeguard but at the same time an incentive to standardise as much as possible. However, it deprives counterparties from applying their own valuation methods and bilateral netting arrangements. All transactions OTC must be reported to a trade repository to create maximum transparency and also enforce discipline in documentation and record keeping. It has already been said in the previous ­section that there is here co-ordination with MiFID II. This concerns especially pre-trade transparency for traded derivatives above a certain threshold. This may result in extra cost for SMEs and force them out of this market. The result is further risk concentration in larger financial institutions but it is also an issue of fair access to these markets. It should be noted in this connection that infringement of EMIR rules is not in itself a cause for invalidating the underlying contract (Art. 12(3)). This is an important indication that the EU is not keen to enter into the realm of contract law for its enforcement, see also the discussion in s­ection 3.7.19 below. This is all the more likely in professional dealings. It also does not see here immediately a stability concern. Another issue was making CCPs safer and establishing a level playing field among them, linking them and perhaps connecting them to the central banking system (as lenders of last resort). In a trans-border scenario this also raises the issue of passporting and the responsible regulator and ultimate liquidity provider. The earlier EU approach had depended on self-regulation in the knowledge that the industry itself had promoted the official derivative markets (for options and futures) and also had developed the concept of the CCP. How far the new EU Regulation, which dates from 4 July 2012 and entered into force on 16 August 2012,559 will manage to bring greater order in 558  See the Regulatory Technical Standards in the EU Commission Delegated Regulation No 876/2013 of 28 May 2013. 559  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.

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OTC derivatives without unintended consequences for the health and future of these necessary risk-management tools or stultify them remains to be seen. Details were left to ESMA, which suggests a dynamic approach. Further rules on OTC derivatives were contained in a delegated Commission Regulation in 2013, followed by others in 2014 and 2015.560

3.7.7  The Alternative Investment Fund Management Directive (AIFMD) In ­chapter 1, ­section 2.7.7 above, this Directive was mentioned while discussing fund management and its regulation. The regulation of hedge funds in particular was the aim of the Directive but it looked for a comprehensive set of rules covering all funds not under UCITS and therefore also covers private equity and venture capital funds. They require authorisation in the home state but are entitled to a passporting facility. This gave rise to much debate and amended proposals, which concerned first the marketing of non-EU funds in the EU by EU fund managers. They must 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. For the rest, the debate largely came down to the access of non-EU (US and offshore tax haven) managers to EU investors.561 Here again they can do so actively but only by way of private placement and subject to its rules in each Member State.

3.7.8  The Securities Law Directive and the Central Securities Depository Regulation (SLD and CSDR) The Securities Law Directive (SLD) and its origin were discussed in ­section 3.6.14 above. It is meant to deal witg the different laws that may become applicable in cross border trading, therefore with legal fragmentation in the EU, and raises very much the issue of EU competence in the field of unificatiuon of private law, see Volume 1, ­chapter 1, ­section 1.4.21. A draft text was released in 2012 but as of 2018 remains under consultation. 560  Delegated Regulation (EU) No 876/2013 of the European Parliament and of the Council of 28 May 2013 [2013] OJ L244/19 with regard to regulatory technical standards on colleges for central counterparties, which was followed by Commission Delegated Regulation (EU) No 285/2014 and Commission Delegated Regulation (EU) 2015/2205 of 6 August 2015 [2015] OJL 314 with regard to regulatory technical standards on the clearing obligation implementing Regulation (EU) No 648/2012 (EMIR). 561  See Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 [2011] OJ L147/1. See for this Directive and its implementation, L van Setten and D Bush, Alternative Investment Funds in Europe (Oxford, 2014). At one stage a blacklist was proposed in respect of some tax havens, which would forbid EU investors to send funds. It implied 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. It was feared that small and medium-sized companies would be hurt as they may depend for funding more particularly on private equity or other more innovative funding activities.

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The Central Securities Depository Regulation (CSDR), on the other hand, became effective in September 2014.562 Central Securities Depositories (CSDs) are important infrastructures in securities markets that organise the registration, safekeeping, settlement and efficient processing of securities transactions in financial markets. They envisage especially transactions in securities entitlements. The Regulation covers the systemically most important of these facilities in the EU (about 30). It aims at shorter settlement periods, settlement discipline measures including penalties and buy-ins for settlement failures, strict prudential and conduct of business rules, access rights to CSD services, and increased prudential oversight for CSDs providing ancillary banking services. Together with EMIR, the AIFMD, MiFID and eventually the SLD, the CSDR is part of a framework in which trading venues, central counterparties, trade repositories, and central securities depositories are meant to come together under common EU rules.

3.7.9  The Regulation on Short Selling and Certain Aspects of Credit Default Swaps (CDS) The view of this book is that governments should not intervene in markets except in cases of market abuse, including anti-competitive behaviour and manipulation. Beyond this, only participants should be regulated in respect of their activities and markets should be left alone. The alternative is false markets and false pricing with the danger of liquidity going elsewhere or underground. For political reasons, after 2008, the EU was forced into an after-crisis programme based on market suspicion and the assumption that governments had been the victims of manipulation. Hence this new Regulation on short selling, effective as of 1 November 2012,563 and also the relevant parts of MiFID II, MiFIR, EMIR, and the Regulation on credit rating agencies (CRAR) and on the Directive on alternative fund management (AIFMD). But the problem was never market failure except perhaps that these markets had been too late in spotting the errors of unsustainable government policies and their consequences, including the stimulation in good times of excessive banking activity with ever lower capital adequacy requirements, not keeping an eye on liquidity management, and generally enforcing financial regulation only minimalistically. Again, it suggests that the true problem was government failure. It followed that once the initial indignation was over, the proposals for these various Directives and Regulations were much watered down in order to retain the confidence of the markets and the integrity of the price formation process in them which in the end changed little. The same fate awaited the lofty principles of the Dodd-Frank Act

562  Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on Securities Settlement and on Central Securities Depositories [2014] OJ L257/1. 563  Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of CDS. See further also the ESMA paper of 13 September 2012, Questions and Answers. Implementation of the regulation on short selling and certain aspects of credit default swaps.

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in the US in their implementation. Only the Volcker rule, which was intended severely to cut proprietary trading in banks, was different and not pursued in the EU at first, although this changed in 2012,564 see ­section 3.7.11 below. As for short selling, the text of this Regulation takes account of the IOSCO 2009 Final Report on Regulation of Short Selling. This was foremost a political reply to unfamiliarity with the subject and to its use in bad markets where downward price spirals were feared. The activity is then often associated with the activity of hedge funds and considered undesirable especially by governments in respect of their sovereign debt, although nobody thinks of capping a boom in opposite circumstances; it is technically the same. The true fear is credit risk, not market risk. In government bonds, investors’ speculating on a government’s ability to repay its debt is then considered improper, but in many countries it proved only too necessary to get any governmental action in terms of sanitising their accounts, which had been far too late in coming. If markets had been quicker to shorten these bonds, it might have saved a lot of trouble. Credit rating agencies similarly had been slow to wake up to the problems. One may see here major market failure compounding government failure. Shorting is normally achieved by selling investments a seller does not have. It can effectively also be achieved by buying put options, selling investments under a future, or by buying credit CDS protection: see c­ hapter 1, ­section 2.5 above. Hence also the inclusion of the latter in the Regulation. Shorting is often a hedging strategy and may in that case also take the form of an imperfect hedge, that is shorting in similar but not identical assets that are easier and more available for this use. Another use of shorting is for market-makers to anticipate a large purchase that must be unwound. Shorting can of course also be done as a pure investment. Technically, a short sale still requires delivery. Again it concerns investments the short seller does not have. Normally the seller will borrow these investments. Stock lending is therefore an important supplementary activity (see c­ hapter 1, s­ ection 4.1.3 above) but the shorts may also be naked, that is that by agreement there will be no delivery to the buyer, who may agree to this (or postpone delivery in which case we have a future). Here the buyer accepts settlement risk but may demand collateral or margin (in the case of securities lending the lender will do so to ensure that 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 not immediately look for an end-buyer, especially when the short is intraday or part of trading activity, which itself suggests lesser need for back-up. The result is that there are temporarily more investments (securities) on the books than there are in reality: see for this complication also ­chapter 1, ­section 4.1.3 above. Equally, CDS protection may be naked, which means that the protection is bought as a speculation or investment, not to protect any particular risk asset, which would be a hedge and that became a concern in theis Regulation also. In this connection, 564  See nn 27, 157 and 173 above. That change came in the EU pursuant to the Erkki Liikanen Report or the Report of the European Commission’s High Level Expert Group on Bank Structural Reform published in ­September 2012, see s 3.7.11 below. The idea had earlier been advised against in Europe as it would limit liquidity in European government bonds, which henceforth would be likely to be traded less. For similar reasons, the Volcker rule was also hotly debated in the US, see n 197 above.

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CDS is sometimes characterised as an insurance contract, which would affect the enforcement of naked protection (lack of an insurable interest leading to an unenforceable policy), but this characterisation is tendentious, see also ­chapter 1, ­section 2.5.8 above; CDS is in truth a primary guarantee—see c­ hapter 1, ­section 2.5.2 above—which can be entirely abstract. Nevertheless, there is much antagonism against naked CDS as there is against naked shorts, probably for the wrong reasons. Extreme shorting corrects itself quickly in the market and is high risk for shorters who are pure investors: once other shorts start covering by purchasing, the party will be over and the idea of a continuing downward spiral is fanciful as long as there is real value in the investment. It has already been said that restricting these market mechanisms is regulatory market manipulation and must be limited to situations of clear abuse or extreme instability, which may be hard to define. In any event, the prohibition should only be temporary, used only in extreme situations, lest the result becomes an artificial market. Within the EU, the decisions in this regard should not normally be left to the discretion of domestic regulators who may be subject to all kinds of pressures and may disturb the EU internal market further. From that point of view, clarification through a Regulation may make sense and was an objective. There is also the question of transparency, allowing regulators to make a better judgement about the need for intervention and to ensure co-operation. Finally there is the lesser issue of settlement risk for naked transactions as this is usually taken care of in the collateral arrangements. As for transparency, the Regulation adopts a different approach for shares and government bonds. In the first case there is a two-tier system, where at a low threshold (0.2 per cent of the issued capital) regulators will be informed of a (net) short position and at a higher threshold (0.5 per cent) to the market at large. For government bonds significant net short positions will be disclosed to regulators only as it is felt that disclosure could affect liquidity. OTC derivative use to achieve similar short positions must also be reported. One might think of CDS and put options and futures; it is not clear. In any event, the latter need not be OTC at all. Under the Regulation, regulatory intervention is indeed limited to extreme circumstances but extends to a wide range of instruments. The Regulation defines the powers, conditions and procedures. ESMA is given a central role in the co-ordination and in ensuring that the powers are correctly exercised. The EU Commission has delegated authority to further define the criteria for intervention, subject to revocation or objection by the EU Parliament and Council within two months. As to the matter of naked shorts, settlement risk and the risk of increased price volatility are here invoked to regulate. For shares, there is in principle a need to borrow although it is left to ESMA to define the type of arrangements and also consider intraday trading and liquidity issues. For government bonds, borrowing is also needed but the restrictions do not apply for imperfect hedges where government bonds are used to hedge other types of bonds the pricing of which has a high correlation to the government bond in question. Market-making activity is altogether exempt as restricting the ability to shorten was considered seriously to limit its liquidity-providing function. As for CDS, the fear is rather destabilisation of the government bond markets, which was considered especially relevant for the debt of southern European governments during the government debt crisis that developed after 2010. Forbidding naked CDS

Part III  The EU Regulations and Directives Concerning the Internal Market 889

was thus foremost a self-serving government protection against what was seen (but not proven) as improper market movements and action. Achieving more stability here means less market involvement for the EU and therefore probably misleading pricing levels. Forbidding naked CDS in this context means that they can only be used as hedges and not as investments. Even if it means more stability, market liquidity in government bonds may be reduced. The Regulation envisages this possibility and allows regulators temporarily to suspend the prohibition but this also means that the area of naked CDS remains in a muddle.

3.7.10  Other Product Intervention Powers The EU regulatory product intervention powers were further reinforced in MiFID II/ MiFIR, see especially Articles 40–42 MiFIR. The issue is here more in particular concern about transferable securities, Article 4(1)(44) MiFIR II, which notably also cover derivatives, which are defined in Article 4 (49) MiFID II and Article 2(1)(29) MiFIR, further elaborated in Annex I Section C (1) MiFID II, and the involvement of investment firms that promote them.565 This may well prove to be a significant limitation in the sense that the issue appears not to be a general concern for the financial markets and their operations. It means that non-MiFID firms like funds may have greater leeway which may lead to regulatory arbitrage.566 Under Articles 40 and 41 MiFIR, the intervention powers are meant to be temporary and accrue to the European Systemic Risk Board (ESRB) and the European Supervisory Authorities (ESAs) supported by Article 9(5) of the European System of Financial Supervision (ESFS) Regulation, see the Committee structure s­ ection 3.7.2 above, pursuant to which they may temporarily prohibit or restrict certain specified financial instruments or activities when there arises a significant investor protection concern or threat to the orderly functioning and integrity of the financial markets, assuming that the ESAs under the ESFS remain within the powers conferred by the basic EU financial Directives and Regulations in this area, especially MiFID II/ MiFIR, see Article 1(2) of the ESFS Regulation. Under Article 18 ESFS Regulation, there are further powers in emergency situations, again dependent on further Directives or Regulations, like MiFID/MiFIR. More generally, the ESAs may give guidelines, recommendations, and warnings to establish consistent, efficient and effective supervisory practices, see Article 16 of the 2010 ESFS Regulation. This is particularly relevant for the ESRB in its macro-prudential function, which should transcend the micro-prudential role of the ESAs which, however, will be guided thereby. In the meantime, under Article 42 MiFIR, Member State authorities also remain competent to prohibit and restrict the marketing, distribution or sale of financial 565  See further also Art 8(e) of the Delegated Regulation EU 2017/565 of 25 April 2016 [2017] OJL 87/1 further implementing MiFID II. 566  See the ESMA Opinion of 12 Jan 2017 identifying this problem and asking to modify the scope of its powers under Arts 40 and 42 MiFIR.

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instruments or structured products or prohibit and restrict the type of financial activity and practice if there are reasonable grounds for investor protection concerns or concerns for the orderly functioning and integrity of the financial markets but only for as long as these grounds exist (Article 42(6). They may intervene even on a precautionary basis. Other Member States that may be affected must be consulted and EU authorities duly informed. There are references to proportionality and anti-discrimination (Article 42(2)), on the other hand, Articles 40(3) and 41(3) only require ESA measures in this regard not to be disproportionate. According to Articles 40(8) and 41 (7) MiFIR, ESA action prevails over that of national authorities of Member States. The essence of the product intervention under MiFID II/MiFIR is its temporary effect (hence also regular reviews) or advisory nature. The EU Commission may adopt further delegated acts under Articles 40(8), 41(8), 42(7) and 50 MiFIR to set forth criteria and has done so in the 2017 Delegated Regulation (EU).567 MiFIR itself specifies the degree of complexity of the product, the degree of innovation, the leverage in the products, and size and notional value of the activity in relation to the orderly functioning of the markets. This is not to ignore that Article 16(3) and Article 24(2) MiFID II, further introduced product governance obligations aimed at strengthening investors’ protections and reinforcing the confidence in financial markets. The purpose of these provisions appears to be the collection of data for distributors of financial products. It is an internal product approval process of the provider of these products and services and not an external collection or regulatory approval process. It means that neither the Commission nor the ESFS intervenes in financial products, structured or otherwise, for so long as investors’ protection does not require it. The facilities granted in MiFIR are therefore not in the nature of market regulation, licensing of products or market interference per se. Notably, the intervention measures must be deemed exceptional and are mostly temporary and not meant to inhibit innovation, but there is a great deal of discretion which also means that the protection of proportionality means little, see the discussion in ­section 4.1.6 below. More obvious would have been to distinguish more fundamentally between wholesale and retail activity. The danger is that these intervention powers become politicised and are operated without a sufficient understanding of the product and facility, if only to play it safe.568 As such innovation could be easily stunted.

3.7.11  The Issue of Trading in Banks. The Volcker Rule in the EU Banks trade and must do so although this is often poorly understood and much criticised of which the Volcker Rule in the US was a consequence. In the EU the Erkki Liikanen Report or the Report of the European Commission’s High Level Expert Group on Bank Structural Reform published in September 2012 covered the same ground.

567 

See n 565 above. This could easily happen in newer derivatives or products that shift risk like credit default swaps or, in the insurance industry, CATs which operate as capital market reinsurance products. 568 

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Earlier in the UK the Independent Commission on Banking, leading to the Vickers Report of 2011, also dealt with these issues, see also ­section 1.3.10 above. To take a step back, large banks are likely to provide a market-making service and provide liquidity in the products they commonly trade, notably foreign exchange, interest rate swaps and repos. They may also be active in over the counter (OTC) nonstandardised future and options trading. Investment banks are likely to be engaged in securities trading. By way of the most ready example, it is normal for a bank to provide foreign currency to their clients. This means that if a bank is euro-based, it may provide dollars against euros. The bank may not have these dollars readily available and may need to buy them itself. It could do so immediately, even ask the client to wait till this is done. In that case, the bank is likely to charge a fee for this service and will not take a position or risk itself. The client gets the exchange rate the bank was getting, that is likely to be the market exchange rate at the moment of dealing and the bank would be required to obtain the best rate for its client. More likely is that the bank will make a market. It means that it will not wait or look for another end client who wants to sell dollars but it will provide the dollars itself. The consequence is that the bank will have an open position in dollars. It may wait for an end seller to show up or it may get the dollars later, hopefully cheaper, usually in a trade with other banks who engage in similar fx activity, that is the risk it takes and the art of the fx trader or market-maker. Banks will allow these traders a limit within which they may run such open positions. They will usually also require the traders to close all these positions before the end of trading day so as not to run overnight positions and risks that are not attended to during that period. This is an important facility because it provides depths in these markets but requires banks to use their own money and take the risk whilst providing this kind of liquidity. It may allow their clients to deal at short notice in very large volumes with them. They may move the spread slightly against them, but at least they can deal and need not wait till somehow enough other clients with opposite needs can be found or the money can be obtained elsewhere which could take a long time. It was already mentioned that also for interest rate swap dealings this has become a very important facility. So it is in many other areas of financial activity. This type of liquidity needs to be well distinguished from the typical asset and liability management in banks (ALM) already discussed in ­section 1.1.3 above. It is market liquidity. How the client gets the right price was dealt with in s­ ection 1.5.5 where spreads were explained. This is the art of trading or market-making. In a normal bank, deposits will be used to provide the necessary funding for market-making activity. It should be well distinguished from so-called proprietary trading. That is the situation in which the bank takes an own investment position which it means to trade later. Deposits may then be used not merely to obtain liquidity for market-making but also to buy investments for the investment book, notably products which are expected to rise in value or take short positions if they are expected to go down. The whole treasury operation of a bank can thus morph into a hedge fund, not unlikely in investment banks, and can be and usually is very profitable, although many commercial banks do not much engage in it. Note first that this takes an entirely different type of trader—these are investors who are allowed to take overnight positions. The activity is often equated with

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pure ­speculation and then considered inappropriate in banks, but that need not be so. Note in this connection that banks have a lot of information and see the commercial and investment flows. Proprietary trading thrives on this. It is not normally assumed to be inside information, the illegal use of which is commonly limited to corporate information not trade information. Hence no insider dealing in the formal legal sense. By limiting or excluding it on the other hands, as is now the regulatory trend, banks are deprived from an important source of income that was never at the heart of their problems in 2008. It is important to realise that in their market-making and liquidity-providing function banks must trade and regularly cover their positions. Hedging and short selling are necessary. But it must be watched carefully by management to which the 2012 LIBOR scandal more than testified. Not doing so makes the trading floor in banks a circus of cowboys and prospective gangsters; again proprietary trading is investing and a different world but even market-makers may take speculative short term positions. Identifying this problem is not the same as solving it. Risks must be managed and cannot be eliminated. Merely setting limits and not allowing overnight positions do not eliminate all problems. The so-called Volcker Rule embodied in the Dodd-Frank Act in the US sought to eliminate much of this but could not define the difference between market-making and proprietary trading. The full text of its implementation document runs to 71 pages with nearly 900 pages of supplementary text which tried to give guidance. It was only agreed (in 2013) after three years of deliberation and ended in self-regulation: banks being able to show that their trading was for hedging purposes, under-writing or market-making, not short term proprietary trading. Hedging must demonstrably reduce and significantly mitigate specific identifiable risk, underwriting and marketmaking must be designed not to exceed the reasonable expected near-terms demands of customers. But it is all a matter of interpretation and ultimately agreement with the regulator on a ‘compliance plan’.569 The policy behind the in-practice much diluted Volcker Rule, which dilution continues under the present Republican administration, see also s­ ection 1.3.10 above, was to prevent deposits being used for proprietary trading and also for investments in hedge funds and private equity. Section 13 Bank Companies Holding Act (12 USC parargraph 1851 as amended) did not allow these activities in any part of a bank holding company,

569  One important additional point should be made when it comes to trading financial products and is another aspect of liquidity, often also poorly understood by non-lawyers, even bankers. Not all financial products are liquid in themselves. Stocks and shares are, because, when meant to trade, they are commonly expressed in the form of negotiable instruments, normally as bearer or order securities (now often superseded by book-entry entitlements in custodial systems of investment security holdings which embody a similar trading facility). But contracts are not. Thus banks loans are not tradable: options, futures and swaps are not tradable, again because they are contracts. The reason is that contracts cover rights and obligations and only monetary rights are commonly transferable without consent of the counterparty (even then assuming that they can be split out). To neutralise future and swap exposure in terms of market risk, opposite positions must therefore be taken to neutralise this risk but it doubles the settlement (or credit) risk. Bilateral set-off and close-out netting may then help, CCPs are here important as we have seen in ch 1, s 2.6.5; it is all to overcome this problem. A modern way around this and which is supported in the US in s 2-210 UCC, is to allow at least sales agreements to be transferred without consent of the counterparty but the transferor remains guarantor for the contractual obligations.

Part III  The EU Regulations and Directives Concerning the Internal Market 893

so there was absolute separation, beyond the more shadowy rules concerning marketmaking. In the UK the Vickers Rule leading to the Financial Services (Banking Reform) Act of 2013 amending the Financial Services and Markets Act 2000, took a different approach and ring fenced deposit-taking activity within a banking group as off 2019. It requires each deposit-taking institution to set up a special entity, which take the deposits from the public and are prohibited from exercising a number of functions, which are grouped as dealing in ‘investments as principal’, further to be detailed by order of the UK Treasury. It means that as of 2019, the deposit base can only be invested in low risk assets, which may have a profound effect on banking in the UK. As already mentioned, for the EU, there appeared in 2012 the Erkki Liikanen Report or the Report of the High Level Group of Experts established by the EU Commission. It dealt with the same issue but again in a different way. It did not ring fence the deposittaking activity but rather the trading activity which could, however, still be exercised within a financial group as a subsidiary (not the other way around) but not take retail deposits or engage in payment services for them. The EU subsequently issued a draft Regulation on structural measures improving the resilience of EU credit institutions.570 Earlier the French and German governments had agreed on a coordinated approach for systematically significant financial institutions along these lines although differently implemented in each country.571 These proposals failed to convince and were withdrawn in 2017.

3.7.12  The Shadow Banking System. The Securities Financing Transactions Reporting Regulation (SFTR) The shadow banking system came under review in so far that certain reporting ­requirements were introduced following recommendations of the EU Financial Stability Board as part of its examination of the shadow banking system in 2013.572 The result was that ESMA came with a securities financing transaction reporting proposal that became the Securities Financing Transactions Regulation or STFR,573 which concerned itself in particular with the funding of investment securities transactions through repos, securities lending or buy/sell back collateral arrangements or other forms of asset backed funding. To provide consistency, it follows the rules and processes already contained in EMIR, see s­ ection 3.7.6 above. It was one way of getting a grip on some of the shadow banking industry by requiring regulated financial entities which it funds to report these transactions if not covered under other regulations the extent these entities have a presence in the EU or even where it concerns assets backing with securities issued by an EU issuer or by an EU branch.

570  COM (2014), 43 final. A final text was reportedly agreed in May 2016 but the proposal was withdrawn in 2017. 571  See M Lehmann, ‘Volcker Rules, Ring-fencing or Separation of Bank Activities—Comparison of Structural Reform Acts around the World’ (2016) 19 JBR 176. 572  See FSB, Policy Framework Addressing Shadow Banking Risks in Securities Lending and Repos (2013). 573  See Regulation (EU) No 648/2012 amended by Regulation (EU) 2015/2365.

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3.7.13  The Credit Rating Agency Regulation (CRAR) In 2009, the EU passed a Regulation concerning credit rating agencies (CRAR I).574 There were amendments in 2011 and 2013 (CRAR II and III) and also a CRA Directive (CRAD).575 The idea is to promote a common regulatory approach to these agencies operating in the EU at a time when they were blamed for much. The quality of the rating methodology and the presentation of the ratings in a transparent and reliable fashion were prime concerns. Much of the substantive law was derived from the 2009 IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. An important and unusual new feature was the civil liability of rating agencies for their ratings (Article 35(a) CRAR III). It leaves open the matters of negligence and causation which are to be determined under local laws, much as in the case of prospectus liability. The Regulation applies to all rating agencies established in the EU. Supervision on a daily basis is through ESMA. Non-EU credit rating agencies may be recognised if they are supervised at least to a level prevailing in the EU. There must also be a co-operation agreement concerning these agencies between the relevant Member State of the EU and the country of the foreign credit rating agency.

3.7.14  The Replacement of the Prospectus Directive (PR3) The 2017 Prospectus Regulation was a replacement of the Directive of 2003 discussed in ­section 3.5.10 above which underpinned the issuer’s passport. The text is now contained in a Regulation commonly called PR3, expressing the third version after the 2003 Directive and earlier the Public Offer Prospectus Directive of 1989, see ­section 3.2.4 above. The Regulation is a refinement of the 2003 Directive and does not indicate a new direction. It became effective as of 2019. Its major innovations were a) the more precise indication of the risk factors according to their materiality (low, medium or high) depending on a combination of likelihood of occurrence and magnitude of consequences, where the EU Commission may release further criteria, and b) less stringent disclosure requirements for securities with denominations of more than EU 100,000 or those trading on regulated markets only open to qualified investors as defined, all focussing therefore on so-called Wholesale Issuance (Articles 1.4 and 13). There are other refinements basically centring on further exemptions. Furthermore, a universal Registration Document (URD) may be used by a frequent user in a regulated market or MTF (Article 9). Completion of an URD annually allows the issuer to obtain fast-tract approval of the prospectus. There is a simplified procedure for

574  Regulation (EU) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 [2009] OJ L302/1, effective since December 2010. 575  Regulation (EU) No 513/2011 [2011] OJ L145/30, Regulation (EU) No 462/2013 [2013] OJ L146/1 (and Directive 2013/14 [2013] OJ L145/1.

Part III  The EU Regulations and Directives Concerning the Internal Market 895

issuers of securities admitting to trading continuously for the preceding 18 months (­Article 14). A new EU Growth Prospectus facility is foreseen for smaller companies that have not so far securities admitted to trading (Article 15). Under PR3 summaries are only required if there is issuance to retail and have a limited length and are subject to some minimum requirements especially in terms of risk warnings and seniority (Article 7). A shorter turnaround time for supplements to a maximum of five working days is foreseen (Article 23).

3.7.15  The Project for a Capital Markets Union (CMU) The CMU project is meant to accelerate the construction of an EU capital market in order to wean the EU and its businesses, also the smaller ones, off their dependence on bank-based funding.576 In practice, much may depend on formalities in terms of prospectus requirements, and on underwriting, trading and clearing facilities beyond what the international markets offer at the moment, especially the delocalised eurobond market and its infrastructure. It is not obvious that especially for smaller issuers such a new market would become a viable alternative if only as a matter of cost whilst forms of asset-backed securities may have to be offered, which is a less common feature of capital market financing, and may make the bonds more local and less easy to trade cross-border and therefore less liquid in the EU or elsewhere in London, assuming that after Brexit London would still figure in terms of origination, support and access to issuers, investors, traders, clearers and investment funds.577

3.7.16  Orderly Resolution, State Aid, an International Safety Net, and International Co-operation. The EU Bank Recovery and Resolution Directive (BRRD) There never was a coherent set of rules for crisis management for banks in the EU and after the 2008 financial crisis, the EU intervention was at first ad hoc under Article 107 TFEU. Although the EU had been moving into the area of financial services since the European Single Act, it had never faced a major banking crisis. Even its state aid apparatus proved ill-prepared and there were no rules in place in the case of a banking crisis and resolution.578 There had been some important situations of special state aid in the EU (particularly concerning Credit Lyonnais and the German regional banks) in the past, but the 2008 banking crisis created an unprecedented situation. 576  See the Commission’s Action Plan on Building a Capital Markets Union (COM (2015) 468, see further also E Micheler, ‘Building a Capital Markets Union: Improving the Market Infrastructure’ (2016) 17 European Business Organisation LR 481. 577  See for an analysis of the possibilities especially with reference to an uncertain equivalency facility and test, N Moloney, ‘Brexit, the EU and its Investment Banker: Rethinking “Equivalence” for the EU Capital, Market’ LSE Law, Society and Economy Working Papers 5/2017. 578  It should be noted in this respect that the word ‘resolution’ stands for bankruptcy and resolves nothing.

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Note that the earlier Winding-up of Credit Institutions Directive, see ­section 3.6.3, only covered the extraterritorial effects within the EU of bank bankruptcy conducted under the ordinary rules of the relevant Member State. In response, an extensive report was published by the Centre of European Policy Studies in 2010, with a number of recommendations.579 Distortion of competition was always a main concern, but in the banking crisis it was immediate stabilisation of the financial system, the consequences to be sorted out later. When a second banking crisis loomed in 2011 as a consequence of the government debt crisis, further emergency measures were necessary. Again, the EU Commission was limited to supervising aid given by EU governments. Beyond that, the EU had to rely on international agreements. There was some co-ordination possible under GATS but the powers were weak.580 In fact, there was no framework for international co-operation at all, not even within the EU. Large international banks, their depositors and other creditors could therefore not be sure if and how such banks could be saved. For foreign operations, it could hardly depend on the home regulator, whose country might in any event be too small. This applied certainly to Dutch, Belgian and Swiss banks. Host regulators might on the other hand fear that they were subsidising head offices elsewhere. It was said before in ­section 1.3.8 above that the absence of an international safety net might have contributed substantially to the 2008 banking crisis now that banking has become a largely globalised business. These matters await resolution, probably in G-20, although in 2012 in the euro area, a single banking regulator was being proposed, which also raised the issue of the lender of last resort, of the safety net, and who pays at that level. It proved sensitive in view of an unavoidable measure of mutualisation of the banking problems to make a safety net of this nature effective. The result will be discussed in ­section 4.1.3 below. In the meantime, for all of the EU, a Recovery and Resolution Directive for Banks and Certain Investment Firms (BRRD) was agreed in April 2014581 and envisages for all Member States of the EU the appointment of competent authorities in charge of resolution plans including assessments of resolvability and the setting of individual bail-in ratios, the implementation of the resolution plan, and support based on contributions from other banks. For the eurozone banking union, the SRM and SRF, while introducing a centralised authority for the eurozone (see ­section 4.1 below), must be seen as building on the BRRD. Thus, the BRRD is not replaced in the eurozone but remains necessary in particular for providing a framework for resolution EU-wide in Member

579  Centre of European Policy Studies, Bank State Aid and the Financial Crisis. Fragmentation or a Level Playing Field? (2010). 580  Art XV GATS deals with subsidies but only asks for further negotiations when given for services and service suppliers. Art XVII:1 introduces national treatment in respect of services and service suppliers but only if individual GATS members accept a specific treaty commitment in this respect. The key is here anti-competitive effect. Benefits to local competitors that do not affect competition are not covered. It means, however, that state aid given to local banks will also have to be given to others. Given the aim to stabilise the financial system, this may be readily forthcoming if branches of foreign banks are substantial, but the WTO ‘Understanding on Commitments in Financial Services’ notably excludes lender-of-last-resort facilities. It also refers to the normal course of ordinary business. If help in crisis conditions were needed, it is thus likely to be offered outside the GATS framework on an ad hoc basis. 581  Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 [2014] OJ L173/190.

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States which are outside the eurozone. It also provides the essence of the mechanism to be used and determines the trigger point. A true international safety net would be even harder to organise and might have to involve institutions like the IMF and be dependent on a proper exit strategy. The G-20 Pittsburgh and London summits stated the importance of ‘co-operative and co-ordinated exit strategies’ but they seem to remain directed at national levels. The creation of a truly international safety net so far does not seem high on the agenda. The position of creditors, especially depositors, is a crucial issue.582 Early bank runs must be avoided, and there should be some guarantees for depositors. This is hardly the case beyond the comfort of deposit guarantee schemes, and thus instability may be enhanced. This is further promoted under the BRRD because (a) the organised ­liquidation and reorganisation regime under domestic bankruptcy laws, and their ­balance of rights and obligations, are suspended, (b) the moment of resolvability is not defined but left to ‘sufficiently early intervention’ (Article 27) or considerations of the ‘public interest’ (Article 32(1)(c) and (5)), (c) the demands of financial stability (or the avoidance of systemic contagion) are paramount, but it remains an undefined concept (see s­ ection 1.1.2 above and also Regulation (EU) No 1092/2010 establishing the European Systemic Risk Board) while it is particularly unclear what general level of economic activity must be considered against with this stability issue may be measured (­Article 31(2)), and (d) the measures that may be taken are wildly different and do not appear to allow for a single set of protections (Article 37(3), (9) and (100). This is policy in the manner of an administrative procedure, and there is hardly an adequate legal framework or appropriate legal protection for participants. They became the objects of political expediency and insight on the day, which guarantees nothing. There is no participation of any sort from creditors. Their ultimate protections derive from three clusters of ideas (a) the general principles governing resolution of Article 34 BRRD (supported in Article 15 SRM), (b) the loss distribution or asset separation and bail-in provisions of Article 42, 43, and 47–50 BRRD (supported by Article 27 SRM), and (c) the procedural safeguards of Title IV, c­ hapter VII BRRD (cf Articles 85 and 86 SRM). In practice, the limits are (a) the creditors receiving at least as much as in the case of an immediate liquidation under the otherwise applicable local bankruptcy laws, which is a wholly speculative concept (see Article 34 (1)(g) and for valuations Article 36), (b) respect in principle for secured interests in a bail-in (Article 44), and (c) the pari passu treatment of similarly situated creditors, which still leaves the question: what does ‘similarly situated’ mean? In fact, the treatment is ‘equitable’, not necessarily ‘equal’, even in the same class (Article 34(1)(f)). Rather than a bail-in proper, in practice thus far, the creation of a good and a bad bank has been the usual resolution tool. It was already said that this creates a great deal of debate in which of these banks assets and liabilities are subsequently located. More complications derive from the cross-border context. This context requires cooperation between authorities in the different countries affected. Article 88 institutionalised group-level resolution authorities as defined in Article 2(1)(44) to establish

582 

See s 4.1.4 below and JH Binder, ‘The Position of Creditors under the BRRD’ (2015), SSRN.

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resolution colleges as an international forum for cooperation. This provision is implemented by Articles 91 and 92. This situation may be simplified; for instance, in the eurozone there is now a single Resolution Board (see s­ection 4.1.4 below). The lack of transparency in this cooperation is only likely to increase the information problem, however, and weakens the position of creditors/depositors further. Local courts of affected parties might step into this breach and review the measures rather than merely recognising them, which could then place foreign creditors in a better position than the domestic ones in the country of resolution.

3.7.17  The New Regime Concerning Relations with Third Countries. The Notion of Equivalence In ­section 3.3.5 above, the EU approach towards third country financial services was described under the early Third Generation Directives. It was reasonably straightforward and supplemented by the Basel Concordat for international bank supervision, see ­section 3.6.5 above and by rules concerning consolidated supervision and international cooperation to that effect, see s­ ection 3.6.6 above. The idea in the EU was that in order to benefit from its passport, non-EU financial institutions had to incorporate a subsidiary in the EU under the domestic law of one of the Member States. Only thereafter could this subsidiary benefit from the passport and the free flow of its services EUwide. The rules concentrated on any limitations on subsidiarisation in this manner and on reciprocity of similar benefits for EU financial institutions when operating outside the EU. Further rules were developed as we have seen in the context of investment management services incoming into the EU from non-EU financial institutions, meaning the marketing on non-EU funds under the AIFMD, see s­ ection 3.7.7 above. In essence, the private placement method was adopted. The EU changed its policy towards third country financial services in the CRD 4 of 2013 (Articles 47 and 48) for credit institutions and in MiFID II of 2014 for investment firms (Preamble 109 and Articles 39ff, cf also Preamble 42 and Article 46(1) MiFIR), the latter coming into force in 2018, see for these Directives and Regulations ­section 3.7.5 above, in which context the notion of equivalence became used and was developed in certain areas. The result is considerable complication short of any other agreement, this is in particular relevant for UK firms after Brexit as the UK will become a ‘third country’.583 Although the new regime means to cover both—third country firm access to the EU as well as the extra territorial application of EU financial regulation—where there results double regulations meaning that the EU financial institution must potentially comply with the foreign as well as EU rules, the more obvious interest after Brexit is in third country investment firm access to EU services, meaning in particular services from London into the EU for wholesale activity when the passport will be lost and there will no longer be free movement of services and the freedom of establishment 583  Moloney, n 577. The emphasis was here on the importance of the concept for the EU Capital Markets Union (CMU) project, see s 3.7.15 above.

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between the EU and UK. Nevertheless the extraterritoriality of EU regulation and the risk of double regulations for EU firms operating elsewhere is real and may motivate greater respect for the foreign rule and a diminished one for the EU rule. From the outset two observations may be made. First the policy behind the new approach is hardly straightforward and is not the same for each activity. Originally it was perceived mainly as an investors’ protection tool, especially protecting retail investors against foreign service providers and products. A similar protection was thus envisaged for EU retail as there was in respect of EU service providers. On the other hand, the EU could not be oblivious to the functioning of and integration in the international markets especially of professional dealings and the need to prevent overlap and friction when coming into the EU. Hence there remained a need to rely on foreign supervised entities compliance under non-EU regulation. The idea thus became that [E]quivalence is not a vehicle for liberalising international trade in financial services, but a key instrument to effectively manage cross-border activity of market players in a sound and secure prudential environment with third country jurisdictions that adhere to, implement and enforce rigorously the same high standards of prudential rules as the EU.584

The second observation was that the rules as they were developed so far are not comprehensive but are disperse, different for issues of establishment and the provision of (some) services. The result is a technical and complex determination of what is required or needed in each instance for the access of foreign financial service providers and services and who and what is involved. This is likely to complicate the Brexit discussions for financial services considerably. Significant further complications derive from the designation of EU bodies that decide the equivalency issue. Sometimes it is the national supervisory body, usually in respect of individual transactions, at other times it is the EU Commission usually by general disposition under which the national bodies may then decide on the implementation per transaction or activity. It leaves in particular the question of what the situation is where the Commission has not (yet) taken an official decision. It follows that, in the new set up, the regime of banking and investment firm activity is no longer identical and was the subject of much debate especially in the discussions concerning investment services under MiFID II and MiFIR. Indeed, the approach became increasingly partial, complex and lacking coherence. For commercial banking activity under the 2013 Directive, Member States may authorise branches from third country banks subject to home country rule provided the terms are not more favourable than those applying to branches from banks from Member States. Particular concerns were money laundering and tax reporting. The authorisation is subject to notification to the EU Commission, the European Banking Authority (EBA), and the European Banking Committee (ECB). The notion of equivalence is not used in this context and there is no passport for these branches to operate elsewhere in the EU.585 584  EU Commission Staff Working Document EU Equivalence Decisions in Financial Services Policy: An Assessment, SWD (2017) 102, 5. 585  The EU Commission either at the request of a Member State or upon its own initiative, may also propose to the Council to negotiate agreements with one or more third countries concerning the exercise of supervision

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If there is a subsidiary, the rules will be the same as for local institutions and the passport applies. The cost of restructuring branches into subsidiaries is likely to be high in terms of capital, staffing and operational needs. Future directives may well require it if third country banking groups have significant activities in the EU through two or more institutions.586 For banking activity the Basel Concordat retains here residual authority, see ­section 1.2.5 above. On the other hand, for the investment industry under MiFID II, a distinction is made between retail clients and professional clients. Member States remain competent to allow access to retail clients from outside the EU and may insist on a branch or subsidiary subject to its regulation. There is alternatively a common EU framework for retail activity under which the establishment of a formal branch is always required. Branches of this nature are subject to the requirements for obtaining a passport, somewhat strangely even including the imposition of capital (or at least stable funding) on branch activity and no better result may be obtained than that applying to EU firms. An equivalence determination by the EU Commission is not mentioned in this context either (Article 39 MiFIR) and would seem to be less relevant in view of the conditions. Importantly, if a branch is so established for retail, it may not extend its services to other Member States. There is no passport. For professional clients and other eligible counterparties, on the other hand, under Article 39 MiFIR, a non-EU investment firm is allowed to provide services and activities (covered under MiFID II) in the EU without establishing a subsidiary or even a branch if the EU Commission deems the regulatory regime of the home jurisdiction equivalent to that of EU and ESMA agrees to include the non-EU firm on its list of permitted entities. That suggests a prior decision to the effect. Subsequently, it must comply with the MiFID II (2014) information requirements that apply to the passporting of services from Member States. Reciprocity is assumed. Here the foreign firm or a branch/subsidiary (which cannot be imposed) in the EU may extend its services into other Member States and has a passport (Articles 46 and 47 MiFIR). Under MiFID, for equivalence, a number of further conditions must be met in the area of prudential supervision and conduct of business. Firms must be subject to authorisation and effective regulatory supervision and enforcement in their home country, must have sufficient capital, and be subject to adequate corporate governance and internal control functions, and appropriate conduct of business and market integrity rules. Importantly, there is discretion of the Commission and the process is initiated at the Commission’s initiative. The above rules are particularly important in the area of establishment. There are also the financial services themselves to be considered where similar rules may apply, notably to third country CCPs and trading venues providing their services to entities from the EU. The former need to be recognised under EMIR (2012), see s­ ection 3.7.6 above,

on a consolidated basis. This is an issue therefore not left to Member States, see for this consolidated supervisions further s 3.6.6 above. 586  See EU Proposal 23 Nov 2016, 2016/0364 (COD), updated 15 June 2018 also referred to as CRD 5, although it covers much more than capital adequacy for these EU inward financial activities.

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which covers derivatives clearing (especially through CCPs).587 The latter also operate under MiFID/MiFIR and both then go in tandem for effective derivatives trading. Also here, a decision of the EU Commission is required in the matter of equivalence, therefore after Brexit for access to or by a UK-based clearer or CCP, Article 25. It means that without adequate equivalence, a third country CCP cannot have EU-based members and cannot provide clearing services for EU investment firms. Where both MiFID II/MiFIR and EMIR operate in this area, it should be considered that there are here potentially two procedures and two different sets of rules to apply when both access to trading and clearing are asked for, under which the equivalency test may not be the same. So far under EMIR there is more experience, 10 jurisdictions having been declared equivalent, amongst whom the CFTC in the US (after protracted and difficult negotiations. The emphasis appears to have been on similarity in outcome. Since the facility is part of the single market mechanism and its functioning, it means the ultimate jurisdiction of the ECJ.588 Again, the EU has the last word and the Commission can withdraw the equivalence finding at any time,589 but as especially derivative clearing is a key function and depends for its success on volume, competition in smaller centres in the EU may prove inefficient. The danger for London is that without privileged access to the EU, size-wise New York might well take over, although there remains a time-zone problem. Further rules apply to accounting standards, auditing, transparency, prospectuses, credit rating agencies, UCITS and AIFs, central securities depositories and securities financing transaction reporting.590 Obviously, the issue of equivalence is further complicated by the fact that different regimes may apply in the EU and elsewhere to different products and activities, whilst even in the EU itself the standards may vary per product or facility: sometimes registration with ESMA is required, in other instances reciprocity or a form thereof. Usually the Commission starts the process and makes the equivalence decision under Article 291 (or sometimes under Article 290) TFEU.591

587  In the UK, the four important CCPs in this connection are LCH.Clearnet, LME Clear, CME Clearing Europe, and ICE Clear Europe, who are here in play in terms of access to trading in the EU and EU trading having access to them, LCH.Clearnet being dominant in the clearing of euro-denominated derivatives. 588  The UK as EU Member was particularly successful in European Central Bank v UK, ECJ Case T-496/11 May 4 2015, defeating for the time being the ‘local policy’ notion of euro denominated derivatives clearing, suggesting that it had to take place in the euro-zone subject to ECB supervision. Obviously, the issue of equivalence is complicated by the fact that very different regimes may apply in the EU and elsewhere to different products and activities. See A and J Brunsden, ‘EU Plan to curb City’s Euro Clearing set to be Flashpoint in Brexit Talks’ Financial Times 16 Dec 2016. 589  L Quaglia, ‘The Politics of “Third Party Equivalence” in Post Crisis Financial Services Regulation in the European Union’ (2015) 38(1) Western European Politics 167. 590  See in particular E Wymeersch, ‘Brexit and the Equivalence of Regulation and Supervision’, EBI Working Paper Series no 15 (2017). 591  This is administrative rule-making by the Commission and an exercise of the Commission’s implementation powers which does not involve the Council or the European Parliament but is comitology subject to committee supervision, in this case of the European Securities Committee, composed of national representatives, which operates by a qualifying majority and can block the commission’s draft equivalence decisions under Regulation (EU) no 182/2011 of the European Parliament and of the Council laying down the rules and general principles concerning mechanisms for control by Member States of the Commission’s exercise of implementing powers, OJL 55/13 (2011).

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ESMA’s advice is normally sought although not necessarily followed and the process may not be wholly transparent.592 In some areas beyond MiFID II/MiFIR and EMIR, third country firms may also be able to rely on the notion of equivalence of their own regulation in order to enter the EU but it is Directive or Regulation and therefore activity dependent and not a universal principle or facility.593 One example was the 2003 Prospectus Directive, see ­section 3.5.10 above, Article 20, where the issue is the recognition of third country prospectuses. The 2012 Short Selling Regulation, see s­ ection 3.7.9 above, also has one, and third country market-makers may then benefit from a number of exemptions. They always give the EU the last word in decisions concerning the equivalence of the regulatory standard and the facility may easily be withdrawn, although formally there may not always be a need for prior EU authorisation. Especially in the area of collective asset management, there may be serious problems of access under UCITS 2009 for non-EU open ended funds after Brexit, see ­section 3.5.14 above, and for the others under the AIFMD 2011, see ­section 3.7.7 above. Notably, UK funds now operating under UCITS would no longer be able to do so after Brexit and for access would depend on the AIFMD which has no equivalence rules. Like all foreign funds offered in the EU, under the AIFMD UK funds would have to be treated as private placements. For individual asset management, MiFID II and MiFIR apply with the noted problems for access to retail, UCIT funds being often in that category but as collective schemes they are not to be promoted and sold in the EU under MiFID II/MiFIR. The equivalence model contrasts with the home/host country division of tasks and labour within the EU. Whatever model, enforcement remains ultimately a national issue, but a rule-based system of a division of labour between host and home country under harmonised standards is easier to operate in this regard and offers more predictability and conformity. That is expressed in the home/host country EU model for crossborder EU financial services to the extent regulated. There may be further international standardisation emanating from G-20 and the Basel Committee, but short of multilateral action in GATS, incorporation in EU rules or bilateral Memoranda of Understanding, in this standardisation there is less structure and unilateralism results, where ultimately only host country notions of equivalence may promote cross-­border international activity. In the US in clearing, the CFTC has recently shown some ­flexibility in this regard, as we have seen, but notably the SEC remains wary of recognition of foreign financial regulation especially in the enforcement aspect and that has also been reflected in the US regulatory attitude in the financial area in GATS, see ­sections 2.2.3/4 above.594 The EU may well take a similar view. 592  In its February 2017 Report on Equivalence, the Commission explained and saw the facility mainly as an EU-oriented process designed to facilitate EU actors in the interaction with non-EU markets and counterparties. The approach is EU centred and purpose-based; there need not be sameness of legal texts but there is due consideration to the size of the third country market, its importance to the functioning of the Single Market, interconnectedness with third country markets, and the risk of circumvention of EU rules. 593  See also the Commission Document, EU Equivalence Decisions in Financial Services Policy: An Assessment, SWD (2017) 102, especially its s 5. 594  See, however, also E Taffra and R Peterson, ‘A Blueprint for Cross Border Access to US Investors: a New International Framework’ (2007) 48 Harvard International Law Journal 31, two SEC officials proposing a ‘substitute compliance’ standard implying a more liberal approach, but the financial crisis did not allow it to get traction

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By international standards, the EU may, however, still be a liberal power but its focus remains on its own prudential stability rather than on international liberalisation and within these confines also on the advance of EU market firms and other EU participants/customers. Especially the position of London as financial centre after Brexit is not a priority. Another issue may be how the eurobond market will fare, which, even though historically delocalised, mostly operates from London, even if its clearing activities are mainly directed from Brussels (Euroclear) and Luxembourg (Clearstream). It avoids the EU prospectus requirements by usually issuing in large denominations as private placement, but it might be happier outside the EU. It may be recalled in this connection, that the WTO/GATS rules, which would apply after Brexit, allow basic access for financial services but fully retain host country rights to regulate, see s­ ection 2.2.3 above.

3.7.18  The EU Securitisation Regulation During the 2008–09 financial crisis securitisation was often identified as one of the culprits as we have seen. Regulators took steps to make this practice safer in their view. Thus in the EU the CRD 4 (2013/36/EU) and the implementing Regulation (CRR 575/2013), see ­section 3.7.4 above, introduce higher risk weightings for securitisation exposure. The consequence was a significant drop in activity in Europeunlike in the US. A change in sentiment then followed and the benefits of securitisation are now better understood. Hence a new Regulation became effective on 1 January 2019.595 It did not mean to be punitive but required some minimum standards. All originators and sponsors must ensure that there are sound and well-defined criteria for credit granting in respect of any exposures to be securitied and any originator or sponsor who buys such exposures for securitisation purposes must verify that the original lender also met such requirements. Notably the five per cent retention or skin in the game is maintained, the disclosure requirements are relaxed, but there are restrictions on selling to retail clients. Resecuritisation transactions are prohibited subject to certain carve-outs to insure 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 have not signed up to FATF and the OECD agreements on the exchange of tax information. A special class of simple, transparent and standardised securitisation (STS) is established, ESMA being in charge of the details. It may be noted that the Regulatioin did not go into private law detail and the considerable problems that may be encountered short of legal unification in the EU especially in the law of assignment. in the US. It assumed a bilateral approach and reciprocity leading to agreed exemptions from SEC and similar host country standards. 595  Regulation (EU) 2017/2402 of the European Parliament and of the Council of December 12 2017, [2017] OJL 347/35.

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3.7.19  Public Regulation and Private Law Consequences in the EU: The Impact of the EU Regulatory System on Private Law In the foregoing, financial regulation was considered from the perspective of financial stability, conduct of business, and market integrity, see ­section 1.1.8 above, further distinctions being made in s­ ection 1.1.10, whilst the possible contradictions were discussed in s­ ection 1.1.11 above. The types of recourse were also discussed: in the area of financial stability, it is likely to be an issue of administrative law of Member States in terms of licensing and prudential supervision, in the area of conduct of business it is likely ultimately to be an issue of private law in terms of damages or undoing of the transaction, however expressed and implemented in Member States, and in market integrity, viz market abuse, monopolisation, money laundering and insider dealing, it is likely to be a matter of civil or criminal sanctions again in the most affected Member States. This differentiation may clarify and in the EU may follow directly more in particular from the relevant Directives or Regulations in the area of conduct of business, although it was also pointed out that there may still be some horizontal or private law effect of the licensing conditions themselves in the sense that breach or lack of reaction of regulators may lead to civil liability of perpetrating intermediaries, but it remains exceptional. The same goes for civil liability of regulators and similar supervisors themselves.596 In prospectus liability, we may see, however, a broader civil liability regime following defective administrative law compliance. There was also an aspect of it in the civil liability of credit rating agencies created in the EU under CRAR, see ­section 3.7.13 above. The main private law area of interest remains here conduct of business and the implementation in Member States in particular of Article 24 MiFID II, which protects the smaller investors, it being determined under local laws whether this is to be breach of contract, breach pof fiduciary duties, negligence, or a cocktail. Important civil consequences follow also from the Settlement and Collateral Directives, stretching as far as bankruptcy, see ­chapter 1, ­sections 1.1.8/9 and ­sections 3.2.4/5 above. In custodial holdings of securities entitlements, see ­chapter 1, ­section 4.1, we may see special notions of ownership and segregation starting to operate, another important bankrupotcy issue, although regulators at the EU level have not so far actively involved themselves. It is different in derivatives and the operations of CCP as we have seen, see in the EU ­section 3.7.6 above for EMIR. In fund management and the way funds can be sold, we have UCITS and the AIFMD in addition to Article 24 MiFID II. The 1996 amendments of Basel I started actively to promote more extended versions of set-off

596  See the discussion in n 40 above and the ECJ in Peter Paul, case C-222/02, ECLI:EU:C2004:606, in which damages were sought from the German State for deficient prudential supervision, but the claim rejected because the relevant legislation had only meant to protect public not private interests. Harmonisation not depositors’ protection had been the prime objective of the supervision system. See further also M Andenas, ‘Commercial Law, Investor protection, EU and Domestic Law’ in M Heidemann and J Lee (eds), The Future of the Commercial Contract in Scholarship and Law Reform (Springer 2016).

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and netting as effective risk management tools for banks, see ­chapter 1, s­ection 3.2 and ­section 2.5.5 above, again particularly important in bankruptcy. In securitization, the new EU Regulation, see s­ection 3.7.18 above, affects their private law structure. It may be noted that even though the EU has no direct competence in the creation and operation of private law, see Volume 1, c­ hapter 1, s­ ection 1.4.21, many private law consequences nevertheless follow from its initiatives in support of the internal market and that has also become clear in the financial area. The question then is in how far Member State laws give expression to the EU measures and imnplement them. In fact in competition law we may see the issue clearer: how are the termination of contract and damages in appropriate cases under EU law handled and brought to completion in the domestic legal systems of Member States? Yet it must be repeated that the EU has no competency in private law formation except to the extent the operation of the internal market demonstrably requires it under Article 114 TFEU, see again Volume 1, c­ hapter 1, ­section 1.4.21, the Commercial Agents Directive of 1986 being perhaps the strongest early example. Although the ECJ has been accommodating in the interpretation of this limitation, it remains nevertheless a fundamental issue, and there is nothing in commercial law per se that suggests otherwise unless one assumes its transnationalisation in a globalising world based on the traditional sources of law of which legislation is only one and subject to their hierarchy as is the approach of this book, but this is not then an EU internal market issue, rather a globalization matter. It may be noted in this connection that even in the US, the UCC has remained and continues to be state law and that federal commercial law was always exceptional, see Volume 1, ­chapter 1, ­section 1.5.9. In this book consumer (and small investor) protection is fundamentally distinguished from professional corporate and commercial dealings. The EU and its civil law Member States in their private law discourse in the PECL, DCFR, CESL still do not make here fundamental distinctions with reference in particular to transnationalisation of the law in the professional sphere inspired and guided by risk management consideration. Moreover, standardisation and the move towards smart contracts both underline an increasingly different environment which can hardly be called contractual in the traditional sense any longer. Party autonomy is here stronger and an autonomous source of law but it is very different from what it is perceived to be in consumer law. It is objectivated and conforms to standards of customary practices in that world. On the other hand, present notions of contract law in the EU remain largely nineteenth century anthropomorphic, stuck in concepts of intent and will, defences, excuses, and fault, and still looks for a unitary approach, especially relevant in contract law but also in the law of fiduciary duties. It is consumer law and that remains the basic model in the perception of most, see the discussion in Volume 2, chapter 1. Yet, it is not fragmentation but rather an imcomplete understanding of modern trends and developments that threatens here the development of EU law.597 However that may be, in terms of law formation authority, the EU authority is not broader in

597  See more recently for the quest to build a new unitary contract law system on consumer law concepts amplified by some commercial law, RSchulze and F Zoll, European Contract Law (2nd ed, Hart Publishing 2018) 25.

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consumer law and small investor protection law: all EU competencies in these fields derive from the needs of the operation of the internal market and there is no original law making jurisdiction. Even the relevant Directives and Regulations in the areas of consumer law and small investors’protection are based on Article 114 TFEU and its limitations and this includes also business to consumer commercial contracts, see notably the Unfair Commercial Practices Directive of 2005, although it must also be admitted that Article 114 TFEU has been pushed ever further even to underly and create the new the system of European Supervisory Authorities, see ­section 3.7.2 above and the Single Resolution Board and Single Resolution Fund see ­section 4.1.3 below. In the meantime, it must be considered how implementation of EU financial regulation and its implementation in Member States especially in the area of civil consequences must be perceived and handled. In the literature there is considerable confusion on how this must be done, whether we are here talking about adminstrative law, private law, or a mixture, ECJ case law seems to opt for the latter and not to be much bothered,598 and whether there is here a broad infusion of EU general principles into Member States’ private laws as some suggest. In Italy, Spain and France there may be a greater inclination to use and integrate domestic contract law in the pursuit of EU integration also at this level, in the UK on the other hand there was a greater disposition to separate the regulatory and contractual response.599 From an EU perspective, these issues may be less than urgent as long as financial stability is not directly endangered and the EU objectives are not demonstrably frustrated, better if a ‘harmonious interpretation’ into domestic private laws can be obtained.600 Without a clear mandate, the EU may hesitate to enter into legal characterisation and qualification issues at Member State level to sort out the differences. The essence remains that under proper conduct of business rules contracts may be deemed void or might have to be taken over by the relevant intermediary who may also need to pay damages. As long as that can be substantially achieved under local laws, there is no great need for EU intervention and it becomes a matter of subsidiarity. 598  See for authors O Cherednychenko, ‘Contract Governance in the EU: conceptualizing the relationship between investor protection regulation and private law’ (2015) 21(4) Eur LJ 500; J Kondgen, ‘Policy responses to credit crises: does the law of contract provide an answer?’ in S Grundmann et al (eds), Financial Services, financial crises and general European contract law:failure and challenges of contracting (Kluwer Law International 2011) 35; S Grundmann, ‘The banking union translated into (private law) duties’ (2015) 16(3) Eur Bus Organ Law Rev 357. The ECJ in Genil 48 SL et al v Bankinter SA et al May 30 2013, C -604 /11 took the view that indeed ­Member States decide on the civil action (eg in terms of causality and remoteness) and on the consquences, subject, however, to the equality and effectiveness principles, cf Art. 69 (2) MiFID II, meaning that the proper application of EU law and its objectives cannot be frustrated. It raises the issue wether under local law the consequences could be more severe than EU law suggests. This case did not answer the question. What may perhaps be more interesting is that the ECJ did not appear to object to a combination of the horizontal effect of administrative law and private law protection in Member State laws, therefore some cocktail. It is in this connection also of interest to consider in how far the parties may deviate from the protections intended by EU regulation. In respect of the smaller investor that would hardly seem possible unless the general good may still require it beyond what MiFIDII now provides. 599  See Andenas, n 596 above at 459ff. 600  This is not guaranteed as became clear in the Danish Ajos case where European general principle was not accepted as guidance notwithstanding the preliminary opinion of the ECJ in Case C-441/14 Danks Industri (DI), acting on behalf of Ajos A/S v Estate of Karsten Eigil Rasmussen, EU:C:2016:278, but it may be different if general (and fundamental) principle can be directly tied to the text of treaty law, Directives or Regulations, see for fundamental and general principle in the EU, Vol 1, ch 1, ss 1.4.6/7.

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4.1  The European Banking Union 4.1.1 Introduction The financial crisis of 2008, which preceded a much more serious government debt crisis especially in Europe in the eurozone after 2010, was in that zone perceived ultimately to be a possible threat to the stability of the euro itself and as such to the continued existence of this currency. The fragmentation of the financial sector in the eurozone was cited as a contributing factor.601 Probably more important was that the attendant need for a common safety net between banks would suggest a single regulatory regime or at least centralised supervision, even though, as we have seen, the ECB as the new single banking regulator for eurozone banks in many of these activities still operates under the laws of Member States, even if harmonised by Directives. It is also hemmed in by the drive for a single rule book organised by the EBA which goes beyond the eurozone. Without affecting these limitations and fully respecting the framework of CRD and CRR, see ­section 3.7.4 above, the new EU Regulations in this area underpin the ECB’s authority more directly, of which the Regulation of 2013602 is the most immediately relevant. It created the Single Supervisory Mechanism (SSM) in the Eurozone as First Pillar and set the scene for the Single Resolution Mechanism (SRM) and the Single Resolution Fund (SRF) as the Second Pillar: see ­4.1.2 and 4.1.3 below. It also provided the background for the third pillar, the Single Deposit Guarantee Scheme, which remains, however, contentious and a project for the future. The SSM is important in another respect as according to Recital 9 of the Preamble to the 2013 Regulation, banking supervision by the ECB could also help to activate the European Stability Mechanism (ESM),603 for it to be used to recapitalise banks in the eurozone. This facility itself is meant as a bailout fund for Member States (not directly for banks) who are subject to the European Fiscal Compact, see also ­section 3.7.1 above for the EU initiatives after 2008, but they may use it also to save their banks if this has become a stability issue for them. This should be well distinguished from the SRM facility, which, as we shall see in ­section 4.1.3 below, is based on

601  See Preamble 2 Council Regulation (EU) no 1024/2013 of the European Parliament and of the Council conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions [2013] OJ L287/63, now commonly referred to as the Single Supervisory Mechanism or SSM. 602  See nn 554 and 601 above. 603  It is an intergovernmental body established in Luxembourg. The ESM like the TSCG were not accepted by the UK because it smacked of fiscal union and suggested a measure of mutualisation of sovereign and banking debt. It was therefore the subject of a separate inter-governmental agreement called the Treaty Establishing the European Stability Mechanism, but it is meant to be fully compatible with existing law and the ECJ is competent to deal with its legal status. To this end, the UK agreed to an amendment of Art 136 of the Treaty on the Functioning of the European Union (TFEU), giving the ESM and also the SRF legal legitimacy in the EU by adding: ‘The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensible to safeguard the stability of the euro area as a whole. The granting of any required assistance under the mechanism will be made subject to strict conditionality.’ That refers especially to state aid restrictions. Again, it is to be remembered that it is a mechanism to save Member States, not banks, unless the relevant Member State wants this help to also include its banks in order to save itself. See further also the discussion in s 3.7.1 and n 30 above.

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a bail-in of depositors and bondholders and is supplemented at that level by the Single Resolution Fund (SRF).

4.1.2  The Single Supervisory Mechanism (SSM) and Resolution Regime (SRM) The SSM envisages a banking union for the eurozone with the ECB as the central regulator helped by national regulators. It directly regulates the major banks in the eurozone,604 around 120. The remaining (about 5,000) are covered by the local regulators although under the ultimate responsibility of the ECB. Banking licences also remain local subject, however, to the various EU Directives in this area, but always as incorporated in the laws of Member States. Although there is therefore a single banking regulator in the eurozone as of November 2014, the regulatory regime is not fully unified. It has already been noted that harmonisation through Directives even in the area of capital adequacy left the final word to Member States and this was not to change, at least not immediately. The Committee structure as developed (see s­ ection 3.7.2 above) also remains in place and it was already said that the ECB will have to respect this, especially the power of the EBA in respect of the Single Rule Book for EU banks it is creating (see Recitals 7 and 32 of the Preamble to the 2013 Regulation) and covers all banking in the EU, therefore not merely the eurozone banks. Although in the eurozone, licences are now granted or withdrawn by the ECB (Article 14), which is also in charge of prudential supervision, again is strictly speaking done under local laws (unless specifically superseded by the SSM Regulation; the ECB can do stress tests, for example, and also has the power under Article 5 of the Regulation to impose extra counter-cyclical capital buffers—this is a beginning of macroprudential supervision: see s­ ection 1.1.14 above). Member States who may still propose and advise on licences remain in charge of the formalities, however, and there is here an area of overlap and potential confusion. International relations also remain the competency of the Member States, therefore also the licensing of branches of non-EU banks and their supervision (Article 8), see further the discussion on equivalence and recognition in ­section 3.7.17 above. Conduct of business also remains local or cross-border, subject to the established home/host regulator divisions of labour. No less is there overlap in the relationship with the ESRB, which is part of the Committee structure, as we have also seen, and gives advice on financial stability issues. Although this Board can only issue recommendations and its role and remit may not be fully clear, as already mentioned the ECB has specific macro-supervisory responsibilities under the SSM. Even though they are limited under Article 5 of the 2013 SSM Regulation, again, because much of this authority is still domestic in Member

604  They are the banks whose asset value exceeds €30 billion or more than 20 per cent of their country’s GDP (unless assets are less than €5 billion), or who are the top three banks in their country. The ECB decided which these were for the time being in September 2014.

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States, under the SSM, notably in the important area of determining counter-cyclical buffers, the ECB can increase these buffers as already mentioned and also ‘apply more stringent measures aimed at addressing systemic or macro-prudential risk at the level of credit institutions’ (Article 5(2)). This suggests a commingling of micro- and macro-­prudential supervision at the level of the ECB. It does not apply to the leverage ratio, which is still not perceived as variable and counter-cyclical in the EU.605 Participation is automatic in eurozone states, but the SSM cannot be enforced in non-euro countries. The ECB cannot therefore carry out its tasks in those Member States either; this is left to home regulators under the existing rules, which therefore also continue to govern the right of establishment in non-eurozone EU countries and how they are being exercised. Non-eurozone Member States may, however, enter into a ‘close cooperation agreement’ with the ECB. Their banks are then supervised by the ECB and they get a seat on its Supervisory Board. The powers of the ECB are extensive, which raises in particular the question of the legal framework in which it operates and the issue of recourse.606 Article 22 of the 2013 SSM Regulation requires due process, especially a hearing for aggrieved persons, for example, when licences are refused or withdrawn (Article 22), taking into account also the Charter of Fundamental Rights (Recital 63), but this does not apply in situations of urgency or to macro-prudential supervision under Article 5. The ECB’s acts are subject to review by the ECJ without prejudice, however, to the ‘margin of discretion left to the ECB to decide on the opportunity to take these decisions’ (Recitals 60 and 64).607 Under Recital 61, the ECB must make good any damage caused by it under ‘the general principles common to the laws of Member States’. There is here a reference to Article 340 TFU, but the standard is not clear. It raises serious issues, more in the case of principle or judgement-based microsupervision, but also in macro-financial supervision, if not immediately of the countercyclical type—see again for these concepts ­section 1.1.14 above. Recital 30 at the end refers to the ‘principles of equality and non-discrimination’ (legality and proportionality are not mentioned) but it is preceded by a long policy declaration emphasising first the safety and soundness of credit institutions, the stability of the financial system, and the unity and integrity of the market. The protection of depositors comes later and there may of course be considerable conflicts of interest; see also the discussion in ­section 1.1.11 above. The legal framework and recourse possibilities appear weak for financial institutions. Clearly in the present climate it had no priority; see further the discussion in s­ ection 4.1.5 below.

605  The cost of the SSM is borne by the banking sector and was estimated for 2015 to be at €260 million per annum. 606  See JH Dalhuisen, ‘The Management of Systemic Risk from a Legal Perspective’ SSRN.com search under Jan Dalhuisen. 607  Under Art 24, an Administrative Board was set up to conduct internal administrative reviews of the decisions taken by the ECB in the exercise of the powers conferred on it by the SSM Regulation. It pertains to the procedural and substantive conformity of the decisions with the Regulation and concerns the issue of legality. One must assume here a formal attitude allowing fully for the substantial discretion given the ECB, not in the least in its macro-prudential role.

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4.1.3  The Single Resolution Mechanism (SRM), the ECB, the Single Resolution Board (SRB) and the Single Resolution Fund (SRF) As we have seen, the need for a resolution regime led to a first EU proposal in June 2012 (see ­section 3.6.3 above) and to a new Directive in this area for all of the EU or BBRD, see s­ ection 3.7.16 above. In an extended form, it subsequently became an integral part of the euro banking union and is its second pillar after the SSM. Firm proposals were published in July 2013 and the relevant Regulation was approved in April 2014.608 Creditors, including depositors to the extent not guaranteed or secured, are made liable for at least eight per cent of the shortfall.609 An important feature is the supplementation of the SRM by a Single Resolution Fund (SRF). The establishment of the latter required yet another inter-governmental agreement or treaty among the eurozone members, which was agreed in December 2013 and signed in May 2014. A further Regulation of April 2014 established a Single Resolution Board (SRB). While the ECB has the principal responsibility for declaring a bank likely to fail, it is the Board that has the duty to determine that no other solution is viable. It subsequently assesses in co-operation with national authorities the need for and manner of resolution of banks in the relevant Member State participating in the banking union and draws up a plan. The ultimate decision lies with the European Commission, which can also activate the SRF. The SRB thus only prepares the plans and issues guidance to the national resolution authorities but does not itself take decisions. It is particularly in this area of resolution where the lack of legal protection for affected parties is a serious issue. This is no bankruptcy regime which carefully balances the interests of all. The issue has already arisen where rather than imposing a haircut on creditors including bondholders and depositors, bad banks are created and a ­division is made between good and bad assets and liabilities. That determination itself needs due process but this is hardly forthcoming, see further also the discussion on this issue in ­section 4.1.5 below.610

608  Regulation (EU) No 806/2014 of the European Parliament and of the Council of 15 July 2014 establishing uniform rules and a uniform procedure for the resolution of credit institutions and certain investment firms in the framework of a Single Resolution Mechanism and a Single Resolution Funds and amending Regulation (EU) No 1093/2010 [2014] OJ L225/1. See M Schillig, Resolution and Insolvency of Banks and Financial Institutions (Oxford, 2016). 609  The trigger point remains uncertain but is put before the moment of insolvency either as a liquidity or balance-sheet issue. The EU Resolution Directive 2014/59/EU of 15 May 2014 [2014] OJ L173/90 (BRRD), s 3.7.16 above, on which the SRM elaborates, insists on earlier intervention but the defining moment is unclear. Recital 7 of the Preamble refers in this connection to the circumstances in which the failure occurs, making a distinction between fragility of the system as a whole and the plight of an individual bank. Recitals 40 and 41 may be a little more specific but leave the ultimate decision with a resolution authority. This suggests broad discretion. But failing the licensing requirements is itself not sufficient. The need for emergency liquidity is not decisive either. Rather ‘an institution should be considered to be failing or likely in the near future to fail when (a) it infringes or is likely to infringe the requirements of continuing authorization, (b) when the assets of the institution are or are likely in the near future to be less than its liabilities, (c) when the institution is or is likely in the near future to be unable to pay its debts as they fall due, or (d) when the institution requires extraordinary public financial support except in the particular circumstances laid down in the Directive’. 610  Recitals 60–65 of the Preamble set out certain rights of shareholders and creditors and concentrate on their contribution. Equitable (not equal) treatment of creditors is the aim and the public interest is invoked to

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Early implementation efforts stranded on exceptions created in practice in Spain and Italy in 2017.611 The whole idea is probably misconceived. Again, it is the task of governments to save their banks in a crisis when regulation has once more failed, all the more so if we accept that banking instability is the consequence of government policy, see also the discussion in s­ ection 1.3.7 above. The creation and management of the SRF had itself been contentious from the beginning, as well as the contributions. As just mentioned it required a special intergovernmental agreement. The transfers from national entities to the SRF as an EU body needed to be covered by this and are not governed by the Regulation proper. It was ultimately decided that banks would make contributions ex ante so that in the eight years after 1 January 2016, one per cent of the projected deposits of all banks in the banking union would be covered. This is estimated to create a fund of €55 billion. More may be demanded ex post if this proves insufficient. It is not said how it is to be invested. The result is a form mutualisation of banking debt in the eurozone.

4.1.4  The Single Deposit Guarantee Scheme (SDGS) The status of the deposit guarantee schemes and relevant EU Directives has already been reported in s­ ection 3.6.2 above. This system remains in place, although restated in a new Directive in April 2014,612 and is therefore still national subject to harmonisation in all EU countries but it is intended that for the eurozone a single deposit guarantee scheme will be developed. That would be the third pillar of the Banking Union but remains a project for the future. It suggests a further form of mutualisation of banking debt, so far strongly resisted by Germany.

4.1.5  The Commingling of Competences and the Lack of a Robust Legal Framework of Recourse in the Eurozone Banking Supervision and Resolution Regime Financial regulation raises major legal issues, especially the question of its legal embedding and the recourse of participants against its failure and the shortcomings in its rules and in all matters of their application. At its best, financial regulation provides a legal framework within which the financial business must be conducted. This would

support regulatory discretion regarding the treatment of creditors in the same class. Art 52 of the Charter of Fundamental Rights is mentioned but subject to the imperatives of financial stability which is also invoked to justify the avoidance of ordinary insolvency proceedings. Interference in property rights (secured transactions) should not be disproportionate. The limit is whatever shareholders and creditors would have received in an immediate liquidation. This raises important valuation issues which evaluation, according to the Regulation (nos 63–65), should already be commenced in the early intervention phase. See further Dalhuisen, n 601 above. 611  612 

See for the fraught implementation so far n 195 above and accompanying text. Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 [2014] OJ L173/149.

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then result in it being taken out of politics and left to regulators as an administrative function, at least that becomes the idea. Although one may be sceptical, particularly of the impact and effect of all micro-management through financial regulation, that kind of regulation cannot be based on discretion. It can also not lead to a direct involvement of regulators in the running of the financial industry. Regulators are not equipped for this and, except perhaps in emergencies, they should not do so, as was discussed in ­section 1.1.8 above. It would lead to a financial system being operated by complete amateurs. Ideas of legality, equality, proportionality and non-discrimination also falter in such an environment. Pursuits of private preferences or vindictive attitudes in regulators or desires to impose large fines and create an income in this manner get free space. As far as these regulators are concerned, in egregious cases, they and their organisations should be accountable for the consequences of their interference, not least also in terms of civil liability. But it is not counter-intuitive that regulators should do more than box ticking, should be proactive, and also be able to consider any destabilisation forces that may surface, affect and undermine the safety and credibility of the financial system and its liquidity-providing and recycling function, see further s­ ection 1.1.14 above. How this is to be framed and guided from a legal point of view then becomes a key issue. It was already noted that this subject is further complicated by the intensive globalisation of the financial markets and financial service industry and the extensive cross-border activity of all major banks, see s­ ection 1.3.11 above. At least for the eurozone of the EU, as we have seen, there is a system of home/host country competency and now a form of banking union in the eurozone. Under it the powers of the ECB are particularly extensive: monetary, lender of last resort, micro-financial regulator, resolution originator, macro-prudential supervisor, and in practice protector of the currency, probably even of banks, and, in the extreme, lender of last resort to governments. The result is many potential conflicts of interest. This raises all the more the question of the legal framework and the issue of recourse for participants. The robustness of the rules in this regard where administrative discretion and policy remain paramount may be seriously questioned and it must be considered whether this is the right price to pay for a new approach that remains untested and may be unlikely to make a difference in a crisis. To resume the discussion in s­ ection 1.1.14 above, even in the UK, we see that when it comes to protecting individuals, especially depositors, borrowers and investors, principle-based micro-prudential regulation may become more proactive. The least that is meant is to treat customers fairly (TCF), although notably in common law countries this raises the issue whether such an attitude and broad principle, probably clarified by the rules issued by regulators, can still give rise to a private cause of action for harmed customers vis-à-vis the offending financial institution. In ­judgement-based supervision, on the other hand, the emphasis is more directly on greater discretion in enforcing the authorisation requirements of banks. It is still considered part of the micro-­financial regulatory regime, and therefore part of a legal framework, but increased discretion immediately limits the administrative recourse possibility or judicial review facility for affected financial institutions. In macro-prudential supervision, on the other hand, the emphasis is on policy and the legal framework may be

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s­ ubstantially abandoned altogether or be reduced to a mere organisational framework. It is not different for monetary policy. It has already been said that if the accent is on anti-cyclical capital and liquidity measures, which are considered in this book as the essence and rationale of macro-prudential supervision, legal recourse is unlikely, just as there is none against the consequences of fiscal and monetary policy. But there may increasingly be overlap and in practice we may imagine a cluster of complications. Assume the macro-regulator in its view of what financial stability may require from time to time forces new models and systems on the financial services industry while notifying to that effect the local micro-prudential regulators. Presumably it will be a general measure not directed at individual financial intermediaries in the nature of all macro-policy, although it is possible that local micro-regulators do not apply them across the board but discriminate, perhaps because these rules cannot work effectively for all for whatever reason. Imagine further that these new systems and models prove defective when there are several possibilities as to who suffers. If the solvency of the intermediary is affected, shareholders will be first in line. If the reporting to clients is affected, they may no longer know where they stand. This is then a matter of conduct of business of the intermediary but subsequently conceivably also a matter of regulator liability in respect of both intermediary (if it had to pay the depositor/ investor) and depositor/investor directly if they cannot recover from the intermediary. Note in this connection that in the eurozone the ECB is the most prominent macroprudential supervisor but is not given here specific powers in conduct of business and market integrity matters but indirectly it may get there. Of course, it has also its function as the ultimate micro-prudential supervisor at the same time, although that is within a legal framework where, however, it is left with considerable powers in arranging the rule books. The issue is whether macro-prudential supervision extends these powers. It has already been mentioned that Article 5(2) of the EU SSM Regulation of 2013 gives the ECB important macro-prudential authority much beyond what is given to the new Financial Stability Committees. It focuses on imposing higher capital buffers ‘if deemed necessary’, including counter-cyclical buffers, even if it is admitted in ­Article 5(1) that this remains foremost the competence of national authorities. Again, this function is seen in this book as macro-economic policy besides monetary and budgetary policies, the rest of macro-prudential policy—notably in the area of resolution and new risk management systems (addressed to and imposed on the miniprudential regulator as just mentioned)—being quite different. However, reading on, this power of the ECB is not limited to setting extra capital buffers but it may indeed also apply ‘more stringent measures aimed at addressing systemic or macro-­ prudential risk’. That is a very broad brief. It may affect not only the capital and liquidity requirements, even leverage ratios, but also the fit-and-proper test (beyond its micro-­prudential powers to remove members of management, Recital 46 of the Preamble) and especially systems and models with the potential of overruling the micro-prudential legal framework. If things go wrong, micro-prudential regulators and the ECB in that role under national laws would be first in line of recourse, but are they immune, especially the ECB while exercising macro-prudential powers on top of its micro-prudential ones?

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Do shareholders have a class action against the competent regulator if the financial entity suffers? If individual depositors or investors are affected, do they have an action first against their immediate intermediary? Do they and the intermediary subsequently also have an action against the micro-prudential regulator? And does the latter (and the aggrieved parties) also have an action against the macro-prudential regulator when guiding the former? Even a judgement-based approach in micro-supervision may incite an arrogant disposition in regulators, much complained of after 2008, but macroprudential supervision or guidance further complicates the issue of liability. Is the local micro-regulator discharged because it acts upon instructions of the macro-regulator (the ECB in that function)? Can, on the other hand, there be a recourse between microand macro-regulators if the former have to pay up? What does the duty of the ECB to make good any damage under Article 340 TFEU mean in this connection, quite apart from the further reference in Recital 61 of the Preamble to the ‘principles common to the laws of the Member States’, except setting here an independent standard, which is itself unclear? What does the reference to the principles of equality and non-discrimination referred to in Recital 30 mean in this connection? It is preceded by a long policy declaration emphasising (a) first the safety and soundness of credit institutions, (b) the stability of the financial system, and (c) the unity and integrity of the internal market. Micro- and macro- prudential considerations come here officially together and complicate any legal recourse further. The protection of depositors comes later and there may of course be considerable conflicts of interest. Altogether, the legal framework and recourse possibilities appear weak for affected financial institutions and individual depositors and investors. Clearly in the present climate, it had no priority. A reference to legality and proportionality is here notably also missing. On the other hand, it was already said that the macro-prudential supervision in as far as it deals with the pro-cyclical aspects of banking, is not regulatory proper and should then not be considered in terms of legal recourse. Thus at least to the extent countercyclical capital barriers and liquidity requirements or leverage ratios are imposed or increased, it would appear understandable that there is no recourse, but it might not be so for the rest of macro-prudential supervision and it raises in any event serious issues in the case of macro-prudential guidance where it impacts on micro-prudential supervision (and no less the resolution regime). It was already mentioned before that these three areas of macro-supervisory involvement should be clearly distinguished. Beyond this, it is uncertain what the references in terms of protection add up to in terms of legal recourse except pious statements. The immunity of the ECB in particular is constantly reinforced. But who then is accountable and responsible and for what? At least it is said in Recital 53 that the ECB has no power to impose fines other than on credit institutions (banks) but by exercising macro-prudential powers in the broader sense potentially instructing micro-prudential supervisors, they may well contribute to a punitive environment and culture. In this connection, the powers of the ECB under the resolution regime also need greater consideration. In fact, under the Single Resolution Mechanism (SRM), the type and degree of protection is not much clearer. Preamble 46 of the SRM Regulation puts the Resolution Board at the center although it is the ECB which has the principal

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responsibility for declaring a bank’s likely failure and has therefore the initiative. Only then will the Board take ‘necessary and proportionate’ measures. Article 27(5) of the Regulation also refers to this concept following Article 44(3) BRRD. In view of the safeguards under Article 16 of the Charter of Fundamental Rights, the Board’s discretion and its measures are here seen as limited to what is necessary to simplify the structure and operations of the [relevant financial] institution … consistent with Union law … neither to be directly or indirectly discriminatory on grounds of nationality … [but] justified by the overriding reason of being conducted in the public interest in financial stability … [although the Board] should be able to achieve the resolution objectives without encountering impediments to the application of resolution tools or its ability to exercise the powers conferred on it by this Regulation … [but] action should not go beyond the minimum necessary to attain the objectives sought.

The Single Resolution Board (SRB) and, where applicable, the national resolution authorities should also take into account the warnings and recommendations of the European Systemic Risk Board (ESRB). As the EU Commission takes the final decisions in matters of resolution, it also become involved and Preamble 30 identifies here two situations: resolution action involving state aid or fund aid. State aid must be compatible with the operation of the internal market, fund aid may be made conditional (without limitation) on burden sharing, losses to be absorbed first by equity, contributions of hybrid capital holders, subordinated debt holders and senior creditors. There may be restrictions on the payment of dividends or coupons, on the purchase of own shares, and acquisitions, either through an asset or share transfer, and prohibitions against aggressive commercial practices. The SRB on the other hand under Preamble 49 concentrates on the nature of the business, shareholding structure, legal form, risk profile, size and legal status and interconnectedness to other institutions, scope and complexity of activities and the effect of ordinary winding up under the normal insolvency proceedings would have a significant negative effect on financial markets or wider economy, ensuring that the regime is applied in an appropriate and proportionate way and that the administrative burden is minimised. It may deviate from the BRRD (Section A of the Annex) in the resolution planning and information requirements on an institution specific basis. The resolution tools themselves are described in Preambles 65 and 68 ff: sale of the business, the creation of a bridge institution, bail-in, and the asset separation tool. Secured, collateralised or otherwise guaranteed claims are not subject to the bail-in, nor are claims covered by deposit protection schemes or those that cannot be bailed in within a reasonable period of time or are necessary for the continuation of the business or will be destructive to the rest of the business or spreads contagion, probably meaning the causation of a bank run (Preambles 76 and 77). Other claims may then be bailed in to a larger extent or if not possible, the Fund will contribute provided that at least losses amounting to eight per cent of total liabilities have been absorbed. Other problems loom. Under Preamble 57, the SRB is required to place an institution under resolution before balance sheet insolvency and before all equity is wiped out, but it may still be different when the entity continues to be viable. Preamble 60 further

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requires the SRB, the EU Commission and the Council to ensure that r­ esolution action is taken in accordance with certain principles including that shareholders and creditors bear an appropriate share of the losses, that the management should in principle be replaced, that the cost of resolution are minimised and creditors of the same class are treated in an equitable (not equal!) manner, barring any discrimination on the basis of nationality. There may be a problem in particular with the separation of creditors between old and new entities. Preamble 62 invokes Article 52 of the Charter and states that the resolution tools should only be applied to those entities that are failing or likely to fail and only where necessary to pursue the objective of financial stability in the general interest. Again, the concept of stability is not defined. In particular, resolution tools should be applied where the entity cannot be wound up under normal insolvency proceedings without destabilising the financial system and the measures are necessary to ensure the rapid transfer and continuation of systematically important functions and where there is no reasonable prospect for any alternative private solution. Note this is all a matter of opinion. Preambles 62, 63, 64 and 65 require any interference with property rights to be proportionate and affected shareholders and affected creditors should not receive less than they would have in an immediate liquidation. This is another (rare) reference to the proportionality concept in this connection, see further ­section 4.1.6 below. Again this is at best a question of ex post estimation and raises the vital issue of valuations. A right of appeal is here delayed to an appeal of the resolution decision itself. Interesting no doubt is the provision that any shortfall will be made good for affected shareholders and creditors by the SRF. Finally, Preamble 120 of the SRM Regulation introduces the ECJ, which is given the jurisdiction to review the legality of the decisions adopted by the SRB, the C ­ ouncil and the Commission under Article 263 TFEU as well as for determining their non-­contractual liability. It may also give preliminary opinions under Article 267 TFEU upon request of national judicial authorities on the validity and interpretation of acts of the institutions, bodies or agencies of the Union. National judicial authorities are competent in accordance with their national law to review the legality of decisions adopted by the resolution authorities of the relevant Member States in the exercise of the powers conferred upon them by the Regulation as well as determine their noncontractual liability. A further reference to the Charter is made in Preamble 121. In summary, it may probably be said that the recourse framework concerning systemic risk and its regulatory supervisions was not given a great deal of attention after the crisis of 2008 and is not strong as policy considerations took precedence over protection of financial intermediaries and depositors, borrowers and investors alike. Legally, one cannot therefore be at all confident in these matters. The issue of recourse and liability did not rank high, probably due to a negative attitude to the financial service industry, which is only popular at the top of the cycle when it gives money to all but, it was submitted all along, is then in fact at its most dangerous. After a crisis, we commonly live in a payback attitude in respect of banks. Whether this makes sense is another matter and whether it sets these banks up better for the future is a matter of opinion. It is not a good climate to provide for proper recourse.

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4.1.6  The Issue of Proportionality in the Application of the EU Financial Regulatory Framework in the Eurozone In Article 92 CRD 4 (and in its Preamble 66) and in Article 27(5) of the SRM Regulation, express references are made to the concept of proportionality, which is also mentioned in Preamble 46 and Preambles 62 ff SRM Regulation as we have seen. What does it mean in this context and what does it contribute? First, all EU acts are in principle subject to the concept of proportionality (Article 5 TEU) which means that ‘the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties’.613 As such, the above specific references would not appear to add much except that not referring to this principle in other instances, where it would also have been more than relevant, would appear to have some meaning and in the limited areas where the concept is mentioned, there may be some further definition which often confines it. The more pedestrian interpretation is that all EU measures must be fit for purpose. It may then also be associated with an imbalance between measures and benefit but the application depends on the area of the EU activity and on the competent decision-makers. The bias is generally pro-EU, pro-integration and pro-single market, but there may be variations depending on issues of administrative discretion, rights of individual, and enforcement like in EU competition law. In matters of procedure, the emphasis is usually on openness, transparency and participation instead. A distinction is often made between its ex post (as to how norms are applied) and ex ante application. Ex post, there is the issue of legality and competences, also the question of proper measures having been used. Ex ante, proportionality may be more of an organising principle, at least in banking regulation and supervision, going into the suitability of the measure, its necessity and appropriateness, perhaps even of the regulatory objectives, avoid unnecessary burdens, achieve coherence, and assume a cost–benefit analysis. This being said, under it, there is generally no recourse to a fully-fledged balancing of interests, but there appears to be little consistency in the decisions. The concept may be a threat to predictability, even to effectiveness and efficiency, and should therefore probably be invoked only exceptionally.614

613  But see Peter Gauweiler v Deutscher Bundestag, ECJ Case C-62/14 of 16 June 2015, which may be more liberal: ‘proportionality requires that acts of the EU institutions be appropriate for attaining the legitimate objectives pursued by the legislation at issue and do not go beyond what is necessary in order to achieve those objectives.’ It concerned a) the ECB’s authority to the purchase in the secondary market government bonds issued by States in the eurozone under its Outright Monetary Transactions (OMTs) programme (which had been a response to the government debt crisis and the difficulty for some eurozone governments to place their bonds despite the European Stability Mechanism put in place for direct government financial assistance), b) the prohibition of monetary financing of Member States in the eurozone, c) the powers conferred on the ECB and the European System of Central Banks, and d) the monetary policy objectives. In the event it was held that the ECB had not exceeded its powers in monetary policy and that its action had not been disproportionate. It was the first time the German Constitutional Court made a formal reference to the ECJ. 614  See also C Hadjiemmanuel, Banking Union and the Debate on Proportionality: a Concept Paper, presentation University of Oslo, Sept 2017, who pleads in this context for a sharper distinction between smaller and bigger banks.

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As for the few references in financial regulation at the EU level identified above, it is of interest that in Preamble 66 and Article 92 CRD 4, which deal with remuneration, for proportionality the idea is to take into account the different institutions, ‘their size, internal organisation, and the nature, scope and complexity of their activities’. In the Preamble 46 to the SRM Regulation, as was noted in the previous section, the SRB will take ‘necessary and proportionate’ measures upon instigation of a resolution by the ECB, see also Article 27(5) (following Article 44(3) BRRD). It was already noted in the previous s­ ection and may be usefully repeated that in view of the safeguards under Article 16 of the Charter of Fundamental Rights, the Board’s discretion and its measures are here seen as limited to what is necessary to simplify the structure and operations of the [relevant financial] institution … consistent with Union law … neither to be directly or indirectly discriminatory on grounds of nationality … [but] justified by the overriding reason of being conducted in the public interest in financial stability … [although the Board] should be able to achieve the resolution objectives without encountering impediments to the application of resolution tools or its ability to exercise the powers conferred on it by this Regulation … [but] action should not go beyond the minimum necessary to attain the objectives sought.

According to Preambles 62, 63, 64 and 65 BRRD any interference with property rights must also be proportionate, meaning in this connection that affected shareholders and affected creditors should not receive less than they would get in an (immediate) liquidation. It was suggested above that the few express uses of the concept of proportionality in the EU financial regulations and directives, where in each case some clarification is attempted, may well serve to limit the impact of the principle. On the other hand, it may be questioned whether in the setting of the SRM the concept could conceivably even be used to apply ordinary bankruptcy rules to the resolution regime where more detailed rules are missing and systematic stability considerations and public interest test (Article 32(5) BRRD and Article 18(5) SRM Regulation) do not prevent it.615 It was already submitted that it is undesirable and a bad idea to have a resolution regime without rules. But perhaps the whole situation is fraught and the concept of proportionality therefore hardly operative in the present regulatory environment in finance in the EU given the nature of the concept itself, the regulatory set-up in the EU, and more in particular in the eurozone. For the concept of proportionality to properly work, one needs a clear rule and clear objectives. In other words, the concept can hardly be used to define a rule which is otherwise unclear or formulate obscure objectives. Where there is clear discretion given, or when the situation is too political or suffers from contradictory rules or is riddled with conflicting interests, the principle can hardly work. These are issues for the legislator to resolve. In this connection, the background of and situation created by the financial regulatory framework in the EU and more in particular in the eurozone may make the concept of proportionality hardly relevant. That would be all the more so in banking resolution. 615  See J-H Binder, ‘Proportionality at the Resolution Stage Calibration of Resolution Measures and the Public Interest test’, SSRN.com. See for the fraught implementation so far, n 195 above.

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The situation is that we have the ECB, all too readily perceived as some pinnacle or beacon of light, but it is riddled with conflicts of interest, see the previous section, which simply follow from the fact that it is in charge of monetary policy, lender of last resort to the banking system, micro-prudential supervisor, macro-prudential supervisor, resolution authority, organiser of QE, and in crises effectively also lender of last resort to eurozone governments, see the previous section. It has been said that it will do whatever it takes to protect the Euro and apparently also the Southern European banking system. Its position has become highly political as a consequence, which sits uneasily with its independence and any rule-based system. It benefits from a strong immunity and the ECJ protects it.616 The SSMR makes it further very clear that even due process does not apply to its macro-prudential activities. Again, in such an environment, the judicial concept of proportionality cannot work. As for the regulatory system itself, its objectives are unclear. Three main prongs of all financial regulation were identified before: financial stability, conduct of business and market integrity. They may be contradictory, see the discussion in ­section 1.1.11 above. For better or worse, the regulatory emphasis is on stability, but as was mentioned before in ­section 1.1.2 we can hardly define it, especially because it is not clear what we want in terms of leverage and economic activity. It was submitted that the situation is further complicated by complexity, innovation, complacency, all kind of bubbles, the economic cycle and pro-cyclicity of banking. It is hardly possible for banking to be stable in such an environment and, it was said, we may not want it because it would drastically affect our borrowing and spending power. There would be less consumer credit and fewer student loans, no credit cards for the multitude. In fact, it was submitted that lack of stability is policy, the only challenge then left is how to handle it best, including chronic overleverage of society as a whole. According to Basel I and II, it resulted in hardly any capital, no liquidity requirements and no leverage ratios, but in affordable housing in the US, Fanny May and Freddy Mack, end of Glass-Steagall, interest rate manipulation by Central Banks and other accommodative policies. In the meantime, micro-prudential supervision is pro-cyclical: banks must build capital in a crisis, but we hardly mind what they do at the top of the market. Anti-cyclical macro-prudential supervision remains underdeveloped and there is little recognition that banking is at its most dangerous at the top of the cycle when all seems going well and there appears to be no risk or a need to build safety nets. Again, that is policy at the back of all of this, meaning that there is hardly room for the concept of legal proportionality to operate. Nevertheless, many still think that a micro-prudential rule-based supervision system is enough and will save us and that we can eliminate government from the scene, even devise a resolution system that leaves the risk at least in part with depositors and senior bondholders and does not hold government to account. But how is it possible when it determines all policy? In the eurozone, the SRM was the further result with hardly any proper form of recourse left. Indeed, it already has given rise to multiple litigation, in a short time more than in all EU banking supervision before. In the meantime, Member States in Southern Europe do their best to create exceptions

616 See

Gauweiler, n 613 above.

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and that is not at all surprising, see ­section 4.1.3. The SRM may work in incidental cases but not when a whole banking system is at risk. Again, it is difficult to see what proportionality can contribute in these circumstances and what it is supposed to add or correct. Other observations are relevant. There is a deep divide in Europe, like anywhere else, about discipline. In the German view, it comes from the administrative state, in the English view in principle from the market. In the first view, regulation is rule-based and everything, all that is not regulated has the aura of illegitimacy. In the latter view, regulation is only support and correction. It is in fact policy. Add to this the different view of banking in the German culture617 where speculation in housing is not encouraged, only the rich have credit cards, and people save before buying a car, and it becomes clear that there is less leverage in such a society, banking is less cyclical (but not a good business.), a rule-based system easier to operate, stability easier to pursue and obtain, and regulatory discretion and government intervention less of an issue. In such an environment, proportionality might mean something, but most banking systems do not operate in that way and the German one is likely to be exceptional (and in fact itself increasingly under pressure from easier consumer credit). Finally, what about nationalism and a return to it even within the EU, hence Brexit, but also a desire for smaller, more national banks. It was already said that it is a romantic notion, especially against the background of the international flows of good, services, capital, information and technology and the globalisation of production and related sales and service, funding and payment activity, on which we are wholly dependent for our welfare. Small national banks cannot support the globalisation of production and sales activity, let alone take-overs and mergers. All would have to be syndicated. Nevertheless, more nationalism is momentarily a strong undercurrent that cannot be denied and in any event our value systems and (spending) cultures are still mostly nationally determined. Here again, proportionality and in particular its defence of the integration notion in the EU runs up against barriers which may be irrational but cannot be ignored. To repeat, proportionality cannot stand for judicial discretion or constitute a legal argument or force of its own in such an environment. The conclusion must therefore be that in the financial regulatory area in the EU at the supranational level, it has little meaning, hence also the very few references to it in the Directives and Regulations as we have seen, which, where used, all appear to confine the concept.

5.1  Summary, Evaluation and Conclusion 5.1.1  The Applicable Regulatory Regime Concerning Banking and Capital Market Activity Under the Latest EU Directives and Regulations In ­section 3.5 above, details were given of the regulatory EU regime concerning banking and investment firm activity under what were then the Credit I­nstitutions 617 

See n 535 above.

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Directive of 2006, the Capital Requirements Directive for investment firms of the same year, and the MiFID of 2004 together with the Prospective Directive of 2003. Important supporting Directives were CARD and the Transparency Directive. For open-ended fund management, there was UCITS and later the AIMFD to cover all others. The essence was the EU passport for financial services, for issuers, trading platforms and collective investment funds alike. In terms of the operation of the internal market, this was the immediate regulatory concern which sought to avoid double regulation in home and host country with the attendant negative effect on the free flow of financial services. But in formulating at the same time common regulatory standards to guide financial regulation which remained otherwise a Member State jurisdiction, there emerged other concerns, foremost the ones for financial stability, conduct of business and market integrity, where the Market Abuse Regulation operated besides the EU competition rules. In 2004 MiFID became also concerned with the operations and infrastructure of the financial markets and its products themselves. The 2013 and 2014 Directives (CRD 4 and MiFID II) and supporting Regulations (CCR and MiFIR) updated this framework and pushed it forward under the pressure of the 2008 financial crisis and its aftermath. In particular, MiFID II/MiFIR extended the coverage into the markets. Supporting regulation came here from EMIR for clearing and from the Short Selling Regulation. Ultimately there also appeared a regime concerning the involuntary resolution of banks, which covered a very different issue. Within the eurozone, in the meantime, there emerged the Single Supervisory Mechanism and centralisation of banking supervision in the ECB supported by an elaborate Single Resolution Mechanism, all building, however, on the existing EU framework for banks and financial market activity, especially the passports, the Single Rule Book, and the existing micro-prudential supervisory framework. In all of this, at EU level, it remained the case that there was never much of a guiding philosophy or policy. There were greatly different views on the form of capitalism and the role of the marketplace more generally, and on the desirable operation of financial markets or systems therein, on public or private sector interests, on supra-nationalism or Member State jurisdiction, on banking German style or banking as a societal leverage component. This led to an incremental and pragmatic approach basically building on a) the past regulatory structures as the best common denominator and on b) what were perceived as pressing needs, not in the least in terms of popular demands and perceptions. There was no model. At the G-20 and Basel Committee (and IOSCO) level, there may have been some more original thinking, no less stultified, however, by local interests in the implementation. Ultimately much depended on the American lead; in s­ ection 3.7.1 some of this was recorded. The sum total was that there was no fundamental new thinking as there had been (in the US) after the crisis of 1929. It probably demonstrated that the 2008 crisis had not been deep enough, the consequences never having exceeded the cyclical turns in the economy. Unemployment had even been higher in Western Europe after the oil crises in the 1970s. In those days, inflation was high but growth resumed quite quickly thereafter, not so after the 2008 financial crisis which lingered on longer, one aspect possibly having been the regulatory stifling of banks which could not resume their

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l­iquidity-providing function on the scale required. They were stuck with the microprudential tools and framework of the past, but much stiffened. It was earlier mentioned that instead we may need a much stronger macro-prudential component and separate regulator who decides on the size of banking in each phase of the economic cycle, see ­1.1.13/14 above. That is pure policy, which sits uneasily with microprudential supervision and also goes into the issue of the need for government support in times of crisis, which, it was submitted, the present resolution regime and ethos wrongly try to avoid or deflect. The end result is a poorly focused regulatory patchwork, in the EU and elsewhere. At EU level, it was in any event always more effective in the passporting, that is the promotion of the internal market, which had indeed been the more direct (single market) concern, than in the regulatory philosophy and the policies behind it. Issues of stability, conduct of business protection and market integrity remain then secondary, also in terms of jurisdiction. In the following, for the EU by way of summary, the attention will turn to seven areas: a) the institutional aspect of the regulatory framework and process in the EU, b) the passporting and the technique of passporting, c) the regulatory involvement in the market infrastructure, d) the aim of financial stability, e) the issue of conduct of business protection, f) the matter of market integrity, including abuse, money laundering and tax avoidance issues, and g) third country activity.

5.1.2  The Institutional Aspects of the EU Regulatory Framework and Process Within the limits of the TEU and TFEU, under which Member States retained in the financial sphere the ultimate authority in authorisation and enforcement matters, the EU operates in the financial area with Directives and Regulations (and earlier also ­Recommendations), see ­2.3.1/2 above. In doing so it is guided in particular by the promotion of the Single Market, see s­ ection 2.3.1 above. This is also called the Level 1 framework legislation. There is an important system of delegation, a matter of comitology,618 pursuant to the Lamfalussy Report mentioned in ­section 3.4.2. This is Level 2 where the Commission is authorised to adopt technical details.619 The European Securities Commission (ESC) operates at this level and may be given regulatory powers assisting the Commission. Advice may be asked from the banking, securities and insurance committees. After the financial crisis, this advisory committee structure was substantially reviewed, resulting in the European Supervisory Authorities (ESAs) in banking, investment and ­insurance within the European System of Financial Supervision (ESFS), see ­section 3.7.2 above,

618  See the Regulation (EU) no 182/2011 in this area and for its importance eg in the equivalence declaration, n 591 above. 619  Delegated powers resulted in particular under the Regulation of 25 April 2016 supplementing MiFID II, OJC (2016) 2396 final. The implementation powers of the Commission are subject to Regulation (EU) no 182/2011 of the European Parliament and of the Council laying down the rules and general principles concerning ­mechanisms for control by Member States of the Commission’s exercise of implementing powers, OJL 55/13 (2011). The ESC may be given supervision and veto powers in this connection.

Part III  The EU Regulations and Directives Concerning the Internal Market 923

notably the European Banking Authority (EBA) and the European Securities and ­Markets Authority (ESMA), in which system the ECS retained its role. In this set-up, Level 3 concerns the transposition in Member States, and Level 4 compliance. It is to be noted that under CRD 4, the EBA concerns itself also with authorisation matters for investment firms. This is therefore the institutional support structure of the passporting which is further backed-up by the Single Rule Book, see also ­section 3.7.2 above, which has become another central EU focus and a key facility in reaching uniformity between Member States as a way to support host country reliance on and knowledge of home country rules. The Single Rule Book goes for all the EU and the SSM in the eurozone cannot ignore it, nor has it an independent role in changing it. Institutionally, this framework is backed up by the ECJ as the ultimate court in EU matters, where the Commission, if necessary, initiates compliance action.

5.1.3  The Passport and the Technique of Passporting From the Third Generation of Directives, the idea was home regulation for all financial activity EU-wide short of subsidiarisation in other Member States. The trade-off was harmonised standards for authorisation and conduct of business, the latter especially important in the investment business. The Regime is now laid down for banks in the CRD 4/CRR and for investment forms in MiFID II/MiFIR, although investment firms are also under CRD 4 for prudential supervision and under CCR especially the capital adequacy regime. MiFIR and now MiFID II mainly concern themselves with market issues like pre- and post-trade transparency, exchange trading of derivatives, and product intervention by national authorities. The Directive deals in this connection with all that has to do with passporting, conduct of business, host/home regulator issues, trading platforms and clearing facilities. For clearing and settlement it is supplemented by EMIR. In banking, the licence is tied in principle to the deposit and lending functions, emphasising the recycling function of banks (see the definition of credit institution Article 4(1)(1) CRR) and the institutional nature of the regulation. In the capital markets, on the other hand, investment firms mean any legal person (unless Member States include others) whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis, see Article 4(1)(1) MiFID II, which emphasises the functional nature of this regulation. Thus investment services and activities are defined in Annex I, Section A with reference the products in Section C. In Section B, corporate finance and M&A activity are now also included. Given this functional approach, it continues to follow that credit institutions for their investment activities are considered investment firms and regulated accordingly. The procedure remains unchanged and in essence the same for credit institutions and investment firms, see Article 17 together with Articles 35, 36 (1–3), 37, 40–46, 49 and 74–75) CRD 4. It follows that host regulator powers are limited (Articles 40–46) and mainly reserved for emergency situations under Article 43. Interested parties have

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to inform their relevant home regulators of their intention to branch out or engage in cross-border services in other EU countries and this has to be agreed by their home regulator. In the case of branching out, the home regulator has a period of three months in which to inform the host regulator concerned. If it does not do so, the petitioning entity may appeal in the home state courts (Article 35 CRD 4). The host country has two months in which to make its own (limited) supervisory arrangements and also explain what rules would be applied in respect of the general good (Article 36(1)). It cannot object to the passport itself and has no blocking powers (Article 36). They are reserved to the home regulator. Explaining the rules concerning the general good is an option of the host regulator and in view of the multifaceted and undefined nature of the general-good exception not a duty, although the foreign service provider should be able to solicit more information. The direct rendering of services short of branch activity is covered by Article 39 CRD 4. As before, the procedure is simplified and the home regulator has only one month to send the file to the host regulator while no further period is set for the host regulator to make its own arrangements and give any indication of general-good exceptions.620 Although the home/host model is operative and commonly used by EU incorporated banks (credit institutions), who also rely on the Single Rule book, and is also common for investment business and markets, it has not remained uncontested and may not always remain favoured in banking.621 It might be more suitable for investment and market activities which may be more incidental and fractured. Subsidiarisation is the alternative, increasingly common eg in mortgage financing activity and financial leasing. It is increasingly favoured also by the regulators.622 For markets and trading platforms, MiFID II covers the passport and expanded the coverage and detail considerably. It now also covers OTC products and favours authorised markets, also for bonds and more especially for derivative products. This does not need to mean the regular and traditional stock exchanges, for which the amended CARD still covers a number of issues, but it also comprises other trading platforms, OFTs and MTFs, see s­ ection 1.5.6 above. There is a tendency to return to established exchanges which may however also be electronic platforms. As for the issuers passport, the revised Prospectus Regulation effective in 2018 sets out the regime, see ­section 3.7.15 above. For collective investment funds, there is UCITS for open-ended funds which are often retail focussed and the AIFMD which focusses on others, notably hedge funds, private equity and venture capital funds. 620  The Commission’s Interpretative Communication of 1997, see n 295 above made it clear that the notification itself was not a customer protection measure and its absence has no effect on any contracts concluded. Prior (legal) cross-border activity excuses a bank or investment firm from giving notification. 621  Z Kudma, ‘Governing the Ins and Outs of the EU’s Banking Union’ (2016) 17 Journal of Banking Regulation 119. See on the other hand for the risk management benefits of branching, A Persaud, ‘The Locus of Financial Regulation: Home versus Host’ (2010) 86(3) International Affairs 637. For specialised banking, like mortgage banks, it may in any event be more normal to be locally subsidiarised. Where a branch of a foreign bank has a large slice of the host country market, there may also be supervisory concern in the host state regulator. The Basel Concordat and its travails have been mentioned in s 1.2.4 above. 622  See n 586 above.

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5.1.4  The EU Regulatory Involvement in the Market Infrastructure In s­ ection 1.5.6 above, the modern operation of regular and OTC markets in respect of investment activity was discussed especially against the background of newer operation of trading platforms. This is an important issue in MiFID II, which distinguishes between three types of markets: the regular exchanges, MTFs and OFTs. Thus MiFID II clarifies and continues to distinguish between regulated markets (Section A of Annex I point 7) and MTFs (Section A of Annex I point 8) but it also introduced a new concept of organised trading facility (OFT, Section A of Annex I point 9). The MTF activity includes all multilateral systems operated by investment firms or market operators which bring together multiple third party buying and selling interests in financial instruments in the system in accordance with non-discretionary rules in a way that results in a contract in accordance with the provisions of Title II of MiFID II. ESMA maintains a database of MTFs. Like under the earlier MiFID I, there is no specific authorisation process as regular markets have subject to harmonised standards, and MTFs thereby receive the passport, Title III MiFID II. The authorisation of MTFs and OFTs and their passport depends therefore on the authorisation of participating investment firms, MTF and OTF activity being considered investment services and activities under Annex I, Section A (8) and (9). There is, however, much regulatory equalisation in the treatment between regulated markets and MTFs, which are notably subject to the same transaction reporting but are not allowed to execute client orders against proprietary capital or actively to engage in matched principal trading (essentially someone who takes no risk, see for a definition Article 4(1)(38)). Rather, an MTF is considered to operate for its own account; if not, it becomes subject to the full provisions of MiFID II, to which proper MTF trading is otherwise an exception (Recitals 20 and 23).623 OTFs on the other hand cover multilateral systems which are not regulated markets or MTFs and in which multiple third party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in a way which results in a contract. Regulated markets and MTFs are now subject to similar entry requirements, but OTFs may notably determine and restrict access depending on the role and obligations they may have in respect of their clients assuming always that there is no discrimination. They are, however, subject to similar requirements in terms of position limits, transaction reporting and market abuse provisions, clearing obligations and margining requirements (see also Preambles 9 and 14 MiFID II). In practice they are mostly perceived as a catch-all for all platforms that are not regulated as MTFs. As we have seen, market operators which are not investment firms or regulated markets but operate an MTF need no special authorisation or licence for doing so and are exempt (see Article 5(2) MiFID II) but are still subject to prior verification by

623  It has given rise to the question whether intragroup activity of this nature is still exempt under Art 2(1)(b). Mere facilitating activity for no profit in the case of large orders should probably also qualify for the exemption. Art 2(1)(d) MIFIR, sets forth technical standards.

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their home r­ egulators for their compliance with the provisions of c­ hapter I MiFID II (the exclusion of Articles 11 for compensation schemes and 15 for relationship with third countries having been deleted in MiFID II). The market function itself required some levelling of the playing field between official or regulated exchanges and the OTC ones, including these MTFs which remained otherwise unregulated in their operations. To repeat, pre-trade transparency requirements became the same for all, at least in shares admitted to regular markets. Post-trade, all must publish details of their transactions as close to real time as possible (price and size), with a possible deferment for block trades (Articles 3 and 4 MiFIR). For the US, some newer approaches were discussed in ­section 1.5.6 above. Here the emphasis is more on the distinction between professional and retail clients or the notion of ‘qualified institutional investor’ (QIB) and the operation of large connected (black) pools to avoid extra commissions or market spreads. The concentration principle was discussed in s­ ection 3.5.7 above, meaning the focus on regular exchanges and favouring them for trading activities, originally especially in equities. The principle was relaxed, but it acquired special importance for derivatives in order to have them cleared through CCPs as a matter of policy, expressed in EMIR see ­section 3.7.5 and MiFID II. See for temporary market intervention, ­section 3.7.10 above.

5.1.5  The Aim of Financial Stability Promotion of financial stability is the professed aim of all modern financial regulation but leaves much to be desired as objective, which was discussed in ­1.1.2 and 1.3 above. It became ever more prevalent in the Regulations concerning the European banking union in the eurozone as we have seen and leaves the concerns for conduct of business and market integrity behind, although deposit guarantee and investor protection schemes at least protect smaller depositors and the smaller investor against the immediate effects of insolvency of their bank or broker. It was already said repeatedly that at the EU level in terms of jurisdiction, the concerns for stability, conduct of business and market integrity are over layered by the demands of the Single Market and the passports which have their own requirements in eliminating double regulation and facilitating the smooth operation of financial services cross-border. The concern with orderly markets is of another nature and more pronounced in MiFID II/MiFIR as we have seen in ­3.7.5 and 5.1.4 above. Product intervention is closely related as we have also seen in the previous section. It should not lead to regulatory action meant to disturb the pricing, operational and risk management functions in the marketplace and its needs for innovation. There is here a regulatory inclination to play it safe and make innovation or any movement into the unknown suspect. Without a clear insight in where we are going and want to end, this is misconceived and only temporary measures to curb disturbances may be appropriate, see ­section 3.7.10 above. The same could be said for the Short Selling Regulation, ­section 3.7.9 above.

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5.1.6  The Issue of Conduct of Business Protection It was mentioned before that conduct of business was not traditionally a banking concern and developed more specifically in investments where the expansion of fiduciary duties against intermediaries, especially brokers became the key issue, see s­ ection 1.5.9 above. This raises the issues of ‘know your customer’ and ‘suitability’ of the advice especially on investments, see Article 24 MiFID II but also the issue of best price or best execution, Article 27 MiFID II, especially in situations of internalisation of trading or self-dealing, see also the discussion in s­ ection 3.5.5 concerning MiFID I. The implementation of these protections in terms of breach of contract, breach of fiduciary duties, or negligence and their requirements is left to Member States assuming the effectiveness in the implementation of the Directives and EU objectives, cf Article 69 (2)­ MiDFID II, see also section 3.7.19 above. Another important issue is pre-trade and post-trade transparency, see Articles 3 and 5 MiFIR for equity trading, Articles 8 and 10 for non-equity instruments and Articles 4 ff for systematic internalisers and investment firms trading OTC. Article 18 covers derivatives, bonds and structured finance products. See for time stamping and audit trails, Article 28 MiFID II. The issue of fees and especially indirect rewards in terms of free research became an important issue especially for fund managers under MiFID II which disallowed the older practice of including the cost in the trading commissions carried by the fund investors.624 This cost must be disclosed to investors and must be allocated fairly to clients’ portfolios. But under ESMA guidance, research may still be given free of charge if available to all investors. Some banks and investment firms went that way, others started charging separately. The value is, however, in more specific or higher value research that should not be available to all and for this fund or other investment managers would have to pay and charge their investors separately, although they have of course the option of paying these costs out of their own resources. If they do not, they have the additional obligation to set a research budget and regularly assess it as an internal control function.

5.1.7  The Matter of Market Integrity, including Abuse, Money Laundering and Tax Avoidance Issues In the EU, the matter of market integrity is partly covered by the 2014 Market Abuse Regulation, see ­section 1.1.20. It deals with insider dealing, market manipulation and abuse of financial structuring. Competition issues are not included and are covered by the general EU competition and state aid rules.

624  Arts 12 and 13 MiFIR, see also Preamble 28 for what is regarded as research in this connection, which refers to material or services concerning one or several financial instruments and provides a substantiated opinion as to the present or future value or price of such instruments. It covers written research, analyst calls and meetings.

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Tax avoidance issues are separate and the 2003 Savings Tax Directive was an early response, see ­section 2.4.2 above. In 2016, a Directive was agreed laying down rules against tax avoidance practices that directly affect the functioning of the internal market.625 It recognises Member State’s tax sovereignty and is meant to effectively promote it by action against base erosion and profit shifting (BEPS). It seeks to curtail aggressive tax planning in the internal market and concerns corporate taxation. In 2017, there were further rules agreed to prevent tax avoidance via non-EU entities that effectively were seen to pay little tax in the EU and sought competitive deals from EU governments.

5.1.8  Third Country Activity The issue of third country activity was discussed in ­section 3.7.17 above, especially in terms of access from the outside in to the EU internal market, relevant more in particular after Brexit now that the UK wants to become a third country. Mutual access to each other’s financial markets may be the more important issue when the passports for banking and investment activity, the issuers’ passports, and fund managers’ passports will disappear for activity in and from the UK, in which connection the not of regulatory equivalence becomes an important issue. There is another aspect. It is the extraterritorial effect issue of the EU legislation as perceived from within the EU when EU banks, firms, issuers or funds operate outside the EU and how this is promoted and guided by EU rules. In many third countries, this may be considered a matter of reciprocity and equivalence where the EU may deal in respect of its financial service industry. Important in this respect was the October 2017 agreement with the Commodity Futures Trading Commission (CFTC) in the US in respect of cross border derivatives transactions and the access to each other’s trading and clearing platforms (CCPs) after MiFID II, which risked disrupting this market, and the access in terms of harmonising the rules, especially the margin requirements.626 With regard to Brexit, one major issue is in how far EU law and ECJ jurisdiction still applies to cross-border traffic.

5.1.9 Evaluation What do all these new measures add up to? What kind of response is this to the crisis scenario painted in ­section 3.7.1? What are the underlying objectives and what is achieved? This issue was briefly touched upon in s­ection 1.3.12 above, showing the increase in EU regulatory powers, the emphasis on rules and rule books, the extension

625 

Council Directive (EU) 21016/1164. Financial Times, 14 Oct 2017.

626 See

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of the group of actors and activities to which they are applied, the revamping and centralising of the regulators, but also the expanded ambition, the doubts as to whether the EU sufficiently understands what it is regulating and can handle this, and its piecemeal approach, which may show a lack of confidence and the absence of a coherent view on what modern finance is and needs to achieve. Not least there continues a negative attitude to international financial activity and actors. Belief in and submission to national rules substitutes for recognition of foreign regulatory regimes and risks breaking up the international markets. In this approach, smaller is often considered better in a globalising world. How this world is to be financed in this manner is not clear. More importantly, that world is hardly waiting for the EU and is doing better. The result is not only thinking small, but also surrendering influence and power in finance in exchange for little in return. How and why has it come to this? Particularly in the EU, after some initial hesitation, the reaction of regulators and politicians to the 2008 financial crisis has, on the one hand, turned out to be one of extreme involvement in order to be seen to be acting with the simple objective of reducing risk without properly understanding it, and, on the other, one of extreme escapism in view of the intractability of the problems and the lack of sufficiently objective guidance. This escapism is demonstrated in three ways: (a) a flight into high regulatory activity without consideration of the basic liquidity needs in the next 25 years and how it is to be provided and the connected financial risk managed in an ever more globalising world, (b) a flight into a belief that capital markets can substitute for banking activity, and (c) in the eurozone a flight of fancy with respect to the ECB, which is given greatly conflicting competences, largely unlimited in all of them, and immunity from suit for the consequences in virtually all lines of its activity. This is irrational and built on the reputation of one person, the President of the ECB, which may fall as fast as it rises. The result is a prolonged malaise and, at the legal level, a poor framework of recourse for participants, financial intermediaries and customers alike, see ­section 4.1.5 above. There can thus be little confidence that things are getting better although in a period of depression all may seem more balanced, but that is no more than the normal downturn in the banking business, which has always been irrational in its pro-cyclical attitudes. This is well known, as is the habitual response: pay-back time for the industry, heavy fines, more regulation, etc, but this never stabilised anything and is likely to be the platform for the next crisis. In the meantime, growth is curtailed because the liquidity-providing function of the banking system is cramped. Low interest rates are used as a growth elixir, with little effect but they connive to hamper further the recovery of banks and threaten savings, including the reserves of pension funds and life insurance companies. It was posited before that liquidity is the key, the oil in the machine of a modern economy. This is what banks and capital markets provide to society. As such the importance of their role cannot be overestimated. As in a car, when oil runs out, all is lost and the engine is likely to blow up. So it is in an economy without liquidity. Shrinking banks—in the view of many of the uninitiated an answer to all our problems—and handicapped capital markets herald a society in which few could survive with present expectations. All need more liquidity than they have: governments, banks and

930 VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

c­ onsumers alike. Companies are not excluded. Leverage is the result. We live by debt and that is not going to change unless we want a very different society and step back at least 50 years. If we were serious about all of this, the G-20 would ask itself only two questions: first, what are the total liquidity requirements worldwide in the next 25 years and second, how are we going to meet them? What kind of gearing can society support and how can we recycle money best to support this? The only other question is: how are we going to safeguard the savings of the elderly so that they can better look after themselves while living ever longer, meaning that social care and pensions may shrink?627 There are no other issues. If these are the questions, the policy should be properly explained and the consequences should be made clear in a long-term plan that should be understood by all. This is not happening. Most people assume that quality and insight reside at the top until one gets there. Rather there is fear, but it is a poor guide. Thus we have regulatory fervour to show that something is being done, but what is not clear. Financial regulation as we now have it is largely meddling with risk management in bad times. Admitting that risk management is a major problem in all banks is not the same as inviting regulation as a saviour; for it to be so it would need much better insights. This being said, it was admitted that there is no academic model that provides an explanation either or provides better tools for risk management: in truth there is also serious academic failure.628 So we muddle through waiting for the next financial crisis, which may teach us a little more.

5.1.10  Public Policy or a System of Legal Rules? The present idea is that we want a system of (micro-prudential) rules, but what can it achieve for us? Do we have the model, can policy be captured in this manner allowing politicians to discharge themselves and their responsibility by creating a system of rules that is judicialised, meaning that the ultimate responsibility for compliance is with the judiciary? This facilitates a box ticking attitude in the regulator and a formal attitude in the courts against which a principle-based or judgement approach is not likely to do a great deal, see the discussion in ­1.1.13/14 above. In this sense it can even be said that regulation as rule-based system is there primarily to protect the regulators, not the participants at least not in the stability objective of the statutory regime.

627  At last, some of this transpired in the EU Commission Green Paper, Long Term Financing of the European Economy (COM) 2013 150/2, concerned with long-term savings and growth but it was hardly inspired. There followed the usual remarks about market integrity, transparency and efficiency. The drift is that all must be captured in regulation and that that will make things better, but it may itself truly be the problem and at least a much more critical and probing attitude would seem legitimate in view of financial regulation’s proverbial failure to prevent crises. 628  The lack of a more precise analytical framework is clearly identified in some writing: see eg SL Schwarcz, ‘Controlling Financial Chaos’ [2012] Wisconsin Law Review 816; I Anabtawi and SL Schwarcz, ‘Regulating Systemic Risk: Towards an Analytical Framework’ (2011) 86 Notre Dame LR 1349.

Part III  The EU Regulations and Directives Concerning the Internal Market 931

Above all, it suggests that the politicians have done their duty in this way and can wash their hands of it. Hence even bail in rather than bail out, also on the basis of a system of (some) rules. But it was said before that the whole concept of financial stability as a legal objective is obscure and the often related concept of systemic risk no less so.629 First there is the inherent instability of banks because of the liquidity mismatch between assets and liabilities which makes banks structurally cash flows insolvent at all times, see ­section 1.1.2 above. This inherent instability is joined by external factors, it was argued, notably by the high societal leverage as we now experience it, the procyclicity of the banking activity, the economic cycle, asset bubbles, innovation and regulatory complacency in good times. Whether systemic risk in terms of connectivity adds much is another issue. It was doubted whether it was an autonomous cause of instability, although it may make it worse. Also when all banks start walking in the same direction, which they like to do, there may be further instability, but that is more in the nature of concerted action rather than connectivity. When the emphasis is on the economic effect, systemic risk becomes identical with instability although instability is still likely to be a broader concept and may have many other causes. More importantly probably, as was also pointed out, we do not know at which level of economic activity we want to achieve financial stability, therefore how large banks and banking activity should be at every phase in the economic cycle. What about building safety nets and who is in charge? But it may be repeated that the biggest failure is probably that we have no concept or idea what kind of liquidity we may need in society in the future and how it is to be provided when many developing nations and their populations also want credit cards and subprime mortgages and developed nations struggle with an elderly population that wants free social care and a pension forever, whilst governments everywhere keep on borrowing over the hilt? Where is this liquidity going to come from? More to the point, how can we speak of a ­stable financial system in those circumstances? Must there be an ultimate inflationary blow out to get rid of all this debt? Could stability ever be achieved with the present micro-prudential rule-based approach which is the same for all in all phases of the economic cycle, as such itself heavily pro-cyclical: it requires banks to rebuild capital at the bottom of the cycle and sees no risk at the top when truly banks are at their most dangerous, it was submitted, lend to all, and engage in the most irresponsible schemes and investments.

629  One may revisit some of the (legal) definitions. The European Systemic Risk Board sees systemic risk as ‘a risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy’, see also n 7 above. Here one sees clearly the concern for the internal market as paramount. The disruption to the financial system as a whole demonstrates that the term ‘systemic risk’ is used here as another term for financial instability. IOSCO sees it as ‘the potential of any widespread adverse effect on the financial system and the wider economy’, see Technical Committee of the International Organisation of Securities Commissions, Mitigating Systemic Risk- A Role for Securities Regulators: Discussion Paper, OICU-IOSCO OR 01/Febr 11 2011, 13, therefore also as another term for financial instability. The Systemic Risk Centre, Systemic Risk (2013), refers to a breakdown of an entire system collapsing rather than simply the failure of an individual part caused by interlinkages within the financial system in a severe economic downturn.

932 VOLUME 3: FINANCIAL PRODUCTS, FINANCIAL SERVICES AND FINANCIAL REGULATION

From a policy point of view, even in their rule-making activity, the EU seems to be handicapped if not G-20 also. It was said before that the reason is that there is no consensus whatever on how society should operate, what the role of the market or finance is in it or should be, let alone what kind of liquidity requirements we face in the future. These issues are not discussed and what we have or had in financial regulation is assumed to form the consensus. This is all the more so between the Members of the EU which each have their preferences. Again, the EU authority only derives from the needs to promote the internal market, there is no original jurisdiction to deal with financial stability or conduct of business, not even with market integrity. Tinkering at the edges becomes then the only option and that is what has happened in the EU after 2008. It can also be argued that apparently the crisis was not deep enough and could be handled by simply opening the liquidity tap, even for long periods, in the hope that all would settle in some new equilibrium under the present rule-based system. But it has delayed the recovery whilst this more modern rule-based system and its application may itself be a major issue, as we have seen from the point of view of rule application and proportionality, in ­section 4.1.6 above. It is also clear that whatever our concerns with financial stability may be which seems to have eclipsed all others, we could do more in the area of conduct of business, which especially for commercial banks remains underdeveloped at least in Europe. In the meantime, we have added a banking resolution regime to the list of new rules, to provide a distinction between government and banks and for politicians to drift away in their responsibilities for banking failure. Again, the flight is into a rule-based system that has in fact so few rules that it has already been shown to be a chimera, riddled with exceptions and discretion at the level of national governments, see n 192 above. Any resolution scheme without proper rules is a bad idea. The whole set-up demonstrates that it remains policy (and conflicts of interest at the level of the ECB). It raises the broader issue when rule-based systems and judiciality can effectively stand in for public policy and become realistic, reliable, sound and effective alternatives. This may not be assumed and can often not be achieved. An altogether quite different example may be given in foreign investor protection against direct and indirect nationalisation of the investments by host states. Is this an issue that can be addressed through legal recourse under Bilateral Investment Treaties, either before arbitrators or in a court system, as is now common, or should this, as before, remain a question between home and host states of the investor and be decided at the diplomatic level, meaning at the political level, going back to what it used to be under the treaties of friendship? It has been a hot debating point for some time, see the discussion in Volume 1, ­chapter 2, ­section 3.5. It shows in an unrelated area, that simply farming out highly political issues to a rulebased system might not always be the answer and has already proven to come under serious stress in the EU resolution regime. But the issue is the same in micro-prudential financial regulation and supervision. The hesitant return to macro-prudential supervision is demonstration of the same dilemma. Micro-prudential supervision, G-20, the Basel Committee and all, did not provide a sound and effective system to stabilise banks and prevent crises. The present set-up remains pro-cyclical and does not avoid serious moral hazard issues either, hence the feeling that we must go back to a more

Part III  The EU Regulations and Directives Concerning the Internal Market 933

macro-prudential approach.630 It re-involves governments and the tax payer. In the view of this book, this is unavoidable and it is wishful thinking to believe otherwise. One could also say that the price of an overleveraged society is the regular need to save the banking system that is at the heart of it, and micro-prudential supervision was never able or even meant to prevent it, see the dramatic reduction under it in capital requirements in Basel I and II and the rejection of liquidity requirements and leverage ratios until after the 2008 financial crisis in Basel III. It means that in a major financial crisis when micro-prudential regulation and supervision have once more failed, governments must come to the rescue lest the banking and payment system collapses completely. It also demonstrates and reconfirms the simple point, that the true stability concern should be at the top of the cycle and in the period leading up to it, not at the bottom, and the remedy is also simple: increase capital and liquidity requirements and leverage ratios drastically in that situation, force the banks to build capital and create an international safety net whilst limiting bonusses and dividends accordingly. This requires a new type of regulator, quite separate from fiscal and even monetary authorities, who at each phase in the cycle decides how large banks can be. That is pure policy and in the view of this book the only model that may prevent major collapses in the banking (and payment) system as we now have it, see the discussion in ­1.1.13/14 above.

630  The Larosiere Report of 2009 ‘The High Level Group on Financial Supervision in the EU’ accentuated this need from the beginning of the reregulation drive, and the stability committees were the result, but they do not have original powers and are only advisory so far, although it was also pointed out above that since Basel III there is now some limited flexibility in the capital adequacy requirements and in the SSM Regulation; the ECB acquired some discretionary power in Art 5, see s 4.1.2 above.

934

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 minimised. Information will be found under the corresponding detailed topics. abandonment  72, 156, 415, 552, 640, 702, 725, 840 absolute title  122, 161, 163 abstract system  70, 83, 105, 229, 367 abstraction  64, 108, 110, 117, 220, 441, 465 abuse of rights  89 academic models  61, 601, 606, 645, 801, 930 lack of  601–3 acceleration  263, 331–34, 392–94, 398–402, 499–500, 672, 677 acceptance  22, 24–25, 56, 364–66, 370–71, 425–29, 431–35, 439–40 acceptance credit  431, 433, 435 accepted bills of exchange  426–30 accessories  33–34, 42, 81, 90, 112, 132, 150, 445 accessory nature  33, 81, 96–97, 112, 132, 158 account debtors  78, 200, 203, 224, 233 account holders  373–74, 542, 650, 677 accountability  636, 668, 734 accountants  302, 346, 453, 611, 633, 835, 863 accounting hedges  289–90 accounting rules  246, 502, 611, 778, 810 accounts  142, 362–64, 372–75, 381, 416–17, 482, 675–77, 708–11 margin  79, 322, 341, 404, 883 securities  457–58, 461, 463, 468, 474, 485–86, 488, 681 trading  340–41, 539 accruing cash flows  15, 308, 662 acquired rights  88, 255 adimpleti contractus  105 administrative law  352, 532–33, 546, 904, 906

Admission Directive  812–14, 827 advanced measurement approach, see AMA advice  17, 343–44, 525–26, 548–49, 557, 560, 710, 715–16 after-acquired property  106, 132, 144, 162 clauses  157, 162 agencies  272–73, 285–86, 542–43, 626–27, 643–45, 712–15, 787–88, 894 credit  298, 542, 627, 633, 799 governmental  342, 530, 546, 669, 847 international  538, 590, 627, 636, 687, 872 agency  55, 127, 321–22, 433–34, 708, 710, 712–15, 724 construction  318, 322, 370, 396, 442 indirect  55, 322, 464, 713–15 law  343, 712, 714, 755 agents  222, 321–22, 425–26, 431–34, 439–41, 706, 712–14, 759–60 matching  692, 694, 696, 723 aggregation  400, 403, 499–500 agreed interest rate  110, 128, 140–41, 153–54, 491 structure  42, 44–45, 127, 130, 150, 154, 194, 246–47 agreed prices  16, 150, 306–7, 314, 337, 415, 490, 661–62 agreed repurchase prices  151, 153, 494 agreements back-to-back  396, 476, 703 collection  142, 209, 212, 225–26, 228, 238–39, 241, 244 credit  81, 115, 189, 252, 674, 863–64 factoring  221, 227, 229, 235, 239

936 INDEX

loan  150–51, 198, 201, 246, 270, 304, 657, 661 netting  59, 61, 63, 335, 337, 394, 397, 403–7 rental  98, 114–15, 139, 145, 250, 252 repurchase  42–45, 85–87, 98, 114, 128, 139–40, 146–47, 489–93 sales  81–84, 92, 95–97, 104–6, 108, 166, 168, 702–3 security  80, 136–40, 142–44, 160, 189–91, 200, 206, 227 supply  248, 250–51, 254, 257, 259–60, 263, 265–68, 399 tripartite  270, 317, 360–61 underlying  23, 117, 126, 128, 211, 218, 220, 239 agriculture  314, 743–44, 804 aircraft  31, 36, 175, 182, 246, 253–54, 262, 267 ALM, see asset and liability management alpha factor  785, 798 AMA (advanced measurement approach)  785, 792, 795 American courts, see United States, courts AMF (Autorité des Marches Financiers)  566, 721, 840, 868 amortisation  112, 160, 249, 253, 259–60, 717 anti-competitive behaviour  527, 538, 627, 886 anti-cyclical approach  528, 610–11, 626 anti-money laundering duties  381 Anwartschaft  107–11, 113–15, 117, 152, 160, 167, 172, 177 apparent ownership  58, 157, 208 applicability  231–32, 234–37, 259–60, 263, 266–67, 407, 409, 447–48 appropriation  43–45, 81, 98–100, 106–7, 126–29, 157–59, 166, 247–48 facility  114, 117, 166, 183, 223 approximation  74, 88, 196–97, 247, 367, 520, 729, 798 arbitrage  312–13 information  698 regulatory  502, 571, 574, 592, 889 arbitration  386, 391, 405, 408, 417, 423, 541, 546 clauses  417, 655 commercial  189, 541 arbitrators  188, 405, 422, 443, 449–50, 932 arm’s length  630 ASF (available stable funding)  793 Asia  402, 454, 574, 594, 693, 736, 794 assessments  298, 768, 771, 773, 775, 781–82, 785, 896

asset and liability management (ALM)  343, 507, 543, 656, 659, 765, 774, 891 asset-backed financing  1, 11, 25–32 asset-backed funding  42, 50, 67, 90, 103, 149–50, 156, 519 asset-backed securities  3, 33, 209, 273, 298, 626, 780, 895 asset bubbles  523, 552, 931 asset classes  12, 76, 79, 89, 118, 768, 770, 777 asset liquidity  514, 769 asset-maintenance obligation  460, 462–64, 468–69, 474, 478, 485, 845 asset managers  54, 645, 710 asset pools  225, 277, 292, 298, 626 asset securitisation  15, 149, 241, 269, 279, 293, 309, 336 and financial engineering  269–76 asset side  2–3, 312, 516, 567, 652, 777 asset substitution  76, 80, 206, 243 assets, see also Introductory Note back-up  292, 465, 474, 682 banking  292, 506, 519, 635, 664, 685, 768–69, 776 client  6, 55, 540, 544, 710–12, 714, 719, 838–39 contingent  775 debtor’s  20, 53, 57, 127, 234, 360 fungible  42, 47, 169, 178, 354–55, 395, 467, 491 illiquid  300, 516, 519, 624, 633 intangible, see intangibles liquid  516, 613, 649, 767, 797, 872 loan  269, 271, 278, 282, 284, 294, 516, 570 long-term  356, 507, 872 off-ledger  383, 485, 487–88 replacement  4, 13, 75–76, 78, 99–100, 199, 201, 203 risk  272, 282, 293, 517, 614, 770–71, 783–84, 788–89 secured  27, 34–35, 42, 90, 136, 190, 198, 210 sold  62, 81, 106–7, 150, 200, 491 toxic  522, 630 transferred  94, 275, 293 trust  102–3 underlying  175–76, 178–79, 306–12, 314–15, 319, 340, 497–99, 661–62 values  283, 306, 499, 517, 661, 765–66, 795, 908 assignability  91, 216, 218, 228, 231–33, 237–38, 240, 243 assigned claims  33, 219, 232, 237

INDEX 937

assignees  33–34, 68–69, 77–79, 218–20, 225–26, 231–37, 240–44, 270–72 collecting  68, 142, 172, 218, 243 security  78, 89 assignments  77–79, 142, 160–61, 209–21, 223–45, 270–74, 296–97, 370–72 agreements  23, 204, 212, 214, 232, 240, 271 bulk  70, 202–3, 209–15, 217–18, 225–31, 233–34, 241–45, 270–71 special problems  209–13 conditional  33, 78, 112, 231 constitutive requirements for  77–78, 100, 116, 239 equitable  33, 69, 203, 394 fiduciary  78, 99, 112 international  23, 25, 70, 187, 218, 231, 234–35 multiple  68, 218, 234 prohibitions  220, 224, 233, 237, 271 of receivables  77, 86, 134, 140, 142, 203, 215, 219 registered  78–80 restrictions  200, 211–13, 216–17, 239, 244–45, 270, 272–73 security  77–78, 101, 142, 197, 218, 223, 230–31, 241 assignors  33–34, 211–12, 218–20, 223–24, 226–35, 241–42, 270–72, 274–75 collecting  78, 89, 272 asymmetric information  544, 550, 601 attachment  88, 132, 135, 137, 142, 145, 163, 389 Aussonderung  39, 52, 106–7, 109, 111–12, 114–15, 167, 205 Australia  195, 292, 343, 397, 401, 410, 731 Austria  759, 863 authorisation  352, 529, 531–34, 588, 718–20, 816, 821–23, 835–38 requirements  544, 548, 723, 751, 805, 816, 835, 862 and supervision  352, 529, 533–34, 541, 577, 751, 815, 817–19 authorities  417, 638, 644, 813–14, 841–44, 849, 878–79, 896–97 national  633, 639, 878, 881, 890, 910, 913, 923 automatic retransfer  91, 229 automatic return  92, 106, 129, 150, 261, 628 automatic set-off  130, 390 automatic transfer  112, 129, 206, 240, 260, 268

automaticity  94, 112, 132, 150, 387–88, 390, 394 autonomous guarantees  444–45 autonomy  25–26, 31, 56–57, 62–63, 65, 68–69, 195–96, 213–14 group  53 international capital markets  725–26 party, see party autonomy Autorité des Marches Financiers (AMF)  566, 721, 840, 868 available stable funding (ASF)  793 aval  427, 430, 445 back-to-back agreements  396, 476, 703 back-to-back letters of credit  443 back-up assets  292, 465, 474, 682 back-up entitlements  459–61, 478, 712 bad banks  522, 551, 640, 855, 897, 910 bail-ins  632, 637–40, 663, 665–66, 668, 896–97, 908, 915 bailees  45, 123, 131, 133, 158, 160–61, 171 bailment  121–22, 133–34, 146, 152, 158, 160–62, 170–72, 248 balance sheet insolvency  512–13, 515, 517–18, 523, 525, 657, 767, 788 balance sheet risk  288, 515, 517 balance sheets  269, 293–94, 309–10, 312, 502, 518–19, 768–70, 775–77 balances  79, 198–99, 278–79, 334–35, 380, 395–97, 481–82, 671–73 bank  186, 198–99, 359, 362, 365, 374, 380, 481–82 cash  79, 474, 482, 487 credit card  269, 276, 279 negative  672–73, 675 net  130, 332, 334–35 positive  513, 648, 650, 671–73, 676 Balkanisation  625, 634, 870 bank accounts  359–60, 374, 380, 383, 458, 463, 675–76, 701–2 bank balances  186, 198–99, 359, 362, 365, 374, 380, 481–82 bank deposits  552, 565, 648, 672, 683–84, 815 Bank for International Settlements, see BIS bank guarantees  24, 34, 430, 436, 440, 442, 444–48, 777 bank loans  12, 127, 241, 276, 568, 650, 685 Bank of England  531–32, 539, 546, 548, 558–59, 566–67, 667, 721 Bank of International Settlement, see BIS bank payments  19, 360, 372, 377, 424, 450, 478

938 INDEX

bank regulators  280, 336, 550, 566, 769, 783, 787 bank transfers  359–68, 370–72, 380, 412, 424, 428, 440 electronic  476, 703 international  404, 424 legal nature and characterisation  370–74 modern  370, 372, 378 bankers  222, 390, 551, 561–62, 596, 604–5, 607, 611 banking  512–24, 538–44, 546–55, 565–71, 591–94, 644–52, 663–74, 765–71 activities  513, 516, 634, 636, 765, 767–68, 830, 832–33 commercial, see commercial banking early EU achievements  808–10 investment  352, 520–21, 529, 534, 571, 573, 715, 718 modern  512, 602, 611, 613, 616, 869, 871, 873 narrow  181, 279, 506, 539, 630, 644, 650, 663–65 possible new theme or paradigm  614–17 procyclical nature  551–56 shadow  505–6, 509, 567–71, 650, 652, 872, 875–76, 893 sharia  181, 663, 665 banking assets  292, 506, 519, 635, 664, 685, 768–69, 776 banking business  2, 539, 551, 592, 625, 628, 774, 780 banking crisis  569, 601, 607, 610, 666–67, 788–89, 793, 895–96 banking debt  623, 634, 907, 911 banking industry  2, 49, 596, 599, 632, 640–41, 788, 791 shadow  559, 571, 634, 872, 893 banking instability  514–15, 554, 765, 911 banking licences  506, 511, 535, 565, 651–52, 670, 718, 751 banking liens  672–73 banking products  2, 12, 15–17, 19–20, 31, 193, 525, 533 banking regulation  298, 515, 525–26, 570, 601, 666, 668, 875–76 banking regulators  193, 411, 550, 570, 648, 656, 666, 668 single  585, 896, 907–8 banking relationship  272, 514, 659, 671, 673–74, 677, 751

banking risk  512, 554, 598, 603, 648, 651, 656, 789–90 banking services  529, 542, 654, 673–74, 767, 808, 827, 832 banking supervision  546–48, 567, 591, 593–94, 666–68, 790, 792, 856 banking supervisors  532, 535, 663, 667, 763, 771, 778, 833 banking system  369–71, 373–74, 449–51, 462–63, 506–7, 509–10, 660, 919–20 banking union  560–61, 854, 875, 878, 906, 908, 910–12, 917 bankrupt brokers  460, 473, 713–14, 868 bankrupt counterparties  53, 59, 109, 376, 394 bankrupt debtors  51, 106, 386 bankrupt estates  5, 10, 51–52, 54, 106, 109, 387, 459–60 bankruptcy  3–11, 50–57, 71–74, 91–99, 109–12, 180–86, 330–35, 386–410 courts  46, 68–69, 71, 185, 331, 338, 403, 410 France  29, 91–92, 94–97, 99, 250, 334, 387–88, 406 Germany  39–40, 42, 50, 105–6, 111–12, 114–15, 166–67, 390 law(s)  50–57, 67–74, 91–97, 180–82, 333–35, 387–95, 397–410, 499–501 Netherlands  39, 44, 89, 96, 98, 167, 401, 406–7 proceedings  28, 92, 185–86, 255, 399, 513, 649 protection  5, 48, 53, 57, 60, 254, 290 resistance  3, 19, 109 set-off  130, 388, 392, 394, 403 situations  42, 54–55, 65, 67, 396, 398, 400, 409–10 trustees  80, 145–46, 152–53, 163–64, 176, 204–5, 459–60, 493 banks  368–79, 505–31, 602–19, 625–40, 643–61, 663–79, 762–73, 775–93 bad  522, 551, 640, 855, 897, 910 central  375–77, 379, 418–19, 521–22, 567, 663–64, 666–68, 762–63 commercial  16–19, 507–8, 529, 533–35, 647–48, 650–53, 656–58, 669 correspondent  365, 381, 438 eurozone  522, 638–39, 746, 821, 854, 907–8 foreign  375, 422, 586–87, 606, 665, 730, 819, 822 house  28, 427, 432, 434, 437, 654 insolvency  509–10, 633, 649, 765, 786, 854

INDEX 939

instructing  373, 428, 431–32 intermediary  369, 371, 373–74, 381, 415, 463 investment, see investment banks of last resort  521–23, 546, 550, 565, 647, 649, 652, 735 major  9, 133, 327, 563, 633, 638, 908, 912 micro-management  537, 604–5, 625, 627, 872 nominated  431–35, 437–38 ordinary  347, 502, 525, 565, 568–69, 616, 718 paying  375, 433–34, 440–41 presenting  428–29, 434 remitting  427–28, 434 risk management  660–63 shadow  567–68, 570, 600 smaller  288, 485, 554, 564, 616, 622, 646, 790 United States  99, 503, 586–87, 640, 646, 670, 730, 787 universal  544, 565–67, 592, 650–51, 664, 708, 834, 843 Basel Committee  591, 593–95, 601, 603, 640, 763–64, 780, 784–85 Basel Concordat  587, 590–94, 668, 762, 810, 856, 898, 900 Basel I  517, 607–8, 762–65, 767–72, 776–77, 780–81, 797, 851 Basel II  535–36, 599–601, 612–15, 763–71, 779–81, 785–91, 794, 851 Basel III  563–64, 569–70, 613–15, 640–41, 765–68, 787–94, 870, 880 derivatives, contingencies and other off-balance-sheet exposures  793–94 bearer securities  457–58, 485–86, 488, 589–90, 680–81, 712–13, 726–28, 730 Belgium  29, 75, 77, 90, 100, 388, 500–1, 874–75 bespoke products  326–27, 840 best-effort basis  654, 683, 704–5 best execution  351, 464, 532, 558, 709, 836, 839–45, 927 best practices  282, 454, 764 best price  51, 154, 588, 708–9, 839–40, 845, 882, 927 Big Bang  282, 402, 535, 708, 719 bilateral netting  329, 331–34, 375–76, 391, 393, 398, 400–1, 409–10 bilateral setoff  4, 467, 892

bills of exchange  32, 64, 360–61, 368, 425–35, 440–41, 445–46, 679–80 accepted  426–30 bills of lading  23–24, 32, 64, 70, 338, 425–31, 436–37, 680 bills of sale  36, 40, 120, 125–31 binding force  453, 749, 763, 851 BIS (Bank for International Settlements)  591–94, 667–68, 757–58, 762–64, 766–67, 771–76, 780, 856–58 Bitcoin  382–83, 385–86, 571–72, 724, 876 black pools  695, 697, 708 black swans  517, 615, 783, 797, 799, 868 blockchain  303–6, 339–41, 382–84, 386, 485–88, 571, 573, 678 permissioned  342, 380, 386, 484, 487 technology  305, 342, 380–81, 384–85 blocking clauses  304 blocking powers  834, 924 blocks  317, 382, 901 bona fide assignees  221, 225, 236, 244, 367, 373 bona fide creditors  6, 9, 57, 59–60, 69, 162–63, 166, 207–8 bona fide outsiders  6, 59, 269 bona fide payees  362, 366–67, 371 bona fide purchasers  30–32, 57–59, 64–65, 68–70, 121–22, 125–26, 159–62, 491–92 protection of  32, 34, 58–59, 63–64, 68–70, 125–26, 159, 161 bona fide successors  182, 214 bona fide transferees  211, 464–65 bond holders  181, 273–76, 284, 292–93, 551, 555, 632, 637 bond issuers  312–13, 768, 780, 850 bond issues  56, 313, 331–32, 505, 568, 669–70, 690, 719 bond portfolios  274, 308, 616, 656, 662, 774, 777 bondholders, senior  274–75, 515, 597, 623, 639–40, 919 bonds  272–78, 291–94, 312–13, 459–61, 520–23, 669, 679–88, 726–28 CoCo  559, 632, 638, 771, 791 corporate  209, 273–74, 310, 686, 694, 779 covered  269, 291–92, 570, 642 government  292, 461, 516–17, 652, 657, 663, 797–98, 887–89 bonuses  550, 552, 555, 596, 604–6, 614, 636, 640

940 INDEX

book-entry entitlements  23, 457, 461, 466, 479, 481, 887, 892 book-entry systems  64–65, 459–61, 470, 476, 478–80, 483–84, 701–3, 712–15 regulatory concerns  483–84 boom and bust  181, 608, 613, 628, 677 bordereau  99, 101 borrowers  198–201, 222–23, 467–69, 495, 652–55, 674, 780–81, 795–96 large  653–54 branches  583–84, 586–87, 751, 805, 808–11, 822–23, 841–42, 899–900 foreign  586–87, 591–92, 668, 730, 738, 751, 833, 835 foreign bank  592, 833, 896 Brazil  41, 75, 595 Bretton Woods Agreements  309, 419, 537, 593, 595, 734–35, 740–42, 757 Brexit  545, 585, 591, 895, 898–99, 901–3, 920, 928 broker/dealers  502, 508, 711, 720 brokerage  354–55, 521, 525–26, 533, 670–71, 707–8, 710–11, 715 activity  349, 355, 525, 651, 718 fees  695, 707–8, 710, 719, 840 prime  342, 715 brokers  461–71, 473–79, 487–88, 507–9, 700–4, 707–15, 839–41, 844–45 bankrupt  460, 473, 713–14, 868 clearing  477, 704 floor  316, 320–23, 396 prime  180, 354–55, 568–69, 715, 718 smaller  462, 477, 704 bubbles  511, 514, 523, 560–61, 596, 598, 603, 612 buffers  383, 555, 562, 569, 615, 632, 784, 909 building block approach  774–76, 851 Bulgaria  375, 745 bulk  13–14, 91, 200–2, 209, 218, 227–29, 243, 270–71 bulk assignments  209–15, 217–18, 225–31, 233–34, 238–39, 241–45, 270–71, 303–4 international  227, 231, 237, 242, 245 special problems  209–13 bulk transfers  116, 196, 198, 202–5, 209–10, 212–13, 215, 241 business models  511, 558, 564 buyer/debtors  427, 430–32, 441–42 buyer/financiers  95, 112–13, 115, 139, 150, 490, 499

buyers  95–97, 106–8, 156–65, 318–22, 424–32, 437–45, 462–70, 490–96; see also purchasers conditional  128, 161, 163, 188, 192 margin  471–73 original  107, 157, 319 in possession  131, 133, 163, 168, 493 repo  114, 155, 176, 178, 490, 493–95, 497–98, 504 calculations  320, 324, 403, 657–58, 771–73, 778, 780, 795 capital  770, 777, 794, 797, 800 call deposits  12, 628, 651, 676 call options  290, 306, 311, 337, 340–41, 468, 490, 492 calls, margin  324, 328–29, 339–40, 503, 510, 631, 793, 883 Canada  195, 253, 389, 418, 676, 731 capacity  24, 359, 362, 364–66, 371–73, 387–88, 397, 465 capital  517–18, 613–15, 627–32, 756–59, 765–74, 777–79, 781–84, 786–89 calculations  770, 797, 800 under Basel I  777–80 under Basel II and III  794–99 core  640, 769–70, 792 for derivatives  775 minimum  352, 549, 763, 768, 778, 783, 790, 883 qualifying  517, 765–67, 770–72, 777–79, 783, 791, 797, 851 regulatory  525, 614–15, 769, 773, 787–88, 791, 798, 800 required  614, 666, 773–74, 779, 781, 792, 816 venture  348, 356, 643, 885 capital adequacy  278–79, 552–53, 626–29, 763–67, 769–70, 772–73, 787–88, 851 EU  851 evaluation of new regulatory approach  799–801 harmonisation of regime  762 purposes  272, 286, 403, 410, 771–72, 774, 776, 779 regime  605, 613, 762, 764, 777–78, 786–88, 851, 879 relief  270–71, 275, 277, 301 requirements/standards  535–36, 606–8, 613–15, 765–68, 778–79, 783–86, 788–90, 795–98 variable  506, 563, 625, 650

INDEX 941

capital charges  503, 772, 774, 777, 779, 782, 785, 796–99 capital flows  536–37, 595, 633, 735, 740–41, 756–58, 761, 803–4 capital goods  191, 259, 267, 425 capital markets  16–18, 272–73, 290–92, 505–7, 574–78, 646–47, 669–70, 679–725 activities  483, 507–8, 565, 613, 642, 684, 715, 825 autonomy  725–26 capital movements  419, 734–35, 740, 757, 803, 857 capital rebuilding  553, 644 capital requirements, see capital adequacy, requirements/standards capital standards  642, 763, 785, 790, 869 care, duties of  530, 532, 709–12, 723–24 case law  44–45, 78–81, 86–89, 109–10, 160–63, 803–5, 807–8, 817–20 cash accounts  50, 198, 463, 467, 469, 474–76, 481, 485–86 cash balances  79, 474, 482, 487 cash deposits  450, 506, 671 cash flow insolvency  511, 513–15, 517–18, 525, 656–57, 765–66, 788 cash flows  12–13, 270–79, 284–86, 291–92, 302–4, 312, 398, 655 fictitious  308–9, 315, 331–32 fixed rate  308, 310 floating-rate  308, 310, 315, 661 underlying  275, 277, 286, 331 cash ledger  340, 486 cash payments  323, 361–64, 366–67, 373, 519 cash settlements  50, 281–82, 315, 340, 684 CCFs (credit conversion factors)  776, 794, 851 CCPs, see counterparties, central CCPs (central counterparties), concept and potential  328–30 CDOs (collateralised debt obligations)  15, 273, 275, 286, 291, 518, 521, 792 CDS (credit default swaps) characterisation and insurance analogy  295–96 contracts  281–82, 296 naked  295, 888–89 single name  281, 298 Cedel  388, 541, 681, 687, 689, 691 central banks  375–77, 379, 418–19, 521–22, 567, 663–64, 666–68, 762–63 as lenders of last resort  521–23

central counterparties  298–99, 306–7, 324, 377–78, 474, 476, 485–86, 882–86 central counterparties (CCPs)  298–301, 316–30, 336–38, 395–96, 476–77, 631, 703–4, 882–86 central securities depositories  886 centralisation  300, 342, 487, 543–44, 631, 667, 874, 879 certainty  70, 91, 109, 173, 395, 557, 790 certificates of deposit  64, 516, 683 pass-through  274 chained transactions  371, 378–79, 463, 468 chains of ownership  171, 680 characterisation  42–43, 46, 140, 146, 250–52, 370–71, 490–91, 493–94 legal  3, 11, 24, 32, 247–48, 532, 670, 673 characteristic obligations  184, 233, 256, 266, 297, 411, 752 characteristic performance  233, 752, 841, 859 chargees  28, 124, 127, 132, 136, 164, 206 charges  13–14, 38–41, 123–24, 126–32, 189–90, 198–208, 213–17, 221–22 capital  772, 774, 777, 779, 782, 785, 792, 796–99 equitable  38, 119–20, 124, 126–27, 130–32, 216 fixed  124, 132, 204–5 floating, see floating charges hidden  39, 59, 69, 221 non-possessory  52, 65, 67, 77, 90, 123–24, 190, 208 registrable  130–32 chattel mortgages  36–38, 41, 119–20, 125, 127, 129, 157, 159 chattels  29–42, 58–60, 65–67, 87–88, 118–23, 125, 161–64, 208–11 interests in  36, 121, 162 law of  30, 90, 121, 134, 183–84, 234 non-possessory security interests in  27, 38–39, 42, 67, 91, 120, 149, 190 checks and balances  528, 619, 731 cheques  360–61, 366, 368–69, 375, 603, 679–80, 730 cherry-picking options  493, 498 China  181, 594–95, 602–3, 612, 732, 739, 787, 789 CHIPS (Clearing House Interbank Payment System)  375–76, 378, 587 choice of law  25, 64–66, 256, 258, 266, 461, 500–1, 730

942 INDEX

citizens  416, 500, 573, 741–42, 744, 746, 748–49, 753 civil codes, see codification; Table of Legislation and Related Documents civil law  32–37, 54–56, 59–60, 121–22, 132–33, 168–75, 194–98, 712–14 approach  37, 118, 120, 126, 133, 172, 193–94, 371–72 countries  13–15, 29–30, 65–66, 151–53, 171–73, 215, 221, 712 lawyers  195 modern  126, 156, 372, 390, 713 notions of commercial law  11 civil liability  532–33, 561, 720, 894, 904, 912 claims  77–80, 208–12, 217–22, 227–29, 231–34, 237–40, 386–96, 405–10 assigned  33, 219, 232, 237 competing  54, 164, 335, 386, 400, 493–94 contractual  3, 241, 380, 480, 492, 494 monetary  1, 3, 211, 213, 217–20, 386, 389, 394 mutual  6, 46, 51, 53, 153, 377, 395, 397 secured  33, 42, 51, 72, 81, 136, 142, 204 underlying  25, 231–32, 238, 407, 409 clearers  300, 325, 541, 688, 713, 723, 895 clearing  316–18, 320–25, 328–30, 374–77, 394–98, 474–78, 687–89, 701–4 agents  377, 702–4 brokers  477, 704 facilities  300, 329, 395, 475, 730, 881, 895, 923 houses/institutions  317, 320, 324, 326–28, 376, 480, 485, 631 members  300, 310, 316, 318–25, 327–29, 337, 631, 633 obligations  327, 700, 883, 885, 925 process  326, 475–76, 702 systems  300, 375, 377, 381, 395–96, 476–77, 541–42, 703–4 Clearing House Interbank Payment System, see CHIPS Clearstream  476–77, 497, 500–1, 541, 659, 681, 687–91, 702–3 client accounts  4, 55–56, 89, 389, 463, 474, 485, 712–15 pooled  714 segregated  463, 714 client assets  6, 55, 540, 544, 710–12, 714, 719, 838–39 clients  320–24, 460–64, 467–71, 508–11, 647–52, 670–78, 708–15, 840–42 corporate  287, 521, 570, 650, 664

protection  532, 534, 540, 545, 557, 560, 723, 728 retail  301, 350, 711, 836, 840–42, 845, 900, 903 close-out events  332, 334, 337, 391, 396 close-out facilities  324, 338, 631 close-out netting  318–20, 324, 333–34, 336–37, 393–94, 396–98, 401, 498–501 bilateral  391, 400, 409–10 clauses  153, 334, 393 closed system of proprietary rights  87–88, 104, 115, 152, 156, 193, 196, 267 co-operation  452, 454, 592, 594–95, 743, 757–60, 762, 764 international  453–54, 857–58, 895–96 regulatory  18, 636, 833 co-ordination  565–66, 595, 667–68, 763–64, 829, 832, 874–75, 879 co-ownership  57, 101, 132, 164, 478, 480, 485 cocktail swaps  308, 662 CoCo bonds  559, 632, 638, 771, 791 codification  49, 63, 75, 83, 89, 257, 431, 439 countries  268 partial  257, 268, 431 private  49 of private law  49 thinking  63 collateral  50, 135–37, 142–44, 199, 466–69, 471–73, 480–82, 653 cross-border use  828, 862 financial  50, 79, 207, 323, 481, 867 rights  139, 145, 183, 248, 250, 257, 260, 265–68 collateral rights under Leasing Convention  265–66 collateralisation  273–75, 296, 300, 316, 318–19, 336, 482, 657 collateralised debt obligations, see CDOs collecting assignees  68, 142, 172, 218, 243 collecting assignors  78, 89, 272 collection agents  140, 199, 271–76, 388 collection agreements  142, 209, 212, 225–26, 228, 238–39, 241, 244 collection arrangements  4, 81, 97, 229, 426 collection risk  224, 229, 427 collections  86–87, 140–42, 198–200, 221–22, 224–30, 232–33, 239, 426–30 excess  112, 230 collective investment schemes  100, 342, 344–46, 352, 685, 815 comitology  828–29, 877, 901, 922

INDEX 943

commercial arbitration, see arbitration commercial banking  12, 508–9, 512–13, 520–21, 527–28, 533–35, 542–44, 647–79 activities  18, 528, 540, 548, 565, 575, 586, 592 products  19, 652 regulation  525–26, 529, 666–68, 788 risks  656–60, 790 types of banks and operations  652 commercial banks  16–19, 507–8, 529, 533–35, 647–48, 650–53, 656–58, 669 intermediation and disintermediation  669–70 commercial courts  90 commercial flows  6, 10, 25–26, 58, 195, 197, 201, 207–8 commercial paper (CP)  195, 278–79, 285–86, 568–69, 654, 664, 683, 704 commercial transactions  49, 120, 138, 386 commerciality  212 commingling  199, 202–3, 472, 474, 482, 491–92, 909, 911 commitments  279, 435, 439–40, 654, 665, 736–39, 776, 882 standby lending  775–77 committee structure  560, 668, 829, 846, 874, 876–77, 889, 908 commodities  8, 38, 306, 314, 329, 346, 348, 394 commoditisation  211, 218–19, 241, 243, 518, 520 of risk  518, 520 commoditised products  5–6, 8, 13, 26, 31, 57–58, 63, 68–69 Commodity Futures Trading Commission (CFTC)  298, 642 common creditors  6, 9, 51, 59–61, 63, 69, 72, 176 bona fide  60, 69 common law  32–37, 45, 58–60, 120–26, 132–34, 168–73, 442–43, 712–15 countries  4–8, 10–11, 13–14, 54–55, 160, 194–97, 387–89, 680–81 courts  122, 133, 159, 391 modern  8, 10–11, 30–31, 35, 51, 60, 67, 196–97 mortgages  15, 45, 118, 122, 124, 126–27, 179 notions of commercial law  11 old  45, 118, 124, 179, 243 tradition  144, 388

companies  272–75, 356, 457, 651, 679–82, 695–96, 715–17, 781 factoring  222, 652 finance  245, 276, 279, 726–27 foreign  222, 275, 706 holding  534, 564, 566, 586, 630, 651–52, 892 insurance  101–2, 222–23, 278–79, 285, 342–43, 511, 516, 520 listed  689, 813, 827, 850 parent  309, 402, 445, 661 private  669, 787, 795 public  356, 795, 862 securities  651, 806, 858 company law  530, 680–81, 742, 805, 810, 813, 828 compartmentalisation  458, 462, 464, 468, 485 compensation schemes  60, 843, 874, 926 competencies  192, 583, 744, 746, 757, 905–6, 908, 912 competent authorities  813–14, 841, 843–44, 849 competing claims  54, 164, 335, 386, 400, 493–94 competing creditors  31, 58, 62, 164, 354, 386–87, 493, 659 competition  542, 576–77, 691–92, 722, 743–44, 826–27, 842–43, 896 regulatory  566, 583, 598, 754, 816–17, 820–21, 826 competitive devaluations  725, 734–35 competitiveness  421, 522, 572, 603, 848 complacency  511, 553, 596, 601, 603–4, 610, 625, 716 completeness  244, 363 completion  173, 379, 474, 583, 644, 654–55, 757, 767 compliance  255, 262, 431–33, 435, 438, 923, 926, 930 departments  535, 599, 789, 875 computers  339, 572, 576, 694 computing power  385–86 concentration principle  829, 842, 845, 850, 926 Concordat  591–92, 594 condicio  82, 167 conditional assignment  33, 78, 112, 231 conditional buyers  128, 161, 163, 188, 192 conditional interests  139, 158, 161 conditional owners  38, 57, 85, 160, 163–65, 171–72, 249

944 INDEX

conditional ownership  81–83, 92–94, 106, 108–9, 117–18, 158, 249, 251–52 interests  160, 195 rights  47, 49, 108, 112, 167, 171, 175, 185 conditional sales  33–45, 81–87, 95–100, 116–20, 125–30, 132–35, 154–67, 230–31 conditional sellers  128, 158, 161, 163–64 conditional title  107–8, 119, 133, 157, 160–62, 171, 173, 183 conditional transfers  85, 87–88, 99, 105, 110, 166–67, 172–73, 228 conditionality  81–83, 94, 97, 108, 152, 332–33, 398–99, 403–4 conditions implied  168, 237, 673, 751 market  165, 273, 521, 658, 704, 814, 841, 843 rescinding  82–83, 91, 108, 112, 167–68 resolving  81–83, 108, 150, 167–68, 170 suspending/suspensive  82–84, 86, 94, 97, 160, 167–70, 249 suspensive  81–84, 86, 97, 160, 167–70 conduct of business  524–27, 529–35, 557–58, 582–83, 722–23, 816–20, 831–32, 838–41 home or host country authority  841–42 rules  728, 755, 818, 838–39, 886 confidence  527, 544–49, 578–79, 601–3, 619, 622, 635–37, 929 confidentiality  284, 304, 452, 459, 463–64, 681, 706, 709 confirmations  265, 326, 382, 395, 500, 588, 641, 861 confirming banks  418, 431, 433–35, 442, 444, 446 confiscation  452, 454 conflicts of law rules  24, 188–89, 236, 238, 240, 255, 258, 266 confusion  43, 86–87, 166–67, 317, 445–48, 554, 601, 668 conglomerate risks  565 conglomerates financial  565–66, 593, 764, 829, 858, 877 supervision  590, 592, 857 connexity  6, 53, 333–34, 361, 387–88, 390–95, 405–6 consensus  139, 305, 384, 406, 526, 563, 640, 932 consent  2–3, 123–24, 161–62, 219–20, 307, 317, 369–72, 469–71

consistency  305, 615, 798, 829, 831, 878, 893, 917 consolidated supervision  519, 591–92, 667, 809, 830, 857–58, 898, 900 consolidation  290, 329–30, 532, 542, 824, 830, 851, 856 constitutive requirements for assignments  77–78, 100, 116, 239 constituto possessorio  105–6, 110, 125, 160 constructive delivery  123, 127, 209 constructive possession  110, 125, 132, 205 constructive trusts  4–5, 10, 26, 33, 53, 55, 711, 714 consumer credit  49, 676–77, 864, 919–20 consumer debt  292, 653, 657 consumer goods  59, 135, 142–43, 189, 248, 860 consumer leases  139, 145, 251, 253 consumer protection  135, 246, 248, 253, 807, 827, 832–33, 859–60 consumers  8–9, 552–53, 602, 743, 805–6, 820–21, 860–61, 863–64 contagion  349, 510, 539, 565, 569, 640, 858, 897 contingencies  172–73, 716, 775–76, 793, 799 contingent assets  775 contingent liabilities, see contingencies continuous novation netting  333, 377 contract interpretation  396 contract principles  236 contracts  307–8, 314–25, 331–34, 388–92, 398–403, 407–11, 421–23, 492–93 derivative  325, 648, 692, 882–83 for differences  312, 314–15, 331–32, 396, 398, 407, 409, 411 executory  146, 157, 159, 163–64, 174, 176–77, 492–93, 498 foreign exchange  313, 403, 757, 776 forward  306, 314, 489 futures  306, 315–16, 319, 322–23, 468, 661, 779 insurance  295, 861, 888 lease  146, 253, 260, 264–65, 267–68 original  271, 322, 328 sales  108, 317, 319, 361, 431, 440, 477, 662 smart  75, 303–5, 339–42, 384, 486, 573, 678–79, 905 standard  310, 315, 325, 682, 688 supply  253, 256, 266 underlying  105, 211, 218, 270, 279, 438–39, 444, 446

INDEX 945

contractual arrangements  140, 145, 150, 152, 159, 251–52, 254, 257 contractual choice of law  25, 64, 256, 258, 266, 335, 461, 730 contractual claims  3, 241, 380, 480, 492, 494 contractual duties  176, 265, 317, 372 contractual netting  55, 331, 391, 393–94, 397, 403–4, 494 clauses, see netting clauses contractual obligations  25, 42, 231–33, 238, 297, 407, 411, 418 contractual rights  3, 53, 145, 176, 262, 269, 276, 280 contractualisation  57, 204, 408 control  70–71, 124, 160, 203–4, 386, 470–71, 481–82, 751 private  52, 205 regulatory  355, 822 risk  376–77, 565 convergence  32–35, 67, 89, 761, 763, 785, 830, 838 conversion  80, 109–10, 167, 175, 230, 247–50, 417, 501 convertibility  363–64, 379, 414–15, 417–19, 429, 537 free  414–16, 419, 735 core capital  640, 769–70, 792 corporate bonds  209, 273–74, 310, 686, 694, 779 corporate clients  287, 521, 570, 650, 664 corporate finance  531, 565, 651, 715, 718, 798, 923 corporate governance  179, 488, 529, 580, 634, 636, 881, 900 corporate information  460, 485, 521, 549, 579, 581, 680, 698 corporate issuers  532, 669, 692, 827 correspondent banks  365, 381, 438 corruption  454–56, 527, 538, 546 costs  154–55, 274–75, 313, 375–77, 665–66, 691–92, 695, 881–82 settlement  329, 476, 702, 712, 840 transaction  186, 329, 342, 346, 358, 412 Council of Europe  453–54, 759 counterclaims  4–5, 223, 331, 360–61, 388, 405–9, 501 counterparties  307–8, 317–20, 332–34, 337–41, 395–96, 682, 712–14, 775–77 bankrupt  53, 59, 109, 376, 394 central (CCPs)  298–301, 316–30, 336–38, 395–96, 476–77, 631, 703–4, 882–86 identifiable  383

counterparty risk  414, 425–26, 488–89, 512, 685, 768–69, 851, 853 coupons  312, 315, 332, 680, 701, 706, 771–72, 775 court orders  123–24, 190, 391–92, 394–95, 441 courts  42, 44, 122–24, 158–59, 255, 422–23, 748–49, 753–54 bankruptcy  46, 68–69, 71, 185, 331, 338, 403, 410 foreign  422–23 supreme  24–25, 77, 85–86, 120, 231 covenants  510, 570, 655, 657, 795 coverage  142–43, 188, 190, 192, 236, 244–45, 268, 455–56 covered bonds  269, 291–92, 570, 642 CP, see commercial paper creation of security interests  64, 93, 123 credibility  244, 279, 283, 290, 535, 541, 545, 748 credit  365–73, 414–15, 426–48, 611–13, 621–24, 675–78, 774–78, 781–86 acceptance  431, 433, 435 consumer  49, 676–77, 864, 919–20 letters of  282, 360–61, 366–68, 414–15, 417–18, 426, 430–48, 776–77 sales  119, 127–28, 131–32, 135, 150, 153–54, 165, 167 standby letter of  280, 445–48, 777 credit agencies  298, 542, 627, 633, 799 credit agreements  81, 115, 189, 252, 674, 863–64 credit card balances  269, 276, 279 credit cards  526, 530, 623, 626, 665, 670–71, 676–77, 919–20 credit culture  19–20, 40, 511, 547, 602–3, 611, 623, 626 credit cultures  19, 40, 547, 602–3, 623, 626, 640, 677 and financial crisis  611 credit derivatives  17, 279–80, 293, 296–98, 302, 518, 661, 782 credit event restructurings  296 credit institutions  529, 809–10, 817–18, 851–54, 879–81, 909–10, 914, 923–24 credit lines  87, 223, 226, 279, 287, 290, 375, 422 credit ratings  273, 279, 285, 780–84, 786, 794, 796, 894 credit risk  222–27, 279–85, 374–76, 427–29, 657–58, 768–72, 774–79, 781–84 weight  781

946 INDEX

credit spread options (CSOs)  279, 281, 283 credit transfers  365, 369–70, 378, 380–81, 462, 644, 864 creditors  35–40, 51–63, 161–64, 201–4, 206–8, 359–62, 364–66, 368–70 bona fide  6, 9, 57, 59–60, 69, 162–63, 166, 207–8 common  9, 51, 53–54, 58–63, 69, 72, 123–24, 134–35 competing  31, 58, 62, 164, 354, 386–87, 493, 659 general  79, 478, 485 secured  28, 32, 51–52, 57–58, 72–73, 111, 123–24, 203–5 unsecured  51, 58, 137, 141, 143, 197, 203, 207 criminal sanctions  454, 541, 581–82, 904 crisis, see financial crisis crisis management  525, 592–93, 619, 895 Croatia  375, 745 cross-border financial services  536, 722, 742, 757, 805, 818 cross-border payments  734, 758 risks  413–15 cross-border services  583–84, 591, 736, 738, 750, 755, 834, 844 cross-border transactions  61 cross-default  332, 400, 499, 570 crowdfunding  571–74, 606, 646, 695, 699, 724 crypto-currencies  305, 340, 380, 382–85 fiat  383, 487 crypto-securities  304–6, 485–88, 724 crypto-tokens  384 cryptographic signatures  383, 485–86 CSOs, see credit spread options currencies  312, 359–64, 378–79, 392–96, 414–19, 421–24, 656, 728–31 common  450, 609, 621, 692, 727, 743, 745 effects of collapse  420–23 freely convertible and transferable  417–19 hard  418, 421, 450, 620, 873 paper  363, 385, 415–16, 572, 725 virtual  382, 571–72 currency election  415–16 currency risk  312, 419, 774, 830, 851, 853, 879 currency swaps  100, 306, 308, 311–12, 331, 393, 398, 402 current account  360, 659, 671–77, 861 custodial holdings  7, 11, 75, 329, 571, 575, 904 custodial systems  3, 7, 50, 149, 458, 469, 892

custodians  458–59, 485–86, 508–9, 681–82, 708, 712–15, 719, 723 custody  17–18, 164, 355, 533, 541–42, 701, 837–38, 840 functions  477, 507, 533, 535, 687, 704, 833 customary law  5, 7–10, 16, 23, 110, 117, 701–2, 764 customers  223–24, 226–27, 355, 540–41, 543–44, 671–72, 675–76, 711 damages  157–58, 163–65, 176, 263–66, 389, 425, 493–94, 904–6 dark pool exemptions  882 dark pools  699, 882 de-globalisation  606, 790 dealers  38, 269, 645, 694, 698, 704–5, 711 debit transfers  368–69, 381, 463 debiting  369–70, 458, 461–63, 465, 474, 476, 488, 492 debits  369–70, 372, 462, 465–66, 474–75, 485, 672–73, 676 direct  368, 644, 864 debt  33–34, 123–24, 189–90, 386–89, 391–95, 420–21, 620–22, 787–88 banking  623, 634, 907, 911 consumer  292, 653, 657 government, see government debt sovereign  424, 727, 762, 887 subordinated  788 debtors  134–38, 199–209, 218–20, 228–35, 237–45, 270–72, 359–61, 368–73 account  78, 200, 203, 224, 233 assets  20, 53, 57, 127, 234, 360 bankrupt  51, 106, 386 defaulting  33, 45, 128, 189 foreign  48, 225, 244–45, 378, 414 decentralisation  756 deduction  128, 158, 205, 284, 771, 779, 791, 798 default, events of  281, 296, 324, 510 default risk  197, 207, 795, 830 default swaps  274, 295, 305, 510, 518, 520, 886, 890 defaulting debtors  33, 45, 128, 189 defaulting parties  46, 85, 166, 175, 324, 376, 500 defeasible titles  34, 139, 161, 170, 173 defects  24, 75, 206, 231, 266, 364, 366–67, 372–73 defences  218–21, 238–39, 266, 271, 390–92, 406–9, 440–41, 444–46

INDEX 947

deficit countries  602–3 deflation  506, 522–23, 603, 612, 636, 663, 735, 871 delayed transfers  96–97, 167, 172, 314, 475, 702 delegated powers  888, 922 delivery  49–50, 63–64, 160–62, 182, 266, 363–65, 465–68, 661–62 constructive  123, 127, 209 obligations  187, 494, 500, 579 of possession  84, 104, 137, 160 requirements  67, 200, 202, 205, 212, 355, 365 versus payment, see DVP dematerialisation  457–58, 484, 681, 701 democratic legitimacy, see legitimacy democratisation of credit  611–12, 677–78, 790 democratisation of financial services  675–78 Denmark  73, 192, 210, 375, 759, 832, 854 Denning Lord  24 dependency  268, 333, 395, 532, 620 deposit-gathering activity  572 deposit guarantee schemes  550–51, 630, 637, 639, 666, 854, 907, 911 deposit insurance  546, 587, 601, 641, 644, 668, 788, 854 deposit money  506, 603, 641, 676 deposit takers  19, 349, 508, 651 deposit-taking function  7, 75, 385, 505, 509, 537, 571, 648 deposit-taking institutions  463, 568, 630, 648, 730, 893 Depositary Trust and Clearing Corporation, see DTCC depositories  458–61, 468–69, 476, 479, 485–88, 681–82, 701, 703 depositors  513–14, 524–25, 532–34, 537–41, 545–46, 548–51, 557–58, 912–14 protection  532, 538, 557–58, 562, 642, 648, 909, 914 deposits  505–8, 570–71, 629–30, 647–48, 651–53, 669–76, 730, 751 call  12, 628, 651, 676 cash  450, 506, 671 euro  726, 729, 759 short-term  506, 516, 575, 616, 656, 665, 872 deregulation  535–37, 585, 708, 729, 736, 738 derivative contracts  325, 648, 692, 882–83 derivative products, see derivatives derivative transactions  94, 290, 339, 348, 631, 665, 794, 884

derivatives  15–20, 308–11, 316–18, 326–30, 336–41, 402–3, 661–63, 775–76 credit  17, 279–80, 293, 296–98, 302, 518, 661, 782 domestic and international regulatory aspects  336 international aspects  335 markets  17, 298, 300, 306, 315–27, 329, 692, 695 regular  316–17, 320, 326, 331, 412, 503 trading  7, 75, 317, 385, 477, 643, 659 types and operation  306–9 use  310–14 valuation  314–15 description, mere  80, 118 destabilisation  278, 285, 460, 511, 516, 520, 579, 603 devaluation  378, 421, 620–21, 874 competitive  725, 734–35 diligence, due  207–8, 374, 453, 575, 863 dilution  175, 290, 552, 681, 892 dingliche Anwartschaft  65, 107, 109–11, 113, 115, 152, 172, 177 dingliche Einigung  83, 105–9, 114, 117, 229 direct debits  368, 644, 864 direct effect  62, 734, 738, 741–42, 750, 753 direct services  751–52, 811, 839, 842 Directives, see under EU disclosure  302–3, 353–54, 542–44, 588, 712–15, 722, 773–74, 813–15 proper  302, 353, 376, 543–44, 574, 600, 675, 727 discount  222, 224, 227, 229, 290, 427, 429–30, 435 discounting  100, 223, 302, 427–29, 435 discretion  122, 390–91, 561–62, 675–76, 710–11, 855, 909–10, 912 administrative  912, 917 regulatory  525, 558, 625, 911, 920 discrimination  671, 676–77, 700, 738, 745, 753–54, 916, 925 disintermediation  507, 571, 573, 577, 650–51, 669, 697–98 disposition duties  44, 128, 145, 158, 230 rights  159–60, 200, 202, 209, 215, 359–60, 363–68, 464–65 dispositions  38–39, 42, 46, 144, 200–2, 205–6, 230, 364–66 disputes  86, 99, 263, 270, 414, 417, 436, 440 resolution  75, 405, 424, 739

948 INDEX

distributed ledgers  339, 341–42, 381–83, 386, 486–89 distributions  51, 54, 60, 205, 345, 587–89, 713, 715 diversification  342, 344, 657–58, 661, 765, 774, 794, 798 diversity  38, 151, 352, 518, 613, 759, 788 dividends  159, 311, 315, 339, 460–61, 485–86, 552, 680 division  536–37, 668, 720, 723, 820, 823–24, 841, 844 documentary letters of credit  338, 432, 436, 441, 446 documentation  23–24, 209–10, 212, 218, 242–44, 317–18, 324–25, 329 swaps  398–99, 401 documents  142–43, 156–57, 210, 424–38, 440–41, 443–46, 475, 679–80 scanned paper  303 of title  3, 64, 195, 425, 680 transport  436 domestic laws  23–27, 40–41, 68, 70–71, 244–45, 412–13, 447, 479–80 applicable  21, 26, 50, 174, 187, 240, 242, 262 domestic markets  24, 175, 686–87, 693, 719, 728–29, 731, 865 domestic regulation  576–77, 693, 728–29, 737–38, 754–55, 807, 870 domestic security interests  74, 175, 191 domestic stock exchanges  576, 686–87, 691, 827, 842 domino effect  510 double gearing  348, 858 double pledging  304 double regulation  346, 582, 591, 738, 803–5, 898–99, 921, 926 drug trafficking  449, 451–52, 454, 456 DTCC (Depositary Trust and Clearing Corporation)  330, 339, 342 dual ownership  117, 145, 156, 174–75, 249, 252, 490 dual regulation, see double regulation duality of ownership  83, 85, 94, 99, 107–8, 112–13, 167, 169–78 Dubai  181, 605 due diligence  137, 207–8, 221, 304, 374, 453, 575, 863 Dutch law  40–41, 76–80, 82–89, 108, 116–17, 167–68, 194, 232 new  40–41, 82, 84–86, 88, 173, 194, 491, 501

duties  218–20, 264–67, 306–7, 431–33, 489–90, 661–62, 709–13, 723–24 of care  530, 532, 709–12, 723–24 contractual  176, 265, 317, 372 disposition  44, 128, 145, 158, 230 fiduciary, see fiduciary duties repurchase  130, 155, 161, 496 DVP (delivery versus payment)  64, 379, 475, 659, 702 dynamism  195 E-commerce Directive  701, 859–60 e-money  758, 862 earnings  17, 290, 604, 633, 656, 717, 735 retained  505, 568, 652, 717, 791–92, 812 Eastern Europe  50, 450, 453–54, 743, 745, 759 EBA (European Banking Authority)  516, 574, 877–79, 899, 907–8, 923 EBC (European Banking Committee)  877, 899 economic cycle  511–12, 514–15, 554–55, 561, 596, 626–27, 789–90, 931 economic growth  288, 517, 603, 607, 801 effective market access  737, 754, 822–23 effectiveness  29–30, 33–34, 96–97, 99, 131–32, 360–61, 444–45, 601 legal  193, 295, 659 efficiency  193, 543, 545, 663–64, 758, 825, 827, 846 Einigung  108, 111, 168, 212 election  146, 157, 163–64, 387, 389, 417, 493, 567 electronic markets  692, 711, 836 electronic money  383, 758, 862 electronic payments  8, 66, 365, 374, 758 electronic trading  316, 577, 696, 843 platforms  325, 534, 573–74, 576, 642–43, 698, 880, 882 elites, local  609, 618, 620 emergencies  522, 528, 549, 561–63, 639, 807, 855, 878 emission allowances  700, 925 employees  55, 91, 291, 293, 513, 597, 633, 847 end-buyers  319, 466, 468, 887 end-investors  318–19, 322–23, 458–61, 463–64, 468–70, 473–74, 477–78, 709 end-sellers  322, 462, 468 end-users  232, 308, 320, 322, 328, 337–38, 631, 730 enforcement  182–86, 213–14, 218, 234, 258–63, 267–68, 481–82, 573 actions  262, 360, 557, 748

INDEX 949

international  184–86, 188, 213, 234, 256–58, 263, 268, 858 proceedings  20, 57, 184, 216 UCC  136, 138, 192 England, see United Kingdom enjoyment  5, 10, 36, 53, 58, 66, 152, 160 enrichment, unjust  53–54, 78, 80, 89, 364, 373 Enron  289–91, 293–94, 302, 580, 624, 662 entitlement holders  458–59, 461, 474, 482, 681, 867 entitlement systems  464, 483, 525, 708, 868 entitlements  457–64, 469–71, 473–74, 478–81, 491–92, 494, 681, 712–13 back-up  459–61, 478, 712 securities  457, 459, 461–65, 467–68, 470–85, 681, 701, 712–13 equality  9, 51, 60, 69, 906, 909, 912, 914 of creditors  9, 57, 197 equipment  38, 90–91, 136, 142, 198–99, 245–46, 259–62, 264–66 leases  137, 139, 143–46, 194, 202, 251, 253–54, 257 mobile  48, 187–88, 191, 193, 196, 208, 269 equitable assignments  203, 394 equitable charges  38, 119–20, 124, 126–27, 130–32, 216 equitable interests  37–38, 48–49, 59, 62, 161–62, 171, 251, 467–68 multiple  162, 171 equitable proprietary rights  31, 34, 38, 58, 60, 63, 66, 70 equitable set-off  26, 391 equitable subordination  56, 117, 138, 674 equity  4, 14–16, 119–21, 169–71, 248–49, 354–58, 771–72, 795 and common law  11, 39 private, see private equity of redemption  15, 45, 119, 123, 126, 128–30 equivalence  183, 585, 591, 823, 832, 895, 898–902, 908 Erkki Liikanen Report  630, 887, 890, 893 erweiterter Eigentumsvorbehalt  107, 109 ESM (European Stability Mechanism)  522, 875, 907, 917 establishment  737–38, 740–41, 749–54, 803–4, 809, 836–38, 844, 898–900 freedom of  738, 751, 753–54, 804, 807, 809–10, 837, 898 right of  741, 743, 749–52, 754, 760, 803–4, 825, 831

estates  54, 72, 78, 80, 85, 87, 106, 109 bankrupt  5, 10, 51–52, 54, 106, 109, 387, 459–60 EU (European Union)  582–85, 740–59, 803–4, 807–12, 814–16, 818–23, 825–29, 844–54 and 2008 crisis  868–97 Admission Directive  812–14, 827 AIFMD (Alternative Investment Fund Management Directive)  354, 357, 571, 645, 826, 868, 876, 885–86 banking  808–10 BRRD (Bank Recovery and Resolution Directive)  563, 638, 668, 895–97, 910 capital adequacy  851, 877–80 CARD (Consolidated Admission and Reporting Directive)  689, 758, 812, 814, 827, 846–47, 850, 864 case law concerning general good  807–8 clearing and settlement  865–68 Commission  747, 752, 758, 809, 819, 824, 859, 862 Consumer Credit Directive  643, 861, 864 CRAR (Credit Rating Agency Regulation)  876, 878, 886 deposit protection and investor compensation  853–54 Directives  214–15, 481, 483, 583–84, 688, 690, 815, 817 division of tasks  820–21 E-commerce Directive  701, 859–60 early concerns and action  803–6 early securities and investments Recommendations and Directives  811–14 ECB (European Central Bank)  522–23, 560–62, 638–39, 820–21, 828–29, 875–79, 907–10, 912–14 ECJ (European Court of Justice)  405, 644, 742–44, 746–49, 751, 753–54, 829, 831 effects of autonomous globalisation forces  762 effects of free flow of capital  757 EIB (European Investment Bank)  522, 687, 770 EMIR (European Market Infrastructure Regulation)  301, 643, 645, 703, 868, 876, 878, 884–86 EMU (European Monetary Union)  494, 667, 761, 832

950 INDEX

ESAs (European Supervisory Authorities)  644, 876 ESC (European Securities Committee)  828–29, 877 ESCB (European System of Central Banks)  375, 494, 667, 762, 820 ESFS (European System of Financial Supervisors)  644, 877–79 ESMA (European Securities and Markets Authority)  327, 643–44, 844, 848, 877–78, 885, 888, 894 European Banking Union  645, 854, 878, 907, 911, 926 European Common Market and Monetary Union  740–47 European Council  639, 743, 747–48, 762, 824, 832 European Parliament  748, 817, 823–24, 850–54, 856–58, 860–64, 878–81, 884–86 European passport  582, 742, 755–56, 803, 809, 814–23, 834, 843 Financial Services Action Plan  644, 758, 762, 815, 823–31, 862–63, 874, 877 and GATS (General Agreement on Trade in Services)  821–22 institutional framework and legislative instruments  747–49 internal market  750–55 Lamfalussy process  828, 846 large exposures  853 long-distance selling of financial products to consumers  860–61 Market Abuse Directive (MAD)  579, 581, 643, 830, 852, 881 MiFID (Markets in Financial Instruments Directive)  548, 684–85, 699, 709–10, 817–20, 826–28, 835–45, 849, 880–82 and money laundering  454–56 mortgage credit  643, 810–11, 863 pension funds  855–56 reciprocity requirements  822–23 Regulation on Short Selling and Certain Aspects of Credit Default Swaps  886–89 Regulations and Directives  803–930 Securities Law Directive (SLD)  867, 885–86 SEPA (Single European Payments Area)  376, 644, 863, 876

Single Deposit Guarantee Scheme (SDGS)  907, 911 Single European Market for Financial Services  762 SRB (Single Resolution Board)  638–39, 898, 910 SRF (Single Resolution Fund)  638–39, 896, 907–8, 910–11 SRM (Single Resolution Mechanism)  523, 623, 638–39, 645, 667–68, 896–97, 907, 910–11 SSM (Single Supervisory Mechanism)  560–62, 639, 645, 667, 791, 854, 878–79, 907–9 Takeover Bids Directive  861–62 Transparency Directive  376, 548, 762, 814, 830, 850, 876, 921 UCITS (Undertakings for Collective Investments in Transferable Securities)  346, 352, 354, 357, 812, 814–16, 868, 876–77 winding up of credit institutions  854 euphoria  299, 516, 519, 554, 601, 608, 613–14, 626 Euro Banking Association  375 euro deposits  726, 729, 759 euro-securities  690, 728, 812, 814, 842 eurobonds  64, 478–80, 497, 499–501, 686–87, 689–91, 705–7, 726–31 central bank involvement  731 markets  18, 576, 578, 686–87, 689–91, 726–27, 729–31, 733–35 Euroclear  29, 461, 476–77, 497, 500–1, 681, 687–91, 702–3 euromarkets  541–42, 687–91, 693, 707–8, 727–29, 752, 756, 824–26 European Banking Authority, see EBA European Banking Committee (EBC)  877, 899 European Banking Union  634, 638, 645, 854, 878, 896, 907, 911 European Common Market  740 European Continent  29, 38, 90, 150, 156, 166, 673, 680 European Parliament  748, 817, 823–24, 850–54, 856–58, 860–64, 878–81, 884–86 European passport  582, 755–56, 803, 809, 814–16, 823, 834, 843 European Stability Mechanism, see ESM

INDEX 951

European Union, see EU eurozone  522–23, 560–64, 620–21, 637–38, 873–76, 907–8, 911–13, 917–19 banking union  634, 638, 645, 854, 878, 896, 911 banks  522, 638–39, 821, 854, 907–8 events of default  281, 296, 324, 510 excess collections  112, 230 excess value  52, 81, 126 excessive leverage  552, 609, 621, 629, 801 exchange of information  456, 567, 592, 763, 855 exchange rates  312, 315, 378, 416, 419, 537, 757, 761 fixed  309, 363, 735, 756–57 execution  50, 62, 71–72, 106–7, 111–12, 151, 339–40, 343 duties  157, 174, 719, 841 sales  42, 85, 106–7, 126, 157–60, 162–63, 165–66, 189–90 executory contracts  146, 157, 159, 163–64, 174, 176–77, 492–93, 498 exemptions  50, 697–700, 705, 719, 727–28, 847–50, 882, 902–3 dark pool  882 expectancies  83–84, 88, 107–9, 115, 160, 167, 169, 172 proprietary  65, 81, 107–8, 110, 152, 172, 249, 495 expectations  115, 602–3, 612, 616, 618, 620, 624, 626 expertise  273, 342, 350, 708, 716, 720, 855, 860 exposure  301, 310–11, 324, 331–32, 353–55, 775–77, 793, 795 large exposures  350, 518, 525, 657, 667, 808, 810, 853 on-balance-sheet  792, 796 risk  271, 310, 430, 593, 851 expropriation  232, 751 extended reservation of title  81, 98–99, 116, 131 extraterritorial effect  49, 184, 418, 422, 585, 896 extraterritoriality  399, 422, 589, 899 factoring  43–45, 85–87, 134, 150–52, 209–10, 216–17, 220–31, 235–41 agreements  221, 227, 229, 235, 239 companies  222, 652 contractual aspects  226–27

proprietary aspects  227–31 of receivables  45, 48, 78, 130, 133–34, 141, 151, 194 recourse  223–24, 238, 244, 248 failed margin calls  510, 883 fair return  545 fair value  791, 794 fairness  89, 196, 443, 605, 722, 816 fault  160, 550, 609, 616, 623, 905 Federal Reserve  299, 348, 375–76, 586, 609, 640, 668, 768 fees  16–17, 272, 313, 350–51, 428, 469, 495–96, 695–97 fiat crypto-currencies  383, 487 fiat currencies, traditional  383–85 fictitious cash flows  308–9, 315, 331–32 fiducia  79, 81, 84, 86, 89, 99, 101, 111 fiduciary assignment  78, 99, 112 fiduciary duties  289, 302–3, 342–44, 351, 708–10, 755, 904–5, 927 reinforced  344, 353, 540 fiduciary sales  29, 65, 76, 79, 98, 150 fiduciary transfers  79, 84, 98, 100, 110, 112 fiducie  91, 98–99, 101–3 fiducie-sûreté  91, 99–100, 103 filing  123–24, 135–38, 140, 142–45, 157, 181, 200–1, 206–8 requirements  50, 135, 140, 151, 156, 161–62, 206, 208 systems  58–60, 138, 143–44, 190, 192, 204, 207–9, 850 finality  16–19, 24, 63–64, 69–70, 363–68, 380, 464–66, 478–80 payment  363–68, 371, 373, 388, 397, 401, 475, 864 finance companies  245, 276, 279, 726–27 finance leases/leasing  43–46, 84–87, 113–15, 133–34, 139, 149–52, 191–94, 245–68 collateral rights under Leasing Convention  265–66 comparative legal analysis  251–54 contractual aspects under Leasing Convention  263–65 domestic and international regulatory aspects  267 enforcement aspects under Leasing Convention  261–63 international aspects  254–56 Leasing Convention  258–60 legal characterisation  247–51

952 INDEX

proprietary aspects under leasing Convention  261 rationale  245–47 uniform substantive law  256–58 finance sales  1–5, 29–33, 43–51, 57–71, 73–77, 85–91, 149–53, 192–97 Germany  113–15 modern  44–45, 57, 133, 152, 194, 245 and secured transactions distinguished  41–47, 149–97 and sharia financing  178–82 United Kingdom  133–34 finance statements  136, 142–44, 201–2 financial centres  197, 449, 591, 595, 605, 718, 727–28, 731 financial collateral  50, 79, 207, 323, 481, 867 financial conglomerates  565–66, 593, 764, 829, 858, 877 financial crisis  516–20, 549–56, 594–97, 599–605, 622–24, 626–28, 853–54, 867–75 approaches and resolution  617–24 and Basel II  786–88 and credit culture  611 effect on financial regulation  596–646 immediate causes of regulatory failure  599–611 and possible new theme or paradigm in banking  614–17 US and European responses  640–45, 868–97 ways ahead  645–46 financial derivatives, see derivatives financial engineering  15, 519 abuse  289–90 and asset securitisation  269–76 excess  285–89 financial flows  21–22, 59, 537, 582, 602 financial futures  307, 314–15, 337, 662, 685 financial information  530, 582, 813, 850 financial innovation  296, 541, 555, 599, 601 financial instability  510–12, 514, 534, 553, 562, 569, 596–98, 931 financial institutions  403, 455, 727–28, 809–10, 828–29, 878–79, 898, 909–10 financial instruments  141, 180, 421, 580–81, 700, 835–36, 844–45, 880–81 financial intermediaries  527–28, 531, 535, 537, 541, 561–62, 913, 916 financial law  11, 21, 95, 115, 180, 298, 391, 393

financial legal order, see commercial and financial legal order financial markets  17–18, 527–28, 544, 575, 600–1, 825, 889–90, 921 globalisation  725–31 financial options  306–8, 316 financial regulation and 2008 financial crisis  596–646 international aspects  582 and moral hazard  549–51 reform problems after 2008  624–26 financial risk  22, 505, 509, 511, 553, 569, 611, 625 financial service providers  486, 505, 529–31, 578, 585, 816 financial services, see also Introductory Note and detailed entries democratisation  675–78 regulation  505–81 international aspects  725–801 Financial Services Action Plan  644, 758, 762, 815, 823–31, 862–63, 874, 877 and Third Generation Directives  831 financial services industry  399–400, 536–38, 631, 634, 807, 810, 815–16, 912–13 financial stability  514–16, 524–25, 537–39, 545–49, 557–58, 560–62, 594–99, 615–16 meaning  596–99 Financial Stability Forum, see FSF Financial Stability Oversight Council, see FSOC financial stress  299, 513, 521–22, 553, 565, 610 financial structures  4, 12, 19, 26, 43, 50, 187, 196 financial structuring  15, 30, 57, 297, 404, 580–81, 662, 826 financial supervision  528, 543, 545, 566, 644, 650, 875, 877 financial system  509–11, 520–21, 523, 548, 558–62, 818–19, 878, 931 financial transactions  46, 50, 55, 67, 71, 95, 99, 403–4 financing  40–45, 150–51, 195–96, 223–25, 238–39, 241–42, 244–47, 655 asset-backed  1, 11, 25–27 ownership-based  44, 46, 64, 155, 167, 252 project  12, 20, 209, 212, 216, 652, 654–55, 659 recourse  87, 228–29 repo  20, 156, 187, 481, 522, 649, 653, 659

INDEX 953

sharia  44, 150, 178–79, 181, 506 trade  629, 653–54, 670 finished products  38, 186, 198, 205, 209 fintech  7, 74, 339, 380, 505, 509, 571–73, 575 and capital markets  724 and commecial banking  678–79 impact on securitisation  303–6 first demand guarantees  34, 282, 303, 445, 447 First Pillar  743–44, 783–85, 907 fiscal policies  522–23, 538, 540, 553, 608, 761, 872, 874–75 fixed exchange rates  309, 363, 735, 756–57 fixed prices  290, 306–7, 310, 661–62 fixed rate cash flows  308, 310 floating charges  1–3, 28–30, 38–41, 50–52, 67–72, 89–91, 123–25, 196–218 comapartive legal analysis  201–6 domestic and international regulatory aspects  215 international aspects  213–15 non-possessory  7, 124 publication or filing requirements  206–9 transnational  16, 519 types  197–201 floating interest rates  310, 656 floating rate cash flow  308, 310, 315, 661 floor brokers  316, 320–23, 396 flows  7–8, 186, 536, 538, 577–79, 584–85, 634, 760–61 commercial  6, 10, 25–26, 58–60, 195, 197, 201, 207–8 financial  21–22, 59, 537, 582, 602 floating-rate cash  308, 310, 315, 661 free  454–55, 536, 634–35, 755–56, 804–7, 819, 824, 831 international  16, 21, 68, 70, 186, 404, 413, 725 ordinary commercial  6, 58–60 fonds communs de créances  100, 273 force majeure  159, 266, 402, 418 foreclosure  45, 123, 129, 261, 278, 287 foreign banks  375, 422, 586–87, 606, 665, 730, 819, 822 regulation in United States  586–87 foreign branches  586–87, 591–92, 668, 730, 738, 751, 833, 835 foreign brokers  584, 590, 752, 841 foreign companies  222, 275, 696, 706 foreign courts  422–23 foreign debtors  48, 225, 244–45, 378, 414

foreign exchange  378, 415–16, 419, 427–28, 651, 653, 761, 772 contracts  313, 403, 757, 776 markets  416–17, 419, 624, 687, 690, 695 regimes  416, 419, 729 transactions  323, 379, 395, 735, 759 foreign interests  61, 65, 69, 71, 175, 183–85 foreign investors  345, 422–23, 686, 727, 735 foreign law  88, 233 foreign proprietary interests  21, 184–86 foreign service providers  738, 755, 819, 823, 834, 899, 924 foreign subsidiaries  590, 716, 738 forfeiture  44, 126, 452 formal markets  576–77, 686, 688–89, 691–92, 695, 697, 707 formalism  580 formalities  79, 81, 88, 98–99, 155–56, 230–32, 241–42, 489 forum  23, 414, 590, 593, 614–15, 636, 674, 740 selection  414 forward contracts  306, 314, 489 France  29, 82–83, 89–104, 165–68, 210, 386–88, 406–7, 873–74 Autorité des Marches Financiers (AMF)  566, 721, 840, 868 bankruptcy  29, 91–97, 101, 250, 334, 387–88, 401, 406 CC (Civil Code), Arts 2488-1–6  91 law  29, 31–33, 77, 88–90, 92–96, 102–4, 126, 389–90 open or closed system of proprietary rights  104 pension livrée  94–96, 98, 101 reservation of title  96–97 securitisation  100–1 solvabilité apparente  58, 92–93, 96, 99 trusts  101–4 vente à reméré  90–91, 93, 95, 98 fraud  365–67, 373–74, 441–42, 454–56, 464–65, 588–89, 807, 819 free disposition  263, 359, 369, 405, 408, 411, 422, 730 free flows  454–55, 536, 634–35, 755–56, 803–7, 819, 824, 831 free movement  725, 734–35, 741–42, 748, 750, 754, 757–59, 804–5 of capital  424, 734, 742, 756–59, 819, 825, 870

954 INDEX

of financial services  742, 760, 805 of goods  419, 725, 733, 741–42, 750, 753–54, 804, 807 of persons  741, 750, 753–54, 803–4 of services  583, 735, 741, 749, 753, 755, 824, 898 freedom  87, 741–43, 750–51, 753–54, 760, 803–4, 809, 855 contractual  124, 811 of establishment  738, 751, 753–54, 804, 807, 809–10, 837, 898 FSF (Financial Stability Forum)  554, 594–95, 615, 625, 636 FSOC (Financial Stability Oversight Council)  353, 560, 564, 642 full title  112–13, 160–61, 163–64, 169, 251, 253–54, 261, 268 functional approach  66–67, 138–39, 141, 166–67, 189, 193–94, 533–35, 722 functions  527–31, 533–35, 538–40, 564–67, 577–78, 663–65, 692–93, 718–19 deposit-taking  509, 537, 648 judicial  531 outsourced  477, 704 recycling  506, 516, 647–48, 912, 923 social  516, 603, 628, 647 fund management  17, 50, 357–58, 565, 567, 715, 852, 885–86 fund managers  17, 351, 353, 358, 841, 885, 927–28 funding  154–56, 174–76, 225–30, 282–86, 291–94, 495–98, 505–7, 520–23 asset-backed  42, 50, 67, 90, 103, 149–50, 156, 519 short-term  181, 278, 286–87, 350, 510, 513, 568–69, 611 techniques  149, 151, 153, 155, 157–59, 161, 195–97, 209 transactions  38, 66, 149–50, 244, 495 funds  344–54, 356–58, 375–76, 381–82, 568–69, 632, 814–15, 855–56 of hedge funds  347, 351 money market  279, 560, 568–69, 630, 633, 652, 664, 814 pension  342, 536, 760, 835, 855 private equity  351, 354, 357, 652, 852 umbrella  344, 347 fungibility  175–77, 182, 324–25, 328, 467, 489, 491–92, 712 fungible assets  42, 47, 169, 178, 354–55, 395, 467, 491

fungible securities  467, 475, 481, 485, 508, 682, 688, 702 futures  2–3, 306–10, 313–20, 322–23, 325–26, 335–38, 661–62, 775–76 contracts  315–16, 319, 322–23, 468, 661, 779 exchanges  18, 315–16, 328, 337, 687–88 standard  310, 313 G-10  453, 594, 668, 763–64, 851 G-20  329–30, 563, 595, 636, 870, 875–76, 896–97, 932 G-30  594, 865 GATS (General Agreement on Trade in Services), and EU  821–22 gearing  288, 299, 352, 517–18, 543, 604, 801, 930 high  181, 285, 289, 348, 518, 619, 628–29, 636 general banking conditions  373, 673, 675 general debt registers  59, 143, 207 general good  752–55, 803–8, 811, 815–21, 831–32, 834, 837–39, 859–60 EU case law  807–8 general power of attorney  321, 396 general principles  188, 236–37, 240, 242, 258, 262–63, 268, 447 generality  76, 78, 90, 139, 206, 219 Germany  29–31, 39–42, 82–84, 105–18, 160, 172–73, 805, 873–74 finance sales  113–15 law  104, 108–9, 113, 115–16, 205, 217, 232, 252 open or closed system of proprietary rights  115–18 Sicherungsübereignung  39–40, 42, 55–56, 65, 67, 69, 105–7, 110–17 Sicherungszession  76, 105, 110, 112, 116, 150, 229 globalisation  26, 572–73, 578, 619–20, 625, 725–26, 731, 760–63 globalising world  69, 413, 678, 905, 929 going concerns  198, 301, 716, 903 gold  363, 415, 417, 606, 725, 732, 795, 874 clauses  415, 417 Goldman Sachs  521, 565, 597, 651, 670, 698, 718 good faith  136, 138, 201–2, 236, 674, 677, 710, 712 case law  839 civil law  89, 118, 196, 442, 710, 712 common law  28, 118, 442–43, 712

INDEX 955

good morals  107, 113–14, 116–17 goods  122–26, 156–62, 202–3, 205–6, 423–29, 435–38, 739–42, 753–54 capital  191, 259, 267, 425 commingled  136, 202 consumer  59, 135, 142–43, 189, 248, 860 cross-border movement  731–34 manufactured  116, 120, 131, 182, 214 replacement  39–41, 52, 54–55, 61–62, 67, 79–81, 132, 205–6 goodwill  90, 716–17, 771, 791, 851 governance, corporate  179, 488, 529, 580, 634, 636, 881, 900 government bonds  292, 461, 516–17, 652, 657, 663, 797–98, 887–89 markets  470, 629, 664, 686, 888 government debt  421, 522, 614, 619, 632, 745, 781 crisis  523, 607, 614, 622, 888, 896, 907, 917 government spending  602, 619, 761 governmental intervention, see intervention Greece  420, 424, 483, 502, 522, 594, 842–43, 873–74 growth  552–53, 608–9, 615–16, 618–19, 621–22, 640–41, 790–91, 869–72 economic  288, 517, 603, 607, 801 elixir  612, 789, 872, 929 guarantees  225–27, 274–75, 277–83, 295, 438–42, 444–48, 663–66, 776–77 autonomous  444–45 bank  24, 34, 430, 436, 440, 442, 444–48, 777 deposit guarantee schemes  550–51, 630, 637, 639, 666, 854, 907, 911 first demand  34, 282, 303, 445, 447 independent  439, 441, 445–46 payment  106, 226, 414, 446 primary  280, 445, 888 third-party  309, 661, 795 guarantors  220, 222, 280–81, 291, 369, 438, 444–45, 848 gute Sitten  107, 113, 116–18, 138, 442 haircuts  497, 502, 772, 779, 782, 795, 910 harmonisation  47–50, 480–81, 755–56, 808–9, 816–17, 819–21, 838, 849–50 of capital adequacy regime  762 private law  49, 102, 710 harmonised standards  803, 843, 902, 923, 925 head offices  592, 668, 751–52, 810, 856–57 health  640, 646, 743, 745, 816, 821, 869, 873 public  746, 754, 816

hedge funds  285–86, 347–55, 357, 568–70, 629–31, 643–44, 651–52, 715 activity  181, 355–57, 630, 653, 885, 887 funds of  347, 351 regulation  350, 352, 357, 885 hedges, imperfect  310, 772, 779, 887–88 hedging  310, 333, 337, 518, 616–17, 658, 661, 892 instruments  2, 309, 336, 613, 678 hidden charges  39, 59, 69, 221 hidden proprietary interests  76, 81, 93, 123, 145 hierarchy of norms  20, 189, 217, 245, 303, 410, 447–48, 484 High Frequency Trading (HTF)  697–98 high gearing  181, 348, 602, 636, 665, 768 high leverage  287, 563, 597, 599, 613, 801 hire-purchases  43–44, 119, 125, 127–29, 133, 246, 248–49, 251–53 holders  55, 121–24, 160, 170, 427, 430, 434, 441 in due course  367, 373 physical  122, 160, 170 security  3, 99, 105, 136, 159, 164, 204, 682 security interest  32–33, 52, 157, 206, 724 holdership  121–22, 169–70 holding companies  534, 564, 566, 586, 630, 651–52, 892 home countries  700, 803, 805, 832–33, 852, 854, 900, 902 home-country regulation, see home regulation home-country rule  590–91, 668, 720, 806, 811, 816–19, 831, 837–39 home-country supervision  357, 812, 856 home regulation  722–23, 755–56, 806, 808, 822, 824, 838–39, 841–42 home regulators  592, 668, 723, 818–19, 821–22, 834, 837–39, 856–57 horizontal effect  531, 533, 906 horizontalisation  634, 733, 804 host countries  582–84, 736–38, 751, 805, 818–19, 832, 837–39, 841–44 host-country powers  819, 831–32 host-country regulation, see host regulation host-country rule  346, 357, 753–56, 808–11, 815, 817–20, 833, 841 host-country supervision  805, 820, 838 host regulation  582–83, 723, 803, 805, 808, 818–20, 822, 841 host regulators  582–83, 592, 668, 722–23, 819–20, 834, 841–42, 924

956 INDEX

host states  751–52, 754–55, 805–7, 810, 816, 819, 849, 932 house banks  28, 427, 432, 434, 437, 654 house brokers  321, 323 house prices  285–86, 612, 678 housing  245, 285, 562, 603, 607, 613, 622, 919–20 HTF (High Frequency Trading)  697–98 human rights  456, 676 to credit  628, 675 ICJ, see International Court of Justice identifiability  304 identifiable counterparties  383 identification  13, 23–24, 39–40, 200, 202–3, 205–6, 209, 218 requirements  135, 142–43, 200, 242 illegality  291, 401 illiquid assets  300, 516, 519, 624, 633 illiquidity  285–86, 300, 513–16, 518, 611, 615, 649, 669–70 immigration  451, 614, 618, 741, 745 imperfect hedges  310, 772, 779, 887–88 implementation legislation  352, 710, 747, 749, 828–29, 839, 841 implied conditions  168, 237, 673, 751 implied terms  242 impossibility  81, 98, 108, 401, 425, 483–84, 492, 556 incentive structures  296, 604, 627 incentives  282, 289, 385, 543, 784, 793, 879, 884 income rights  5, 53, 58, 66, 152, 173 income streams  28, 139–41, 209, 276, 310, 312, 455, 655 incoming payments  382, 677 indebtedness  5, 21, 27, 59, 124, 135, 142, 270 independence  23–24, 80, 215, 243–44, 373, 438–41, 445–46, 465 principle  442–43 independent guarantees  439, 441, 445–46 independent third parties  426, 436, 475, 702 India  181, 595 indirect agency  55, 464, 714–15 individualisation  13, 75, 117, 210, 243 industry practices  189, 303, 412, 447, 504, 762, 835 inflation  46, 165, 276, 612, 615, 620, 869, 871 informal markets  576, 687–93, 696, 705, 707–8, 720, 723, 842–43

information  304–5, 353–54, 579–81, 696–98, 813–14, 846–50, 855–58, 881–83 arbitrage  698 corporate  460, 485, 521, 549, 579, 581, 680, 698 exchange of  456, 567, 592, 763, 855 financial  530, 582, 813, 850 gathering  544, 600, 819–20 insider  579, 581 price  542, 549, 843–44 regular information supply  346, 353, 541, 688, 692, 696 supply  533–34, 541–42, 548, 577–78, 696, 701, 705, 813–14 regular  346, 353, 541, 688, 692, 696 infrastructure  18, 24, 612–13, 722–23, 757, 763, 837, 844 ingenuity  48, 302, 348, 869 innovation  511, 596–98, 608–9, 618–19, 623–24, 825–27, 890, 926 financial  296, 541, 555, 599, 601 insider dealing  578–79, 581 insider information  579, 581 insiders  544, 546, 548, 578–79, 581–82, 603, 698, 720 professional  31, 58, 63, 202, 208 insolvency  73, 106, 111, 130–31, 390–93, 509–15, 632–33, 718–19 balance sheet  512–13, 515, 517–18, 523, 525, 657, 767, 788 banks  509–10, 512, 633, 649, 765, 786, 854 cash flow  511, 513–15, 517–18, 525, 656–57, 765–66, 788 proceedings  20, 74, 387, 480, 911 risk  512, 524, 539, 566, 719 instability  510–12, 514, 596–98, 600–1, 605, 662, 664, 931 banking  514–15, 554, 765, 911 financial  510–12, 514, 534, 553, 562, 569, 596–98, 931 instalment payments  128, 159 instalment sales  127–28, 177 instalments  82, 125, 152, 179, 246–47, 249–50, 268 institutional framework  511, 564, 721, 747, 829 institutional investors  101, 342–44, 347, 352, 687, 690–91, 693, 697–98 institutions  275–76, 528–29, 533–35, 564, 743–44, 854–56, 910, 915–18 deposit-taking  463, 568, 648, 730

INDEX 957

instructing banks  373, 428, 431–32 instructions  321, 365–66, 368–69, 371–73, 428–29, 439, 463, 465 payment  323, 360–61, 364, 367–68, 371, 374, 381, 384 insurable interests  295–96, 888 insurance  295–96, 586–87, 652, 667–68, 805–10, 816–18, 832–35, 856–59 companies  101–2, 222–23, 278–79, 285, 342–43, 511, 516, 520 contracts  295, 861, 888 deposit  546, 587, 601, 641, 644, 668, 788, 854 industry  299, 550, 806, 832, 890 policies  25, 295, 520, 655 products  295, 806, 818 regulation  296 intangible assets, see intangibles intangible claims  6, 182, 214, 221 intangibles  30–31, 37–39, 44–45, 66–68, 76–78, 87, 118, 122 integration  332–34, 392–93, 398–400, 402, 409, 496, 499, 671–72 integrity  536–38, 541, 557, 561–62, 577, 819, 886, 889–90 market  524, 527, 544–46, 599, 697, 904, 921–22, 926–27 intent  24, 158–59, 359, 364–67, 371–73, 387–88, 397, 465 original  367 underlying  108, 110, 362, 423, 749 interbank lending  631, 649, 781, 797 interbank market  286–87, 503, 521–22, 565, 569, 649, 652, 656 interconnectedness  510–11, 514, 534, 539, 564, 568, 574, 596 interdependence  333, 375, 399–400, 733–34, 737 interest holders  38, 52–53, 64, 77, 87, 109, 121, 145 interest payments  12, 29, 270, 273, 276, 717, 726, 758 interest rate risk  309, 312, 685, 771, 830 interest rate swaps  300, 308, 393, 396, 402, 684, 728, 775 interest rates  154–55, 308–10, 312, 314, 490–91, 661–62, 717, 869–70 agreed  110, 128, 140–41, 153–54, 491 floating  310, 656 low  420, 506, 599, 608–9, 621, 656, 767, 869 market  315, 513, 658, 669

interests  35–40, 48–53, 58–60, 65–68, 120–21, 157–65, 171–74, 709–14 conditional  139, 158, 161 conflicts of  354, 548, 707, 709, 711–12, 723–24, 838, 845 equitable  37–38, 48–49, 59, 62, 161–62, 171, 251, 467–68 insurable  295–96, 888 international  25, 191–92, 231 local  183, 807, 877, 921 non-possessory  42, 93, 118, 123, 164, 190 ownership  111, 138, 166, 179, 712 possessory  164, 207, 470 proprietary, see proprietary interests reversionary  83, 92, 121, 171, 470, 472, 490, 494 secured  28, 32–33, 91, 112, 121, 138, 183, 192–93 security, see security interests suspensive  84, 169–70 interference, political  624, 763 intermediaries  381–84, 458–66, 468–70, 474–78, 480–89, 528–34, 544–46, 681–83 financial  527–28, 531, 535, 537, 541, 561–62, 913, 916 immediate  458, 460, 465, 485, 914 replacement  460, 713 intermediary banks  369, 371, 373–74, 381, 415, 463 intermediated securities  187–88, 478, 484 intermediation  319, 328, 385, 426, 479, 508, 669 internal market  745–46, 803, 859–61, 905–7, 913–15, 921–23, 927–29, 931–33 internalisation  462–63, 474, 483, 709, 829, 841–42, 844–45, 881 internalisers, systematic  836, 840, 844–45, 927 international assignments  23, 25, 70, 187, 218, 231, 234–35 international bulk assignments  227, 231, 237, 242, 245 international capital markets  278, 420, 733, 780 autonomy  725–26 international co-operation  453–54, 857–58, 895–96 international commerce  24, 196 international contracts  417, 426 international convergence, see convergence international dealings  196, 573, 722

958 INDEX

international finance  7–8, 10, 23–24, 27, 30, 74, 617, 619 international flows  2, 7, 12, 16, 21, 68, 70, 186 international harmonisation, see harmonisation international interests  25, 191–92, 231 international minimum standards  8, 303, 572 International Organisation of Securities Commissions, see IOSCO international organisations  49, 179, 226, 420, 770, 931 international payments  16, 167, 359, 379–81, 383, 385–86, 413, 415 traditional forms  413–48 international practices  26, 177, 229, 231, 237, 244, 405, 414 international safety net  538, 623, 627, 634–37, 646, 789, 791, 895–97 international sales  49, 242, 416, 425 International Securities Market Association, see ISMA international-style offerings  693 International Swap Dealers Association, see ISDA international trade  23–24, 47–48, 187–88, 216–17, 225–27, 414–15, 725–26, 732 international transactions  24, 380, 414–15, 417, 433, 438, 460, 484 internationalisation  634–36, 720, 723, 725–27, 731, 733–34, 758, 761 internationalism  23 internationality  184, 231 internet  572, 695–96, 700, 711, 844, 859–60, 864 interoperability  306, 339, 488 interpretation  138, 188, 191, 236–37, 242, 244–45, 258, 743–44 contract  115, 235–36, 252, 368, 396, 411 expansive  744 uniform  191, 236, 240, 256, 258 intervention  452–53, 625, 667, 669, 819–20, 888, 906, 910 regulatory  330, 358, 787–88, 871, 888 intraday trading  346, 375, 887–88 intragroup activity  593, 630, 700, 925 intrinsic value  276, 344, 347, 385, 415 introducing brokers  477, 704 inventory  13–14, 38, 136, 198–200, 202–3, 209, 461–62, 653 investment advice  17, 343, 529, 531, 535, 549, 684–85, 837 investment advisers  17, 507

investment banking  352, 520–21, 529, 534, 571, 573, 715, 718 investment banks  16–18, 355–56, 508–9, 528–31, 533–35, 650–52, 704–8, 715–16 as brokers and investment managers  708–11 as underwriters and market makers  704–8 investment-based crowd funding  574 investment books  507, 629, 685, 768–69, 772, 793, 891 investment firms  817–18, 835–36, 843, 851–54, 857–58, 879–80, 923, 925 investment funds  344, 567–68, 815, 895 investment management  342–44, 347, 533, 627, 651, 833 investment managers  342–44, 347, 351, 508, 526, 577, 648, 708–10 investment portfolios  15, 299, 507, 616, 623, 685, 770, 772 investment products  193, 277, 530, 723, 755, 758, 760 investment securities  16–18, 42–46, 94–95, 153–55, 457–59, 464–74, 489–91, 496–501 investment services  508, 647, 650, 767, 835–37, 861, 923, 925 investments  281–83, 285–90, 342–49, 351, 679–85, 834–39, 855–56, 887–89 as principal  630, 893 underlying  281, 308, 458, 461, 467, 479, 482, 492 investor protection  524, 530–31, 548–49, 574, 576, 712, 812–13, 826–27 investors  283–86, 342–54, 356–58, 458–67, 679–83, 689–99, 703–15, 726–29 foreign  345, 422–23, 686, 727, 735 institutional  101, 342–44, 347, 352, 687, 690–91, 693, 697–98 private  343, 356, 533, 573, 640, 691, 727, 839 professional  277, 313, 690–91, 720, 727, 839, 847, 850 retail  347–49, 351–53, 485, 530, 533, 544, 845, 848 smaller  347, 351, 358, 469, 707–8, 720–21, 814, 817 IOSCO (International Organisation of Securities Commissions)  179–80, 327, 354–55, 549, 592–94, 596, 762, 764 IPMA (International Primary Market Association)  690, 728, 866

INDEX 959

ISD (Investment Service Directive)  710, 817, 819, 833–39, 842–43, 846, 849, 851 ISDA (International Swap Dealers Association)  180, 281–82, 325, 331, 333–34, 338, 395, 402 ISMA (International Securities Market Association)  412, 499, 541, 688, 690, 728 issuance  278, 304, 361, 518, 573, 587, 654, 847 issuers  457–60, 530–33, 587–89, 685–94, 704–7, 718–20, 726–28, 846–51 corporate  532, 669, 692, 827 issuing activity  17, 272, 531, 686, 688–90, 693, 696, 826 issuing bank  426, 430–35, 437–43 Italy  63, 195, 225, 238, 639–40, 806–7, 906, 911 ius commune  36, 39, 120, 150, 162, 166, 168, 390 ius in re aliena  102 Japan  73, 416, 566, 660, 664, 765, 770, 778 judgement-based approach  528, 556, 558, 560, 562, 909, 912, 914 judicial discretion  244, 390, 920 judicial liens  137, 143, 206 judicial review  524, 531 jurisdiction  71, 182, 185, 405–6, 422, 454–55, 748–49, 751 justice  125, 138, 159, 392, 451, 582, 743, 747 justified reliance  24, 344, 366–67, 373 Justinian  82, 91, 108, 111, 126, 168, 390 Keynesian theory  601, 619, 790 keys private  486, 724 public  486, 724 Keystone  724 know your customer duties  381, 453, 532, 711, 838, 927 knowledge  37, 53, 72, 75, 138, 240, 879, 884 labour  198, 346, 531, 536–37, 583, 735, 902, 908 lading, bills of  23–24, 32, 64, 70, 338, 425–31, 436–37, 680 Lamfalussy process  828, 846 land  33, 36–37, 118, 121, 123–24, 126, 251, 254 language  236, 258, 434, 444, 813, 837, 841, 848–49 large exposures  350, 518, 525, 657, 667, 808, 810, 853

last resort banks of  521, 523, 550, 565, 570, 635, 647, 649 lenders of  287, 550, 593, 633, 635, 649, 663, 767 law merchant  20, 32, 46, 63–64, 195, 439, 446, 679–80 layering of risk  276–79, 291, 785 lease assets  146, 246, 248–51, 254, 258–62, 264, 268 lease contracts  146, 253, 260, 264–65, 267–68 leases  85, 113–14, 139, 141, 144–46, 245–56, 258–62, 266–68 consumer  139, 145, 251, 253 equipment  137, 139, 143–46, 194, 202, 251, 253–54, 257 finance  43–46, 84–87, 113–15, 133–34, 149–52, 191–94, 245–61, 267–69 operational  144–45, 165, 250–51, 257, 260, 264, 267–68 leasing  98, 114–15, 186–87, 245–47, 250–54, 256–60, 266–69, 652–53 finance  43–46, 84–87, 113–15, 133–34, 149–52, 191–94, 245–61, 267–69 real-estate  247, 257, 259–60, 267 ledger distributed  339, 341–42, 381–83, 386, 486–89 transfer  724 legal acts  359, 361, 364–65, 368, 387–88, 394, 398 legal capacity, see capacity legal characterisation  3, 11, 24, 32, 247–48, 532, 670, 673 legal dynamism, see dynamism legal formalism, see formalism legal interests  59, 88, 161, 171 legal owners  161, 253, 476, 681, 701 legal possession  108, 121, 170 legal pragmatism, see pragmatism legal principles  27, 674 general  674 legal reasoning  367 legal relationship  77–78, 200–1, 218, 243, 271, 387–88, 390, 439 legal risk  15, 19, 26–27, 60–61, 518–19, 525, 530, 532 legal scholarship  257 legal status  139, 338, 360, 404, 426, 482, 907, 915 Euromarket instruments  730–31

960 INDEX

legal systems  4, 6, 84, 87, 271, 274, 367, 370 legal transnationalisation  3, 7–11, 19, 22, 40, 186–87, 196, 726 legitimacy  451, 527, 634, 638, 729, 734, 746, 753 Lehman Brothers  325, 472, 481, 510–11, 517, 521, 525, 631 lenders  198–201, 209, 217, 312–13, 466–69, 495, 521–24, 574–75 of last resort  521–24, 585, 587, 633, 635, 667, 912, 919 lenders of last resort  287, 550, 593, 633, 635, 649, 663, 767 lending function  201, 509, 571, 648, 673, 833, 923 interbank  631, 649, 781, 797 peer to peer  573–74 secured  12, 29, 41, 43–45, 87, 129–30, 150, 224 lessees  85–86, 133, 144–46, 165, 176, 245–54, 256–57, 259–68 lessors  46, 85, 144–46, 165, 176, 247–56, 258–59, 261–66 letters of credit  282, 366–68, 414–15, 417–18, 426, 430–36, 438–48, 776–77 back-to-back  443 documentary  338, 432, 436, 441, 446 legal nature  438–41 non-performance  441–43 right of reimbursement of issuing bank  437–38 standby  280, 444–48, 776–77 transferable  443 types  434–35 level playing field  524–25, 556, 604, 606, 765, 777–79, 786–87, 789–90 leverage  353–54, 357, 514–15, 517, 597–98, 602–5, 644–45, 919–20 excessive  552, 609, 621, 629, 801 high  287, 563, 597, 599, 613, 801 ratio  551–52, 559–60, 625–27, 629, 767–69, 787–89, 792, 800–1 societal  507, 511, 596, 606, 627, 636, 921, 931 leveraged society  562, 597, 600, 621, 645, 871 lex commissoria  81–83, 90, 105, 110, 126, 166, 168–69 Netherlands  82 lex commissoria tacita  82–83, 92, 105, 168 lex contractus  213, 254–55, 407 lex executionis  184, 192

lex fori  188, 406–10 lex mercatoria  20–23, 63–65, 187–89, 380, 412–14, 446–48, 483–84, 504 approach  236, 443, 447, 483 old  64 operation  64, 446, 479, 483 transnational  32, 46, 58, 63–64, 443, 446, 478–79, 484 lex rei sitae, see lex situs lex situs  46–47, 65, 68–69, 180, 182–85, 213–14, 255, 259 lex societatis  182 liability  159–60, 181, 264, 310, 312–13, 346, 719–20, 848 civil  532–33, 561, 720, 894, 904, 912 product  159, 264 prospectus  574, 689, 719, 848, 894, 904 side  2–3, 310, 332, 518, 568, 715 state  751, 850 liberalisation  536–37, 725–26, 733–34, 736, 754–57, 760–62, 806–9, 815–18 liberating payments  218, 225, 231, 240, 359, 365 licences  531, 533, 736, 821, 823, 837–38, 843, 908 banking  506, 511, 535, 565, 651–52, 670, 718, 751 liens  52–53, 55, 71–73, 111–13, 136–38, 204–6, 221–23, 672 hidden  221, 223 perfected  137, 222 statutory  52, 71, 73, 89, 111–13, 137 tax  52, 55, 59, 137, 143, 205 life insurance  342, 755, 877 lifestyle  421, 608, 617, 622, 801, 869, 874 Linq  573 lip service  207, 553, 585, 727, 787 liquid assets  516, 613, 649, 767, 797, 872 liquid markets  487, 600, 844 liquidation  69, 73, 112, 130, 204–5, 457, 911, 918 immediate  649, 897, 911, 916 liquidity  2–3, 505–7, 513–18, 599–603, 615–19, 623–25, 663–65, 765–69 buffers  516, 607, 657 coverage ratio  503, 613, 615 crisis  290–91, 510, 523, 649, 657, 767 management  287, 514–16, 518, 613, 615, 624, 769, 870–72 providers  567, 638, 698, 870 requirements  524–25, 551–54, 561, 626–28, 646–47, 768–69, 800–1, 932–33

INDEX 961

risk  375–76, 384–85, 511, 513–15, 517–18, 596, 768–69, 774–75 supervision  552, 604 liquidity-providing function  514–17, 551–53, 561–63, 567–69, 598–99, 641–42, 645–47, 870–71 listed companies  689, 813, 827, 850 listing  16, 576–77, 683, 686, 688–90, 693, 812–14, 846–47 litigation  246, 249, 387–88, 390–92, 406, 409, 414, 441 loan agreements  150–51, 198, 201, 246, 270, 304, 657, 661 loan assets  269, 271, 278, 282, 284, 294, 516, 570 loan books  286–87, 507, 653, 658, 769, 777, 795 loan data  303–5 loan financing  61, 85, 87, 116, 129, 155, 179, 247 secured  42–43 loan portfolios  270–71, 274–76, 279–80, 658, 661, 777–78, 794, 797 loan tokens  304, 306 loans  127–30, 153–55, 198–201, 269–72, 505–7, 652–55, 768–70, 781 bank  12, 127, 241, 276, 568, 650, 685 secured  43, 140–41, 152, 155, 177, 293, 489–91, 652–53 student  269, 515, 553, 653, 919 subordinated  101, 274, 771, 781, 791 local laws  22–23, 25–27, 30, 32, 47, 237, 413, 906 location  68–69, 212–14, 233–34, 244, 258–59, 296–97, 425–26, 752 Loi Dailly  77, 91, 98–101, 203, 210 long positions  775–76, 779, 782 losses  97, 158–60, 288–90, 294–96, 335, 658–59, 662–63, 772–73 low risk assets  630, 893 Luxembourg  687, 690, 693, 745, 747, 759–60, 903, 907 macro-financial supervision  524, 562, 909 macro-prudential policy  556, 628, 663, 768, 913 macro-prudential powers  913–14 macro-prudential regulation  562, 625, 914 macro-prudential supervision  528–29, 552–56, 558–61, 595–98, 610–11, 628–29, 908–9, 912–14

management  302, 344–45, 348–49, 352–53, 356–57, 515, 611–13, 626 risk, see risk management managers  343–44, 347, 349–52, 354, 357–58, 579, 604, 707 mandatory rules  133, 253, 255, 263, 268, 413, 419, 755 manipulation  541, 545, 575, 577, 579, 599, 606, 886 market  295, 578–79, 581, 706–7, 800, 807, 843, 852 manufactured goods  116, 120, 131, 182, 214 margin  300, 316, 323–25, 327–28, 341, 466–69, 497–98, 883–84 accounts  79, 322, 341, 404, 883 buyers  471–73 calls  324, 328–29, 339–40, 503, 510, 631, 793, 883 failed  510, 883 requirements  319, 323–25, 327, 329, 337, 495, 498, 510 trading  477, 483, 704 mark-to-market values  286, 288, 772, 777, 779, 784, 794, 797 market abuse  538, 541–42, 578, 580–81, 633, 636, 882, 886 market access  736–38, 818 effective  737, 754, 822–23 market conditions  165, 273, 521, 658, 704, 814, 841, 843 market forces  8, 283, 330, 614, 618–20, 622, 824, 830 market functions  533–34, 542, 544, 577, 692, 719, 722, 826 market integrity  524, 527, 544–46, 599, 697, 904, 921–22, 926–27 market interest rates  315, 513, 658, 669 market makers  318–24, 327–28, 576–77, 689–95, 697–98, 707–8, 843, 845 market manipulation  295, 578–79, 581, 706–7, 800, 807, 843, 852 market participants  282, 339, 341, 535–36, 697, 706, 878, 883 market prices  306–7, 311, 314–15, 507, 658, 661–62, 694, 776 market risk  511–13, 518, 657–58, 766–67, 769, 771–76, 782–84, 797–99 market value  51, 129, 154, 281, 311, 314, 495, 498 markets  507–11, 541–44, 575–81, 686–99, 704–11, 715–29, 824–29, 839–51

962 INDEX

derivatives  17, 298, 300, 315–27, 329, 331, 692, 695 domestic  24, 175, 686–87, 693, 719, 728–29, 731, 865 electronic  692, 711, 836 eurobonds  18, 576, 578, 686–87, 689–91, 726–27, 729–31, 733–35 financial  17–18, 527–28, 544, 575, 600–1, 825, 889–90, 921 foreign exchange  18, 416–17, 419, 624, 687, 690, 695 formal  576–77, 686, 688–89, 691–92, 695, 697, 707 informal  576, 687–93, 696, 705, 707–8, 720, 723, 842–43 interbank  286–87, 503, 521–22, 565, 569, 649, 652, 656 official  356, 411, 533, 535, 576–77, 686, 693, 696–97 offshore  576, 584, 729, 731 OTC  17–18, 329, 331–32, 533, 541, 686, 836, 842–43 primary  16, 353, 458, 507, 509, 530, 692–93, 718–20 regular  328, 332, 335, 337, 841, 844, 850, 925–26 regulated  699–700, 720, 836–37, 842–43, 846–49, 862, 894, 925 repo  6, 11, 18, 23, 491, 494, 502–3, 575 secondary  507, 509, 686, 690–93, 695, 698–99, 707, 719–20 securities  300, 316, 329, 468, 477, 487, 497, 720–22 single  583–84, 803, 827, 830, 863–64, 879, 922, 926 swap  308, 317, 323, 328, 332, 337, 502, 510 unofficial  689, 693, 720, 839, 847 master agreements  153, 281, 393, 401, 403, 494, 499–500, 504 repo  335, 396, 401, 412, 496 swap  23, 281, 332–33, 337, 398, 400, 402, 410 matched principal trading  700, 925 matching agents  692, 694, 696, 723 mature claims  230, 389, 391, 514 maturity  308–9, 331, 340–41, 513–14, 683–85, 779, 782, 796–98 dates  157, 163, 306–7, 339–40, 366, 368, 658, 662 mismatch  507, 513, 517, 568, 653, 658, 769 transformation  487, 506, 513, 568, 656

mere description  80, 118 mergers  207, 531, 651, 654, 715–16, 835, 837, 847 methodology  288, 659, 763, 772, 781 Mexico  73, 594 micro-financial regulation  525, 599, 613, 912 micro-lending  574 micro-management  537, 548, 560, 604–5, 625, 627, 871–72, 912 micro-prudential regulation  526, 528, 602, 604–5, 610–11, 625, 627, 912–14 micro-prudential supervision  523, 525, 527–28, 538–39, 556, 558–59, 595–96, 932–33 million  589, 662, 777–79, 797 minimum standards  408, 410, 758, 766, 815, 822, 849, 857 international  8, 303, 572 minimum supervision  357, 574 ministers  743, 747–48, 752, 807, 823, 838 misbehaviour  268, 714 mismatch, maturity  507, 513, 517, 568, 653, 658, 769 mismatches  517, 656, 660, 769, 774, 782 mispricing  286, 350, 516, 622 mobile equipment  48, 187–88, 191, 193, 196, 208, 269 models  273, 487, 516–17, 553, 559, 600, 797–98, 913 academic  797 modern finance sales  44–45, 57, 133, 152, 194, 245 modern financial regulation  527–34, 538, 549, 596, 709, 926 aims  538–44 modern lex mercatoria, see new lex mercatoria modern private law, see private law modern society  242 monetary claims  1, 3, 211, 213, 217–20, 386, 389, 394 assignment  217–22 monetary policy  537, 545–47, 561, 567, 601–3, 761, 819–20, 913 monetary union  635, 740, 743, 745, 757–58, 761, 829, 874–75 money  314–16, 359–60, 362–69, 449–55, 505–10, 513–14, 646–49, 712–15 markets  568, 575, 684 notions  362–63 printing  523, 609, 869, 871, 873

INDEX 963

recycling  16, 287, 505, 507–9, 551–52, 568, 571, 679 short-term  300, 507, 513, 521, 568, 647 money laundering  448–56, 538, 546, 862–63, 899, 904, 922, 927 and EU (European Union)  454–56 international action  454 remedies and objectives of combating  451–53 techniques and remedies  448–51 money market funds  279, 560, 568–69, 630, 633, 652, 664, 814 money market instruments  685, 815, 835 money supply  506, 523, 537, 761 moral hazard  296, 298, 350, 352, 550–51, 632–33, 637, 663–64 and financial regulation  549–51 morality  229, 580, 605, 610, 743, 745, 816 mortgage credit  770, 778, 786, 808–11, 818, 833 EU  643, 810–11, 863 mortgagees  35, 123, 126–27, 131, 158 mortgages  12–15, 35–36, 119–20, 123–30, 132, 516–17, 659–60, 670–72 chattel  36–38, 41, 119–20, 125, 127, 129, 157, 159 common law  15, 45, 118, 122, 124, 126–27, 179 equitable  119, 124–26 real estate  3, 35–36, 45, 111, 113, 127, 197, 653 mortgagors  35, 45, 119, 123, 125–27, 132, 559 most characteristic performance  233, 752, 859 movable assets, see movables movable property  11, 13, 25–26, 90, 171, 173, 195, 197 law  10–11, 13, 26, 55, 58, 90, 173, 195 movables  13, 31, 35–38, 76, 89–90, 99–100, 105–6, 213–14 MTFs (multilateral trading facilities)  576–77, 695, 699–700, 827, 829, 835–37, 842–45, 924–26 multilateral netting  282, 319–20, 378, 395, 398, 406, 409, 758 multilateral trading facilities, see MTFs multiple assignments  68, 218, 234 mutual claims  6, 46, 51, 53, 153, 377, 395, 397 mutual funds  344, 346, 643 mutual recognition  811–13, 816–17, 819, 824, 831, 843, 846–47, 855–56 mutualisation  551, 634, 639, 831, 896, 907, 911 mutuality  333, 388–89

naked credit default swaps  295–96, 888–89 naked options  330, 351 narrow banking  181, 279, 506, 539, 630, 644, 650, 663–65 NASDAQ  305, 573, 576, 588, 686, 692, 720 national banks  522, 548, 586, 606, 668, 684, 920 National Best Bid and Offer (NBBO)  698 national laws  20–21, 23, 66, 71, 188–89, 519, 913, 916 national treatment  732–33, 736–38, 822, 896 nationalisation  232, 520, 546, 556, 680, 731 nationalism  69, 725, 920 nationality  753, 806, 915–16, 918 natural persons  50, 91, 736, 750, 805 NBBO (National Best Bid and Offer)  698 negative balances  672–73, 675 negligence  160–61, 170, 263, 342–43, 346, 388, 894, 904 negotiability  23, 680, 682–83, 730 negotiable instruments  23–24, 32, 64, 277, 337–38, 367, 679–83, 730 negotiation  220, 360, 431, 434–35, 591, 733–34, 737–38, 822 net balances  130, 332, 334–35 net payments  320, 335, 392, 409, 476, 500 net settlement  375, 379, 396, 475 Netherlands  39, 75–91, 105–6, 167–68, 172–73, 230–32, 406–7, 744–45 bankruptcy law  29, 401, 494 lex commissoria  82 open or closed system of proprietary rights  87–89 reservation of title  79–82 netting  23, 130, 318–20, 328–38, 376–78, 391–412, 498–501, 771–72 agreements  59, 61, 63, 335, 337, 394, 397, 403–7 arrangements  19, 47–48, 361, 659 clauses  5, 7, 9, 51, 334–35, 397, 399–400, 402 expansion of set-off through  394–97 in swaps and repos  397–401 close-out, see close-out netting domestic and international regulatory aspects  411 facilities  1–2, 17, 19, 27, 60–61, 328–29, 398–99, 500 novation  331–33, 336, 338, 377, 395–96, 398, 407, 409 principle  23, 331, 335, 391, 413, 484, 502, 673

964 INDEX

and private international law  404–8 repo  19, 72, 403, 500 swap  72, 153, 330–32 and transnational law  408–11 New York Stock Exchange, see NYSE Nigeria  225, 238, 256 nineteenth century  13, 34, 36–40, 42, 106, 124 nodes  304, 339, 382, 486 nominal values  226–27, 254, 777, 779, 796 nominated banks  431–35, 437–38 nominating banks  440–41 non-bankrupt parties  4–6, 109, 330–31, 333–35, 386–87, 399–400 non-banks  287, 539, 560, 568–69, 650, 652, 664, 851 non-defaulting parties  23, 166, 335, 400, 404 non-discretionary rules  700, 836, 925 non-discrimination  561–62, 806, 809, 832, 843, 909, 912, 914; see also discrimination non-payment  53, 83, 105, 168, 226, 441–42, 444, 513 non-possessory charges  52, 65, 67, 77, 90, 123–24, 190, 208 non-possessory interests  42, 93, 118, 123, 164, 190 non-possessory pledges  76, 79–81, 107 non-possessory security interests  34–39, 42–43, 67, 79–81, 89–91, 120, 144, 197–98 in chattels  27, 38–39, 42, 67, 91, 120, 149, 190 non-recourse factoring  221, 223–24, 226, 239 normativity  380 norms  20, 189, 217, 245, 303, 447–48, 757, 766 notification  37–38, 77–79, 99–101, 212, 230–33, 236–37, 239–40, 387–88 requirements  77–78, 99, 210, 218, 231, 237, 243–44, 387 novation  218–19, 270–71, 317–18, 321–22, 359–62, 371–72, 394–98, 411 netting  331–34, 336, 338, 377, 395–96, 398, 407, 409 numerus clausus  10, 25, 58, 68, 79, 84, 152, 156 NYSE (New York Stock Exchange)  686, 692, 695–96, 721 objectivation  22, 63 objective criteria  75, 515, 555, 675, 836

objective law  20, 24–25, 57, 62–63, 674, 681 objective standards  327, 410, 581 obligation netting, see novation, netting obligations  219–20, 242, 359–60, 372–73, 375–78, 393–96, 430–32, 444–45 characteristic  184, 233, 256, 266, 297, 411, 584, 752 contractual  231–33, 238, 297, 335, 339, 407, 411, 418 delivery  187, 494, 500, 579 law of  25, 108, 231, 233, 238, 256, 297, 823 payment  360–64, 367–68, 404, 420–21, 423, 430–31, 440, 445–46 primary  438–39, 445, 447 obligatory rights  36, 66, 229, 232, 475, 702 OECD countries  737, 765, 770, 777–78, 780, 794, 851 off-balance-sheet exposures  775, 777–78, 788, 793–94, 796 off-blockchain pingers  342 off-ledger assets  383, 485, 487–88 off-ledger securities trading  484, 487 official exchanges  530, 534, 544, 686–89, 691–92, 721, 843, 846 official markets  356, 411, 533, 535, 576–77, 686, 693, 696–97 offshore markets  576, 584, 729, 731 offshore tax havens  357–58, 453, 885 oil shocks/crises  511, 555, 597, 608, 727, 733, 874, 921 on-balance-sheet exposures  792, 796 opacity  303, 305, 503, 511 open-ended funds  352, 357, 643, 835, 852, 921, 924 open positions  464, 483, 521, 629, 772, 891 openness  59, 171, 302, 718, 734, 917 operational leases  144–45, 165, 250–51, 257, 260, 264, 267–68 operational risk  656–57, 659, 765–66, 768–70, 782–86, 788–89, 792, 798–99 operational standardisation  318, 326–27, 329 options  93, 157–58, 251–53, 306–8, 310–11, 313–18, 335–40, 661 call  290, 306, 311, 337, 340–41, 468, 490, 492 credit spread  279, 281 financial  306–8, 316 naked  330, 351 repurchase  79, 92–93, 106, 150, 161, 166 standardised  313, 316, 328, 662 orderly resolution  667, 895

INDEX 965

ordinary commercial flows  6, 58–60 original contract  271, 322, 328 originators  101, 272–75, 277–80, 285–87, 291–94, 301, 303, 519 orphanage  382 ostensible ownership  123, 143 OTC (over-the-counter)  507, 576, 631, 683, 686–87, 842–44, 882–83, 888 derivatives  298–99, 324, 330, 336, 339, 636, 642, 883–85 markets  17–18, 329, 331–32, 533, 541, 827, 836, 842–43 products  316, 330, 518, 643, 845, 880–81, 924 outsiders  6, 281, 290, 347, 356, 719, 722, 739–40 bona fide  6, 59, 269 outsourced functions  477, 704 over-collateralisations  292, 502, 795 over-leveraging of society  287, 350 over-the-counter, see OTC overdrafts  12, 22, 127, 647, 653, 665, 669–73, 676–77 overleverage  511, 873, 919 overleveraged society  287, 553, 598, 800, 933 Overstock  305, 572, 724 overvalue  42–45, 85–86, 123–24, 127–30, 149–51, 157–60, 165–66, 472–73 return of  38, 42, 44, 46, 58, 62, 128, 247–48 owners  69, 83–87, 112, 159–62, 164, 169–71, 306–8, 458–59 conditional  38, 57, 85, 160, 163–65, 171–72, 249 full  43, 51, 108–9, 150, 159, 167, 490, 493 legal  161, 253, 476, 681, 701 original  112, 160, 163, 172, 482 unconditional  30, 115, 194 ownership  42–47, 82–85, 96–99, 106–9, 111–15, 121–23, 155–78, 246–52 concepts  30, 121, 145, 170, 175 conditional  81–83, 92–94, 106, 108–9, 117–18, 158, 249, 251–52 duality of  83, 85, 94, 99, 107–8, 112–13, 167, 169–78 full  43, 45, 112–14, 168, 172, 176–77, 247, 251–52 interests  111, 138, 166, 179, 712 ostensible  123, 143 protection  121–22, 132–33, 152, 161, 169–71, 176–77, 193–95, 247–48

reputed  93, 96, 98–99, 123, 125, 131 rights  46–47, 53–55, 87, 120–23, 152–53, 170–71, 173–78, 248–49 conditional  82, 108–9, 152, 166–67, 171, 173–75, 194–95, 248–49 temporary  15, 54, 82, 85, 87, 167, 171, 173–74 structures  55, 57, 113, 177, 730 temporary  45, 82, 173, 467, 472, 481, 490 transfer of  46, 84, 98–99, 122–23, 132, 173–75, 250–52, 680 ownership-based financing/funding  44–46, 62, 64, 153, 155–56, 165, 167, 175 pactum de retroemendo  91, 150 pactum de vendendo  126 paper currencies  363, 385, 415–16, 572, 725 paperless trading  576, 681 par conditio creditorum  9, 197 parent companies  309, 402, 445, 661 participants  299–301, 375–77, 395–96, 475–77, 480, 485–87, 580–81, 702–3 market  282, 339, 341, 535–36, 697, 706, 878, 883 participation certificates  3, 344, 457 participations  56, 179, 277–78, 605, 607, 734, 909, 917 parties, see also Introductory Note bankrupt  331, 399–400, 406 defaulting  46, 85, 166, 175, 324, 376, 500 non-defaulting  23, 166, 335, 400, 404 original  218, 229, 321–22 swap  312, 334, 395, 399–400 third  31–32, 56–59, 107–8, 121–23, 136–38, 160–62, 261–64, 712–14 partners  54, 164, 172, 272, 332, 346, 500 partnerships  54, 345–47, 605, 847 party autonomy  5–10, 19–22, 25–26, 31, 46–47, 56–58, 62–63, 213–14 degree of  9, 40, 47 pass-through certificates  274 passporting  357, 643, 699–700, 720, 812, 880–81, 884–85, 922–23 rights  643, 881 passports  822–23, 826–27, 833–37, 843, 898–900, 921, 923–26, 928 payees  24, 296, 359–62, 364–68, 370–75, 379, 417–18, 462 paying agents  578, 680, 706, 726, 759–60, 813 paying banks  433–34, 440–41 payment circuit  366, 369, 372, 446, 448, 464

966 INDEX

payment finality  16, 64, 70, 316, 358, 365, 397, 572 payment guarantees  106, 226, 414, 446 payment instructions  323, 360–61, 364, 367–68, 371, 374, 381, 384 payment obligations  360–64, 367–68, 404, 420–21, 423, 430–31, 440, 445–46 payment protection  414, 424, 426, 440 payment risks  404, 414, 426–27, 430–31 reduction  425–34, 444–46 payment services  15, 529, 670–71, 676, 863–64, 893 payment systems  366–69, 377–81, 384–85, 462–64, 539–42, 545–46, 663–64, 757–58 payments  238–42, 318–24, 359–89, 409–19, 421–38, 440–45, 474–76, 757–58 clearing and settlement in banking system  374–78 coupon  339, 520, 813 electronic  8, 66, 365, 374, 758 immediate  277, 307, 337, 374, 428, 440, 496 incoming  382, 677 instalment  128, 159 interest  12, 29, 270, 273, 276, 717, 726, 758 international aspects  378–79 legal aspects  363–68 liberating  218, 225, 231, 240, 359, 365 net  320, 335, 392, 409, 476, 500 notion and modes of payment  359–62 in open account  424–25 proper  168, 250, 300, 378, 414 regular  245–46, 248, 329, 340, 477, 672 regulatory aspects  379 substitute  469, 495–96 payors  313, 359–62, 364–68, 370–74, 379, 388, 400, 416–18 peer-to-peer lending  573–74 peer-to-peer networks  341, 382–83 pension funds  342, 536, 603, 760, 835, 855–56, 870, 929 EU (European Union)  855–56 pension livrée  94–96, 98, 101 pensions  516, 608, 621, 829, 855, 873, 877, 930–31 perfected security interests  137–38, 437 perfection  29, 37, 135, 137–38, 142, 144, 182–83, 481–82 performance  138–39, 157–58, 264–65, 359–60, 444–47, 713–14, 752, 772–73 beginning of  54

bonds  441, 444–45 characteristic  233, 752, 841, 859 most characteristic  233, 411, 752, 859 permission-less systems  380, 382–85, 484–85 permissioned blockchains  342, 380, 386, 484, 487 permissioned distributed ledger network  339–42 permissioned systems  383–86, 724 perpetuals  683, 707, 771, 778, 791 perpetuities  120, 122, 458 personal property  30–31, 35, 37, 125, 135, 139–40, 194–95, 206–7 personal responsibility  606 Pfandbriefe  291 physical delivery  160–61, 457 physical existence  75, 468 physical movable assets  78, 91 physical possession  35–38, 42, 84–86, 104–5, 110, 115, 159–63, 169–72 physical transfers  67, 160, 309, 702 placement  16, 584, 588–89, 704–7, 718, 726, 844, 850 activity  17, 727–28 private, see private placement placements, private  358, 588–89, 630, 698–99, 705–6, 846–47, 885, 902–3 pledgees  79–80, 127, 133, 136, 140, 159–60, 162, 164 pledges  13, 76–77, 90–91, 124–27, 132, 159–60, 478–79, 481–82 non-possessory  76–77, 79–81, 107 possessory  33, 35, 37, 82, 111, 113, 126, 178 pledgors  77, 80, 85, 120, 159–60, 162, 470–71, 481 Poland  375, 759 political interference  624, 763 politicians  289, 604, 607, 610–11, 618, 800–1, 929–32 pooling  54–55, 203, 295, 400, 579, 639, 712 pools  101, 198–99, 232–33, 276–77, 286, 304, 465, 729–30 dark  699, 882 greyish  882 token  304 portfolio risk  657, 797 portfolios  224–25, 227–29, 238–39, 280–81, 311, 709–10, 779, 798 investment  15, 299, 507, 616, 623, 685, 770, 772

INDEX 967

loan  270–71, 274–76, 279–80, 658, 661, 777–78, 794, 797 receivable  151, 211, 221, 224–25 underlying  278, 287, 518 Portugal  252, 594, 609, 639, 735, 757, 843, 874 position limits  700, 925 position risk  309–10, 656–58, 766, 768–69, 773, 775–76, 786, 788 positive law  181, 580 possession  84–86, 107–12, 121–27, 131–33, 136–40, 157–64, 168–72, 259–65 constructive  110, 125, 132, 205 delivery of  84, 104, 137, 160 physical  35–38, 42, 84–86, 104–5, 115, 121, 159–63, 169–72 quiet  261, 263–64, 268 possessory interests  164, 207, 470 possessory pledges  33, 35, 37, 82, 111, 126, 178 possessory security interests  35, 59 post-trade transparency  699, 841, 881, 923, 927 post-trading information  541, 643, 688, 729, 836, 842, 881 Pothier, R-J  83, 93, 372 powers  604–5, 744–48, 819–20, 829–32, 876–79, 888–89, 908–9, 912–18 delegated  888, 922 host-country  819, 831–32 macro-prudential  913–14 regulatory  548, 593, 668, 820, 829 practices  11, 20–23, 46–48, 113–14, 187–90, 378–80, 446–49, 727 best  282, 454, 764 practitioners  66, 589 pragmatism  193 precedence  52, 78, 137–38, 188, 221, 916 predictability  70, 188, 524, 557, 601, 902, 917 preferences  1–2, 5–6, 55, 58–59, 78–79, 106–7, 111, 116–17 statutory  9, 59–60, 205, 253 premiums  95, 295, 306, 310, 324, 351, 402, 633 presentation  363, 428–29, 431, 434, 436, 440–41, 443, 894 presenting banks  428–29, 434 price formation  300, 527, 536, 538, 541, 577, 579, 886 price information  542, 549, 843–44 prices  157–59, 313–14, 493–98, 661–62, 692–94, 696–98, 704–9, 840–44 agreed  16, 150, 306–7, 314, 337, 415, 490, 661–62

fixed  290, 306–7, 310, 661–62 market  306–7, 311, 314–15, 507, 658, 661–62, 694, 776 purchase  41–42, 45, 81, 92–93, 155, 157–59, 161, 163–64 repurchase, see repurchase prices striking  290, 306, 310–11, 314, 492, 661, 682, 795 PRIMA approach  182, 482–83 primary guarantees  280, 445, 888 primary market  16, 353, 458, 507, 509, 530, 692–93, 718–20 prime brokerage  342, 350, 354–55, 521, 715, 835 prime brokers  180, 354–55, 568–69, 715, 718 principle-based regulation  558, 560 priority  38–40, 51–52, 56–57, 71–73, 80–81, 135–37, 204, 207–8 rights  55, 58, 71, 136 privacy  305, 452–53, 572 private blockchains  340–41 private companies  669, 787, 795 private control  52, 205 private equity  344, 348, 355–58, 627, 629–30, 643, 885, 892 funds  351, 354, 357, 652, 852 private international law  24–25, 182, 187–88, 231, 235–37, 258, 404–5, 446–47 modern  30, 64, 378, 409 rules  49, 64–65, 187–88, 235–37, 258, 404–5, 408, 447 private keys  486, 724 private law  22, 69–70, 302–3, 358, 532–33, 540–41, 546, 904–6 domestic  73, 88, 215, 243, 267, 303, 906 harmonisation  49, 102, 710 intervention  358, 532, 541 nature  302–3, 380, 530 transnationalisation of  380 uniform  73 private placements  358, 588–89, 630, 698–99, 705–6, 846–47, 885, 902–3 pro-cyclicity  511, 551–52, 562, 596, 598, 600, 606, 870–71 proceedings  73–74, 89, 98, 182–86, 255, 262, 265, 355 enforcement  20, 57, 184, 216 insolvency  7, 20, 74, 387, 480, 911 reorganisation  51, 56, 71, 202, 204, 262 procyclical effect  551, 603, 606, 768, 870

968 INDEX

product control  534, 543, 565, 578, 583, 755, 817–20, 831–32 product liability  159, 264 product supervision  526, 530, 534–35, 560, 718, 722, 805, 808 products derivative  15, 327, 402, 682, 756, 880 finished  38, 186, 198, 205, 209 investment  193, 277, 530, 723, 755, 758, 760 securitisation  613, 629, 879 securitised  516, 519, 629, 631, 786, 788, 873, 879 standardised  317, 326 professional dealings  48–50, 70, 151, 295–96, 541, 818, 824, 829 professional investors  277, 313, 690–91, 720, 727, 839, 847, 850 professional parties  8, 10–11, 58, 70, 151, 165–66, 207–8, 542 professional sphere  5, 22, 28, 58, 70, 94, 188–89, 216 professionals, see professional parties profits  307–9, 335, 345–46, 351, 517–18, 658–59, 661–62, 776–78 project financing  12, 20, 209, 212, 216, 652, 654–55, 659 promises  124, 363, 365, 368, 380–81, 384, 389, 609 promissory notes  18, 32–33, 211, 215–16, 219–20, 271, 359–62, 457 proof  130, 199, 334, 383, 385–86, 544, 549, 557 proof-of-identity consensus mechanisms  383 proof-of-work validation process  383, 385 proper disclosure  302, 353, 376, 543–44, 574, 600, 675, 727 proper payment  168, 250, 300, 378, 414 property  11–14, 83–84, 119–26, 132–33, 157–58, 160–64, 206–8, 345 after-acquired  106, 132, 144, 162 law  24–27, 36–37, 83–84, 110–11, 118–22, 160–62, 193–96, 202–4 movable  13, 55, 90, 171, 173, 197, 214, 216 rights  51–54, 57–60, 62–63, 87–88, 117–18, 122, 181–82, 492–93 property-based funding  66, 132, 177 property-based protection  128–29 proportionality  561–62, 744, 746, 806, 827, 831–32, 890, 916–20 proprietary effect  44, 68, 82–83, 91–92, 108, 149–50, 166–68, 194

proprietary expectancy  65, 81, 107–8, 110, 152, 172, 249, 495 proprietary interests  40–42, 58–60, 74, 76, 150–52, 169, 171–72, 183–86 foreign  21, 184–86 hidden  76, 81, 93, 123, 145 proprietary issues/matters  4–5, 18, 25, 63–64, 182, 232–33, 242, 478–79 proprietary protection  4–5, 20–21, 57, 121–22, 153, 161–62, 176–77, 261–62 proprietary status  39, 64, 66, 81, 84, 176–78, 253–55, 259 proprietary structures  4, 31, 59, 74, 170, 174, 479, 489 proprietary trading  299, 347, 349–50, 521, 613, 629, 651, 891–92 prospectus liability  574, 689, 719, 848, 894, 904 prospectus requirements  574, 577, 584, 689, 719, 727, 729, 846–47 prospectuses, liability  689 protection bankruptcy  5, 48, 53, 57, 60, 254, 290 basic  81, 128, 497, 574, 860–61 of bona fide purchasers  32, 34, 58–59, 63–64, 68–70, 125–26, 159, 491–92 buyers  280–84, 286, 295–96, 298, 520 of depositors  532, 538, 548, 557–58, 562, 642, 648, 810 givers  280, 282, 298, 883 payment  414, 424, 426, 440 proprietary  4–5, 20–21, 57, 121–22, 153, 161–62, 176–77, 261–62 providers  293, 518, 520 retail  353, 544, 556, 825, 829, 838 sales credit  105, 133, 193 sellers  281–83, 296–97 special protections  9, 15, 128, 321, 358, 455, 540, 672 prudential regulation  296, 530, 600, 737–38 prudential rules  532, 827, 831, 837, 839, 855, 899 prudential supervision  529, 531, 533–34, 577–78, 718–19, 816–18, 821–22, 836–38 prudential supervision of credit institutions  851, 876, 907 public companies  356, 795, 862 public interest  576, 578, 581, 639, 642, 910, 915, 918 public keys  486, 724

INDEX 969

public offerings  298, 526, 587–88, 689, 697, 723 public order  9, 26, 58, 69, 193, 196, 722, 745 exceptions  745 requirements  193 public placements  272, 705, 847 public policy  6, 8–9, 59–60, 73–74, 367, 422–23, 546, 807 domestic  26, 59, 243, 754, 807 test  117, 754 transnational  8, 31, 63 public support  563, 597, 623, 633 publicity  37, 77, 90, 99, 104, 137, 206–8, 490 pull systems  368–69, 463 purchase prices  41–42, 45, 81, 92–93, 155, 157–59, 161, 163–64 purchasers  5–6, 57–59, 68–70, 136–37, 160–62, 164, 195, 207–8 bona fide, see bona fide purchasers push systems  368, 370, 381, 462 QIBs (qualifying institutional buyers)  589–90, 698, 926 qualifying capital  517, 765–67, 770–72, 777–79, 783, 791, 797, 851 qualifying institutional buyers (QIBs)  589–90, 698, 926 qualitative restrictions  741, 743 quality  278, 298–99, 414, 436, 441–42, 444–45, 543, 625–26 quantitative easing (QE)  420, 522, 871 quiet possession  261, 263–64, 268 rank  39–40, 51–52, 76–78, 137–38, 164, 183, 186, 204–5 original  4, 13–14, 27, 39, 67, 76, 270 ranking  51–52, 69, 72, 74, 135–37, 184–86, 206, 637–38 rating agencies  273, 275, 285–86, 302–3, 611, 643–45, 787–88, 894 ratings  273, 275, 277, 279, 285–86, 781–83, 787–88, 894 credit  273, 279, 285, 780–84, 786, 794, 796, 894 Raumsicherungsvertrag  109, 116, 205 re-characterisation  41–42, 47, 191, 194, 229–30, 246–47, 250, 292–94 risk  149, 175, 194, 292–94 re-regulation  533, 535–37, 622, 624, 729, 754, 757, 762

real estate  12–13, 35–36, 124, 126, 596, 598, 660, 778 mortgages  3, 35–36, 45, 111, 113, 127, 197, 653 real-time gross settlement, see RTGS reasonableness  89, 196, 482, 557 reasoning, legal, see legal reasoning rebalancing  460, 463–64, 474, 745 receivables  75–81, 86–88, 98–106, 115–16, 140–42, 194–205, 208–31, 237–44 financing and factoring  45, 133–34, 140–42, 149–51, 194, 209–10, 216–45, 652–53 assignment of monetary claims  217–22 donmestic and international regulatory aspects  243 international aspects  231–35 origin and approaches  222–26 UNIDROIT and UNICTRAL Conventions  236–43 portfolios  151, 211, 221, 224–25 trade  3, 43, 76, 150, 187, 221, 241, 279 reciprocity  388, 563, 733, 736, 822–23, 898, 900, 903 recognition  20–22, 72–73, 88, 182–86, 255, 811–13, 816–17, 846–47 mutual  811–13, 816–17, 819, 824, 831, 843, 846–47, 855–56 state  813, 846, 856 recommendations  49, 559–60, 596, 749, 809–10, 812, 853, 867 reconciliation  303, 341 recourse  223–24, 427, 429–30, 434–35, 531–32, 561–62, 911–14, 916–17 factoring  223–24, 238, 244, 248 financing  87, 228–29 recovery  28, 157, 159, 231–32, 281, 283, 929, 932 rights  59, 84, 100, 115, 163 separate  28, 52, 124 recycling  12, 16, 505–6, 508–9, 513, 517, 520, 525 function  506, 516, 647–48, 912, 923 money  16, 287, 505, 507–9, 551–52, 568, 571, 679 redelivery  400, 473 redemption  15, 45, 81, 118–19, 123, 126, 128–30, 157 equity of  45, 119, 123, 126, 128–30 redenomination  378, 420, 422–23, 865 refinancing  12, 348, 356, 613

970 INDEX

reforms  619–21, 624, 634, 636, 641, 829, 874–75, 877 structural  421, 555, 620, 869 registered assignments  78–80 registered offices  806, 849–50, 862 registered securities  458, 485, 682, 701 registers  14, 130, 182, 192, 457–58, 680, 727, 730 general debt  59, 143, 207 registrable charges  130–32 registration  77–79, 119–20, 124–27, 129–31, 190–92, 353–54, 588, 705–6 requirements  36, 39, 77, 210, 819, 839 shelf  588, 691, 848 regular derivatives markets  316–17, 320, 326, 331, 412, 503 regular exchanges  307–8, 310, 318, 695, 697, 841, 843–44, 925–26 regular information supply  346, 353, 541, 688, 692, 696 regularity  690, 751 regulated markets  699–700, 720, 836–37, 842–43, 846–49, 862, 894, 925 regulation  343–57, 517–39, 541–51, 581–607, 633–53, 717–25, 815–33, 897–913 2008 picture  604–7 banking  298, 515, 525–26, 570, 601, 666, 668, 875–76 commercial banking  525–26, 529, 666, 788 double  346, 582, 591, 738, 803–5, 898–99, 921, 926 financial  505, 533–39, 543–49, 592–95, 736–38, 805–8, 824–25, 830–31 home  722–23, 755–56, 806, 808, 822, 824, 838–39, 841–42 host  582–83, 723, 803, 805, 808, 818–20, 822, 841 judgment-based, see judgment-based approach micro-financial  525, 599, 613, 912 micro-prudential  526, 528, 602, 604–5, 610–11, 625, 627, 912–14 modern  278, 324, 527, 533–34, 538–39, 549, 709, 719 principle-based  558, 560 prudential  296, 530, 600, 737–38 securities, see securities regulation regulators  526–35, 544–47, 556–58, 565–66, 603–5, 638–44, 856–60, 912 bank  280, 336, 550, 566, 769, 783, 787

home  592, 723, 818–19, 821–22, 834, 837–39, 856–57, 924 host  582–83, 592, 668, 722–23, 819–20, 834, 841–42, 924 securities  720–22, 764, 825, 829, 931 single  566–67, 601, 645, 820, 825 regulatory arbitrage  502, 571, 574, 592, 889 regulatory capital  525, 614–15, 769, 773, 787–88, 791, 798, 800; see also capital adequacy regulatory co-operation  18, 636, 833 regulatory competition  566, 583, 598, 754, 816–17, 820–21, 826 regulatory control  355, 822 regulatory discretion  525, 558, 625, 911, 920 regulatory failure  567, 597, 599–600, 627, 637, 639 regulatory frameworks  180, 306, 342, 528, 549, 561, 570, 922 regulatory interests  215, 267, 411–12, 642 regulatory intervention  330, 358, 787–88, 871, 888 regulatory objectives  509, 538, 560, 587, 601, 917 conflicting  545–49 regulatory powers  548, 593, 800, 829, 878, 922, 928 regulatory reforms  299, 514, 594, 626–34 regulatory regimes  637, 750, 752, 820–21, 826, 856, 860, 866 regulatory standards  737, 752, 755–56, 809, 816, 848 technical  858, 884–85 regulatory supervision  477, 532, 565–66, 610, 633, 664, 675, 704 rehypothecation  466, 471–73, 478, 481, 485–86, 492, 568 reimbursement  82, 227, 369, 430, 432, 434–35, 437 release  33, 38, 123, 157, 218–19, 359–60, 362–66, 368 reliability  305, 325, 477, 545, 688, 704, 757, 773 reliance  19, 24, 237, 342, 344, 366–67, 373, 580–81 justified  24, 344, 366–67, 373 religion  676 remedies  111, 192, 266, 424, 448, 451–52, 530, 532–33 remitting banks  427–28, 434

INDEX 971

rental agreements  98, 114–15, 139, 145, 250, 252 rentals  98, 245, 252–54, 259, 261, 263–64, 266, 268 reorganisation  71–72, 112, 138, 143, 185, 207, 334, 513 proceedings  51, 56, 71, 202, 204, 262 repayments  93–94, 98–99, 110–13, 122–23, 162–63, 199, 201, 655–56 replacement assets  4, 13, 75–76, 78, 99–100, 199, 201, 203 replacement goods  39–41, 52, 54–55, 61–62, 67, 79–81, 132, 205–6 replacement intermediaries  460, 713 replacement values  324, 328, 332 repledging  162, 323, 457, 466, 470–73, 492, 504 repos  42–48, 86–87, 113–15, 133–34, 139–41, 149–57, 470–73, 489–504 buyers  114, 155, 176, 178, 490, 493–95, 497–98, 504 markets  6, 11, 23, 491, 494, 502–3, 575, 631 master agreements  335, 396, 401, 412, 496 netting  72, 403, 498–500 securities, see securities, repos sellers  42, 113–14, 154–55, 176, 355, 492, 494, 498 repossession  28–29, 52–53, 95, 111–12, 149, 157–58, 204–5, 261 rights  52, 56–57, 111, 262 representative offices  587, 592, 751–52 repurchase  29–30, 91–92, 94, 139–40, 150, 229, 489–91, 496–98 duty  130, 155, 161, 496 options  79, 92–93, 106, 150, 166 prices  42–43, 94–95, 150–53, 155, 172–73, 489–90, 492–96, 498 reputation  125, 529, 544, 666, 718, 818, 831–32, 837 reputed ownership  93, 96, 98–99, 123, 125, 131 resale  107, 116, 136, 157–58, 202, 425, 437, 589 rescinding conditions  82–83, 91, 108, 112, 167–68 rescission  81–82, 92, 96, 99, 106, 108, 128, 133 rescues  85, 332, 521, 550, 623, 660, 872 resecuritisation transactions  301, 903 reservation of title  43–47, 79–85, 96–99, 104–13, 115–20, 131–35, 152–58, 168–73 extended  81, 98–99, 116, 131

France  96–97 Netherlands  79–82 United Kingdom  131 reserves  402, 506, 605, 655, 791, 929 undisclosed  771, 810, 851 residence  23, 188, 258, 262, 584, 752, 759–60, 771–72 resolution  556, 559, 854, 895–98, 910, 913, 915–16, 918 regime  522–23, 551–53, 555, 637, 908, 910–11, 914, 918 SRB (Single Resolution Board)  638–39, 898, 910 SRF (Single Resolution Fund)  638–39, 896, 907–8, 910–11 SRM (Single Resolution Mechanism)  523, 638–39, 645, 667–68, 896–97, 907, 910, 914 resolutive condition  82, 84, 86, 105, 160, 168–70, 249 restitution  53, 581 retail  344, 351–52, 665, 795–96, 839–40, 847–48, 899–900, 902 clients  301, 350, 711, 836, 840–42, 845, 900, 903 investors  347–49, 351–53, 530, 533, 544, 588, 845, 848 protection  351, 353, 544, 556, 825, 829, 838 retained earnings  505, 568, 652, 717, 791–92, 812 retention  49, 52, 62, 76, 82, 89, 437, 493 rights  52–53, 121, 437 retirees  291, 293 retransfer  42, 87, 93–95, 97, 112, 229, 404, 458 automatic  91, 229 retrieval rights  123, 249, 473 retroactivity  50, 77, 80, 82, 97, 168, 389–90, 394–95 return  91–94, 122–23, 125–26, 128–29, 149–51, 157–58, 174–75, 493 of overvalue  38, 42, 44, 46, 58, 62, 128, 247–48 reversion  119, 128–29, 408, 472, 491, 494, 504, 665 reversionary interests  83, 92, 121, 171, 470, 472, 490, 494 revindication  92, 106, 111, 122, 164, 493 rights  82, 89, 92, 117, 126, 133 revocability  381

972 INDEX

reward structures  41, 44, 155, 194–95, 238, 246–47, 292, 295 rights contractual  53, 145, 176, 250, 262, 269, 276, 280 direct  254, 265–66, 292, 346, 460, 677, 715, 744 of establishment  741, 743, 749–52, 754, 760, 803–4, 822, 825 obligatory  36, 66, 229, 232, 475, 702 ownership, see ownership, rights personal  94–95, 387 priority  55, 58, 71, 136 property  21, 24, 62, 118, 122, 911, 916, 918 recovery  59, 84, 100, 115, 163 repossession  52, 56–57, 111, 262 retention  52–53, 121, 437 retrieval  123, 249, 473 revindication  82, 89, 92, 117, 126, 133 set-off  53, 212, 218–19, 238, 241, 271, 273, 333 split-ownership  152, 156, 195 temporary ownership  15, 75, 82, 85, 87, 167, 171, 174 voting  159, 354, 460–61, 469, 485, 713, 862 ring-fencing  102, 140, 630, 655, 665, 893 risk asset ratios  768, 770, 776, 780 risk assets  272, 282, 293, 517, 614, 770–71, 783–84, 788–89 risk buckets  768, 770, 778, 781, 788 risk concentrations  299, 338, 560, 604, 775, 878, 884 risk control  376–77, 565 risk exposure  271, 310, 430, 593, 851 risk layering  271, 279, 287, 291, 294, 297, 299, 302 risk management  1–5, 7–9, 18–19, 57–61, 517–19, 660–61, 780–85, 787–88 banks  660–63 facilities  19, 38, 50, 75, 153, 330, 661 modern  6, 27, 406, 515, 518, 773 requirements  193, 383 systems  352, 651, 666, 773, 784, 798 tools  4–6, 15, 17–18, 70, 319, 386–87, 407–8, 412–13 risks  283–92, 299–303, 349–51, 412–15, 518–20, 655–59, 768–78, 783–85 banking  512, 554, 598, 603, 648, 651, 656, 789–90 collection  224, 229, 427 commercial banking  656–60, 790

counterparty  324, 329, 414, 425–26, 488–89, 685, 768–69, 851 credit  222–27, 279–85, 374–76, 427–29, 657–58, 768–72, 774–79, 781–84 cross-border payments  413–15 currency  312, 419, 774, 830, 851, 853, 879 default  197, 207, 795, 830 financial  22, 505, 509, 511, 553, 569, 611, 625 layering  276–79, 291, 785 legal  15, 19, 26–27, 60–61, 518–19, 525, 530, 532 liquidity  375–76, 384–85, 511, 513–15, 517–18, 596, 768–69, 774–75 market  511–13, 518, 657–58, 766–67, 769, 771–76, 782–84, 797–99 operational  656–57, 659, 765–66, 768–70, 782–86, 788–89, 792, 798–99 portfolio  657, 797 position  309–10, 656–58, 766, 768–69, 773, 775–76, 786, 788 settlement  309–10, 318–19, 328–29, 475–76, 657–59, 702–3, 768–69, 887–88 swaps  330–32 systemic  353–54, 509–11, 514–16, 524–25, 539, 546–50, 558–59, 931 transferability  379, 414–15 Roman law  32–33, 36–37, 81–82, 105–6, 111, 122, 126, 166–68 classical  82, 167 ius commune  36, 120, 166 Romania  375, 745 RTGS (real-time gross settlement)  374–75, 475, 596 rule-based systems  527, 555, 558, 627–28, 801, 919–20, 930, 932 rule-making powers  540, 644, 646, 722 Russia  450, 594–95, 618, 649, 660, 732, 739 safe harbours  589–90, 752 safeguards  50, 52, 128–29, 285, 287, 572, 915, 918 safety  743, 745–46, 804, 807, 873, 875, 912, 914 safety nets  547, 550–51, 598–99, 635, 637–38, 869, 872–73, 896 international  538, 623, 627, 634–37, 646, 789, 791, 895–97 sale of goods  123, 125–26, 131, 133, 159, 202–4, 220, 234–35 sales agreements  81–84, 92, 95–97, 104–6, 108, 166, 168, 702–3

INDEX 973

conditional  33–45, 81–87, 95–100, 116–20, 125–30, 132–35, 154–67, 230–31 contracts  108, 317, 319, 361, 431, 440, 477, 662 credit  119, 127–28, 131–32, 135, 150, 153–54, 165, 167 credit protection  105, 133, 193 fiduciary  29, 65, 76, 79, 98, 150 finance, see finance sales instalment  127–28, 177 prices  94, 98, 132, 152, 154, 430, 432, 495–97 temporary  41, 67, 79, 151, 173–74, 468 sales-price protection  31, 35, 44, 61–62, 82, 115, 172, 189 savings  421, 545, 637, 659–60, 755–60, 798, 873, 929–30 scalability  305, 342, 488–89 scanned paper documents  303 scholarship, see legal scholarship Scotland  40, 120, 296, 710 screen trading  843–44 search duty  6, 14, 37, 58–59, 91, 126, 192, 201–2 Second Pillar  743, 779, 783, 785–86, 907 secondary markets  507, 509, 574, 686, 690–95, 698–99, 707, 719–20 secured assets  27, 34–35, 42, 90, 136, 190, 198, 210 secured claims  33, 42, 51, 72, 80–81, 136, 142, 204 secured creditors  28, 32, 51–52, 57–58, 72–73, 111, 123–24, 203–5 secured financing  42–43, 143, 192, 217, 224 secured interests  28, 32–33, 91, 112, 121, 138, 183, 192–93 secured lending  12, 29, 41, 43–45, 87, 129–30, 150, 224 secured loans  43, 140–41, 152, 155, 177, 293, 489–91, 652–53 secured transactions  27–35, 41–51, 65–77, 139–41, 143–45, 149–53, 155–59, 193–94 and finance sales distinguished  41–47, 149–97 securities  76–81, 458–76, 485–89, 491–98, 679–86, 701–3, 711–15, 846–50 activities  355, 539, 586, 658, 699, 818, 853, 858–60 asset-backed  3, 33, 209, 273, 298, 626, 780, 895

bearer  479, 485–86, 488, 589–90, 712–13 business  535, 538, 542, 576–77, 718, 833–34, 851, 853 companies  651, 806, 858 entitlements  457, 459, 473–75, 478–79, 481–82, 484–85, 679, 681 fungible  467, 475, 481, 485, 508, 682, 688, 702 industry  525–26, 529, 531, 719–20, 775, 817, 834 intermediated  187–88, 478, 484 investment  16–18, 42–46, 94–95, 153–55, 457–59, 464–74, 489–91, 496–501 lending  354–55, 462, 466, 470, 494–96, 503, 887, 893 listed  589, 686, 693, 697 markets  300, 316, 329, 468, 477, 487, 497, 720–22 organisation  686–89 purchase money  45, 90, 137, 190 registered  458, 485, 682, 701 regulation  179, 587, 593, 718, 721–22, 825, 827, 830 international aspects  722–24 regulators  720–22, 764, 825, 829, 931 repos  42, 44, 46, 86–87, 139, 176, 178, 489–504 development  494–97 domestic and international regulatory aspects  502–3 international aspects  500–1 transferable  338, 346, 643, 679, 682, 684–86, 728, 814 transfers  78, 80, 201–2, 218, 230, 460–61, 463–64, 474–76 underlying  153, 345, 458–59, 468, 473, 478–80, 482, 502 Securities Information Processors (SIPs)  697–98 Securities Law Directive (SLD)  867, 885–86 securitisation  99–101, 269–74, 283–85, 290–94, 301–3, 518–20, 629–31, 661–62 cycle  304–6 domestic and international regulatory aspects  297–301 France  100–1 impact of fintech  303–6 international aspects  296–97 products  613, 629 re-characterisation risk  292–94 synthetic  279–80, 284

974 INDEX

securitised products  516, 519, 629, 631, 786, 788, 873, 879 security accounts  11, 458, 462–63, 466–67, 470–71, 495, 701–2, 712 security agreements  80, 136–40, 142–44, 160, 189–91, 200, 206, 227 security assignees  78, 89 security assignments  77–78, 101, 142, 197, 218, 223, 230–31, 241 security entitlements  457, 459, 461–65, 467–83, 485, 681, 701, 712–13 security holders  3, 99, 105, 136, 159, 164, 204, 682 security interest holders  32–33, 52, 157, 206, 724 security interests  27–30, 32–43, 46–50, 64–74, 89–91, 134–44, 157–62, 247–50 creation  64, 93, 123 domestic  74, 175, 191 non-possessory, see non-possessory security interests perfected  137–38, 437 unperfected  138, 183 security substitutes  44, 68, 79, 81, 84, 88, 167, 173 security transfers  78, 80, 201–2, 216, 218, 230, 460–66, 474–76 segregation  1–3, 102–3, 463, 508, 519–20, 540, 711–15, 723–24 facilities  2, 4, 8, 53 proper  272, 292, 525 structures  19 self-assessment  766, 773, 776, 780, 782–86, 789, 797, 799–800 self-dealing  462–64, 483, 709, 844–45, 927 self-help  33, 39, 73, 111–12 self-help remedies  111–12 self-regulation  273, 354, 541, 576, 721, 728, 884, 892 sellers  41–43, 90–97, 106–12, 157–65, 167–71, 318–22, 424–44, 488–99 conditional  128, 158, 161, 163–64 original  45, 94–95, 107, 112–13, 161–62 repo  114, 154–55, 176, 355, 472, 492, 494, 498 short  355, 468–69, 579, 887 senior bondholders  274–75, 515, 597, 623, 639–40, 919 SEPA (Single European Payments Area)  376, 644, 863, 876 separate recovery  28, 52, 124

separation  1–3, 51–56, 242–43, 270–71, 535, 566–67, 651, 881–82 service providers  529–41, 559–61, 577, 581–85, 699–701, 736–38, 817–18, 859–60 services  15–18, 582–84, 670–72, 734–43, 749–55, 803–12, 820–22, 898–900 cross-border movement  735–38 direct  751–52, 811, 839 set-off  6–7, 10–11, 50–55, 130, 331–35, 359–62, 386–99, 403–13 automatic  130, 390 bankruptcy  130, 388, 392, 394, 403 equitable  26, 391 extended  95, 153, 394 facilities  5, 7, 50, 53, 327, 337, 391, 394 as form of payment and risk management tool  386–90 international aspects  404–8 principle  23, 59, 63, 153, 391, 393–94, 397, 403 evolution  390–93 rights  53, 212, 218–19, 238, 241, 271, 273, 333 settlement  315–21, 374–79, 394–98, 474–78, 657–59, 687–89, 700–4, 865–67 agents  475–76, 480, 486, 488, 688, 702 cash  50, 281–82, 315, 340, 684 costs  329, 476, 702, 712, 840 net  375, 379, 396, 475 risk  309–10, 318–19, 328–29, 475–76, 657–59, 702–3, 768–69, 887–88 systems  375–76, 378–79, 475–76, 480, 640, 658–59, 719, 865–66 severability  211, 241, 270 shadow banking  505–6, 509, 567–71, 650, 652, 872, 875–76, 893 Shadow Committee  780, 787–88 shareholders  290, 345, 579, 604–5, 861–62, 910–11, 913–14, 916 shares  457–60, 468–69, 679–84, 686–88, 695–96, 714–17, 769, 813 sharia banking  181, 663, 665 sharia financing  44, 150, 178–79, 181, 506 and finance sales  178–82 sharia law  178, 180–81 shelf registrations  588, 691, 848 short positions  310–11, 464, 495–96, 579, 774–75, 779, 888, 891 short sales, see shorting short sellers  355, 468–69, 579, 887 short selling, see shorting

INDEX 975

short-term deposits  506, 516, 575, 616, 656, 665, 872 short-term funding  181, 278, 286–87, 350, 510, 513, 568–69, 611 short-term money  300, 507, 513, 521, 568, 647 shorting  295, 348, 354–55, 466–67, 469, 483–84, 643–45, 886–87 Sicherungsübereignung  39–40, 42, 52, 65, 67, 69, 105–7, 110–17 Sicherungszession  76, 105, 110, 112, 116, 150, 229 simplification  358, 476, 600, 702, 704, 712, 830, 866 simultaneity  379, 424–26, 475, 659, 702 simultaneous exchange  429, 688 single banking regulator  585, 896, 907–8 Single European Payments Area, see SEPA single market  583–84, 803, 827, 830, 863–64, 901 single name CDS  281, 298 single regulator  566–67, 601, 645, 820, 825 Single Supervisory Mechanism (SMM)  562, 638, 667, 746, 791, 821, 878, 907–8 SIPs (Securities Information Processors)  697–98 situs  25–26, 30–31, 49, 68–69, 182–86, 213–14, 240, 255 skin in the game  278, 296, 301, 550, 608, 646, 903 small investors  193, 701, 707, 808, 818, 821, 854, 859 smart contracts  75, 303–5, 339–42, 384, 486, 573, 678–79, 905 embedded  488 SMM, see Single Supervisory Mechanism social welfare state  554, 607, 646, 789 societal leverage  507, 511, 596, 606, 627, 636, 921, 931 soft law  23, 764, 768 software  385, 700, 844 solidarity  609, 618, 620, 874 solvabilité apparente  92–93, 96, 99 solvency  300, 323, 326, 524, 633, 638–39, 649, 666 southern Europe  522–23, 621, 624, 667, 712, 812, 823, 874 sovereign debt  424, 727, 762, 887 sovereignty  192, 621, 627, 633, 639, 748, 757, 928 Spain  610, 637, 639–40, 757, 759, 842–43, 906, 911

specificity  13, 36, 40, 109, 116, 132, 209, 215 split ownership  46, 97, 103, 117, 119–20, 152, 156–64, 195 practical issues and relevance  165–67 stabilisation  580, 706–7, 728 stability  60–61, 525–27, 543, 545–48, 552–53, 594–96, 633, 824–31 boards  553, 597, 643, 871, 878 committees  556, 625, 913, 933 financial  514–16, 524–25, 537–39, 545–49, 557–58, 560–62, 594–99, 615–16 standard approaches  766, 773, 782–83, 785, 787–88, 794, 796–98 standard contracts  310, 315, 325, 682, 688 standard terms  675, 709 standardisation  282, 299–300, 316–17, 323–26, 328–29, 339–40, 631, 902 operational  318, 326–27, 329 standardised options  313, 316, 328, 662 standardised products  317, 326 standards  577, 580, 687, 779, 781, 826, 838, 847–48 accounting  299, 502, 848, 901 capital  642, 763, 785, 790, 869 international  303, 517, 592, 846, 903 minimum  408, 410, 758, 766, 815, 822, 849, 857 objective  327, 410, 581 regulatory  737, 752, 755–56, 809, 816, 848 regulatory technical  858, 884–85 standby lending commitments  775–77 standby letters of credit  280, 444–48, 776–77 standstill agreement  732–33 Star Chamber  123 state aid  640, 743, 870, 875, 895–96, 915, 927 state intervention, see intervention statistical models  273, 285, 776 status  4–5, 23–24, 52, 85–87, 89–90, 186, 403, 479–80 international  186, 258 legal  139, 338, 360, 404, 730, 739, 907, 915 transnational  22–23, 410, 415, 730 statutory interpretation, see interpretation statutory law  35, 120, 123, 194, 196, 365, 367, 390 statutory liens  52, 71, 73, 89, 111–13, 137 statutory preferences  9, 59–60, 205, 253 stock exchanges  533–35, 541–42, 576–77, 681, 683, 686, 688, 718–19 official  477, 530, 687, 704, 846 stock lending  94, 355, 469, 568, 887

976 INDEX

stress tests  273, 515, 554, 559, 610, 870, 908 striking prices  290, 306, 310–11, 314, 492, 661, 682, 795 structural reforms  421, 555, 620, 869 structured products  540, 569, 700, 890, 925, 927 student loans  269, 312, 515, 553, 612, 653, 919 sub-custodians  458, 475, 681, 701–2 sub-participations  271, 276, 655, 657 sub-prime mortgage market  285–87, 348, 607 subjectivity  24, 765, 789, 796 subordinated loans  101, 274, 771, 781, 791 subordination  51, 56, 101, 274, 285 equitable  56, 117, 138, 674 subsidiaries  565–67, 583, 586–87, 591, 664, 751, 822–23, 900 financial  856, 858 foreign  590, 716, 738 subsidiarisation  898, 923–24 subsidiarity  667, 738, 744, 746, 820, 827, 831, 906 substantive law  234, 256, 894 substitute payments  469, 495–96 substitutes  34, 368, 516, 520, 569, 573, 609, 617 security  44, 68, 79, 81, 84, 88, 167, 173 substitutionability  511, 564 successors  125, 128, 161, 548, 557–58, 828, 832, 835 bona fide  182, 214 sui generis character  252, 370–72, 374, 378, 380, 459, 464, 472 sukuk  180–81 supervision  528–29, 591–92, 667–68, 720–21, 809–13, 815–21, 825–27, 831–34 and authorisation  352, 529, 533–34, 541, 577, 751, 815, 817–19 banking  546–48, 567, 591, 593–94, 666–68, 856, 919, 921 conglomerates  590, 592, 857 consolidated  519, 591–92, 667, 809, 830, 857–58, 898, 900 liquidity  552, 604, 629 macro-financial  524, 562, 909 macro-prudential  528–29, 552–56, 558–61, 595–98, 610–11, 628–29, 908–9, 912–14 micro-financial  524, 598 micro-prudential  523, 525, 527–28, 538–39, 556, 558–59, 595–96, 932–33 minimum  357, 574

product  526, 530, 534–35, 582, 718, 722, 805, 808 prudential  529, 531, 533–34, 577–78, 718–19, 816–18, 821–22, 836–38 regulatory  477, 532, 565–66, 610, 633, 664, 675, 704 supervisors  533, 546, 550, 558, 784, 904, 912–13, 919 supervisory authorities  531, 721, 809, 857, 882 supplementation  188, 191, 236–37, 240, 242, 244–45, 256, 258 suppliers  143–45, 238–40, 248, 250–51, 253–54, 256–61, 264–67, 443–44 supply  415, 575, 579–81, 583, 587, 686, 689, 695–96 agreements  248, 250–51, 254, 257, 259–60, 263, 265–68, 399 contracts  253, 256, 266 support functions  24, 533, 753 public  563, 597, 623, 633 sureties  34, 438–39, 445, 448 suspending/suspensive conditions  82–84, 86, 94, 97, 160, 167–70, 249 suspensive interests  84, 169–70 suspensive ownership  160, 170, 177 suspensive title  169–70, 177 swap contracts  393, 398–99 swap markets  308, 317, 323, 328, 332, 337, 502, 510 central clearing and standardisation  323–27 swap master agreements  23, 281, 332–33, 337, 398, 400, 402, 410 swap netting  72, 153, 330–32 swap parties  312, 334, 395, 399–400 swaps  2–4, 308–13, 315–18, 323–39, 392–404, 408–12, 661–62, 775–77 cocktail  308, 662 currency  100, 306, 308, 311–12, 331, 393, 398, 402 default  274, 295, 305, 510, 518, 520, 886, 890 documentation  398–99, 401 interest rate  300, 308, 393, 396, 402, 684, 728, 775 legal aspects  332–35 risk and netting  330–32 total return  279, 281, 283, 309, 643 SWIFT  375, 424, 866 Switzerland  393, 454, 632, 635, 759–60, 762, 787, 791

INDEX 977

syndicates  17, 578, 580, 654, 704–5, 707, 718, 728 synthetic securitisation  279–80, 284 system thinking  8, 13, 118 systematic internalisers  836, 840, 844–45, 927 systemic risk  353–54, 509–11, 514–16, 524–25, 539, 546–50, 558–59, 931 meaning  596–99 Takeover Bids Directive  861–62 takeovers  12, 283, 469, 579, 640, 654, 716–18, 862 tangible movable assets  31, 77, 116, 213–14 TARGET 2  375 tariffs  416, 424, 603, 725, 731–33, 735, 742, 821 tax  275–76, 451, 453, 632, 644, 717, 726–27, 758–60 avoidance  453, 757, 759, 922, 927–28 tax evasion  385, 451, 453, 455, 759 tax havens  254, 267, 357, 595, 760, 885 offshore  357–58, 453, 885 tax liens  52, 55, 59, 137, 143, 205 tax treatment  155, 182, 349, 865–66 taxation  275–76, 451, 578, 632, 717, 726–28, 758–60, 862–63 withholding taxes  500, 578, 726–29, 758–60, 813 taxpayers  621–22, 633, 635, 639–40, 665–66, 759, 854, 858 technical standards, regulatory  858, 884–85 temporary ownership  15, 45, 82, 467, 472, 481, 490, 493 rights  15, 75, 82, 85, 87, 167, 171, 174 temporary sales  41, 67, 79, 151, 173–74, 468 temporary transfers  103, 151, 173, 241, 293, 491, 501, 503 tendering  42–43, 157, 161, 178, 365 termination  261, 323–24, 326, 332, 399–401, 498, 674, 676–77 terminology  108, 111, 139, 143, 280, 282, 491, 671 territory  736, 750, 752–53, 804, 806, 809, 818, 841–42 terrorism  450–54, 456, 745, 799 terrorist financing  456, 863 think-tanks  593–94, 640, 668, 763 third countries  183, 185, 585, 742, 822, 898–901, 926, 928 EU approach  585

third parties  31–32, 56–59, 107–8, 121–23, 136–38, 160–62, 261–64, 712–14 Third Pillar  455, 639, 743, 748, 784, 786, 907, 911 time deposits  12, 307, 314–15, 506, 514, 662, 671, 676 title  43–47, 79–85, 96–99, 104–20, 131–35, 152–66, 168–74, 247–55 absolute  122, 161, 163 conditional  107–8, 119, 133, 157, 160–62, 171, 173, 183 documents of  3, 64, 195, 425, 680 reservation of, see reservation of title suspensive  169–70, 177 titrisation  100, 203, 210 Tobin tax  629, 632, 644 token pools  304 token transfer  304, 384 tokens  304–6, 383–85, 485–88, 724 tort  42, 122, 142, 170–71, 220, 241, 388–89 total return swaps  279, 281, 283, 309, 643 toxic assets  522, 630 tracing  75–76, 78–80, 178, 203, 467, 471–72, 491–92, 710–15 tradability  3, 277, 516, 520, 706 trade financing  629, 653–54, 670 trade receivables  3, 43, 76, 150, 187, 221, 241, 279 trading activities  574, 577, 629–30, 644, 650, 657, 887, 893 electronic, see electronic trading margin  477, 483, 704 platforms  300, 643, 691, 698, 700, 839, 921, 923–25 electronic  325, 534, 576, 643, 880, 882 proprietary  299, 347, 349–50, 521, 613, 629, 651, 891–92 screen  843–44 trading accounts  340–41, 539 trafficking, drugs  449, 451–52, 454, 456 transaction costs  186, 329, 342, 346, 358, 412 transaction messages  382, 384, 488 transactions chained  371, 378–79, 463, 468 commercial  49, 120, 138, 386 cross-border  19, 61, 94, 175, 329, 375, 379–80, 723 derivative  94, 290, 339, 348, 631, 665, 794, 884 foreign exchange  323, 379, 395, 735, 759

978 INDEX

funding  38, 66, 149–50, 244, 495 reporting  285, 700, 835, 842, 893, 901, 925 secured  27–35, 41–51, 65–77, 139–41, 143–45, 149–53, 155–59, 193–94 transfer ledgers  724 transferability  2, 280–81, 363–64, 379–80, 414–18, 429–30, 679–83, 685–86 risks  379, 414–15 transferable letters of credit  443 transferable securities  338, 346, 643, 679, 682, 684–86, 728, 814 transferees  24, 94, 106, 110, 112, 122–23, 125, 152 bona fide  211, 464–65 transferors  67, 107, 110–11, 115–16, 118, 122–25, 203, 209 transferred assets  94, 275, 293 transfers  80–84, 103–10, 160–62, 227–30, 363–68, 461–67, 475–85, 680–82 of assets  36, 175, 269, 283, 293, 359, 364, 367 automatic  112, 129, 206, 240, 260, 268 bank, see bank transfers in bulk  67, 91, 196, 202, 243 conditional  85, 87–88, 99, 105, 110, 166–67, 172–73, 228 credit  365, 369–70, 378, 380–81, 462, 644, 864 debit  368–69, 381, 463 delayed  96–97, 167, 172, 314, 475, 702 fiduciary  76, 79, 84, 98, 100, 110, 112 physical  67, 160, 309, 702 securities  78, 80, 201–2, 218, 230, 460–61, 463–64, 474–76 temporary  103, 151, 173, 241, 293, 491, 501, 503 title  96–98, 105–6, 108, 110, 172–74, 363, 475, 481–83 transnational commercial and financial legal order, see international commercial and financial legal order transnational floating charges  16, 519 transnational public policy  8, 31, 63 transnational status  22–23, 410, 415, 730 transnationalisation  10–11, 20–22, 24–27, 69–71, 195–96, 243–45, 380, 478–80 effects  182 legal  3, 7–11, 19, 22, 40, 186–87, 196, 726 transparency  298–300, 324–25, 329–30, 542–44, 577–78, 615, 841–44, 882–84 post-trade  699, 841, 881, 923, 927

transport documents  436 transportation  414, 425–26, 588, 744, 750, 804 treasury operations  348, 616, 653, 891 treaty law  48, 187–89, 211, 216, 228, 244, 256–57, 408 uniform  20, 48, 188, 211, 228, 244, 446 tripartite agreements  270, 317, 360–61 trust assets  102–3 trust structures  2, 4–6, 19, 56, 104, 124–25, 228–29, 276–77 trustees  51–52, 54–55, 102–3, 111–12, 163–64, 387–89, 493, 706 bankruptcy  80, 145–46, 152–53, 163–64, 176, 204–5, 459–60, 493 trusts  54, 88–90, 102–4, 122, 195, 203, 271–72, 345 constructive  4–5, 10, 26, 53, 55, 203, 711, 714 France  101–4 UK, see United Kingdom umbrella funds  344, 347 unbundling  57–59, 195 uncertified securities  572, 724 unconditional owners  30, 115, 194 under-collateralisation  283 underlying agreements  23, 117, 126, 128, 211, 218, 220, 239 underlying assets  175–76, 178–79, 306–12, 314–15, 319, 340, 497–99, 661–62 underlying cash flows  275, 277, 286, 331 underlying claims  25, 231–32, 238, 407, 409 underlying contracts  105, 211, 218, 270, 279, 438–39, 444, 446 underlying instruments  4, 285, 775, 844 underlying intent  108, 110, 362, 423, 749 underlying investments/investment securities  281, 308, 458, 461, 467, 479, 482, 492 underlying portfolios  278, 287, 518 undertakings  56, 365, 430, 438–39, 441, 445–46, 655, 814 undervalue  33–34, 38, 45, 123–24, 127, 157, 159 underwriters  507–9, 526, 530, 577, 580, 589, 704–6, 718–19 underwriting  16–17, 508–9, 650–51, 670, 704–7, 718, 726–28, 730–31 undisclosed reserves  771, 810, 851

INDEX 979

unemployment  420, 511, 555, 597, 608, 622, 786, 874 UNIDROIT  48–49, 186–87, 191–92, 220, 225–27, 230–31, 235–41, 256–57 unification  22, 49–50, 61, 70, 187, 189, 867, 874 Uniform Customs and Practice for Documentary Credits, see UCP uniform law  38, 106, 186–89, 212, 236, 242, 256, 268 uniform rules  142, 188, 237–40, 244, 256–57, 266, 447, 480–81 uniform treaty law  20, 48, 188, 211, 228, 244, 446 unintended consequences  301, 503, 625, 642, 870, 885 unitary approach  67, 134, 138, 177, 193, 213, 244, 292 unitary system  134, 193, 380 United Kingdom  35–40, 118–34, 389–92, 531–32, 556–60, 566–67, 666–68, 720–21 conditional sales and secured transactions distinguished  127–31 differences from civil law  118–20 English law  119–20, 127, 129–30, 132–34, 155, 390–91, 400, 501 FCA (Financial Conduct Authority)  531, 534, 557–58, 566, 667, 721 finance sales  133–34 FSA (Financial Services Authority)  349, 531, 534, 556–58, 566–67, 667, 721, 839–40 PRA (Prudential Regulation Authority)  531, 534, 558, 566, 667, 721 reservation of title  131 United Nations  453–54 United States  71–74, 133–47, 156–60, 220–25, 246–57, 586–93, 726–27, 730–33 Art 9 UCC  134–44 banks  99, 503, 586–87, 640, 646, 670, 730, 787 DTC (Depository Trust Company)  458, 476 FDIC (Federal Deposit Insurance Corporation)  586, 633, 668 Federal Reserve  299, 348, 375–76, 586, 609, 640, 668, 768 and foreign issuers/intermediaries  587–90 FSOC (Financial Stability Oversight Council)  353, 560, 564, 642 investors  530, 587–88, 590, 696, 727, 902

proprietary characterisations  144–47 regulation of foreign banks  586–87 Shadow Committee  780, 787–88 unity  66, 71, 213–14, 216, 236, 258, 909, 914 universal banks  508, 544, 565–67, 592, 650–51, 664, 833–34, 843 universal natural law, see natural law unjust enrichment  53–54, 78, 80, 89, 364, 373 unofficial markets  689, 693, 720, 839, 847 unsecured claims  33, 101, 335, 425 unsecured creditors  51, 58, 137, 141, 143, 197, 203, 207 unsophisticated investors  296, 719 updating  200, 548, 643, 689, 706, 746, 824 US/USA, see United States usage  23, 242, 414, 730 users  5, 51, 53, 121–22, 152, 245–47, 339, 581–82 usufructs  5, 82, 84–87, 92, 167, 173, 490–91, 501 utility  209, 330, 587, 663 validation  381, 383–84 validity  25–26, 77–78, 142, 232–33, 237–38, 271–72, 364–65, 391 contractual  106, 114, 231, 262, 335, 391 valuations  281, 285, 288, 346, 349, 352–53, 394, 715–17 proper  53, 71, 199, 482, 520, 636 value at risk, see VaR values  280–85, 289–90, 311–15, 493, 498–500, 657–58, 716–17, 777–79 fair  791, 794 intrinsic  276, 344, 347, 415 mark-to-market  772, 779 market  51, 129, 154, 281, 311, 314, 495, 498 replacement  324, 328, 332 VaR (value at risk)  180, 336, 615, 766, 773, 780, 788, 797–98 variable capital adequacy  506, 563, 625, 650 vente à reméré  90–91, 93, 95, 98 venture capital  348, 356, 643, 885 Verarbeitungsklausel  106–7, 109, 116, 205 verification  316, 318, 324, 329, 377, 488, 589, 843 viability  301, 600, 769, 788, 816, 903 volatility  289, 311, 313–14, 325, 555, 572, 598, 644 Volcker Rule  616, 629, 642, 644, 646, 887, 890, 892–93

980 INDEX

Vorausabtretungsklausel  107, 109, 116, 205 voting rights  159, 354, 460–61, 469, 485, 713, 862 vulnerabilities  86, 340, 342, 396 warehouse receipts  64, 90, 425, 436, 680 weightings  765, 778, 781, 851

welfare state, social  554, 607, 646, 789 Windscheid B  82, 108, 168 withholding taxes  500, 578, 726–29, 758–60, 813 working capital advances  4 World Bank  448, 594–95, 687, 729, 734, 770