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FINANCIAL LAW


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FINANCIALLAW

JOANNA BENJAMINReader in Law, London School of EconomicsConsultant, Freshelds Bruckhaus Deringer


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1Great Clarendon Street, Oxford ox 2 6dp

Oxford University Press is a department of the University of Oxford.It furthers the Universitys objective of excellence in research, scholarship,

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Oxford is a registered trade mark of Oxford University Pressin the UK and in certain other countries

Published in the United Statesby Oxford University Press Inc., New York

Joanna Benjamin, 2007

The moral rights of the author have been assertedDatabase right Oxford University Press (maker)

Crown copyright material is reproduced under Class LicenceNumber C01P0000148 with the permission of OPSI

and the Queens Printer for ScotlandFirst published 2007

All rights reserved. No part of this publication may be reproduced,stored in a retrieval system, or transmitted, in any form or by any means,

without the prior permission in writing of Oxford University Press,or as expressly permitted by law, or under terms agreed with the appropriate

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Oxford University Press, at the address above You must not circulate this book in any other binding or cover

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Printed in Great Britainon acid-free paper by Biddles Ltd., Kings Lynn

ISBN 9780199282937

1 3 5 7 9 10 8 6 4 2


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To Benjamin Reiner


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FOREWORD

In this country, since at least the 14th century, like Dick Whittington, people whoare determined to make their fortune have been drawn to the City of London.In Dick Whittingtons case it was because he thought the City was paved withgold. Today it is the domestic and international nancial markets, of whichthe City is the hub, which attract many of the brightest graduates on leavinguniversity.

I am afraid that in those markets a cat may be a companion but it will be of nohelp in making your fortune. What is needed is an understanding of nancial law

which controls those markets and the products, often highly sophisticated, whichare traded there. So my advice to those who seek their fortune in the City is to tradein the cat and acquire a copy of this hugely valuable innovative book. It makes thoseproducts comprehensible and explains the workings of nancial law.

The number and the nature of those products have grown exponentially. Theyare frequently given names that provide little assistance as to their nature, sourceor value. So they can be backed by sub prime mortgages of domestic properties

in California, that are traded in London and owned in Japan. Like nancial lawitself they are nothing if not international and very much part of the global marketplace. Collectively their value has to be measured in billions of pounds or dollars.Financial markets are fuelled by liquidity and today these products make a vastcontribution to its availability.

I know the author of Financial Law , Dr Joanna Benjamin, through my currentChairmanship of the Bank of Englands independent Financial Markets LawCommittee of which Joanna Benjamin is a most experienced and thoughtfulcontributor. Her contributions always reect her deep understanding of oursubject matter and a real sense of order. She brings this same quality to bear on thecontents of her book. Its subject matter is carefully organised so as to be under-standable and user friendly, notwithstanding the complex and technical natureof its subject matter. It is a comprehensive consideration of the practice, regula-tion and law of the insurance, derivatives, commercial banking, capital marketsand investment management sectors and offers a conceptual scheme for the wholeof this subject matter.


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For whom will it be of value? Certainly someone like myself, who is no more thanan interested layman. However, its audience is undoubtedly much larger than theinterested lay person. This book will appeal to students who are studying nancialmarkets and the law that applies to them. It will be a useful reference book for

those who work in these markets or advise those who do so. In fact everyone,including commercial lawyers and judges, who has anything to do with nanciallaw and its subject matter will increasingly nd themselves dependent on thisbook for the help it provides. Undoubtedly ownership of this book will provea safe investment and a step towards achieving the wealth that success fromoperating in the nancial markets of the City of London can bring.

The Right Honourable Lord Woolf,Formerly Lord Chief Justice

Foreword


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PREFACE

I wrote this book in the hope of making the practice and study of nancial laweasier. The insurance, derivatives, commercial banking, capital markets, andinvestment management sectors are dynamic and converging. The purpose of thebook is to offer a scheme for understanding the law and regulation of these sectorsas a coherent whole.

The idea for this book started during a long period of bed rest while I was pregnant with my boy Ben Reiner. Ben is now ve, and I hope the six-year gestation periodis the only similarity between the book and a Brachiosaurus. As Ben has grownand ourished, the book has taken shape. In both my boy and nancial law I seethe same irresistible and unruly vitality. As both rush tumbling into the future, my

job is chiey to do no harm, tell a story, and tidy up.

The law is stated as it is known to me at 1 June 2007. This book is not intended toprovide legal advice and should not be relied on as such.

Finchley, July 2007


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ACKNOWLEDGEMENTS

I am greatly honoured by the foreword kindly written by Lord Woolf. Thereafter,my rst debts are to my colleagues in the Law Department at the London Schoolof Economics for kindly granting me leave to write this book, and to those atFreshelds Bruckhaus Deringer for the generous sponsorship that enabled me tonish it.

My further debts are to my colleagues for the intellectual inspiration toattempt an ambitious project, and to Nina Farhi for the moral courage to carryit through.

Grateful acknowledgement is made to all the authors and publishers of copyrightmaterial which appears in this book, and in particular to the following for permis-sion to use material from the sources indicated:

Extracts from P. Ali and J. J. de Vries Robb,Synthetic, Insurance and Hedge FundSecuritisations, Thomson, Sydney, 2004 are reproduced with the kind permissionof the authors.

Extracts from Allen & Overy,Instructions to Robin Potts, QC, Credit Derivatives,19 May 1997 are reproduced with the kind permission of Allen & Overy.

Extracts from Robin Potts QC, Credit Derivatives Opinion delivered to ISDA, Erskine Chambers, Lincolns Inn, 24 June 1997 are reproduced with the kindpermission of Robin Potts QC.

Extracts from the Loan Market Association syndicated single currency term facil-ity agreement are reproduced with the kind permission of the Loan Market

Association.

The ideas in the book draw on the work of colleagues too numerous to mentionhere. I am particularly grateful to the following for their invaluable guidancein the course of writing: Len Berkowitz, Julia Black, Peter Bloxham, WilliamBlair QC, Hugh Collins, Geoff Davies, Stephen Lucas, Andrew Marsh, RogerMcCormick, Andrew McKnight, Guy Morton, Simon Orton, David Quest,Michael Raffan, Robert Reiner, Simeon Rudin, James Smethurst, and MartinThomas. Any errors are my own. I have sought throughout to acknowledge mydebts, but if through oversight I have omitted any appropriate reference, I hopeto be told so that the omission can be corrected in any future edition.


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I am grateful also to the editorial and production teams at Oxford University Pressfor successfully and tirelessly managing this large project; to my research assistant,

Joanna Pearson, for her skilful work; to the business development and know-howteams at Freshelds Bruckhaus Deringer for their hard work and professional help

in taking the project forward; and to my secretaries, Lucy Wright and EmmaSantry, for their considerable patience.

As ever, my greatest debt is to my family, and in particular to my husband and son.Throughout Robert has offered unagging kindness, concern and encourage-ment, and undertaken so much more than his share at home that it is remarkablethat he has also just completed a major book. I am also indebted to Robert for hisinspiration as a writer and thinker. And to little Ben for being his wonderful selfin spite of his mother having been so often on another planet; for poking his curlyhead under my elbow, reading my laptop screen and saying, Mum, I think thisis interesting!; and most of all for proudly declaring to Robert and me, WhenI grow up, Im going to be a bookmaker like you.

Acknowledgements


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CONTENTSSUMMARY

Foreword viiPreface ix

Acknowledgements xiTable of Cases xxxiiiTable of Legislation xliTable of European Legislation xlix

Table of International Treaties and Conventions liii

I INTRODUCTION 1. Terms of Reference 3 2. Credit Risk 27

II SIMPLE FINANCIAL POSITIONS

3. Overview 49 4. Transaction Types 51 5. Comparison of Simple Financial Positions 85 6. Trends 145

III FUNDED POSITIONS

7. Overview 149

8. Options for Raising Capital 151 9. Managed Funds 18710. Regulation of Funded Positions: Five Points of Comparison 219

IV NET POSITIONS

11. Overview 26112. Set Off and Netting 263

13. Title Transfer Collateral Arrangements 30514. The Rise of Net Positions 325


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V ASSET-BACKED POSITIONS

15. Overview 33116. Property Rights 333

17. Security 36118. Asset-backed Securities 40119. Indirectly Held Securities 42520. Financial Collateral 44521. Trends 483

VI MARKETS AND REGULATORY PROJECTS

22. Overview 49923. Market Forces in Financial Law and Regulation 50324. Judges, Markets, and Consumers 51925. The Arms Length Regulatory Project 52726. The Fiduciary Project 54327. The Consumerist Project 56328. Conclusions 585

Bibliography 593Index 607

ContentsSummary


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CONTENTS

Foreword viiPreface ix

Acknowledgements xiTable of Cases xxxiiiTable of Legislation xliTable of European Legislation xlixTable of International Treaties and Conventions liii

I INTRODUCTION

1. Terms of Reference

1.1 Terms of Reference 1.051.1.1 Nature and content of nancial law 1.051.1.2 Ambition of the book 1.101.1.3 Convergence 1.151.1.4 Plan of the book 1.18

1.2 Risk Transfer 1.251.2.1 Emphasis on risk 1.251.2.2 Nature of risk 1.271.2.3 Financial institutions and markets 1.28

1.3 Comparison of Regulatory Projects 1.31

1.4 Comparison of Transactions 1.381.5 Five Core Ideas in Financial Law 1.46

2. Credit Risk

2.1 Credit Risk as a Medium of Risk Transfer 2.022.2 Corporate Personality 2.05

2.3 Limited Liability 2.06

2.4 The Corporate Fund 2.09

2.5 Corporate Insolvency 2.13General principles of distribution 2.23Policy debates 2.26Property and set off rights 2.27


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Mandatory 2.31Pro-market measures 2.32Functions of insolvency law 2.33

2.6 Credit Risk Management 2.34Mandatory provisions 2.35Private law credit enhancement 2.36

2.7 Credit Risk Measurement 2.37

II SIMPLE FINANCIAL POSITIONS

3. Overview

4. Transaction Types4.1 Overview 4.01

4.2 Guarantee 4.02Suretyship 4.02Secondary liability of guarantor 4.03Protections for guarantor 4.08Distinguish indemnity 4.10Generally 4.11

4.3 Insurance 4.13Elements of contract of insurance at common law 4.14Non-disclosure, misrepresentation, and breachof warranty 4.25Subrogation 4.26Types of insurance 4.27

4.4 Derivatives 4.304.4.1 Essential nature of derivative 4.314.4.2 Basic types of derivative 4.33

Forwards 4.34Options 4.35Swaps 4.36Generally 4.42

4.4.3 Reference assets, entities, and benchmarks 4.434.4.4 Markets: exchange traded derivatives, OTC derivatives,

and derivatives in structured products 4.464.4.5 Physical and cash settlement 4.504.4.6 Credit derivatives 4.51

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Overview 4.51Elements 4.53Functions of credit derivatives 4.63Synthetics 4.64

Sensitivities 4.654.5 Standby Credits 4.66

4.6 Performance Bonds 4.70

4.7 Alternative Techniques 4.734.7.1 Comfort letters 4.744.7.2 Joint and several liability 4.75

5. Comparison of Simple Financial Positions

5.1 Functions 5.025.1.1 Security 5.035.1.2 Hedging 5.055.1.3 Speculation 5.095.1.4 Arbitrage 5.115.1.5 Synthetics 5.145.1.6 Avoidance 5.185.1.7 Conclusions 5.21

5.2 Risk of Non-payment 5.225.2.1 Category-specic legal rule reducing risk of

non-payment: autonomy 5.235.2.2 Category-specic legal rules increasing risk of non-payment 5.39

5.2.2.1 Guarantees 5.40Secondary and co-extensive liability of guarantor 5.41Discharge of guarantor 5.42Non-disclosure to guarantor of unusual features 5.47Contractual modication 5.48Undue inuence 5.51Generally 5.52

5.2.2.2 Insurance 5.55Contractual modication 5.62Proposals for reform 5.65

5.2.2.3 Performance bonds and standby letters ofcreditstrict compliance 5.67

5.2.3 Category-specic rules: conclusions 5.695.2.4 Payment culture 5.70

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5.3 Documentation 5.73 5.3.1 Requirement for writing 5.74 5.3.2 Availability of standard documentation 5.76

5.4 Regulatory Capital Treatment 5.80

5.5 Requirement for Authorization 5.86The general prohibition 5.87Insurance 5.89Derivatives 5.94

5.6 Credit Risk Management 5.95

5.7 Insolvency Priority for Protection Buyers 5.101 5.8 Liquidity 5.102

5.9 Flexibility and Precision 5.108Liabilities only 5.108 All risks 5.109Disaggregation of risks 5.110

5.10 Parties Understanding of Risk 5.111

5.11 Recharacterization Risk 5.1195.11.1 Generally 5.1205.11.2 Sensitivities 5.121

Guarantee or indemnity 5.122Guarantee or performance bond 5.127Guarantee or insurance 5.129Life insurance or investment product 5.131Holding insurance securitization bonds

and insurance 5.133Debt indemnity services or insurance 5.134Derivatives and gaming contracts 5.135

6. TrendsInnovative uses of traditional contract

categories 6.02Structuring 6.04The rise of derivatives 6.05

III FUNDED POSITIONS

7. Overview

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8. Options for Raising Capital

8.1 Overview 8.018.1.1 Debt and equity 8.02

8.1.1.1 Comparison 8.038.1.1.2 Gearing 8.078.1.1.3 Income 8.08

8.1.2 Bank loans 8.128.1.2.1 Overview 8.128.1.2.2 Forms of loan facility 8.14

Overdraft 8.16Term loan 8.18Revolving facilities 8.19Syndicated loan 8.21Several obligations 8.22Sharing 8.23Voting 8.24Not partnership 8.25Role of arranging bank and agent bank 8.26

8.1.2.3 Credit risk mitigationcontractual provisions 8.27Conditions precedent 8.28Representations and warranties 8.29Covenants (undertakings) 8.34Information undertakings 8.35Financial covenants 8.36General undertakings 8.37Negative pledges 8.38Events of default 8.43Good faith 8.45Latent lies and broken promises 8.46Lenders power over borrowers 8.47

8.1.2.4 Secondary loan market 8.488.1.3 Capital markets 8.52

8.1.3.1 Overview 8.53Generally 8.53Equity 8.58Debt 8.61

8.1.3.2 Legal nature of investment securities 8.62Legal meaning 8.63Bearer and registered 8.67Indirectly held securities 8.68

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8.1.3.3 Eurobonds 8.70Role of settlement systems 8.71Role of managers 8.72Credit risk mitigation 8.75

Paying or scal agents, trustees, and meetings 8.768.1.4 Syndicated loans and Eurobonds 8.77

9. Managed Funds9.1 Categories of Fund 9.05

9.1.1 Regulated and private 9.079.1.2 Open ended and closed ended 9.109.1.3 Legal structures 9.149.1.4 Investment policy 9.159.1.5 Tax status 9.229.1.6 Jurisdiction 9.269.1.7 Listed and unlisted funds 9.279.1.8 Unlimited and limited life funds 9.28

9.2 Professional Roles 9.299.2.1 Management 9.309.2.2 Other roles 9.36

Custody 9.36Supervision 9.37Investment advice 9.38Brokerage 9.39

Administration 9.42Distribution 9.43Legal support 9.44Sponsors 9.45

9.3 UCITS 9.46

9.3.1 Background and history 9.479.3.2 Criteria for UCITS status 9.509.3.3 Authorization of UCITS 9.519.3.4 Prudential and investor protection requirements 9.52

Unit trusts and common funds 9.53Investment companies 9.56

9.3.5 Product regulation 9.58Investment and nancial transaction powers 9.59Unit dealing 9.61

Income, fees, and expenses 9.62

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9.3.6 Cross-border marketing 9.63 9.3.7 Cross-border management 9.64 9.3.8 Further reforms 9.65

9.4 Regulated Funds 9.66

9.5 Listed Funds 9.67Investment trusts 9.68Exchange traded funds 9.70

9.6 Private Funds 9.72

9.7 Convergence 9.75

10. Regulation of Funded Positions: Five Points of Comparison

10.1 Fiduciary Duty and the Recipients of Capital 10.0210.1.1 The nature of duciary duty 10.0310.1.2 The directors of issuers 10.05

The general duties 10.06By and to whom the general duties are owed 10.08

10.1.3 Fund vehicles and their managers 10.1010.1.4 Borrowers 10.12

Borrowers and duciary duty 10.13Deposit takers and duciary duty 10.14

10.1.5 Summary 10.1510.2 Authorization Requirements 10.16

10.2.1 The authorization regime 10.17The general prohibition 10.17Permission 10.18FSA 10.19Threshold conditions 10.21FSMA and Handbook 10.22

Approved persons 10.26Generally 10.27

10.2.2 Issuers 10.2810.2.3 Managers 10.2910.2.4 Borrowers 10.3010.2.5 Summary 10.31

10.3 Disclosure Requirements 10.3210.3.1 The regulatory strategy 10.3210.3.2 Issuers 10.34

10.3.3 Borrowers 10.40

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10.3.4 Investment funds and/or their managers 10.4110.3.5 Summary 10.43

10.4 The Regulation of Promotions 10.4410.4.1 Financial promotion restriction 10.45

10.4.1.1 Overview 10.46Financial promotion regime 10.46Overview of restriction 10.48Term of the restriction 10.49Exemptions from the restriction: Financial

Promotions Order 10.50Conduct of Business Rules 10.54Investment securities, fund units, and loans 10.56Investment securities 10.57Fund units 10.58Loans 10.59

10.4.2 Scheme promotion restriction 10.62Overview 10.63Meaning of CIS 10.64The terms of the restriction 10.68The exemptions 10.70Policy justication 10.73

10.4.3 Summary 10.75

10.5 Product Regulation 10.7610.6 Regulatory Anomalies 10.79

Generally 10.79Lenders not protected 10.80Disclosure regulation and investment securities 10.81Investment funds a different strategy 10.82Regulatory arbitrage 10.83Regulatory projects 10.85

IV NET POSITIONS

11. Overview

12. Set Off and Netting

12.1 Set Off and Netting: Overview 12.0312.2 Types of Netting 12.08

12.2.1 Novation netting 12.09

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12.2.2 Close out netting 12.10Nature 12.10Importance; legal risk 12.14Legislative protection 12.15

Regulatory capital recognition 12.2012.2.3 Settlement netting 12.21

12.3 Legal Bases for Set Off 12.2312.3.1 Insolvency law 12.2412.3.2 Current account 12.2512.3.3 Litigation procedure 12.2712.3.4 Closely related claims (common law and equity) 12.2912.3.5 Contract 12.33

12.3.6 Limits 12.34 Wrongdoing 12.34Mandatory provisions of insolvency law 12.35

12.4 Insolvency Set Off 12.3912.4.1 Rule 4.90 overview 12.4112.4.2 The mandatory principle 12.4512.4.3 The retroactivity principle 12.4612.4.4 The hindsight principle 12.4712.4.5 Insolvency set off and choice of law 12.48

12.5 The Requirement for Mutuality 12.4912.5.1 Trust 12.53

The insolvency of which party? 12.54Trust not legal person 12.55Parties to the set off 12.56Possible want of mutuality 12.57

Arguments for mutuality 12.5912.5.2 Money paid for a specic purpose 12.64

12.6 Set Off and Interveners 12.6512.7 Adjusting the Scope of Set Off 12.84

12.7.1 Cross-product netting 12.8512.7.2 Mutli-branch exposures 12.8612.7.3 Multi-lateral exposures 12.8712.7.4 Group exposures 12.8812.7.5 Exposures to protected cell companies 12.95

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13. Title Transfer Collateral Arrangements

13.1 Essential Nature 13.03

13.2 Repos, Buy/Sell-backs, and Securities Loans 13.0413.2.1 Repos 13.0613.2.2 Buy/sell-backs 13.1013.2.3 Securities lending 13.11

13.3 Functions and Importance of TTCAs 13.1513.3.1 Cash-driven transactions 13.1613.3.2 Securities-driven 13.1913.3.3 Hedging 13.2313.3.4 Arbitrage 13.2413.3.5 Speculation 13.2513.3.6 Voting 13.2713.3.7 Synthetics 13.28

13.4 Transaction Structure 13.3013.4.1 Outright transfer and equivalent redelivery 13.3213.4.2 Benets and burdens of ownership 13.3313.4.3 Master agreements 13.3413.4.4 Marking to market 13.3513.4.5 Substitution 13.3913.4.6 Manufactured income 13.4013.4.7 Close out netting 13.42

13.5 The Involvement of Third Parties 13.4413.6 Recharacterization Risk 13.49

13.6.1 Generally 13.5013.6.2 Key sensitivities 13.52

13.7 Trends 13.53

14. The Rise of Net PositionsThe protection of risk takers 14.05

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V ASSET-BACKED POSITIONS

15. Overview

16. Property Rights

16.1 Personal Rights and Property Rights 16.0216.1.1 The doctrinal distinction 16.0316.1.2 Property and possession 16.0416.1.3 Property rights and credit risk 16.0816.1.4 Concerns for third parties 16.10

16.2 Legal and Equitable Property Rights 16.1316.3 Property in Claims 16.14

16.4 The Requirement for Ascertainment 16.1816.5 The Requirement for Publicity 16.20

16.6 Consensual Property Rights 16.21

16.7 Equitable Property Remedies and Related Processes 16.2216.7.1 Following and tracing 16.2416.7.2 Constructive trusts 16.2816.7.3 Resulting trusts 16.3816.7.4 Theme of informed consent 16.49

16.8 Priority 16.5016.8.1 Nature of priority disputes 16.5116.8.2 Contractual subordination 16.5316.8.3 Original owner claims 16.5816.8.4 Successive dealing 16.6016.8.5 Order of appropriation of payments 16.6116.8.6 Law reform 16.63

17. Security17.1 Essential Nature 17.04

Limited property rights 17.05Equity of redemption 17.06Compare title transfer collateral arrangements 17.08Equity of redemption v personal right of

equivalent redelivery 17.10Power of sale/foreclosure v set off 17.11Choice for collateral taker 17.27

Security interests lawyered 17.28Choice of law uncertainties 17.29Priority sensitivities 17.30

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Enforcement problems 17.31Right of use sensitivities 17.32Registration 17.33Choice for collateral giver 17.39

17.2 The Impact of Security 17.40Benets for secured creditor 17.41Benets for debtor 17.45The position of general creditors 17.46Economic impact 17.47

17.3 Types of Security Interest 17.49Possessory 17.51Non-possessory 17.53Mortgage 17.54Charge 17.56Legal and equitable 17.58

17.4 Steps in Taking Security 17.60Contractual steps 17.62Property steps 17.64

Attachment 17.65Perfection 17.66Registration 17.67

Priorities 17.75Benecial ownership 17.76Enforcement 17.77Remittance 17.78Displacement 17.79

17.5 Floating Charges and Recharacterization 17.80Characteristics 17.81Corporate security interests 17.84Commercial function 17.85

Policy concerns 17.89Legal disadvantages 17.90Registration 17.91Insolvency priorities 17.92Insolvency displacement 17.93Double dealing priorities 17.94Impact of FCAR 17.95Overseas collateral giver 17.96Freedom to deal and recharacterization 17.97Recharacterization 17.98Late judicial denition of rights and duties 17.99

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Freedom to deal as key characteristic 17.102Partial freedom to deal 17.107Removal of assets 17.108Exercise of control in practice 17.110

17.6 Quasi Security 17.11117.6.1 Asset sales 17.11217.6.2 Flawed asset arrangements 17.11317.6.3 Security trusts 17.11417.6.4 Retention of title 17.116

17.6.4.1 Overview 17.11617.6.4.2 Recharacterization 17.11717.6.4.3 The approach of judges 17.12017.6.4.4 Publicity 17.122

UK law 17.123UNCITRAL 17.124EU legislation 17.125

18. Asset-backed Securities

18.1 Essential Nature 18.0218.1.1 Economic transfer of nancial positions to investors 18.0218.1.2 The functions of ABS 18.04

Cash ow 18.05Balance sheet 18.07

Arbitrage 18.0818.1.3 Terminology 18.09

18.2 Elements of an ABS Transaction 18.1018.2.1 SPV 18.1118.2.2 Transfer 18.1318.2.3 Note issue 18.16

18.2.4 Security 18.2218.2.5 Credit enhancement 18.23

18.3 Key Sensitivities 18.24

18.4 Developments 18.2618.4.1 Synthetic transactions 18.28

CDOs 18.29Elements of synthetic transactions 18.30

18.4.2 The role of derivatives 18.3818.4.3 Insurance transactions 18.39

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18.4.3.1 Catastrophic risk securitizations 18.4118.4.3.2 Life insurance securitizations 18.50

18.4.4 Asset management transactions 18.5818.4.5 Whole of business transactions 18.62

18.4.6 Impact 18.64

19. Indirectly Held Securities19.1 Operational Change 19.03

19.2 Legal Challenges 19.0719.2.1 Nature of asset 19.0819.2.2 Ring fence 19.1119.2.3 Choice of law 19.12

Look through 19.16PRIMA 19.17Party autonomy 19.18Governing law approach 19.20

19.2.4 Priorities 19.22Loss of negotiable status 19.24Loss of equitys darling defence 19.25

19.2.5 Shortfalls 19.28Liability of intermediary 19.29Loss sharing 19.32

19.3 Law Reform Measures 19.33National measures 19.33UNIDROIT 19.36Legal Certainty Group 19.37UK 19.38

19.4 Financial Positions and Property Rights 19.40

20. Financial Collateral20.1 Fundamental Aspects of Financial Collateral 20.04

20.1.1 Importance 20.04The need to collateralize 20.05

Attractive asset class 20.06Types of exposure 20.07Systemic importance 20.14

20.1.2 Categories of nancial collateral asset 20.17

Cash 20.17Securities 20.20

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Receivables 20.2420.1.3 Collateral structures 20.25

The use of master agreements 20.26 Availability of FCAR protections 20.27

20.2 Key Risks 20.2820.2.1 Collateral giver insolvency 20.29

Close out netting 20.30Insolvency displacement 20.35Preference rules 20.36Margining and substitution 20.37Share of assets for unsecured creditors 20.42

20.2.2 Recharacterization 20.43

20.3 Procedural Requirements 20.44 20.4 Enforcement 20.47

20.5 Priority Problems 20.50Generally 20.50Indirectly held securities 20.51Law reform 20.54Representations to brokers 20.57

20.6 Managed Collateral Portfolios 20.62

20.7 Legal Sensitivities 20.6520.7.1 Collateral takers right of use 20.6620.7.2 Issuer set off 20.7020.7.3 Proceeds of book debts 20.74

Withdrawals partially restricted, single charge 20.77 Withdrawals unrestricted, single charge 20.80 Withdrawals unrestricted, split drafting 20.81Re New Bullas 20.82

Agnew 20.84Spectrum 20.86FCAR 20.94

20.7.4 Charge backs 20.95The practice 20.95Charge Card 20.96Re BCCI (No. 8) 20.98

20.7.5 Freeze orders 20.99

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20.8 FCD and FCAR 20.10520.8.1 Protections 20.10620.8.2 Criteria 20.10920.8.3 UK implementation 20.11120.8.4 Control 20.11220.8.5 Other limitations 20.11820.8.6 Review 20.120

20.9 UNIDROIT 20.123

20.10 Conclusions 20.124

21. Trends

21.1 The Adaptation of Property Rights in theFinancial Markets 21.0221.1.1 The conventional model of property rights 21.0421.1.2 Property in intangible assets 21.0621.1.3 Property in fractional or pooled assets 21.0721.1.4 Property in future assets 21.1421.1.5 Property in changing assets 21.1921.1.6 Property in depleting assets 21.2321.1.7 Property in intermittently absent assets 21.25

21.1.8 The role of equity 21.2821.2 The Decline of Property 21.29

VI MARKETS AND REGULATORY PROJECTS

22. Overview

23. Market Forces in Financial Law and Regulation

23.1 Arbitrage 23.03Market arbitrage 23.05Regulatory arbitrage 23.06Tax arbitrage 23.08Legal arbitrage 23.09Functionalism 23.11

23.2 Globalization 23.14The phenomenon 23.15The limits of national law 23.21

Market solutions 23.22

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24. Judges, Markets, and Consumers

25. The Arms Length Regulatory Project

25.1 Supply and Demand 25.02

25.2 Transfers 25.03Techniques 25.04The promotion of rules facilitating transfer 25.12The reduction of rules hindering transfer 25.19

25.3 Informed Consent 25.29

26. The Fiduciary Project

26.1 The Occurrence of Fiduciary Duty 26.03

26.2 Fiduciary Duty and Structuring 26.06 Agency 26.17Trust 26.20Partnership 26.25Company 26.36Protection of the risk taker 26.41

26.3 The Erosion of Fiduciary Duty 26.42The role of equity 26.43

Fiduciary duty and contract 26.47Fiduciary duty and statute 26.50

26.4 The Limits of Fiduciary Duty 26.51

27. The Consumerist Project

27.1 Consumer Protection Legislation 27.03

27.2 Consumerism and Financial Services Regulation 27.1527.3 Consumerism and Europe 27.18

Good faith and fairness 27.19Good faith and fairness in the Continental

tradition 27.20Good faith and fairness in English law 27.21FSAP 27.27

27.4 PBR and the Problem of Risk 27.29

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28. Conclusions

28.1 Convergence 28.02

28.2 Regulatory Projects and Risk 28.08

28.3 Concepts and Imagination 28.15

Bibliography 593Index 607

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Part I

INTRODUCTION

1. Terms of Reference 32. Credit Risk 27


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1TERMS OF REFERENCE

No system ever works perfectly.1

One of the most popular comedies of the seventeenth century was ThomasShadwellsThe Virtuoso in which the virtuoso of the title is a scientic theorist, SirNicholas Gimcrack, who is found imitating the movements of a frog in order tolearn how to swim. I content myself with the speculative part of swimming, hedeclares, I care not for the Practick . . .2 Financial law is rooted in practice, andthe purely theoretical swimmer is likely to sink. This book offers a conceptualscheme that aims to help lawyers in their business, which is of course to get wet.

The scheme presents nancial law as a system of risk transfer. It is argued that thefunction of nancial law is to permit risks (and the rewards associated with takingthem) to be transferred from protection buyers to risk takers, and to circulateamongst risk takers in the nancial markets. Financial law serves to translate risksof many kinds into the form of credit risk, which is the risk of a debt not beingpaid or another obligation not being performed. The nancial markets treat creditrisk as measurable, manageable, and transferable. The media through which riskcirculates are contractual arrangements referred to as nancial positions, whereby

1 Royal Bank of Scotland Plc v Etridge (No. 2) [2002] 2 AC 773, per Lord Nicholls at 810.2 Peter Ackroyd, Albion; The Origins of the English Imagination, (London: Chatto & Windus,2002), 402.

1.1 Terms of Reference 1.051.1.1 Nature and content of

nancial law 1.051.1.2 Ambition of the book 1.101.1.3 Convergence 1.151.1.4 Plan of the book 1.18

1.2 Risk Transfer 1.251.2.1 Emphasis on risk 1.251.2.2 Nature of risk 1.27

1.2.3 Financial institutionsand markets 1.28

1.3 Comparison of RegulatoryProjects 1.31

1.4 Comparison of Transactions 1.381.5 Five Core Ideas in

Financial Law 1.46

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Chapter 1: Terms of Reference

4

the risk taker typically agrees to receive the protection buyers risk in exchange fora return. The exposure of the risk taker under nancial positions may result inunforeseen losses, and therefore attracts regulation.

This introductory chapter presents the scheme of the book as a whole. Aftersetting out the books terms of reference, it turns to the central theme of risktransfer. This theme is analysed in two ways. The rst is a categorization of stylesof regulation into the arms length, duciary, and consumerist regulatory projects.The second is a categorization of types of nancial position, into simple, funded,net, and asset-backed. Finally, Chapter 1 presents the ve imaginative ideas on

which nancial law fundamentally depends, namely (i) legal personality, (ii) con-tingent obligation, (iii) bank debt as money, (iv) set off, and (v) the reication ofclaims. These ideas in turn give rise to the core nancial market structures of(i) credit risk, (ii) simple positions, (iii) funded positions, (iv) net positions, and(v) asset-backed positions. The link between legal personality and credit risk isconsidered in Chapter 2. Section 2.1 turns to the remarkable translation of risksas diverse as natural and man-made disasters and mortality itself, into the tradableform of credit risk. In order to explain credit risk, Chapter 2 goes into a certainlevel of legal detail. It explains that the idea of corporate personality supports therelated ideas of limited liability and the corporate fund. The exhaustion of thatfund delivers the fullest realization of credit risk, in the form of corporate insolvency.Chapter 2 goes on briey to introduce the credit risk management around which somuch of nancial law is organized, and nally the measurement of credit risk.

The remaining structures, and the ideas on which they rest, are discussed in thefollowing chapters.

1.1 Terms of Reference

1.1.1 Nature and content of nancial law

The book considers the law and regulation of the insurance, derivatives, commer-cial banking, capital markets, and investment management sectors (nancial law).Financial law forms part of commercial law; for example, the sale of goods ispart of commercial law but not part of nancial law. Financial law has three com-ponents, each with a different origin and style. The rst component is marketpractice, which has long been recognized as a source of law.3 Today, it is expressed

3 The law merchant . . . is neither more nor less than the usages of merchants and traders in thedifferent departments of trade, ratied by the decisions of Courts of law . . . By this process, whatbefore was usage only, unsanctioned by legal decision, has become engrafted upon, or incorporatedinto, the common law, and may thus be said to form part of it. Cockburn CJ,Goodwin v Robarts (1875) LR 10 Exch 337, 346.

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chiey through trade associations, which publish standard documentation, legalopinions, codes of practice, and guidance.4 This material, although not ofciallybinding, is highly inuential, and constitutes a form of soft law.5 The style ofthis component of nancial law is functional, pragmatic, and positive. Firms use

nancial law in order to do business, and their lawyers are problem solvers. Theoryhas no value here.

The second component is case law, which originates in litigation, and is made upof judgments, both reported and unreported. The body of nancial case law is farfrom complete; indeed, in some areas of the wholesale and offshore markets thereis nothing on the ofcial map except There be dragons. There are two reasons forthis. Firstly, banks tend to avoid the expense and publicity of litigation whereverpossible. Avoiding litigation tends to become impossible in the face of disaster,and case law accordingly clusters around major frauds and insolvencies, thecollapse of markets and currencies, wars and revolutions. (Contrast howeverthe newer breed of (litigious) lenders in the form of hedge funds.)6 Secondly, theevolution of case law is unsystematic, as the haphazard nature of litigationeither throws points up, or leaves them untaken.7 The style of nancial case lawis, in general, as pragmatic as that of the markets it serves. See for example thereverse engineering to a commercially helpful outcome inPetrona (U.K.) Ltd. v Magnaload Ltd.:8 If that is the result which convenience dictates is there anything which makes it illegal . . . ?9 Although there are notable exceptions,10 the smooth

4 Particularly active in the derivatives and capital markets respectively are the InternationalSwaps and Derivatives Association (ISDA) () and the International CapitalMarkets Association (ICMA) ().

5 Soft law is the expression commonly used to describe codes of conduct, rules, guidance,statements of approved practice, etc that emanate from various agencies, associations, and otherinstitutions and have sufcient authority in the markets to inuence participants and their advis-ers institutions and have sufcient authority in the markets to inuence participants and theiradvisers responses to legal and other questions, and, possibly, to inuence the courts but do not inthemselves constitute law (ie do not have the force or status of law, such as case law, regulation,or statutethe latter being known in this context as hard law). R. McCormick,Legal Risk in theFinancial Markets , (Oxford: Oxford University Press, 2006), 145.

6 These non-bank lenders are much more willing than banks to litigate in order to achieve theirobjectives. M. Hughes,Legal Principles in Banking and Structured Finance , 2nd ed., (HaywardsHeath: Tottel, 2006), vi.

7 The great case of Macmillan Inc. v Bishopsgate Investment Trust plc (No. 3) [1995] 1 WLR 978,[1996] 1 WLR 387 did not consider the choice of law implications of the indirect holding patternof investment securities, thereby tantalizing those of us with an interest in clarifying them. See thediscussion in section 19.2.3.

8 [1984] AC 127. 9 Per Lloyd J. at 136.10 See R. McCormick, Legal Risk in the Financial Markets , (Oxford: Oxford University Press,

2006), commenting on the House of Lords decision inHazell v Hammersmith and Fulham LondonBorough Council [1992] 2 AC 1: The judicial pronouncement appeared to many as if it had comefrom another planet, 48.

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operation of the nancial markets is typically a dominant judicial criterion.No branch of law exists in isolation from society,11 but nancial case law largelyfollows practice, both in time and in direction. The international nancial mar-kets operating in London are important to the UK economy, and our judges are

generally protective of them,12

as discussed further in Chapter 24. In line with thisfunctionalism, judicial reasoning is typically inductive and analogical, nota priori .

Yet for all this, the subject matter of nancial case law is elaborately conceptual.Market participants are sometimes accused of materialism, but the language ofnancial law is ethereal. It comprises arrangements between legal (as opposed tonatural) persons,13 concerning legal claims (as opposed to physical things).14 These persons are subject to legal procedures such as insolvency,15 and the claimsare subject to legal procedures such as transfer by novation16 and set off.17 In casesaffecting the nancial markets, judges have adapted the traditional laws of con-tract, equity, and property to serve market ends, and here contract, trust, and chargeare such elastic ideas that they cannot be understood except by reference to evolv-ing practice. The imaginative ideas informing nancial case law are discussed fur-ther in section 1.5. But here, imagination serves a practical purpose, and issecondary to it.

. . . the law is fashioned to suit the practicalities of life and legal concepts like prop-erty interest and charge are no more then labels given to clusters of related andself-consistent rules of law. Such concepts do not have a life of their own from whichthe rules of law are inexorably derived.18

And the great pleasure of case law, particularly in the House of Lords, is that it isoften expressed in prose that is beautiful, because informed by Olympian clarity

11 . . . the fact that law is determined to a considerable extent by political inuences, economicstructures, and social factors concedes Gunther Teubner, in derogation from his general thesis that,It is the self-referential nature of law, the application of legal operations to the results of legal opera-tions which gives the law validity. Legal validity cannot be brought in from outside; it can only beproduced within the law inLaw as an Autopoietic System, (Oxford: Blackwell, 1993), 212.

12 See Lordsvale Finance plc v Bank of Zambia [1996] QB 752, per Colman J. 767, cited inMartin Hughes, Legal Principles in Banking and Structured Finance , 2nd ed., (Haywards Heath:Tottel, 2006), 12: It would be highly regrettable if the English courts were to refuse to give effect tosuch prevalent provisions while the courts of New York are prepared to enforce them. For there tobe a disparity between the law applicable in London and New York on this point would be of greatdisservice to international banking.

13 Legal persons include incorporated companies, as explained in section 2.2.14 Financial assets are intangible, as explained in section 16.1.2.15 Insolvency is briey discussed in section 2.5.16 Novation involves the modication of contractual rights and obligations by agreement: see

section 25.2 (transfer by novation). See also section 12.2.1 (netting by novation).17 Set off involves the use of a credit to pay a debt, as explained in section 12.1.18 Lord Hoffmann, Re BCCI (No. 8) [1998] AC 214, 228.

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of thought, by judges whose identication with its traditions is so great that theirtone may become almost oracular.

And then, in contrast, there is legislation. This is the third component of nanciallaw, and recent years have seen a legislative ood, mostly from Europe.19 The styleis often at odds both with practice and case law, and so in two respects. Firstly (andperhaps inevitably, given the EU legislative process),20 the approach is principles-based.21 Secondly, the service of markets is tempered with a social agenda. To thealready strange mix of work and imagination is added a kind of welfarism, in theform of consumerist regulation.22 The mixture is unique.

1.1.2 Ambition of the book

As well as being mixed, nancial law is excessively large. No one ever sees the

library as a whole, for it is too big to print. As well as copious industry materialsand many tens of thousands of cases, it includes among other things the outputsof the Financial Services Authority and of the organs of the European Union,

which in recent years have been more active than the broom of the sorcerersapprentice. As one struggles daily to stay aoat,23 one is entitled to an answer tothe very reasonable question, What is this?

There are two parts to the question. To answer the rst, one needs to meet thechallenge, carved into the lintel of London School of Economics, to know wherethings come from.24 The second part of the question is carved in imagined lettersinto the lintel of Freshelds Bruckhaus Deringer, and indeed the soul of everypractitioner: and where are they going? In order to offer some answers, and tokeep them short, this book attempts a synthesis. Systematic treatment of this vast,

19 This brings with it the jurisprudence of the ECJ, and more importantly, the range of interpre-tations of EU directives in different member states, which in turn permits divergent practice andeven policy to continue within ostensibly harmonized markets. I am grateful to Martin Thomas forthis point.

20 The Lamfalussy Report (Final Report of the Committee of Wise Men on the Regulation ofEuropean Securities Markets , 2001), 22: The Committee believes that all European nancial servicesand securities legislation should be based around a conceptual framework of overarching princi-ples. .

21 See the discussion of principles-based regulation in section 27.4.22 See the discussion of the consumerist regulatory project in Chapter 27.23 Even judges, endearingly, occasionally relax the normal convention of narrative omnipotence,

and admit to struggling. See for exampleHIH Casualty and General Insurance Ltd. v New HampshireInsurance Co. and others [2001] 2 Lloyds Rep 161, per Rix LJ, 166: I remain concerned, however,that in this case the Judge and his Court have been set an unusually academic examination paper,and in a sub-category of subject which can be said to be familiar territory. That said, the paper mustbe answered, wherever possible, as best as can be done . . .

24 Rerum Cognoscere Causas (to understand the causes of things), from Virgil, Georgics No. 2,458: Felix qui potuit rerum cognoscere causas (lucky is he who has been able to understand the causesof things, of Lucretius).

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complex and rapidly changing subject is neither feasible, nor necessary in view ofthe many excellent existing texts on the particular sectors, branches of law,or clusters thereof within it. I have relied heavily and gratefully on these texts,

which are cited throughout this work, and which of course are a form of soft

law in themselves. This is not an encyclopaedia, but a new way of looking at thesubject.

The ambition of the book is to offer a new scheme for analysing nancial law, withillustrative and topical examples. The purpose of the scheme is to address theproblem that nancial law is not readily accessible as a whole. Today, few have acondent grasp of the laws of all the sectors. While many lawyers have impressivespecialized knowledge, the big picture may remain elusive. Financial law is not

widely taught at undergraduate level.25 Indeed it is not universally accepted that itis a distinct subject. English law is not codied. Medical law, sports law, energylaw, and monetary law have recently been added to the list of accepted branches.But the law of insurance, derivatives, commercial banking, capital markets, andinvestment management has not been widely recognized as forming an integrated

whole. This is notwithstanding the consolidated regulation of these industriesunder the Financial Services and Markets Act 2000.26

As well as being fragmented, nancial law is muddled. One encounters a vasttangle of interconnecting ideas, and there is no agreed order to the whole. Thenancial markets are a perennial source of legal risk.27 Practice regularly throws up

intellectual problems, and the more intellectuals consider these problems, theless agreement there is about them or indeed about how to approach them.28 The book is intended to make the subject easier, and to put it in exportable form,by offering a simple conceptual scheme for nancial law as a whole.

As briey indicated above, the scheme has two aspects, of which the rst relates tothe judicial and statutory protection of those who take risks under nancialpositions. As discussed in section 1.3, the nancial markets are subject to threedifferent (and indeed inconsistent) regulatory projects. These are based on threedifferent views of the proper nature of nancial market relationships, namely

25 In contrast, land law is a core undergraduate subject. This is strange, as nancial assets and notland make up the greater part of our economic wealth, and have done so for some time.

26 Although anecdotally rms report continuing sectoral fragmentation even within the FinancialServices Authority.

27 See generally R. McCormick,Legal Risk in the Financial Markets , (Oxford: Oxford UniversityPress, 2006).

28 Examples of such chestnuts are the law relating to charge backs (see section 20.7.4, xedcharges over book debts (see section 20.7.3, trustee set off (see section 12.5.1), indirectly held securi-ties and choice of law (see section19.2.3) and the allocation problem (see section 21.1.3). It is arguedin paragraph 24.12 that the essential difculty is simple, and relates to the true role of doctrine innancial law.

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arms length, duciary, and consumerist. The second aspect of the scheme relatesto transactions and their components. Four categories are identied in section 1.4,namely simple, funded, net, and asset-backed positions. It is argued that all nan-cial market transactions comprise one or, more likely, an aggregate of several of

these four types of position. The effect of all nancial positions is to transfer riskbetween the parties. To the best of my knowledge, this conceptual structure isoriginal. It was developed over twenty years of practice and study, and I believe ithas power to explain.

1.1.3 Convergence

One reason for the fragmentation of nancial law has been the traditionalsegregation of the industry into sectors. Sectoral divisions have been strengthenedby regulatory restrictions on the permitted business of different types of rm.29 Historically, the business of each sector has been conducted by differentinstitutions, staffed by different individuals, served by different support indus-tries, reported in different journals, and studied in different university coursesby people reading different books. All of the foregoing have used sector-specic jargon.

An integrated approach to nancial law is overdue, because the nancial marketshave been converging for more than two decades. Functions traditionally per-formed in one sector are now undertaken in others, and nancial techniques are

emerging which combine characteristics of various traditional transaction types.Investment banks30 offer new forms of investment to their private banking 31 clients in the form of structured products, whereby one type of underlyingasset (such as overseas investment securities) are packaged in the form of another

29 . . . the 1929 collapse led to the revival in the Glass-Steagall Act of a legal separation of bank-ing from securities business. . . . The Glass-Steagall Act was under enormous pressure for years . . .the upshot was the Gramm-Leach-Bliley Act of 1999, which repealed part of the Glass-Steagall Act.Banks are still prohibited from acquiring securities and engaging in underwriting and dealing withsecurities, and securities rms must not accept deposits. However, banks which are members ofthe Federal Reserve System can now be afliated with securities rms in the one holding group.R. Cranston, Principles of Banking Law , 2nd ed., (Oxford: Oxford University Press, 2002).

Restrictions on permitted business also apply to insurance companies (INSPRU 1.5.13) andUCITS management companies; as to the latter see para. 9.54.

30 A distinction is traditionally made between commercial banks (whose core business is deposittaking and lending) and investment banks The originally US term investment bank is generallyreplacing the traditional UK term merchant bank, largely because of the success of UK based invest-ment banks in London. See P. Augar,The Death of Gentlemanly Capitalism, (London: Penguin, 2000).The core business of the investment bank is corporate nance services and proprietary securities andderivatives trading. But this distinction is becoming blurred in practice, as the range of businessundertaken by commercial banks and bank groups expands. In Britain the typical multifunctionalbank has been formed by the merger of what used to be [these] separate activity institutions . . .R. Cranston, Principles of Banking Law , 2nd ed., (Oxford: Oxford University Press, 2002), 3.

31 High net worth individual.

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(such as a bank account).32 Indeed, structured products may be offered in arange of alternative legal wrappers. For example, a capital-protected product33 might be offered alternatively as a bank account, bond, or an insurance policy.Securitization is a type of transaction, discussed in section 18.1, whereby a port-

folio of income-producing nancial assets are economically translated into debtsecurities issued in the capital markets, under which the rights of investors arebacked by the underlying portfolio. Credit derivatives are an important form ofnancial contract that transfers credit risk between the parties.34 Together, securi-tization and credit derivatives are a dominant force,35 drawing ever more catego-ries of business into the capital markets as an ever-wider range of assets and risksare economically converted into asset-backed securities, including in recent yearsreinsurance risk and the risks of pension shortfalls due to an ageing population.

Due in part to limited cross-sectoral legal awareness, such innovations have beenassociated with a high level of legal risk,36 and the cross-sectoral freedoms offeredby deregulation have not been fully exploited.37 A fragmented approach to nan-cial law is unhelpful, for example to the rm whose choices today for laying offcredit risk include credit derivatives as well as traditional techniques. Fragmentedlegal study is also unhelpful to the manager, regulator, or scholar wishing to see the

whole picture.

1.1.4 Plan of the book

Part I provides an introduction. As mentioned above, Chapter 1 sets out the con-ceptual scheme of the book, and Chapter 2 presents the rst piece of that scheme, which is the creation and management of credit risk.

Part II relates to simple nancial positions. Chapter 3 provides an overview andChapter 4 presents the essential legal natures of guarantees, insurance, derivative,standby letters of credit, and performance bonds. Chapter 5 offers a functionalcomparison between them. It notes that, while the same functions may be per-formed by any category of contract, the legal rules affecting them differ radically.

32 SeePeekay Ltd. v ANZ [2006] 2 Lloyds Rep 511.33 Under which the investor has the right at the end of the arrangement to receive back at least

the capital originally invested.34 See the discussion in section 4.4.6.35 See Chapter18 on asset-backed securities.36 See for exampleHIH Casualty and General Insurance Ltd. v New Hampshire Insurance Co. and

others [2001] 2 Lloyds Rep 161 andHIH Casualty and General Insurance Ltd. v Chase ManhattanBank [2003] 2 Lloyds Rep 61 (HL). Instead of relying on guarantees or other traditional commer-cial bank arrangements to manage credit risk, lm nanciers relied on credit insurance as a cheapalternative, but were caught out by the special disclosure, misrepresentation, and breach of warrantyrules affecting insurance, and became embroiled in litigation.

37 It may only be a matter of time before swaps are used in place of commercial insurance, andprivate equity moves into reinsurance risk.

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Chapter 6 notes the numerous legal and operational advantages of derivatives, which are bilateral contracts that serve to transfer risk between the parties.It argues that the only reason to doubt the continued rise of derivatives is theircomplexity, because parties common failure to understand them is a source of

legal risk.Part III turns to funded positions. After an overview (Chapter 7), bank loans, andcapital markets securities, such as shares and bonds (Chapter 8) and managedfunds which are forms of collective investment scheme (Chapter 9), are discussedin turn, and the increasing convergence between them is noted. The regulation offunded positions is compared (in Chapter 10) in terms of duciary duty, authori-zation requirements, disclosure requirements, promotions regulation, and prod-uct regulation. The radically discrepant treatment of the different sectors is noted,together with the associated policy challenges and arbitrage opportunities.

Part IV considers net positions. After an overview (Chapter 11), the nature andlaw of set off and netting are explained (Chapter 12), title transfer collateralarrangements considered (Chapter 13), and the rise of net positions assessed.Public sector support for net positions is noted, together with the associateddecline in property rights in the nancial markets (Chapter 14).

Part V discusses asset-backed positions. It opens with an overview of propertyrights (Chapters 15 and 16), and briey presents security and quasi security(Chapter 17), asset-backed securities (Chapter 18), and indirectly-held securities(Chapter 19), before turning in a little more detail to nancial collateral (Chapter 20).The adaptation and (with derivatives) the decline of property in the nancialmarkets is considered in Chapter 21.

Part VI turns to the three regulatory projects, and assesses in turn the arms lengthproject (with its ambition of informed consent to risk), the duciary project (withits aim of good faith) and the consumerist project (which promotes fairness).It considers the role of judges in serving markets and consumers respectively,before offering some concluding remarks on the changing nancial markets.

No commercial experience, and only basic legal knowledge, is assumed. The focusis on the international nancial markets based in London.

1.2 Risk Transfer

In advanced modernity the social production of wealth is systematically accompaniedby the social production of risks.38

38 U. Beck,Risk Society, Towards a New Modernity , (London: Sage, 1992), 19.

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1.2.1 Emphasis on risk

This book argues that all nancial transactions comprise one or more position,and that the effect of a position is to transfer risk from one person to another.It may be obvious that risk transfer is the business of certain nancial market sec-tors, such as insurance and derivatives. It may be less obvious that the commercialbanking, capital market, and investment management39 sectors are doing thesame thing. The business of these latter sectors is traditionally understood to bemoving money,40 not risk. However, the approach of this book is to focus, not onthe money, but on the credit risk that attends it.

There are four reasons for emphasizing risk rather than money. Firstly, it offersa simply way of considering all the nancial market sectors together: onlysome transaction types transfer money, but all transfer risk. Secondly, as we all

know, money has not taken the form of gold and silver coin for some time. In thenancial markets, payment does not involve the delivery of physical assets withintrinsic value, but is made by credits to bank accounts.41 Money comprises debtsowed by banks to account holders,42 with the associated risk of bank default.It follows that today, money necessarily involves credit risk,43 and the loan ofmoney to a borrower is accompanied by the simultaneous transfer of credit risk tothe lender. Thirdly, with the rise of nancial derivatives,44 risk management isarguably the dominant economic function of the nancial markets.45 Fourthly,the emphasis on risk reects contemporary market language, which is dominated

by derivatives. As teams of traders move from derivatives desks to capital marketsdesks, private equity rms,46 and hedge funds,47 investment bankers today speakof originating risk into the capital markets rather than raising money from it, andinstitutional investors are no longer invited to invest funds, but rather to buyrisk participations. It may be time to stop referring to the providers of nancial

39 Investment management involves the discretionary management of client investment port-folios, as discussed in section 9.2.1.

40 From savers to borrowers, thereby ensuring the efcient allocation of capital.41 Or other forms of cash account.42 See the discussion in section 1.5.43 It will be argued below that credit risk functions in the nancial system as a universal medium

of exchange for risk, as money functions as a universal medium of exchange for economic value.44 i.e. derivatives in which the rights and obligations of the parties are dened by reference to

nancial assets, entities, or benchmarks. See section 4.4.3.45 The balance of the global nancial system has tilted away from conventional tasksraising

capital and matching the needs of savers and borrowersto the management of risk. J. Plender,The Limits of Ingenuity Editorial, (2001) 16 JIBFL 447.

46 Private equity describes the wide range of risk capital investments made by specialistinvestment managers in all types of companies, using share capita that is privately held rather thanpublicly tradeable.The Myners Report: Institutional Investment in the United Kingdom; A Review ,2001, 152.

47 This is a form of high risk, private managed fund, as discussed in section 9.6.

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market capacity as capitalists (with that terms 19th century evocation of top hats,spats, and cigars). Today, we have risk takers (and my young colleagues will tell mehow risk takers dress).

1.2.2 Nature of risk As to risk, [t]his apparently simple notion unlocks some of the most basic charac-teristics of the world in which we now live.48 It is the human condition not toknow what is going to happen next. Attempts to rise above this condition havealways attracted severe penalties, from Chapter 3 of Genesis to Part VIII of theFinancial Services and Markets Act 2000.49 In the face of this condition, philoso-phers advocate stoicism and the devout, faith. For those unable to live up to theseexacting standards the answer was, until the rise of the nancial markets in the18th century, magic.50 Magic was the functional precursor of both derivatives51 and insurance.52 With the early modern era came the ambition of measuring thelikelihood of future loss, that is of identifying risk. Risk is a measure ofexposure to danger, of the likelihood and the extent of loss.53 The identication of risk pro-vides a basis for decision-making.54 Every day in thousands of different contextsbusiness executives and government ofcials must make decisions requiring anassumption as to the futurea future that by its nature is unknown.55 The con-cept of risk leads, by necessary implication, to an active approach to the uncertainfuture.56 Risk is traditionally identied by using proxies for knowledge of the

48 A. Giddens, Runaway World , (New York: Routledge, 2000), 39.49 The latter relates to market abuse.50 Keith Thomas wonderful study of popular belief in England during the 16th and 17th cen-

turies (K. Thomas, Religion and the Decline of Magic , (Penguin, (1971), (1991)) demonstrates theimportance of magical healing, astrology, witchcraft, and other forms of magic in the effort toanticipate and control sickness, re, and other future hazards.

51 Seventeenth century farmers predicted the price of corn by watching the behaviour of grainsplaced on a hot hearth, 285.

52 Even in the middle of the eighteenth century it was customary in North America for a horo-scope to be cast to determine sailing-dates. Thomas, 367.

53 Risks areestimations of possible events . Unlike dangers or hazards, risks never exist outside ofour knowledge of them. D. Garland, The Rise of Risk in R. Ericson and A. Doyle (eds.),Risk and Morality , (Toronto: University of Toronto Press, 2003), 51. See also F. Ewald, Insurance and Riskin The Foucault Effect, Studies in Governmentality , Burchell, Gordon, and Miller (eds.), (London:Harvester Wheatsheaf, 1991), 199: Nothing is a risk in itself; there is no risk in reality.

In Against the Gods (P. L. Bernstein, Against the Gods , (New York: Wiley, 1996)) Peter Bernsteintraces the possibility of measurement, and therefore of risk management, back to the introductionto Europe of Arabic numerals in the 13th century.

54 Bernstein shows the evolution from risk measurement (with Fermat & Pascals probabilitytheory and the beginnings of demographic science in the 17th century) to risk management (withthe development of a rst theory of decision-making in the 18th century).

55 J. K. Galbraith, A History of Economics , (1987), (Penguin, 1991), 264.56 Contrast the role of fate in Oedipus Rex , by Sophocles, with the approach of Kay: Because

the world is complicated and the future uncertain, decision making in organisations and economicsystems is best made through a series of small scale experiments, frequently reviewed, and in a

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(unknown) future. The chief of these is the use of the past as a guide.57 Risk man-agement is a characteristically modern project, and contemporary society hasbeen designated the risk society.58 The unequal distribution of risk is identiedas the key social variable,59 and the traditional business of government as manag-

ing risk for the population.60

With the decline of welfarism, this role is transferredto the population and thence to the nancial markets, as discussed below.

1.2.3 Financial institutions and markets

The business of nancial institutions is to take risks in exchange for rewards, andthey do this by entering into nancial positions. For example, insurers take insuredrisks in exchange for premium income, investment banks take interest rate risk inexchange for swap fees, and lending banks take credit risk in exchange for interest

on loans. For nancial institutions, risk is the raw material of production.61

The function of the nancial markets is to allow positions (with their attendantrisks and returns) to move from person to person. Positions circulate as units ofrisk, and risk ows always to those able to bear it and willing, for a price, to do so.The nancial system may offer no help to those troubled by the risks, for example,of losing their looks, their spouses, or their faith,62 but it is able to absorb com-mercial risks of all kinds, and for this purpose the denition of commercial riskis becoming ever wider.63 Catastrophe or Cat bonds serve to transfer the risk of

structure in which success is followed up and failure recognised but not blames: the mechanisms ofdisciplined pluralism. J. Kay,The Truth about Markets , (London: Allen Lane, 2003), 108.

57 This approach is customary, but often unreliable, as things change. We are . . . determinedby custom to transfer the past to the future, in all our inferences . . . David Hume, An EnquiryConcerning Human Understanding , ed. Tom Beauchamp, (Oxford: Oxford University Press, 1999),132, but If there be any suspicion, that the course of nature may change, and that the past may be norule for the future, all experience becomes useless, and can give rise to no inference or conclusion,117. See also COBS 4.6.2(4).

58 See U. Beck,Risk Society, Towards a New Modernity , (London: Sage, 1992).59 In this analysis, the key historical actors are not so much social classes asrisk categories .

D. Garland, The Rise of Risk in R. Ericson and A. Doyle (eds.),Risk and Morality , (Toronto:University of Toronto Press, 2003), 62. See also U. Beck,Risk Society , (London: Sage, 1992), 19.

60 Over the last two decades, neo-liberal governments have sought to move away from the clas-sic post-war model of the risk-managing state. D. Garland, The Rise of Risk in R. Ericson and

A. Doyle (eds.),Risk and Morality , (Toronto: University of Toronto Press, 2003), 62.61 See D. Garland, The Rise of Risk in R. Ericson and A. Doyle (eds.),Risk and Morality ,

(Toronto: University of Toronto Press, 2003), 64, 65.62 Private markets fail to provide effective protection against the principle risks of lifeaccidents,

redundancy and unemployment, and relationship breakdown, J. Kay,The Truth about Markets ,(London: Allen Lane, 2004), 371.

63 See F. Ewald, Insurance and Risk inThe Foucault Effect, Studies in Governmentality , Burchell,Gordon and Miller (eds.), (Chicago: Harvester Wheatsheaf, 1991), 199: Today it is hard to imagineall the things which insurers have managed to invent as classes of riskalways, it should be said,

with protable results.

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disasters from insurance companies to the bond markets.64 In the past year, somenanciers have taken the idea further . . .,65 by transferring into the bond marketsthe risks and rewards associated with pandemics.66 And on 23 November 2006the front page of Financial Times bore the headline, Trading in death risk offers

boom for London.67

Risk management in the nancial markets proceeds on the basis that we arefundamentally powerless to stop bad things happening, or to see them coming.The achievement is to create a synthetic approximation of a controlled and knownfuture. This is done through a system of legal rights and obligations that adjust tothe future as it unfolds. Misfortune will not be left lying where it may fall, butprospectively diverted from protection buyer to risk taker. The modern project ofrisk management has been described by Anthony Giddens as the colonisation ofthe future.68 Its fullest development is in the nancial markets. This is the mostambitious technological project ever undertaken, and its scale is routinely under-estimated because (unlike for example the Great Wall of China and Apollo 11) itis wholly invisible.

All men by nature desire to know.69 Financial law is so sophisticated in its opera-tion that is does not immediately appear as what it is, namely a bite at the apple.This book offers a view of nancial law as a system of risk transfer, which serves usby approximating a controlled and known future. The merit of this view is thatit makes simple sense. Without it, the nancial law library, with its vast size,

minute detail, and sometimes appalling, committee-generated drafting can seem

64 A few years ago, nanciers at banks such as Goldman Sachs invented an instrument knownas a catastrophe bondor cat bond, where an insurance company writes out policies to cus-tomers wanting to protect themselves against a catastrophefor example, farmers worried abouthurricanes destroying their cropsand then issues a bond. The money collected from policyhold-ers is then used to pay the bondholders income. But if a hurricane hits, and the farmers claim theirinsurance, the bondholders stop receiving payments. Thus, by issuing the bonds the insurancecompany is sharing hurricane riskand the value of the bonds depends on how many hurricanesoccur. G. Tett and J. Chung, Death and the salesmen, Financial Times, 24.2.07.

65 G. Tett and J. Chung, Death and the salesmen, Financial Times, 24.2.07.66 Insurance companies have followed suit, launching mortality bonds that bet on whether

death rates will riseusually due to something such as bird u.Ibid .67 London is set to become the centre of a potentially huge new global market in trading lon-

gevity risk faced by pension funds, industry experts predict. Financial Times, D. Wighton andG. Tett. See further G. Tett and J. Chung, In recent decades, bankers have become adept at usingthe nancial markets to trade all manner of risks, such as the oil price, ination or currency swings.Now companies such as Goldman Sachs, Deutsche bank and ABN Amro are trying to devise waysof making money from the new risk facing modern humanitythat of living too long. Deathand the salesmen, Financial Times, 24.2.07.

68 A. Giddens, Modernity and self-identity , (Cambridge: Polity Press, 1991), 117.69 Aristotle, The Complete Works of Aristotle, The Revised Oxford Translation, ed. J. Barnes,

(Princeton: Princeton University Press, 1995), Vol. 2, 1552.

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(in Philip Woods lofty language) like bus timetable law, or (in Kafkas) likesawdust.70

1.3 Comparison of Regulatory ProjectsWhere you insure a ship or a house you cannot insure that the ship shall not belost or the house burnt . . .71 The nancial system does not reduce risk; it merelydiverts it from person to person.72 There is no choice as to the occurrence of lossevents, but only as to who will pay for them, and someone always pays. To speakplainly, what circulates in the nancial system are potential harms, the occurrenceand extent of which are unforeseeable. This creates the moral need for judicial andstatutory rules to protect the risk taker. But the function of nancial markets is too

important for them to encounter strong resistance, and the regulatory response tothis moral problem is, on the whole, modest. The functional analysis of nancialtransactions proposed in the following section facilitates the comparison of thistype of regulation in the different sectors. In turn, the comparison highlightsregulatory anomalies, which may suggest reforms to some, and arbitrageopportunities to others.

It will be argued that the inconsistent sectoral approaches to such regulation isconceptually attributable to inconsistent models of the ideal nancial marketrelationship. Three are identied. The rst is the arms length relationship. Here,each party deals in its own interests, and there is no duty of good faith between theparties. An arms length approach is consistent with the general commercial lawprinciple ofcaveat emptor .73 The traditional justication of this principle is that, inthe sale of goods, the purchaser is able to acquire relevant information pre-bargainby inspection of the goods. But [w]hen the product is the contract, however, asin the case of an insurance policy . . .,74 inspection is not possible. In lieu ofinspection, risk takers are given the benet of intense disclosure requirements, for

70 So I studied law. This meant that in the few months before the exams, and in a way that toldseverely on my nerves, I was positively living in an intellectual sense, on sawdust, which had more-over already been chewed for me in thousands of other peoples mouths. Franz Kaf kas letter to hisfather, . (Like Dickens, Kafka makes failed legalstudies seem a kind of triumph.)

71 Prudential Insurance Co. v Inland Revenue Commrs . [1904] 2 KB 658, per Channell J. at 663.72 The risk does not, of course, disappear; it is transferred to speculators who are willing to enter

into such offsetting contracts. Simpson, 196. For a discussion of hedging, see L. G. Telser, Why arethere organised futures markets, (1981) 24 Journal of Law and Economics , 1, 2.

73 Let the buyer beware.74 H. Collins, Good Faith in European Contract Law, (1994) Oxford Journal of Legal Studies

229, 232.

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example through policyholders duties of good faith disclosure,75 prospectus law 76 and market transparency rules.77 Disclosure is required as the precondition of theinformed consent of the risk taker. This arms length model of regulation draws onclassical economic theory, according to which traders create wealth by dealing in

their own interests in transparent markets. The mischief addressed by arms lengthregulation is that . . . the affected parties are becoming incompetent in mattersof their own afiction.78 The concern is that the risks may not be understood;regulation does not go on to address the harms that may be suffered. Whereas theregulation of highways, airways, medicine, and construction set compulsorystandards intended to separate the population from unacceptable risks, the styleof arms length regulation is Faustian: any deal, however ruinous, is permitted andenforced, provided the loser entered into it with informed consent. The informedconsent of the risk taker is a pervasive regulatory concern in the arms length

regulatory project. It has also been received into the duciary regulatory project,discussed below, which allows implied equitable duties to be waived by the client,provided it consents to their waiver following suitable disclosures.79 But informedconsent forms no part of consumerist regulation, also discussed below, which isgaining ground, largely through EU legislation.

The second regulatory project is duciary. Many nancial market arrangementsinvolve the use of one or more legal persons to hold clients assets and/or controlclients liabilities. Although essential to the functioning of the nancial markets,such structuring exposes clients to the bad faith of the intermediaries. The historiclegal response to this problem has been to impose duties on good faith on suchpersons, by characterizing them as duciaries. Examples of duciary relationshipsinclude agent/principal, partner/partner, director/company, trustee/beneciary,and asset manager/investor.80 Here, the regulatory concern is that trust should notbe misplaced. In contrast to the consumerist project, discussed below, the relativeeconomic strengths of the parties is irrelevant. The essence of the duciary conceptof good faith is faithfulness to duty, notwithstanding any conict of interest.The duciary has an implied duty to place the clients interest above its own, andis subject to rules relating to no prot, no conict, undivided loyalty, and con-dentiality. In general, however, implied duciary duties (other than core duty ofloyalty) can be modied by contract. Brokers terms, custody agreements, andother market standard documents now include wording,81 which displaces

75 See section 4.3.76 See section 10.3.2.77 See section 10.3.2.78 U. Beck,Risk Society , 53.79 See section 26.3.80 See section 9.2.1.81 Often under the heading condentially etc.

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implied rules against prot, conict, divided loyalty, and breach of condence.It does this using the familiar technique of disclosure and informed consent.

While the core duty of good faith remains, contract is king and the use of contracthas caused many duciary relationships to resemble arms length relationships.82

The third ideal type of nancial market relationship is consumerist. Whereas thelegal characteristics of arms length and duciary relationships are historicallyderived from case law,83 the consumerist relationship is primarily derived fromlegislation, mostly European. It presumes an inequality of power and/or under-standing that precludes informed consent. The regulatory concern is to avoid asignicant imbalance of interests to the detriment of consumer and/or distortionof consumer behaviour. Unlike in the duciary project, the presence or absence oftrust and reliance is irrelevant. Because the client is taken to be weak, the products

which may be sold to it84 and the promotional material which it may receive85 aresubject to elaborate restrictions. The risk taker may be the client, protected byconsumerist legislation (for example as an investor in regulated funds) or, interest-ingly, the rm, denied the usual private law recourse by consumerist legislation(for example as provider of consumer credit).

With convergence, these three projects regularly rub together. The resultingfriction explains many of the regulatory anomalies encountered in the contempo-rary nancial markets. For example, as will appear in Chapter 3, the sale of deriva-tives to the general public is (i) regulated by product, disclosure, and duciary

regulation where a regulated fund vehicle is used; (ii) regulated by disclosure andduciary regulation only where a closed ended corporate vehicle is used; (iii) pro-hibited where a private fund vehicle is used; and (iv) regulated only by generalconduct of business rules where no vehicle is used. Thus, option (iv) is the leastregulated, but it probably involves the greatest risk to the public. The differencesare explained by which regulatory projects happen to be triggered by the differentforms of offering.86 Collision between inconsistent regulatory projects alsoexplains a number of legal risks. For example, the issue of collateralized loanobligations (CLOs), which involve the securitization of bank loans,87 may bring

capital market duties of disclosure into conict with bankers duties ofcondentiality.

82 See section 26.3.83 Although directors duties have been codied in the Companies Act 2006 and trustees duties

claried in the Trustee Act 2000.84 See the discussion of product regulation in section 10.5 on the regulation of funded positions.85 See the discussion of promotions in section 10.4 on the regulation of funded positions.86 See generally Chapter 10 on the regulation of funded positions.87 See section 18.4.1.

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Industry has long been the chief protection buyer. The ability of commercialenterprises to transfer risk into the nancial markets88 encourages commercial risktaking and therefore economic growth. A more controversial development overthe last quarter century has been the recruitment of the general publicas risk

takers . With demographic change and the end of big government, individualsmust save for their pensions, and take investment risk. With the erosion of publiceducation and health services, many families are considering private arrangementsfor the rst time, and turning to the nancial markets to provide or fund it.

The arms length model is apt to regulate the relationships between nancial insti-tutions, and the duciary model is suitable to protect their business customers.But retail investors are another matter, because here the result of unforeseen lossesmay be not merely the insolvency of a limited liability company, but personalhardship, and hence the rise of consumerism. But consumerism in the nancialmarkets is problematic. While the arms length and duciary models have, througha series of 1990s judgments, found a workable contractual synthesis,89 the con-sumerist regulatory project cannot be readily integrated into the fabric of nanciallaw. This is because it takes certain risks to be unsuitable for consumers, irrespec-tive of consent. The uneasy relationship between consumerism and the rest ofnancial law is considered further in Chapter 27.

1.4 Comparison of Transactions

Under a nancial position, the risk taker agrees to take risk from the protectionbuyer. As explained in section 1.2.2 above, risk relates to future losses. It followsthat the delivery of protection under a nancial position also lies in the future,

when the protection buyer is indemnied or otherwise held harmless by the risktaker from loss events as they arise. When the position is entered into, the protec-tion buyers asset takes the form of the risk takers promise.90 Promises may bebroken, and therefore nancial positions expose the protection buyer to the creditrisk of the risk taker. Thus, the protection buyer lays off the agreed risk, for exam-ple, where she takes out a one-year insurance policy covering re risk in respect ofcommercial premises, the risk of loss due to re damage to those premises over thenext 12 months. But in its place she acquires a new risk, in the above example that,if and when she suffers loss due to re damage to those premises during the next

88 For example through insurance, foreign exchange swaps, or corporate nance received througha limited liability vehicle.

89 On the basis that contract is king; see the discussion in section 26.3.90 In other words, they are executory contracts.

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12 months, the insurer may default on its contractual obligation to pay her,perhaps because it has become insolvent.

Participants in the insurance, derivatives, commercial banking, capital markets,and investment management sectors enter into a very wide variety of contracts.For ease of analysis, these contracts or, except in the very simplest cases, theircomponents may be divided into four categories. These are simple, funded, net,and asset-backed positions respectively. A common factor is that there is alwaysone or more protection buyer and one or more risk taker. Another commonfactor is that the protection buyers have a credit exposure to the risk takers. Thedifferences between the position types relates to whether, and if so how, this creditrisk is managed.

The starting point is simple nancial positions. These are discussed in Part II, and

include guarantees, insurance, derivatives, standby credits, and performancebonds. The commercial terms of these types of contracts, and in particular ofderivatives, may be furiously complicated. However, they are referred to as simplepositions in this book because the rights and duties of the parties which must bepresent in order for the contract to be characterized as a contract of insurance,a guarantee, a derivatives contract, a standby credit, or a performance bondrespectively, do not include provisions that address the credit exposure of theprotection buyer to the risk taker. Under the core provisions of these contracts, theguaranteed creditor takes the credit risk of the guarantor, the policyholder takes

the credit risk of the insurer, the derivatives customer takes the credit risk of itscounterparty, and the beneciary of a standby credit or performance bond takesthe credit risk of the issuer, as explained in section 5.6.

Of course, the nancial institutions that take position risk by way of business arerequired to be authorized, and, as explained in section 5.5, authorized rms aresubject to (i) prudential regulatory requirements that address s

benjamin 2007 (part)

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