Financial law

Overview

Financial law is the law and regulation of the commercial banking, capital markets, insurance, derivatives and investment management sectors. Understanding financial law is crucial to appreciating the creation and formation of banking and financial regulation, as well as the legal framework for finance generally. Financial law forms a substantial portion of commercial law, and notably a substantial proportion of the global economy, and legal billables are dependent on sound and clear legal policy pertaining to financial transactions. Therefore financial law as the law for financial industries involves public and private law matters. Understanding the legal implications of transactions and structures such as an indemnity, or overdraft is crucial to appreciating their effect in financial transactions. This is the core of financial law. Thus, financial law draws a narrower distinction than commercial or corporate law by focusing primarily on financial transactions, the financial market, and its participants; for example, the sale of goods may be part of commercial law but is not financial law. Financial law may be understood as being formed of three overarching methods, or pillars of law formation and categorised into five transaction silos which form the various financial positions prevalent in finance. Financial regulation can be distinguished from financial law in that regulation sets out the guidelines, framework and participatory rules of the financial markets, their stability and protection of consumers, whereas financial law describes the law pertaining to all aspects of finance, including the law which controls party behaviour in which financial regulation forms an aspect of that law. Financial law is understood as consisting of three pillars of law formation, these serve as the operating mechanisms on which the law interacts with the financial system and financial transactions generally. These three components, being market practices, case law, and regulation; work collectively to set a framework upon which financial markets operate. Whilst regulation experienced a resurgence following the 2008 financial crisis, the role of case law and market practices cannot be understated. Further, whilst regulation is often formulated through legislative practices; market norms and case law serve as primary architects to the current financial system and provide the pillars upon which the markets depend. It is crucial for strong markets to be capable of utilising both self-regulation and conventions as well as commercially mined case law. This must be in addition to regulation. An improper balance of the three pillars is likely to result in instability and rigidity within the market contributing to illiquidity. For example, the soft law of the Potts QC Opinion in 1997 reshaped the derivatives market and helped expand the prevalence of derivatives. These three pillars are underpinned by several legal concepts upon which financial law depends, notably, legal personality, set-off, and payment which allows legal scholars to categorise financial instruments and financial market structures into five legal silos; those being (1) simple positions, (2) funded positions, (3) asset-backed positions, (4) net positions, and (5) combined positions. These are used by academic Joanna Benjamin to highlight the distinctions between various groupings of transaction structures based on common underpinnings of treatment under the law. The five position types are used as a framework to understand the legal treatment and corresponding constraints of instruments used in finance (such as, for example, a guarantee or asset-backed security).

Three pillars of financial law formation

Three different (and indeed inconsistent) regulatory projects exist which form the law within financial law. These are based on three different views of the proper nature of financial market relationships.

Market practices

The market practices in the financial field constitute a core aspect of the source of law of the financial markets, primarily within England & Wales. The actions and norms of parties in creating standard practices creates a fundamental aspect of how those parties self-regulate. These market practices create internal norms which parties abide by, correspondingly influencing legal rules which result when the market norms are either broken or are disputed through formal, court, judgments. The principle role is to form soft-law; as a source of rules of conduct which in principle have no legally binding force but have practical effects. This has created standard form of contracts for various financial trade associations such as Loan Market Association, which seeks to set guidance, codes of practice, and legal opinions. It is these norms, particularly those provided by Financial Market Law Committees, and City of London Law Societies which the financial market operates and therefore the courts are often quick to uphold their validity. Oftentimes "soft law" defines the nature and incidents of the relationships that participants of particular types of transactions expect. The implementation and value of soft law within the system, is particularly notable in its relationship with globalisation, consumer rights, and regulation. The FCA plays a central role in regulating the financial markets but soft law, voluntary or practice created legal schemes play a vital role. Soft law can fill market uncertainties what are produced by common law schemes. Obvious risk that that participants become lulled into believing statements of soft law is the law. However, the perception that an opinion constitutes ipso facto a clear and widely held opinion is wrong. For example, the consumer relationship in the case of Office of Fair Trading v Abbey National [2009] UKSC 6 where the bank was fined by the FSA for failing to handle complaints set out in soft law principle practices on broadly worded business principles which state that the bank must pay due regard to the interests of its customers and treat them fairly. Oftentimes the self-regulation of soft law can be problematic for consumer protection policies. Another example of the expansiveness of soft law in the financial market is the explosion of credit derivatives in London, which has flourished on the back of the characteristically robust opinion of Potts for Allen & Overy regarding the ISDA Master Agreement in 1990 which helped the industry separate itself from current market restrictions. A the time, it was unclear whether Credit Derivatives were to be categorised as insurance contracts under English legislation of the Insurance Companies Act 1982. ISDA was firm in rejecting a statutory definition of insurance, stating that

In practice market participants have had few concerns as to the impacts of boundary issues between CD's and contracts of insurance. This was crucial as Insurance companies were restricted from participating in other financial market activities and a licence needed to be granted to participate in the financial market. As a result of the Potts Opinion, credit derivatives were categorised as outside of insurance contracts, which allowed them to expand without the limitations set in place by insurance legislation. Soft law has practical effects in that it is liable in many cases to be turned into "hard law", but with verified and experienced practice evidence. In the case Vanheath Turner (1622) the court remarked that custom of merchants is part of the common law of the United Kingdom. This highlights a long history of incorporating and accounting for the lex mercatoria into the English law in order to facilitate financial markets. Law merchant had been so absorbed by the 18th century that the Bills of Exchange Act 1882 could provide common law rules and merchant law in tandem. We might consider Tidal Energy Ltd v Bank of Scotland, where Lord Dyson held that "a man who employs a banker is bound by the usages of bankers", meaning that if a sort code and account number was correct, it did not matter if the name did not match. There are risks on over-reliance on soft law sources, however. English law makes it difficult to create a type of security and reliance on rules may result in established views which reinforce errors. This could result in unacceptable security even if legally valid.

Case law

The second category which financial law draws most of its pragmatism with regard to the standards of the markets originates in litigation. Often, courts seek to reverse engineer matters to make commercially beneficial outcomes and so case law operates in a similar manner to market practice in producing efficient results.

There are two exceptions, attempting to limit the expectations to reasonable commercial men and uphold the freedom of contract. Autonomy is at the heart of commercial law and there is the strong case for autonomy in complex financial instruments. Re Bank of Credit and Commerce International SA (No 8) highlights the striking effect a commercially beneficial practice can have on financial law. Lord Hoffman upheld the validity of a security charge over a chose in action the bank held which it owed to a client. Despite the formidable conceptual problems in allowing a bank to place a charge over a debt the bank itself owed to another party, the courts have been driven to facilitate market practices as best as possible. Thus, they are careful to declare practices as conceptually impossible. In BCCI, the court held that a charge was no more than labels to self-consistent rules of law, an opinion shared Lord Goff in Clough Mill v Martin where he wrote concepts such as bailment and fiduciary duty must not be allowed to be our masters, but tools of the trade fashioning to aspects of life Unfortunately, case coverage is unsystematic. Wholesale and international finance is patchy as a result of a preference to settle disputes through arbitration rather than through the courts. This has the potential to be detrimental to advancing the law regulating finance. Market participants generally prefer to settle disputes than litigate, this places a greater level of importance onto the "soft law" of market practices. However, in face of disaster, litigation is essential, especially surrounding major insolvencies, market collapse, wars, and frauds. The collapse of Lehman Brothers provides a good example, with 50 judgments from the English Court of Appeal and 5 from the Supreme Court of the United Kingdom. Despite these problems, there is a new breed of litigious lenders, primarily hedge funds, which has helped propel the pragmatic nature of financial case law past the 2008 crisis.

Regulation and legislation

The third category of law formation within the financial markets are those deriving from national and international regulatory and legislative regimes, which operate to regulate the practice of financial services. Three regulatory lenses ought to be highlighted namely arm's length, fiduciary, and consumerist approaches to financial relationships. In the EU these might be exampled by MiFiD II, payment services directive, Securities settlement regulations and others which have resulted from the 2008 financial crisis or regulate financial trade. Regulatory control by the Financial Conduct Authority and the former Office of Fair Trading set out clear rules replacing extra-statutory codes of conduct and has seen recent resurgence following the 2008 financial crisis. The regulatory policies have not all been rectified in regard to how they the new rules will be coherent with current market practices. We may consider In Re Lehman Brothers [2012] EWHC(Extended liens case) where Briggs J struggled to determine the legislative intent of the Financial Collateral Directive.

Financial collateral regulations

In addition to national and cross-national regulations on finance, additional rules are put into place in order to stabilise the financial markets by reinforcing the utility of collateral. In Europe, two regimes of collateral carve-outs exist; the Financial Collateral Directive, and the Financial Collateral Arrangement (No 2) Regulations 2003. The EU's development of the Financial Collateral Directive is curious if we view it through the lens of only a regulatory matter. It is clear that the law here developed through market practice and private law statutory reform. The EU has played a substantial role in this field to induce and encourage the ease of transfer & realisation of assets and liquidity within markets. The provisions are well adapted to short term transactions such as repos or derivatives. Further harmonisation rules pertaining to commercial conflict of laws matters were clarified. The additional Geneva Securities Convention set by UNIDROIT provides a basic framework for minimum harmonised provisions governing rights conferred by the credit of securities to an account with an intermediary. However, this international project has as of late been ineffective with only Bangladesh signing.

Legal concepts prevalent in financial law

Several legal concepts underpin the law of finance. Of these, perhaps the most central concept is that of legal personality, the idea that the law can create non-natural persons is one of the most important common myths and among the most ingenious inventions for financial practice because it facilitates the ability to limit risk by creating legal persons which are separate. Other legal concepts, such as set-off and payment are crucial to preventing systemic risk by lessening the level of gross exposure of credit risk a financial participant might be exposed to on any given transaction. This is often mitigated through the use of collateral. If financial law is centrally concerned with the law pertaining to financial instruments or transactions, then it can be said that the legal effect of those transactions is to allocate risk.

Limited liability and legal personality

A limited liability company is an artificial creation of legislature which operates to limit the level of credit risk and exposure a person, natural or legal, will participate within. Lord Sumption summarised the position by stating Subject to very limited exceptions, most of which are statutory, a company is a legal entity distinct from its shareholders. It has rights and liabilities of its own which are distinct from those of its shareholders. Its property is its own, and not that of its shareholders [...] [T]hese principles appl[y] as much to a company that [i]s wholly owned and controlled by one man as to any other company For financial markets, the allocation of financial risk through separate legal personality allows for parties to participate in financial contracts and transfer credit risk between parties. The ambition of measuring the likelihood of future loss, that is of identifying risk, is a central part of the role legal liability plays in economics. Risk is a crucial part of financial market sectors: [I]t is not just legally but economically fundamental, since limited companies have been the principal unit of commercial life for more than a century. Their separate personality and property are the basis on which third parties are entitled to deal with them and commonly do deal with them.

Financial collateral

Financial markets have developed particular methods for taking security in relation to transactions, this is because collateral operates as a central method for parties to mitigate the credit risk of transacting with others. Derivatives frequently utilise collateral to secure transactions. Large notional exposures can be reduced to smaller, single net amounts. Often, these are designed to mitigate the credit risk one party is exposed to. Two forms of financial collateralization have been developed from the Lex Mercatoria;

Title transfer; or By granting a security interest A security interest may be granted with a right of use, conferring disposal powers. There is an increasing reliance on collateral in financial markets, and in particular, this is driven by regulatory margin requirements set out for derivatives transactions and financial institution borrowing from the European Central Bank. The higher the collateral requirements, the greater demand for quality exists. For lending, it is generally regarded that there are three criteria for determining high-quality collateral. Those being assets which are or can be:

Liquid; and Easily priced; and Of Low credit risk There are several benefits to having financial collateral provisions. Namely, financial reduces credit risk, meaning the cost of credit and the cost of transacting will be lowered. The reduced insolvency risk of the counter-party, combined with more credit being available to the collateral taker will mean the collateral taker can take additional risk without having to rely on a counter-party. Systemic risk will be reduced by increased liquidity, This produces "knock-on effects" by increasing the number of transactions a collateral taker can safely enter, freeing up capital for other uses. However, there is a need for balance; the removal of limitations on insolvency rules and security registration requirements, as observed in the FCARs, is dangerous as it degrades powers and protections which have been conferred deliberately by the law.

Financial collateral regulations

The primary objective of the Financial Collateral Directive was to reduce systemic risk, harmonise transactions and reduce legal uncertainty. It achieved this by exempting qualified "Financial collateral arrangements" from the performance of formal legal requirements; notably registration and notification. Second, the collateral taker is provided effective right of use and said arrangements are exempted from being re-characterised as different security arrangements. Perhaps most significantly, traditional insolvency rules which may invalidate a financial collateral arrangement; such as freezing assets upon entering into insolvency, are suspended. This allows a collateral taker to act without the limitation which may arise from a collateral provider entering bankruptcy. The FCARs focus on outlining when a financial collateral arrangement will be exempted from national insolvency and registration rules. In England, the requirements that a financial collateral arrangements only applies between non-natural persons with one being a financial institution, central bank, or public body; the FCAR has been "gold-platted" by allowing any non-natural person to benefit. Thus, to qualify as a "financial collateral arrangement" under the FCARs, a transaction must be in writing and regard "relevant financial obligations". The criteria for a "relevant financial obligations" is set out in Part I Paragraph 3

The purpose of the provision is to increase the efficiency of markets and lower the transaction costs. The disapplied formal and perfection requirements accelerates the effectiveness of security through FCAR Reg 4(1),(2),(3) and 4(4). Two things might be said of this. Firstly, academics have highlighted the risk of dappling statute of frauds and other requirements. It runs real risk of repealing substantial protections which were developed, at least in English common law, because of real risks of exploitation. Other forms of protection which has been repealed includes the ability to allow parties to implement Appropriation if expressly agreed is permitted.

Extensive litigation has resulted from the determination of the FCAR regulations, specifically the meaning of "possession or control" as set out in paragraph 3. Recital 10 states that possession or control is for the safety of third parties, however, the type of mischief this is seeking to remove is unclear. In C-156/15 Swedbank, the CJEU enforced the requirement that practical control was that of legal negative control. second sentence of Article 2(2) provides that any right of substation or to withdraw excess financial collateral in favour of the collateral provider must not prejudice the FC having been provided to the collateral taker. That right would lack any force if the taker of collateral consisting in monies deposited in a bank account were also to be regarded as having acquired "possession or control" of the monies where the account holder may freely dispose of them […] it follows that the taker of collateral in the form of money lodged in an ordinary bank account may be regarded as having acquired 'possession or control' of the monies only if the collateral provider is prevented from disposing of them. What is clear is that (1) possession is more than merely custodial and dispossession is mandatory. Some legal control is also crucial, meaning practical or administrative control is insufficient.

Possession

Requirement that collateral must be in possession is unclear. Is it one, two things? Does possession apply to intangibles? We do know that you cant. Is the requirement of control the same as the test for fixed charges. The scope of the regime is not clear. There are several unanswered questions. Only the collateral providers can have is right of substitution and right to withdraw surplus. Possession applies to intigble if it is credited to an account. Gullifer suggests that this is a redundant definition. The directive drafted with English and Irish laws not being centrally in mind. It was about disposition. To some extent, ownership discourages transactions for the risk of ostensible wealth. It was held that the phrase was to be construed in a manner consistent with meaning and purpose. This is not merely a matter of English law, Lord Briggs' judgment in Client Money [2009] EWHC 3228 held that to interpret the meaning of the directive a court ought to 1. Interpret the directive. We can look at different language texts and cases if any. 2. Interpret domestic legislation in light of the directive (as interpreted through stage 1) This is not restricted by conventional rules. Meaning that the court can and will depart from literal meaning and may imply words as necessary however, one cannot go against domestic legislation, nor require the court to make decisions it is not prepared to make. Repercussions must be and are considered by the court.

Control

By contrast, Control has been shown to not be that of practical (Administrative) control. It is clear that FCARs require a standard of negative legal control. Practical control, is the Collateral Taker's exclusive ability to dispose and it is suggested this will additionally be required if the parties are to avoid fraud. It is established by the rights and prohibitions in the security agreement but there is limited case-law on the matter Scholars identify two forms of control:

positive negative (Collateral Provider has no rights in relation to dealing with or disposal of collateral) Positive and Negative control differ where one either has the right to dispose without reference to the collateral provider, or where collateral provider is able to do so without collateral taker. What is undeniable however, is that dispossession is central to both possession and control. Rights of the Collateral taker must be beyond merely custodial; he must be able to refuse to hand collateral back. There are a handful of risks to these arrangements - as previously outlined - the ill definition of what constitutes the activation of the FCAR arrangements creates a danger. However, within the context of appropriation, a provider only has a personal right against a taker for the surplus. There is no proprietary right. Should a taker (like Lehman) become insolvent, a provider may well be at a loss for the excess. It encourages the party to reclaim excess value whenever possible/reasonably practical. This is not always possible due to the variation of the markets. Further, the risk of appropriation is that these can be used for ulterior purposes. Which as created the Cukurova problem; there parties had constructed a scheme to capture shares with a clause preventing the collateral taker from selling large securities at once and spooking the market, but valuation is not linear which made it difficult, if not impossible to determine what a commercially reasonable price for securities would be in an illiquid market.