Benjamin 2007 (Part)

FINANCIAL LAW
1
FINANCIAL
LAW
JOANNA BENJAMIN
Reader in Law, London School of Economics
Consultant, Freshelds Bruckhaus Deringer
1
Great Clarendon Street, Oxford ox2 6dp
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Joanna Benjamin, 2007
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First published 2007
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To Benjamin Reiner
vii
FOREWORD
In this country, since at least the 14th century, like Dick Whittington, people who
are 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 with
gold. Today it is the domestic and international nancial markets, of which
the City is the hub, which attract many of the brightest graduates on leaving
university.
I am afraid that in those markets a cat may be a companion but it will be of no
help in making your fortune. What is needed is an understanding of nancial law
which controls those markets and the products, often highly sophisticated, which
are traded there. So my advice to those who seek their fortune in the City is to trade
in the cat and acquire a copy of this hugely valuable innovative book. It makes those
products comprehensible and explains the workings of nancial law.
The number and the nature of those products have grown exponentially. They
are frequently given names that provide little assistance as to their nature, source
or 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 law
itself they are nothing if not international and very much part of the global market
place. 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 vast
contribution to its availability.
I know the author of Financial Law, Dr Joanna Benjamin, through my current
Chairmanship of the Bank of Englands independent Financial Markets Law
Committee of which Joanna Benjamin is a most experienced and thoughtful
contributor. Her contributions always reect her deep understanding of our
subject matter and a real sense of order. She brings this same quality to bear on the
contents of her book. Its subject matter is carefully organised so as to be under-
standable and user friendly, notwithstanding the complex and technical nature
of its subject matter. It is a comprehensive consideration of the practice, regula-
tion and law of the insurance, derivatives, commercial banking, capital markets
and investment management sectors and offers a conceptual scheme for the whole
of this subject matter.
viii
For whom will it be of value? Certainly someone like myself, who is no more than
an interested layman. However, its audience is undoubtedly much larger than the
interested lay person. This book will appeal to students who are studying nancial
markets 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 nancial
law and its subject matter will increasingly nd themselves dependent on this
book for the help it provides. Undoubtedly ownership of this book will prove
a safe investment and a step towards achieving the wealth that success from
operating in the nancial markets of the City of London can bring.
The Right Honourable Lord Woolf,
Formerly Lord Chief Justice
Foreword
ix
PREFACE
I wrote this book in the hope of making the practice and study of nancial law
easier. The insurance, derivatives, commercial banking, capital markets, and
investment management sectors are dynamic and converging. The purpose of the
book is to offer a scheme for understanding the law and regulation of these sectors
as 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 period
is the only similarity between the book and a Brachiosaurus. As Ben has grown
and ourished, the book has taken shape. In both my boy and nancial law I see
the 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 to
provide legal advice and should not be relied on as such.
Finchley, July 2007
xi
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 School
of Economics for kindly granting me leave to write this book, and to those at
Freshelds Bruckhaus Deringer for the generous sponsorship that enabled me to
nish it.
My further debts are to my colleagues for the intellectual inspiration to
attempt an ambitious project, and to Nina Farhi for the moral courage to carry
it through.
Grateful acknowledgement is made to all the authors and publishers of copyright
material 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 Fund
Securitisations, Thomson, Sydney, 2004 are reproduced with the kind permission
of 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 kind
permission 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 mention
here. I am particularly grateful to the following for their invaluable guidance
in the course of writing: Len Berkowitz, Julia Black, Peter Bloxham, William
Blair QC, Hugh Collins, Geoff Davies, Stephen Lucas, Andrew Marsh, Roger
McCormick, Andrew McKnight, Guy Morton, Simon Orton, David Quest,
Michael Raffan, Robert Reiner, Simeon Rudin, James Smethurst, and Martin
Thomas. Any errors are my own. I have sought throughout to acknowledge my
debts, but if through oversight I have omitted any appropriate reference, I hope
to be told so that the omission can be corrected in any future edition.
xii
I am grateful also to the editorial and production teams at Oxford University Press
for successfully and tirelessly managing this large project; to my research assistant,
Joanna Pearson, for her skilful work; to the business development and know-how
teams at Freshelds Bruckhaus Deringer for their hard work and professional help
in taking the project forward; and to my secretaries, Lucy Wright and Emma
Santry, 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 remarkable
that he has also just completed a major book. I am also indebted to Robert for his
inspiration as a writer and thinker. And to little Ben for being his wonderful self
in spite of his mother having been so often on another planet; for poking his curly
head under my elbow, reading my laptop screen and saying, Mum, I think this
is interesting!; and most of all for proudly declaring to Robert and me, When
I grow up, Im going to be a bookmaker like you.
Acknowledgements
xiii
CONTENTSSUMMARY
Foreword vii
Preface ix
Acknowledgements xi
Table of Cases xxxiii
Table of Legislation xli
Table 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 187
10. Regulation of Funded Positions: Five Points of Comparison 219
IV NET POSITIONS
11. Overview 261
12. Set Off and Netting 263
13. Title Transfer Collateral Arrangements 305
14. The Rise of Net Positions 325
xiv
V ASSET-BACKED POSITIONS
15. Overview 331
16. Property Rights 333
17. Security 361
18. Asset-backed Securities 401
19. Indirectly Held Securities 425
20. Financial Collateral 445
21. Trends 483
VI MARKETS AND REGULATORY PROJECTS
22. Overview 499
23. Market Forces in Financial Law and Regulation 503
24. Judges, Markets, and Consumers 519
25. The Arms Length Regulatory Project 527
26. The Fiduciary Project 543
27. The Consumerist Project 563
28. Conclusions 585
Bibliography 593
Index 607
ContentsSummary
xv
CONTENTS
Foreword vii
Preface ix
Acknowledgements xi
Table of Cases xxxiii
Table of Legislation xli
Table of European Legislation xlix
Table of International Treaties and Conventions liii
I INTRODUCTION
1. Terms of Reference
1.1 Terms of Reference 1.05
1.1.1 Nature and content of nancial law 1.05
1.1.2 Ambition of the book 1.10
1.1.3 Convergence 1.15
1.1.4 Plan of the book 1.18
1.2 Risk Transfer 1.25
1.2.1 Emphasis on risk 1.25
1.2.2 Nature of risk 1.27
1.2.3 Financial institutions and markets 1.28
1.3 Comparison of Regulatory Projects 1.31
1.4 Comparison of Transactions 1.38
1.5 Five Core Ideas in Financial Law 1.46
2. Credit Risk
2.1 Credit Risk as a Medium of Risk Transfer 2.02
2.2 Corporate Personality 2.05
2.3 Limited Liability 2.06
2.4 The Corporate Fund 2.09
2.5 Corporate Insolvency 2.13
General principles of distribution 2.23
Policy debates 2.26
Property and set off rights 2.27
xvi
Mandatory 2.31
Pro-market measures 2.32
Functions of insolvency law 2.33
2.6 Credit Risk Management 2.34
Mandatory provisions 2.35
Private law credit enhancement 2.36
2.7 Credit Risk Measurement 2.37
II SIMPLE FINANCIAL POSITIONS
3. Overview
4. Transaction Types
4.1 Overview 4.01
4.2 Guarantee 4.02
Suretyship 4.02
Secondary liability of guarantor 4.03
Protections for guarantor 4.08
Distinguish indemnity 4.10
Generally 4.11
4.3 Insurance 4.13
Elements of contract of insurance at common law 4.14
Non-disclosure, misrepresentation, and breach
of warranty 4.25
Subrogation 4.26
Types of insurance 4.27
4.4 Derivatives 4.30
4.4.1 Essential nature of derivative 4.31
4.4.2 Basic types of derivative 4.33
Forwards 4.34
Options 4.35
Swaps 4.36
Generally 4.42
4.4.3 Reference assets, entities, and benchmarks 4.43
4.4.4 Markets: exchange traded derivatives, OTC derivatives,
and derivatives in structured products 4.46
4.4.5 Physical and cash settlement 4.50
4.4.6 Credit derivatives 4.51
Contents
xvii
Overview 4.51
Elements 4.53
Functions of credit derivatives 4.63
Synthetics 4.64
Sensitivities 4.65
4.5 Standby Credits 4.66
4.6 Performance Bonds 4.70
4.7 Alternative Techniques 4.73
4.7.1 Comfort letters 4.74
4.7.2 Joint and several liability 4.75
5. Comparison of Simple Financial Positions
5.1 Functions 5.02
5.1.1 Security 5.03
5.1.2 Hedging 5.05
5.1.3 Speculation 5.09
5.1.4 Arbitrage 5.11
5.1.5 Synthetics 5.14
5.1.6 Avoidance 5.18
5.1.7 Conclusions 5.21
5.2 Risk of Non-payment 5.22
5.2.1 Category-specic legal rule reducing risk of
non-payment: autonomy 5.23
5.2.2 Category-specic legal rules increasing risk of non-payment 5.39
5.2.2.1 Guarantees 5.40
Secondary and co-extensive liability of guarantor 5.41
Discharge of guarantor 5.42
Non-disclosure to guarantor of unusual features 5.47
Contractual modication 5.48
Undue inuence 5.51
Generally 5.52
5.2.2.2 Insurance 5.55
Contractual modication 5.62
Proposals for reform 5.65
5.2.2.3 Performance bonds and standby letters of
creditstrict compliance 5.67
5.2.3 Category-specic rules: conclusions 5.69
5.2.4 Payment culture 5.70
Contents
xviii
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 5.86
The general prohibition 5.87
Insurance 5.89
Derivatives 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 5.108
Liabilities only 5.108
All risks 5.109
Disaggregation of risks 5.110
5.10 Parties Understanding of Risk 5.111
5.11 Recharacterization Risk 5.119
5.11.1 Generally 5.120
5.11.2 Sensitivities 5.121
Guarantee or indemnity 5.122
Guarantee or performance bond 5.127
Guarantee or insurance 5.129
Life insurance or investment product 5.131
Holding insurance securitization bonds
and insurance 5.133
Debt indemnity services or insurance 5.134
Derivatives and gaming contracts 5.135
6. Trends
Innovative uses of traditional contract
categories 6.02
Structuring 6.04
The rise of derivatives 6.05
III FUNDED POSITIONS
7. Overview
Contents
xix
8. Options for Raising Capital
8.1 Overview 8.01
8.1.1 Debt and equity 8.02
8.1.1.1 Comparison 8.03
8.1.1.2 Gearing 8.07
8.1.1.3 Income 8.08
8.1.2 Bank loans 8.12
8.1.2.1 Overview 8.12
8.1.2.2 Forms of loan facility 8.14
Overdraft 8.16
Term loan 8.18
Revolving facilities 8.19
Syndicated loan 8.21
Several obligations 8.22
Sharing 8.23
Voting 8.24
Not partnership 8.25
Role of arranging bank and agent bank 8.26
8.1.2.3 Credit risk mitigationcontractual provisions 8.27
Conditions precedent 8.28
Representations and warranties 8.29
Covenants (undertakings) 8.34
Information undertakings 8.35
Financial covenants 8.36
General undertakings 8.37
Negative pledges 8.38
Events of default 8.43
Good faith 8.45
Latent lies and broken promises 8.46
Lenders power over borrowers 8.47
8.1.2.4 Secondary loan market 8.48
8.1.3 Capital markets 8.52
8.1.3.1 Overview 8.53
Generally 8.53
Equity 8.58
Debt 8.61
8.1.3.2 Legal nature of investment securities 8.62
Legal meaning 8.63
Bearer and registered 8.67
Indirectly held securities 8.68
Contents
xx
8.1.3.3 Eurobonds 8.70
Role of settlement systems 8.71
Role of managers 8.72
Credit risk mitigation 8.75
Paying or scal agents, trustees, and meetings 8.76
8.1.4 Syndicated loans and Eurobonds 8.77
9. Managed Funds
9.1 Categories of Fund 9.05
9.1.1 Regulated and private 9.07
9.1.2 Open ended and closed ended 9.10
9.1.3 Legal structures 9.14
9.1.4 Investment policy 9.15
9.1.5 Tax status 9.22
9.1.6 Jurisdiction 9.26
9.1.7 Listed and unlisted funds 9.27
9.1.8 Unlimited and limited life funds 9.28
9.2 Professional Roles 9.29
9.2.1 Management 9.30
9.2.2 Other roles 9.36
Custody 9.36
Supervision 9.37
Investment advice 9.38
Brokerage 9.39
Administration 9.42
Distribution 9.43
Legal support 9.44
Sponsors 9.45
9.3 UCITS 9.46
9.3.1 Background and history 9.47
9.3.2 Criteria for UCITS status 9.50
9.3.3 Authorization of UCITS 9.51
9.3.4 Prudential and investor protection requirements 9.52
Unit trusts and common funds 9.53
Investment companies 9.56
9.3.5 Product regulation 9.58
Investment and nancial transaction powers 9.59
Unit dealing 9.61
Income, fees, and expenses 9.62
Contents
xxi
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 9.67
Investment trusts 9.68
Exchange 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 10.02
10.1.1 The nature of duciary duty 10.03
10.1.2 The directors of issuers 10.05
The general duties 10.06
By and to whom the general duties are owed 10.08
10.1.3 Fund vehicles and their managers 10.10
10.1.4 Borrowers 10.12
Borrowers and duciary duty 10.13
Deposit takers and duciary duty 10.14
10.1.5 Summary 10.15
10.2 Authorization Requirements 10.16
10.2.1 The authorization regime 10.17
The general prohibition 10.17
Permission 10.18
FSA 10.19
Threshold conditions 10.21
FSMA and Handbook 10.22
Approved persons 10.26
Generally 10.27
10.2.2 Issuers 10.28
10.2.3 Managers 10.29
10.2.5 Summary 10.31
10.3 Disclosure Requirements 10.32
10.3.1 The regulatory strategy 10.32
10.3.2 Issuers 10.34
Contents
xxii
10.3.4 Investment funds and/or their managers 10.41
10.3.5 Summary 10.43
10.4 The Regulation of Promotions 10.44
10.4.1 Financial promotion restriction 10.45
10.4.1.1 Overview 10.46
Financial promotion regime 10.46
Overview of restriction 10.48
Term of the restriction 10.49
Exemptions from the restriction: Financial
Promotions Order 10.50
Conduct of Business Rules 10.54
Investment securities, fund units, and loans 10.56
Investment securities 10.57
Fund units 10.58
Loans 10.59
10.4.2 Scheme promotion restriction 10.62
Overview 10.63
Meaning of CIS 10.64
The terms of the restriction 10.68
The exemptions 10.70
Policy justication 10.73
10.4.3 Summary 10.75
10.5 Product Regulation 10.76
10.6 Regulatory Anomalies 10.79
Generally 10.79
Lenders not protected 10.80
Disclosure regulation and investment securities 10.81
Investment funds a different strategy 10.82
Regulatory arbitrage 10.83
Regulatory projects 10.85
IV NET POSITIONS
11. Overview
12. Set Off and Netting
12.1 Set Off and Netting: Overview 12.03
12.2 Types of Netting 12.08
12.2.1 Novation netting 12.09
Contents
xxiii
12.2.2 Close out netting 12.10
Nature 12.10
Importance; legal risk 12.14
Legislative protection 12.15
Regulatory capital recognition 12.20
12.2.3 Settlement netting 12.21
12.3 Legal Bases for Set Off 12.23
12.3.1 Insolvency law 12.24
12.3.2 Current account 12.25
12.3.3 Litigation procedure 12.27
12.3.4 Closely related claims (common law and equity) 12.29
12.3.5 Contract 12.33
12.3.6 Limits 12.34
Wrongdoing 12.34
Mandatory provisions of insolvency law 12.35
12.4 Insolvency Set Off 12.39
12.4.1 Rule 4.90 overview 12.41
12.4.2 The mandatory principle 12.45
12.4.3 The retroactivity principle 12.46
12.4.4 The hindsight principle 12.47
12.4.5 Insolvency set off and choice of law 12.48
12.5 The Requirement for Mutuality 12.49
12.5.1 Trust 12.53
The insolvency of which party? 12.54
Trust not legal person 12.55
Parties to the set off 12.56
Possible want of mutuality 12.57
Arguments for mutuality 12.59
12.5.2 Money paid for a specic purpose 12.64
12.6 Set Off and Interveners 12.65
12.7 Adjusting the Scope of Set Off 12.84
12.7.1 Cross-product netting 12.85
12.7.2 Mutli-branch exposures 12.86
12.7.3 Multi-lateral exposures 12.87
12.7.4 Group exposures 12.88
12.7.5 Exposures to protected cell companies 12.95
Contents
xxiv
13. Title Transfer Collateral Arrangements
13.1 Essential Nature 13.03
13.2 Repos, Buy/Sell-backs, and Securities Loans 13.04
13.2.1 Repos 13.06
13.2.2 Buy/sell-backs 13.10
13.2.3 Securities lending 13.11
13.3 Functions and Importance of TTCAs 13.15
13.3.1 Cash-driven transactions 13.16
13.3.2 Securities-driven 13.19
13.3.3 Hedging 13.23
13.3.4 Arbitrage 13.24
13.3.5 Speculation 13.25
13.3.6 Voting 13.27
13.3.7 Synthetics 13.28
13.4 Transaction Structure 13.30
13.4.1 Outright transfer and equivalent redelivery 13.32
13.4.2 Benets and burdens of ownership 13.33
13.4.3 Master agreements 13.34
13.4.4 Marking to market 13.35
13.4.5 Substitution 13.39
13.4.6 Manufactured income 13.40
13.4.7 Close out netting 13.42
13.5 The Involvement of Third Parties 13.44
13.6 Recharacterization Risk 13.49
13.6.1 Generally 13.50
13.6.2 Key sensitivities 13.52
13.7 Trends 13.53
14. The Rise of Net Positions
The protection of risk takers 14.05
Contents
xxv
V ASSET-BACKED POSITIONS
15. Overview
16. Property Rights
16.1 Personal Rights and Property Rights 16.02
16.1.1 The doctrinal distinction 16.03
16.1.2 Property and possession 16.04
16.1.3 Property rights and credit risk 16.08
16.1.4 Concerns for third parties 16.10
16.2 Legal and Equitable Property Rights 16.13
16.3 Property in Claims 16.14
16.4 The Requirement for Ascertainment 16.18
16.5 The Requirement for Publicity 16.20
16.6 Consensual Property Rights 16.21
16.7 Equitable Property Remedies and Related Processes 16.22
16.7.1 Following and tracing 16.24
16.7.2 Constructive trusts 16.28
16.7.3 Resulting trusts 16.38
16.7.4 Theme of informed consent 16.49
16.8 Priority 16.50
16.8.1 Nature of priority disputes 16.51
16.8.2 Contractual subordination 16.53
16.8.3 Original owner claims 16.58
16.8.4 Successive dealing 16.60
16.8.5 Order of appropriation of payments 16.61
16.8.6 Law reform 16.63
17. Security
Limited property rights 17.05
Equity of redemption 17.06
Compare title transfer collateral arrangements 17.08
Equity of redemption v personal right of
equivalent redelivery 17.10
Power of sale/foreclosure v set off 17.11
Choice for collateral taker 17.27
Security interests lawyered 17.28
Choice of law uncertainties 17.29
Priority sensitivities 17.30
Contents
xxvi
Enforcement problems 17.31
Right of use sensitivities 17.32
Registration 17.33
Choice for collateral giver 17.39
17.2 The Impact of Security 17.40
Benets for secured creditor 17.41
Benets for debtor 17.45
The position of general creditors 17.46
Economic impact 17.47
17.3 Types of Security Interest 17.49
Possessory 17.51
Non-possessory 17.53
Mortgage 17.54
Charge 17.56
Legal and equitable 17.58
17.4 Steps in Taking Security 17.60
Contractual steps 17.62
Property steps 17.64
Attachment 17.65
Perfection 17.66
Registration 17.67
Priorities 17.75
Benecial ownership 17.76
Enforcement 17.77
Remittance 17.78
Displacement 17.79
17.5 Floating Charges and Recharacterization 17.80
Characteristics 17.81
Corporate security interests 17.84
Commercial function 17.85
Policy concerns 17.89
Legal disadvantages 17.90
Registration 17.91
Insolvency priorities 17.92
Insolvency displacement 17.93
Double dealing priorities 17.94
Impact of FCAR 17.95
Overseas collateral giver 17.96
Freedom to deal and recharacterization 17.97
Recharacterization 17.98
Late judicial denition of rights and duties 17.99
Contents
xxvii
Freedom to deal as key characteristic 17.102
Partial freedom to deal 17.107
Removal of assets 17.108
Exercise of control in practice 17.110
17.6 Quasi Security 17.111
17.6.1 Asset sales 17.112
17.6.2 Flawed asset arrangements 17.113
17.6.3 Security trusts 17.114
17.6.4 Retention of title 17.116
17.6.4.1 Overview 17.116
17.6.4.2 Recharacterization 17.117
17.6.4.3 The approach of judges 17.120
17.6.4.4 Publicity 17.122
UK law 17.123
UNCITRAL 17.124
EU legislation 17.125
18. Asset-backed Securities
18.1.1 Economic transfer of nancial positions to investors 18.02
18.1.2 The functions of ABS 18.04
Cash ow 18.05
Balance sheet 18.07
Arbitrage 18.08
18.1.3 Terminology 18.09
18.2 Elements of an ABS Transaction 18.10
18.2.1 SPV 18.11
18.2.2 Transfer 18.13
18.2.3 Note issue 18.16
18.2.4 Security 18.22
18.2.5 Credit enhancement 18.23
18.3 Key Sensitivities 18.24
18.4 Developments 18.26
18.4.1 Synthetic transactions 18.28
CDOs 18.29
Elements of synthetic transactions 18.30
18.4.2 The role of derivatives 18.38
18.4.3 Insurance transactions 18.39
Contents
xxviii
18.4.3.1 Catastrophic risk securitizations 18.41
18.4.3.2 Life insurance securitizations 18.50
18.4.4 Asset management transactions 18.58
18.4.5 Whole of business transactions 18.62
18.4.6 Impact 18.64
19. Indirectly Held Securities
19.1 Operational Change 19.03
19.2 Legal Challenges 19.07
19.2.1 Nature of asset 19.08
19.2.2 Ring fence 19.11
19.2.3 Choice of law 19.12
Look through 19.16
PRIMA 19.17
Party autonomy 19.18
Governing law approach 19.20
19.2.4 Priorities 19.22
Loss of negotiable status 19.24
Loss of equitys darling defence 19.25
19.2.5 Shortfalls 19.28
Liability of intermediary 19.29
Loss sharing 19.32
19.3 Law Reform Measures 19.33
National measures 19.33
UNIDROIT 19.36
Legal Certainty Group 19.37
UK 19.38
19.4 Financial Positions and Property Rights 19.40
20. Financial Collateral
20.1 Fundamental Aspects of Financial Collateral 20.04
20.1.1 Importance 20.04
The need to collateralize 20.05
Attractive asset class 20.06
Types of exposure 20.07
Systemic importance 20.14
20.1.2 Categories of nancial collateral asset 20.17
Cash 20.17
Securities 20.20
Contents
xxix
Receivables 20.24
20.1.3 Collateral structures 20.25
The use of master agreements 20.26
Availability of FCAR protections 20.27
20.2 Key Risks 20.28
20.2.1 Collateral giver insolvency 20.29
Close out netting 20.30
Insolvency displacement 20.35
Preference rules 20.36
Margining and substitution 20.37
Share 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 20.50
Generally 20.50
Indirectly held securities 20.51
Law reform 20.54
Representations to brokers 20.57
20.6 Managed Collateral Portfolios 20.62
20.7 Legal Sensitivities 20.65
20.7.1 Collateral takers right of use 20.66
20.7.2 Issuer set off 20.70
20.7.3 Proceeds of book debts 20.74
Withdrawals partially restricted, single charge 20.77
Withdrawals unrestricted, single charge 20.80
Withdrawals unrestricted, split drafting 20.81
Re New Bullas 20.82
Agnew 20.84
Spectrum 20.86
FCAR 20.94
20.7.4 Charge backs 20.95
The practice 20.95
Charge Card 20.96
Re BCCI (No. 8) 20.98
20.7.5 Freeze orders 20.99
Contents
xxx
20.8 FCD and FCAR 20.105
20.8.1 Protections 20.106
20.8.2 Criteria 20.109
20.8.3 UK implementation 20.111
20.8.4 Control 20.112
20.8.5 Other limitations 20.118
20.8.6 Review 20.120
20.9 UNIDROIT 20.123
20.10 Conclusions 20.124
21. Trends
21.1 The Adaptation of Property Rights in the
Financial Markets 21.02
21.1.1 The conventional model of property rights 21.04
21.1.2 Property in intangible assets 21.06
21.1.3 Property in fractional or pooled assets 21.07
21.1.4 Property in future assets 21.14
21.1.5 Property in changing assets 21.19
21.1.6 Property in depleting assets 21.23
21.1.7 Property in intermittently absent assets 21.25
21.1.8 The role of equity 21.28
21.2 The Decline of Property 21.29
VI MARKETS AND REGULATORY PROJECTS
22. Overview
23. Market Forces in Financial Law and Regulation
23.1 Arbitrage 23.03
Market arbitrage 23.05
Regulatory arbitrage 23.06
Tax arbitrage 23.08
Legal arbitrage 23.09
Functionalism 23.11
23.2 Globalization 23.14
The phenomenon 23.15
The limits of national law 23.21
Market solutions 23.22
Contents
xxxi
24. Judges, Markets, and Consumers
25. The Arms Length Regulatory Project
25.1 Supply and Demand 25.02
25.2 Transfers 25.03
Techniques 25.04
The promotion of rules facilitating transfer 25.12
The 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 26.17
Trust 26.20
Partnership 26.25
Company 26.36
Protection of the risk taker 26.41
26.3 The Erosion of Fiduciary Duty 26.42
The role of equity 26.43
Fiduciary duty and contract 26.47
Fiduciary 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 27.15
27.3 Consumerism and Europe 27.18
Good faith and fairness 27.19
Good faith and fairness in the Continental
tradition 27.20
Good faith and fairness in English law 27.21
FSAP 27.27
27.4 PBR and the Problem of Risk 27.29
Contents
xxxii
28. Conclusions
28.1 Convergence 28.02
28.2 Regulatory Projects and Risk 28.08
28.3 Concepts and Imagination 28.15
Bibliography 593
Index 607
Contents
Part I
INTRODUCTION
1. Terms of Reference 3
2. Credit Risk 27
3
1
TERMS OF REFERENCE
No system ever works perfectly.
1
One of the most popular comedies of the seventeenth century was Thomas
Shadwells The Virtuoso in which the virtuoso of the title is a scientic theorist, Sir
Nicholas Gimcrack, who is found imitating the movements of a frog in order to
learn how to swim. I content myself with the speculative part of swimming, he
declares, I care not for the Practick . . .
2
Financial law is rooted in practice, and
the purely theoretical swimmer is likely to sink. This book offers a conceptual
scheme 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 the
function of nancial law is to permit risks (and the rewards associated with taking
them) to be transferred from protection buyers to risk takers, and to circulate
amongst risk takers in the nancial markets. Financial law serves to translate risks
of many kinds into the form of credit risk, which is the risk of a debt not being
paid or another obligation not being performed. The nancial markets treat credit
risk as measurable, manageable, and transferable. The media through which risk
circulates 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 1.05
1.1.1 Nature and content of
nancial law 1.05
1.1.2 Ambition of the book 1.10
1.1.3 Convergence 1.15
1.1.4 Plan of the book 1.18
1.2 Risk Transfer 1.25
1.2.1 Emphasis on risk 1.25
1.2.2 Nature of risk 1.27
1.2.3 Financial institutions
and markets 1.28
1.3 Comparison of Regulatory
Projects 1.31
1.4 Comparison of Transactions 1.38
1.5 Five Core Ideas in
Financial Law 1.46
1.01
1.02
Chapter 1: Terms of Reference
4
the risk taker typically agrees to receive the protection buyers risk in exchange for
a return. The exposure of the risk taker under nancial positions may result in
unforeseen losses, and therefore attracts regulation.
This introductory chapter presents the scheme of the book as a whole. After
setting out the books terms of reference, it turns to the central theme of risk
transfer. This theme is analysed in two ways. The rst is a categorization of styles
of 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 of
claims. 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 is
considered in Chapter 2. Section 2.1 turns to the remarkable translation of risks
as diverse as natural and man-made disasters and mortality itself, into the tradable
form of credit risk. In order to explain credit risk, Chapter 2 goes into a certain
level of legal detail. It explains that the idea of corporate personality supports the
related ideas of limited liability and the corporate fund. The exhaustion of that
fund 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 so
much 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 the
following 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 is
part 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 market
practice, 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 the
different departments of trade, ratied by the decisions of Courts of law . . . By this process, what
before was usage only, unsanctioned by legal decision, has become engrafted upon, or incorporated
into, the common law, and may thus be said to form part of it. Cockburn CJ, Goodwin v Robarts
(1875) LR 10 Exch 337, 346.
1.03
1.04
1.05
5
chiey through trade associations, which publish standard documentation, legal
opinions, codes of practice, and guidance.
4
This material, although not ofcially
binding, is highly inuential, and constitutes a form of soft law.
5
The style of
this component of nancial law is functional, pragmatic, and positive. Firms use
nancial law in order to do business, and their lawyers are problem solvers. Theory
has no value here.
The second component is case law, which originates in litigation, and is made up
of judgments, both reported and unreported. The body of nancial case law is far
from complete; indeed, in some areas of the wholesale and offshore markets there
is nothing on the ofcial map except There be dragons. There are two reasons for
this. Firstly, banks tend to avoid the expense and publicity of litigation wherever
possible. Avoiding litigation tends to become impossible in the face of disaster,
and case law accordingly clusters around major frauds and insolvencies, the
collapse of markets and currencies, wars and revolutions. (Contrast however
the newer breed of (litigious) lenders in the form of hedge funds.)
6
Secondly, the
evolution of case law is unsystematic, as the haphazard nature of litigation
either throws points up, or leaves them untaken.
7
The style of nancial case law
is, in general, as pragmatic as that of the markets it serves. See for example the
reverse engineering to a commercially helpful outcome in Petrona (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 International
Swaps and Derivatives Association (ISDA) (<http://www.isda.org>) and the International Capital
Markets Association (ICMA) (<http://www.icma-group.org>).
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 other
institutions 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 their
advisers responses to legal and other questions, and, possibly, to inuence the courts but do not in
themselves 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 the
Financial Markets, (Oxford: Oxford University Press, 2006), 145.
6
These non-bank lenders are much more willing than banks to litigate in order to achieve their
objectives. M. Hughes, Legal Principles in Banking and Structured Finance, 2nd ed., (Haywards
Heath: 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 pattern
of investment securities, thereby tantalizing those of us with an interest in clarifying them. See the
discussion 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 in Hazell v Hammersmith and Fulham London
Borough Council [1992] 2 AC 1: The judicial pronouncement appeared to many as if it had come
from another planet, 48.
1.06
6
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 largely
follows 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 this
functionalism, judicial reasoning is typically inductive and analogical, not
a 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 of
nancial law is ethereal. It comprises arrangements between legal (as opposed to
natural) persons,
13
concerning legal claims (as opposed to physical things).
14

These persons are subject to legal procedures such as insolvency,
15
and the claims
are subject to legal procedures such as transfer by novation
16
and set off.
17
In cases
affecting the nancial markets, judges have adapted the traditional laws of con-
tract, equity, and property to serve market ends, and here contract, trust, and charge
are 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 is
secondary 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 and
self-consistent rules of law. Such concepts do not have a life of their own from which
the rules of law are inexorably derived.
18
And the great pleasure of case law, particularly in the House of Lords, is that it is
often 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, economic
structures, 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 be
produced within the law in Law 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 in
Martin 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 to
such prevalent provisions while the courts of New York are prepared to enforce them. For there to
be a disparity between the law applicable in London and New York on this point would be of great
disservice 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.
1.07
1.08
7
of thought, by judges whose identication with its traditions is so great that their
tone may become almost oracular.
And then, in contrast, there is legislation. This is the third component of nancial
law, and recent years have seen a legislative ood, mostly from Europe.
19
The style
is often at odds both with practice and case law, and so in two respects. Firstly (and
perhaps 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 the
already strange mix of work and imagination is added a kind of welfarism, in the
form 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 materials
and many tens of thousands of cases, it includes among other things the outputs
of 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 sorcerers
apprentice. As one struggles daily to stay aoat,
23
one is entitled to an answer to
the very reasonable question, What is this?
There are two parts to the question. To answer the rst, one needs to meet the
challenge, carved into the lintel of London School of Economics, to know where
things come from.
24
The second part of the question is carved in imagined letters
into the lintel of Freshelds Bruckhaus Deringer, and indeed the soul of every
practitioner: and where are they going? In order to offer some answers, and to
keep 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 and
even policy to continue within ostensibly harmonized markets. I am grateful to Martin Thomas for
this point.
20
The Lamfalussy Report (Final Report of the Committee of Wise Men on the Regulation of
European Securities Markets, 2001), 22: The Committee believes that all European nancial services
and securities legislation should be based around a conceptual framework of overarching princi-
ples. <http://ec.europa.eu/internal_market/securities/docs/lamfalussy/wisemen/nal-report-wise-
men_en.pdf>.
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 example HIH Casualty and General Insurance Ltd. v New Hampshire
Insurance 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 must
be 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 causes
of things, of Lucretius).
1.09
1.10
1.11
8
complex and rapidly changing subject is neither feasible, nor necessary in view of
the 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 the
subject.
The ambition of the book is to offer a new scheme for analysing nancial law, with
illustrative and topical examples. The purpose of the scheme is to address the
problem that nancial law is not readily accessible as a whole. Today, few have a
condent grasp of the laws of all the sectors. While many lawyers have impressive
specialized knowledge, the big picture may remain elusive. Financial law is not
widely taught at undergraduate level.
25
Indeed it is not universally accepted that it
is a distinct subject. English law is not codied. Medical law, sports law, energy
law, and monetary law have recently been added to the list of accepted branches.
But the law of insurance, derivatives, commercial banking, capital markets, and
investment management has not been widely recognized as forming an integrated
whole. This is notwithstanding the consolidated regulation of these industries
under the Financial Services and Markets Act 2000.
26
As well as being fragmented, nancial law is muddled. One encounters a vast
tangle of interconnecting ideas, and there is no agreed order to the whole. The
nancial markets are a perennial source of legal risk.
27
Practice regularly throws up
intellectual problems, and the more intellectuals consider these problems, the
less 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 to
the judicial and statutory protection of those who take risks under nancial
positions. As discussed in section 1.3, the nancial markets are subject to three
different (and indeed inconsistent) regulatory projects. These are based on three
different 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 not
land 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 Financial
Services Authority.
27
See generally R. McCormick, Legal Risk in the Financial Markets, (Oxford: Oxford University
Press, 2006).
28
Examples of such chestnuts are the law relating to charge backs (see section 20.7.4, xed
charges 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 argued
in paragraph 24.12 that the essential difculty is simple, and relates to the true role of doctrine in
nancial law.
1.12
1.13
1.14
9
arms length, duciary, and consumerist. The second aspect of the scheme relates
to 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 risk
between the parties. To the best of my knowledge, this conceptual structure is
original. It was developed over twenty years of practice and study, and I believe it
has power to explain.
1.1.3 Convergence
One reason for the fragmentation of nancial law has been the traditional
segregation of the industry into sectors. Sectoral divisions have been strengthened
by regulatory restrictions on the permitted business of different types of rm.
29

Historically, the business of each sector has been conducted by different
institutions, staffed by different individuals, served by different support indus-
tries, reported in different journals, and studied in different university courses
by people reading different books. All of the foregoing have used sector-
specic jargon.
An integrated approach to nancial law is overdue, because the nancial markets
have 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 banks
30
offer new forms of investment to their private banking
31

clients in the form of structured products, whereby one type of underlying
asset (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 with
securities, and securities rms must not accept deposits. However, banks which are members of
the 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) and
UCITS management companies; as to the latter see para. 9.54.
30
A distinction is traditionally made between commercial banks (whose core business is deposit
taking and lending) and investment banks The originally US term investment bank is generally
replacing 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 and
derivatives trading. But this distinction is becoming blurred in practice, as the range of business
undertaken by commercial banks and bank groups expands. In Britain the typical multifunctional
bank 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.
1.15
1.16
10
(such as a bank account).
32
Indeed, structured products may be offered in a
range of alternative legal wrappers. For example, a capital-protected product
33

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 debt
securities issued in the capital markets, under which the rights of investors are
backed by the underlying portfolio. Credit derivatives are an important form of
nancial 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 risks
are economically converted into asset-backed securities, including in recent years
reinsurance risk and the risks of pension shortfalls due to an ageing population.
Due in part to limited cross-sectoral legal awareness, such innovations have been
associated with a high level of legal risk,
36
and the cross-sectoral freedoms offered
by 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 off
credit risk include credit derivatives as well as traditional techniques. Fragmented
legal 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 and
Chapter 4 presents the essential legal natures of guarantees, insurance, derivative,
standby letters of credit, and performance bonds. Chapter 5 offers a functional
comparison 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
See Peekay 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 example HIH Casualty and General Insurance Ltd. v New Hampshire Insurance Co. and
others [2001] 2 Lloyds Rep 161 and HIH Casualty and General Insurance Ltd. v Chase Manhattan
Bank [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 cheap
alternative, but were caught out by the special disclosure, misrepresentation, and breach of warranty
rules 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, and
private equity moves into reinsurance risk.
1.17
1.18
1.19
11
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 their
complexity, 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, and
capital markets securities, such as shares and bonds (Chapter 8) and managed
funds which are forms of collective investment scheme (Chapter 9), are discussed
in turn, and the increasing convergence between them is noted. The regulation of
funded 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 and
law of set off and netting are explained (Chapter 12), title transfer collateral
arrangements considered (Chapter 13), and the rise of net positions assessed.
Public sector support for net positions is noted, together with the associated
decline in property rights in the nancial markets (Chapter 14).
Part V discusses asset-backed positions. It opens with an overview of property
rights (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 nancial
markets is considered in Chapter 21.
Part VI turns to the three regulatory projects, and assesses in turn the arms length
project (with its ambition of informed consent to risk), the duciary project (with
its 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 focus
is on the international nancial markets based in London.
1.2 Risk Transfer
In advanced modernity the social production of wealth is systematically accompanied
by the social production of risks.
38
38
U. Beck, Risk Society, Towards a New Modernity, (London: Sage, 1992), 19.
1.20
1.21
1.22
1.23
1.24
1.2 Risk Transfer
12
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 commercial
banking, capital market, and investment management
39
sectors are doing the
same thing. The business of these latter sectors is traditionally understood to be
moving money,
40
not risk. However, the approach of this book is to focus, not on
the money, but on the credit risk that attends it.
There are four reasons for emphasizing risk rather than money. Firstly, it offers
a simply way of considering all the nancial market sectors together: only
some 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 the
nancial markets, payment does not involve the delivery of physical assets with
intrinsic value, but is made by credits to bank accounts.
41
Money comprises debts
owed 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 of
money to a borrower is accompanied by the simultaneous transfer of credit risk to
the lender. Thirdly, with the rise of nancial derivatives,
44
risk management is
arguably 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 markets
desks, private equity rms,
46
and hedge funds,
47
investment bankers today speak
of originating risk into the capital markets rather than raising money from it, and
institutional investors are no longer invited to invest funds, but rather to buy
risk 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 specialist
investment managers in all types of companies, using share capita that is privately held rather than
publicly 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.
1.25
1.26
13
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 me
how 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 to
know what is going to happen next. Attempts to rise above this condition have
always attracted severe penalties, from Chapter 3 of Genesis to Part VIII of the
Financial 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 these
exacting standards the answer was, until the rise of the nancial markets in the
18th century, magic.
50
Magic was the functional precursor of both derivatives
51

and insurance.
52
With the early modern era came the ambition of measuring the
likelihood of future loss, that is of identifying risk. Risk is a measure of exposure
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 contexts
business executives and government ofcials must make decisions requiring an
assumption 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 uncertain
future.
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 the
importance of magical healing, astrology, witchcraft, and other forms of magic in the effort to
anticipate and control sickness, re, and other future hazards.
51
Seventeenth century farmers predicted the price of corn by watching the behaviour of grains
placed 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 are estimations of possible events. Unlike dangers or hazards, risks never exist outside of
our 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 Risk
in 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 Bernstein
traces the possibility of measurement, and therefore of risk management, back to the introduction
to Europe of Arabic numerals in the 13th century.
54
Bernstein shows the evolution from risk measurement (with Fermat & Pascals probability
theory and the beginnings of demographic science in the 17th century) to risk management (with
the 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 economic
systems is best made through a series of small scale experiments, frequently reviewed, and in a
1.27
1.2 Risk Transfer
14
(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 has
been designated the risk society.
58
The unequal distribution of risk is identied
as 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 transferred
to 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, and
they do this by entering into nancial positions. For example, insurers take insured
risks in exchange for premium income, investment banks take interest rate risk in
exchange 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 attendant
risks and returns) to move from person to person. Positions circulate as units of
risk, 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 risk
is 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 of
disciplined 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 . . . determined
by custom to transfer the past to the future, in all our inferences . . . David Hume, An Enquiry
Concerning 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 no
rule 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 as risk 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 in The Foucault Effect, Studies in Governmentality, Burchell,
Gordon and Miller (eds.), (Chicago: Harvester Wheatsheaf, 1991), 199: Today it is hard to imagine
all the things which insurers have managed to invent as classes of riskalways, it should be said,
with protable results.
1.28
15
disasters from insurance companies to the bond markets.
64
In the past year, some
nanciers have taken the idea further . . .,
65
by transferring into the bond markets
the risks and rewards associated with pandemics.
66
And on 23 November 2006
the 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 are
fundamentally powerless to stop bad things happening, or to see them coming.
The achievement is to create a synthetic approximation of a controlled and known
future. This is done through a system of legal rights and obligations that adjust to
the future as it unfolds. Misfortune will not be left lying where it may fall, but
prospectively diverted from protection buyer to risk taker. The modern project of
risk management has been described by Anthony Giddens as the colonisation of
the future.
68
Its fullest development is in the nancial markets. This is the most
ambitious technological project ever undertaken, and its scale is routinely under-
estimated because (unlike for example the Great Wall of China and Apollo 11) it
is 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 us
by approximating a controlled and known future. The merit of this view is that
it 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 known
as 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 about
hurricanes 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 their
insurance, the bondholders stop receiving payments. Thus, by issuing the bonds the insurance
company is sharing hurricane riskand the value of the bonds depends on how many hurricanes
occur. 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 and
G. Tett. See further G. Tett and J. Chung, In recent decades, bankers have become adept at using
the 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 ways
of making money from the new risk facing modern humanitythat of living too long. Death
and 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.
1.29
1.30
1.2 Risk Transfer
16
(in Philip Woods lofty language) like bus timetable law, or (in Kafkas) like
sawdust.
70
1.3 Comparison of Regulatory Projects
Where you insure a ship or a house you cannot insure that the ship shall not be
lost or the house burnt . . .
71
The nancial system does not reduce risk; it merely
diverts it from person to person.
72
There is no choice as to the occurrence of loss
events, but only as to who will pay for them, and someone always pays. To speak
plainly, what circulates in the nancial system are potential harms, the occurrence
and extent of which are unforeseeable. This creates the moral need for judicial and
statutory 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 to
this moral problem is, on the whole, modest. The functional analysis of nancial
transactions proposed in the following section facilitates the comparison of this
type of regulation in the different sectors. In turn, the comparison highlights
regulatory anomalies, which may suggest reforms to some, and arbitrage
opportunities to others.
It will be argued that the inconsistent sectoral approaches to such regulation is
conceptually attributable to inconsistent models of the ideal nancial market
relationship. 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 the
parties. An arms length approach is consistent with the general commercial law
principle of caveat emptor.
73
The traditional justication of this principle is that, in
the sale of goods, the purchaser is able to acquire relevant information pre-bargain
by inspection of the goods. But [w]hen the product is the contract, however, as
in the case of an insurance policy . . .,
74
inspection is not possible. In lieu of
inspection, 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 told
severely 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 his
father, <http://www.kafka-franz.com/KAFKA-letter.htm>. (Like Dickens, Kafka makes failed legal
studies 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 are
there 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.
1.31
1.32
17
example through policyholders duties of good faith disclosure,
75
prospectus law
76

and market transparency rules.
77
Disclosure is required as the precondition of the
informed consent of the risk taker. This arms length model of regulation draws on
classical economic theory, according to which traders create wealth by dealing in
their own interests in transparent markets. The mischief addressed by arms length
regulation is that . . . the affected parties are becoming incompetent in matters
of 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 the
regulation of highways, airways, medicine, and construction set compulsory
standards intended to separate the population from unacceptable risks, the style
of arms length regulation is Faustian: any deal, however ruinous, is permitted and
enforced, provided the loser entered into it with informed consent. The informed
consent 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 informed
consent forms no part of consumerist regulation, also discussed below, which is
gaining ground, largely through EU legislation.
The second regulatory project is duciary. Many nancial market arrangements
involve the use of one or more legal persons to hold clients assets and/or control
clients liabilities. Although essential to the functioning of the nancial markets,
such structuring exposes clients to the bad faith of the intermediaries. The historic
legal response to this problem has been to impose duties on good faith on such
persons, by characterizing them as duciaries. Examples of duciary relationships
include agent/principal, partner/partner, director/company, trustee/beneciary,
and asset manager/investor.
80
Here, the regulatory concern is that trust should not
be misplaced. In contrast to the consumerist project, discussed below, the relative
economic strengths of the parties is irrelevant. The essence of the duciary concept
of 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, and
is subject to rules relating to no prot, no conict, undivided loyalty, and con-
dentiality. In general, however, implied duciary duties (other than core duty of
loyalty) can be modied by contract. Brokers terms, custody agreements, and
other 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.
1.33
1.3 Comparison of Regulatory Projects
18
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 contract
has caused many duciary relationships to resemble arms length relationships.
82
The third ideal type of nancial market relationship is consumerist. Whereas the
legal characteristics of arms length and duciary relationships are historically
derived from case law,
83
the consumerist relationship is primarily derived from
legislation, mostly European. It presumes an inequality of power and/or under-
standing that precludes informed consent. The regulatory concern is to avoid a
signicant imbalance of interests to the detriment of consumer and/or distortion
of consumer behaviour. Unlike in the duciary project, the presence or absence of
trust and reliance is irrelevant. Because the client is taken to be weak, the products
which may be sold to it
84
and the promotional material which it may receive
85
are
subject to elaborate restrictions. The risk taker may be the client, protected by
consumerist 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 resulting
friction 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 and
duciary 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 general
conduct of business rules where no vehicle is used. Thus, option (iv) is the least
regulated, but it probably involves the greatest risk to the public. The differences
are explained by which regulatory projects happen to be triggered by the different
forms of offering.
86
Collision between inconsistent regulatory projects also
explains a number of legal risks. For example, the issue of collateralized loan
obligations (CLOs), which involve the securitization of bank loans,
87
may bring
capital market duties of disclosure into conict with bankers duties of
condentiality.
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.
1.34
1.35
19
Industry has long been the chief protection buyer. The ability of commercial
enterprises to transfer risk into the nancial markets
88
encourages commercial risk
taking and therefore economic growth. A more controversial development over
the last quarter century has been the recruitment of the general public as risk
takers. With demographic change and the end of big government, individuals
must save for their pensions, and take investment risk. With the erosion of public
education and health services, many families are considering private arrangements
for 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 losses
may be not merely the insolvency of a limited liability company, but personal
hardship, and hence the rise of consumerism. But consumerism in the nancial
markets is problematic. While the arms length and duciary models have, through
a series of 1990s judgments, found a workable contractual synthesis,
89
the con-
sumerist regulatory project cannot be readily integrated into the fabric of nancial
law. This is because it takes certain risks to be unsuitable for consumers, irrespec-
tive of consent. The uneasy relationship between consumerism and the rest of
nancial 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 protection
buyer. As explained in section 1.2.2 above, risk relates to future losses. It follows
that 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 risk
taker 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 be
broken, and therefore nancial positions expose the protection buyer to the credit
risk 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 of
commercial premises, the risk of loss due to re damage to those premises over the
next 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 through
a 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.
1.36
1.37
1.38
20
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, their
components may be divided into four categories. These are simple, funded, net,
and asset-backed positions respectively. A common factor is that there is always
one or more protection buyer and one or more risk taker. Another common
factor is that the protection buyers have a credit exposure to the risk takers. The
differences between the position types relates to whether, and if so how, this credit
risk is managed.
The starting point is simple nancial positions. These are discussed in Part II, and
include guarantees, insurance, derivatives, standby credits, and performance
bonds. The commercial terms of these types of contracts, and in particular of
derivatives, may be furiously complicated. However, they are referred to as simple
positions in this book because the rights and duties of the parties which must be
present in order for the contract to be characterized as a contract of insurance,
a guarantee, a derivatives contract, a standby credit, or a performance bond
respectively, do not include provisions that address the credit exposure of the
protection buyer to the risk taker. Under the core provisions of these contracts, the
guaranteed 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 its
counterparty, and the beneciary of a standby credit or performance bond takes
the credit risk of the issuer, as explained in section 5.6.
Of course, the nancial institutions that take position risk by way of business are
required to be authorized, and, as explained in section 5.5, authorized rms are
subject to (i) prudential regulatory requirements that address such credit expo-
sures. Further, where the protection buyer is itself a nancial institution and/or in
a strong bargaining position, it will typically address its credit exposure further;
see the discussion of credit enhancement in section 2.6 below. These further
measures may involve (ii) contractual credit risk mitigation provisions, including
representations, covenants, and events of default, discussed in section 8.1.2.3.
More ambitiously, its credit enhancement may involve arrangements for the risk
takers obligations to be (iii) pre-funded, (iv) balanced by mutual obligations of
the protection buyer to the risk taker, and/or (v) supported by the earmarking of
particular assets, to which the protection buyer may look upon the default of
the risk taker.
91
But in each case, the regulatory and private law arrangements
91
As explained below, (iii) amounts to a funded position, (iv) to a net position, and (v) to an
asset-backed position.
1.39
1.40
1.41
21
mentioned in (i) to (v) above are additional to the simple position itself, and extra-
neous to its legal nature.
Funded positions are discussed in Part III, and include bank loans, capital market
investments, and units in collective investment schemes. The risk taker is a pro-
vider of capital. In the event that the position risks materialize, the exposure of the
risk taker is not merely an obligation to pay, as under a simple position, for it has
paid already. Its exposure is the prospect of losing its capital. (If insurance took the
form of a funded position, your insurer would pay you the cost of rebuilding your
premises at the beginning of the term of the policy, and be entitled to receive it
back if re did not occur. But insurers are so wedded to the simple model of posi-
tion, that such insurance contracts are highly unusual, and indeed some insurance
companies investing in Cat bonds are able to negotiate the right to do so on an
unfunded basis, only paying up if and when the position loss occurs.) Unlike the
other forms of position, funded positions involve the transfer of capital. Like all
the other forms of position, they also involve the transfer of risk; capital goes one
way, and risk goes the other.
As discussed in Part IV, a net position is a development of either a simple or a
funded position. It arises only where the parties have mutual obligations, and this
mutuality enables each party to use its claim to discharge its obligation. Obligations
are mutual when they are owed between the same parties and in the same capacity.
Thus, if A has made a promise to B, so that B bears As credit risk, and if B has
also made a mutual promise to A, so that A bears Bs credit risk, the two credit
exposures may be offset. A net position may address the credit exposure arising
under a simple position, a funded position, or indeed both, as for example where
the obligations of a guarantor to a bank are set off against the obligations of the
bank to repay the guarantors deposits.
92
Important examples of net positions in
the nancial markets arise under repo, securities loan, and swaps master docu-
mentation,
93
and against the central counterparties serving nancial markets.
Netting has assumed systemic importance in the management of nancial market
credit risk, as discussed in Chapter 14, and receives signicant legal and regulatory
support.
Asset-backed positions are considered in Part V. An asset-backed position is a
development of a funded position. Here, the risk taker advances money (or other-
wise extends credit) to the counterparty, and thereby assumes credit risk, which
it goes on to address by identifying certain assets, and earmarking those assets
to meet its claims. This earmarking may take the form of the asset partitioning
of a limited liability company, i.e. the presence of equity capital, discussed in
92
See for example M.S. Fashions Ltd. v BCCI [1993] Ch 425 (AC), discussed in section 12.4.1.
93
See Chapter 13 on title transfer collateral arrangements.
1.42
1.43
1.44
22
section 2.4 below. Alternatively, the earmarking may take the form of property
rights, for example where a creditor takes proprietary security or quasi security.
94

Examples of proprietary security are mortgages and charges, and examples of
quasi security are awed asset, security trust, and retention of title arrangements,
as discussed in Chapter 17. The use of property rights in the nancial markets is
highly distinctive and sophisticated, and necessarily so. This is because the nan-
cial assets in which property rights are taken are typically intangible and may be
fungible (i.e. interchangeable within a class), changing, and otherwise less solid
than the land and goods that provide the historic subject matter of the law of
property, as discussed in Chapter 2. As also discussed in that chapter, and sadly for
enthusiasts, the role of asset-backing in the nancial markets is in decline. This is
because of the corresponding rise of net positions. Where A has a credit exposure
to B, and B is able to offer nancial market claims to address that exposure,
A often has the choice of structuring the arrangement either as a net position or as
an asset-backed position. The increasing trend is to choose the former, because of
the lower degree of legal risk typically associated with netting, as discussed in
Chapter 14.
The different types of nancial position are regularly combined in nancial trans-
actions, often into complex composite structures, as discussed in the following
chapters of this book.
1.5 Five Core Ideas in Financial Law
The argument so far has identied ve legal structures at the heart of nancial law,
namely (i) the conversion of a wide range of risks into credit risk, (ii) simple posi-
tions, (iii) funded positions, (iv) net positions, and (v) asset-backed positions.
Each of these rests on a distinctive idea or set of ideas, which are so familiar to
nancial lawyers that we forget their strange and even unearthly quality. Most of
these ideas have old or even ancient origins, but their nancial market adaptation
belongs to the last 150 years (and continues today).
The rst idea is that law can usurp the divine and parental functions of creating
persons. Persons also are divided by the law into either natural persons, or arti-
cial. Natural persons are such as the God of nature formed us: articial are such as
created and devised by human laws for the purposes of society and government;
which are called corporations or bodies politic.
95
Corporate personality has a long
94
See Chapter 17.
95
Blackstones Commentaries on the Laws of England, facsimile of 1st ed., (Chicago: University of
Chicago Press, 1979) Vol. 1, 119.
1.45
1.46
1.47
23
and charismatic
96
history. The modern incorporated company is the . . . articial
creation of the Legislature.
97
Like a natural person, a legal person may contract,
hold property, otherwise enjoy rights and incur obligations, exercise powers and
discretions, litigate, and commit crimes,
98
all in its own name.
99
. . .[t]he
company is ex hyypothesi a distinct legal persona,
100
with an identity differing
from that of its members or shareholders.
101
This identity is conventional rather
than empirical.
102
A company is merely a legal idea, and . . . has no soul to be saved
or body to be kicked . . ..
103
Neither can a corporation be excommunicated; for
it has no soul, as is gravely observed by Sir Edward Coke.
104
The vital importance
of legal personality to the nancial markets is its role in facilitating the related
ideas of limited liability, the corporate fund and (upon that funds exhaustion)
insolvency.
105
As explained in Chapter 2, this series of ideas translates the various
commercial risks of the company into the credit risk of its bondholders and
other creditors. As also explained in Chapter 2, such credit risk is measured,
managed, and transferred in the nancial markets so as to permit the most
efcient allocation of risk.
The second foundational idea is a certain kind of contingent obligation. The para-
digm obligation is a debt, and a debt is an obligation to a pay certain sum.
106

But the obligations imposed by simple nancial positions such as contracts of
96
. . . so far as the public was concerned, the monarchs healing power was an innate, mystical
quality attaching to his ofce. K. Thomas, Religion and the Decline of Magic, (Penguin, 1991) (rst
published 1971) 228, 2301.
97
Salomon v Salomon [1897] AC 22 (HL), per Lord Halsbury LC, 29. However, commenta-
tors argue that the legal personality of individuals is also a construct. See N. Lacey, Philosophical
Foundations of the Common Law: Social not Metaphysical, in Oxford Essays in Jurisprudence,
4th Series, ed. J. Horder, (Oxford: Oxford University Press, 2000), 26, 28, and H. Hansmann and
R. Kraakman, The Essential Role of Organizational Law, (2000) Yale Law Journal 110, 387, 392.
98
Tesco Supermarkets Ltd. v Nattrass [1972] AC 153.
99
See Salomon v Salomon [1897] AC 22 (HL), per Lord Davey, 55.
100
Salomon v Salomon [1897] AC 22 (HL), per Lord Herschel, 42.
101
The company is also distinct from its directors.
102
See Lord Hoffmann in Meridian Global Funds Management Asia Ltd. v Securities Commission
[1995] 3 All ER 918, 922: But a reference to a company as such might suggest that there is
something out there called the company of which one can meaningfully say that it can or cannot do
something. There is in fact no such thing as the company as such, no ding an sich . . ..
103
Stepney Corporation v Osofsky [1937] 3 All ER 289 (CA), per Greer LJ, 292.
104
Blackstone, Blackstones Commentaries on the Laws of England, Vol. 1, 465.
105
Hansmann and Kraakman identify legal personality and limited liability as two of the ve
basic legal characteristics of business corporations: H. Hansmann and R. Kraakman, What is
Corporate Law? in Kraakman et al., The Anatomy of Corporate Law, a comparative and functional
approach, (Oxford: Oxford University Press, 2004), 1.
See further the discussion of business vehicles in section 26.2.
106
A debt is a sum of money payable in respect of a liquidated money demand and recoverable
by action. British Eagle International Air Lines Ltd. v Compagnie Nationale Air France [1975] 1 WLR
758 (HL), per Lord Simon, 772.
1.48
24
insurance and guarantee on the risk taker are not debts.
107
These obligations are
measured by risks, i.e. by possible future losses that are not knowable prospec-
tively. Thus, for example, the insurer is contractually bound, from the outset of the
cover, to pay the policyholder a sum equal to its losses caused by the insured risk
and attributable to events occurring during the term of the policy.
108
If no such
losses arise, then the obligation of the insurer proves to have no content. But in
any event, the corresponding legal right of the policyholder arises before the loss
events to which it relates. The existence of a present legal right, whose content if
any lies in the conditional future, is a complex idea. This ability of the law to
speak, as it were, simultaneously in more than one linguistic tense, is the key to
legal risk transfer, and the basis on which simple nancial positions are drafted.
We all speak of money at the bank, and we all know that there is no such thing.
It has been established for almost 200 years that, when a person deposits money
with a bank,
109
she ceases to own that money.
110
The deposited money becomes
part of the banks capital, and the bank is free to use it in its own business.
111

Instead of owning the deposited money, the depositor is owed a debt by the bank
equal to the sum deposited.
112
But for this principle, commercial banking busi-
ness could not have developed. Moreover, in the international nancial system,
money consists in practice of credits to bank accounts, and that only. There is not
nearly enough paper money to match bank credits,
113
and in any case a bank note
is merely a promise to pay. In the nancial markets, debts are discharged by credits
to bank accounts; and of course, such credits merely create new debts. Debt is
never discharged, merely moved from person to person. Money consists of (circu-
lating) debt, together with faith that it has value. This is the basis on which the
capital markets, and the funded positions that constitute them, exist, as discussed
in Part III.
The importance of net positions to the functioning of the nancial markets was
mentioned in section 1.4 above. Chapter 12 explains that the legal basis for net-
ting is set off. This is the strange and beautiful idea that mutual obligations match
and extinguish each other. Its visual image is evoked by the story of Narcissus,
who fell in love with his reection in the river, and drowned. The poignancy of his
story recalls two important points about nancial law. Firstly, nancial assets are
107
Of course, they may turn into debts, once the sum payable is ascertained.
108
In the case of occurrence insurance, or in relation to claims made during the term, in the case
of claims made insurance, as discussed in section 4.3.
109
Subject to contrary agreement.
110
Carr v Carr (1811) 1 Mer 541n; Foley v Hill (1848) 2 HL Cas 28.
111
South Australian Insurance Co. v Randell (1869) 16 ER 755 [at 759]; Joachimson v Swiss Bank
Corporation [1921] 3 KB 110; Coutts & Co. v Stock [2002] 2 All ER 56 at 59.
112
Re Halletts Estate, Knatchbull v Hallett [1874 80] Ell ER Rep 793, per Thesiger LJ at 646.
113
See Libyan Arab Foreign Bank v Bankers Trust Co. [1989] 3 All ER 252.
1.49
1.50
25
intangible claims, not physical things. They are enforced, not by delivery of
possession, but by performance, and performance serves to end them so that
fullment is extinction. Secondly, the claims to receive rewards make up only one
aspect of a nancial position. They are balanced by the positions other aspect,
namely risk. Firms seek always to increase their rewards while reducing their risks,
and the chief way they do this is by netting.
The fth idea is the strangest. Some things are corporeal, some incorporeal . . .
Incorporeal things cannot be touched. They consist of legal rights . . . obligations
however contracted.
114
The treatment of obligations as things, that is their reica-
tion, in Roman law is described by P. Birks and G. McLeod as a brilliant leap.
115

The most signicant use of this idea is in the nancial markets. Financial assets of
all kinds, including rights under insurance and derivatives contracts, bank loans,
and investment securities, comprise personal obligations, that is rights to be paid
by insurers, derivatives counterparties, borrowers, issuers, and others. As explained
in Chapter 16, private law distinguishes between rights in personam, and rights
in rem. The former are personal rights enforceable against particular persons, and
the latter are property rights relating to assets and generally enforceable against
the world at large. Financial law fundamentally compromises this distinction, by
treating obligations as things or res. It follows that they are subject to rights in rem,
that is property rights, which are widely used in asset-backed positions, as explained
in Chapter 15. Chapter 21 discusses the fantastical development in nancial law
of the concept of property in relation to legal claims, so as to capture even future,
changing, depleting, intermediated, pooled, and intermittently absent assets.
This permits the maximum efciency of risk transfer through nancial collateral
structures,
116
including those relating to indirectly held securities.
117
The idea that
claims are things also permits the transfer of and therefore markets in nancial
positions, whereby risk circulates throughout the nancial system.
118
All the strange and intriguing ideas outlined there are routinely brought together,
for example, in an issue of asset-backed securities. These are a form of investment
security in which the rights of investors to payment are dened and supported by
underlying assets.
119
A more complex variety of asset-backed bonds are created
by a process known as securitization, in which the underlying assets form a mixed
and possibly changing portfolio. Today, everwider classes of assets are being
securitized.
120
Many of us rst heard about securitization, and the proposition (for
114
Justinian, Institutes, P. Birks and G. McLeod, (transl.), (London: Duckworth, 1987), J.2.2.pr-2.
115
Justinian, Institutes, P. Birks and G. McLeod, (transl.), (London: Duckworth, 1987), 15.
116
See Chapter 20.
117
See Chapter 19.
118
See section 25.2.
119
120
1.51
1.52
26
example) that the revenues of a particular brewerys future beer sales were currently
circulating in the nancial markets, with a sense of entering Wonderland. We are
in the imaginative realm. This level of conceptual development is hard to match
in theology or literature. Financial law is beautiful as well as useful, and the great-
est expression of English imagination since Shakespeare. We are not as proud of it
as we ought to be.

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FINANCIAL LAW

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